o n inuestsent monogers present their historical perfonsonce records to proapcti
ID: 2789625 • Letter: O
Question
o n inuestsent monogers present their historical perfonsonce records to proapctiw ad existing cuutomera inueators, marbaoquine the manogT to qualify those records with the comt that paat perfarmance is no gca of futur. prrfonmarace." In on·fficient mrtrt, uuty' uould auch odmorition bar particular, appropriore? lo marke) b) Does the foot thot the morket exbibits o weok form of efficieneg necessorly imply that it is alao ztrong forro·fficent? Nu, dbout the conurae atatament? Explain. 6 ma-ka el If the premiuno on a coll option hos recently deelined, does this decline indioate that the option is a better ag thon it wos before? Why or why not? (3 marks) d. Lit the fiue voriables needed to eatioate the ualue of a call apeion. Deacribe ha a charge in each of thene ariable affecta the o of a coll option (10 marts)Explanation / Answer
a) The efficient market hypothesis says that it is not possible to beat the market on a consistent basis through stock selection as stock prices reflect all the available information. Thus, the scope of identifying undervalued and overvalued securities is limited. Efficient market is hypothesis holds for fund managers as net of fees they usually underperform the market. The broader implication of the statement “past performance is no guarantee of future performance” is that whatever strategy the fund manager has devised by looking at the past performance of the stock is already reflected in the stock price, and hence the scope of stock outperformance is limited.
b) There are three forms of market efficiency:
Weak form Efficient: In a weak form efficiency past trading data is already reflected in the prices, and investors or manager cannot earn superior return by extrapolating past returns. Thus, according to weak form efficiency technical analysis is useless.
Semi Strong form Efficiency: In this form of efficiency prices reflect all publicly known information which includes previous returns, financial statements, etc. Thus, we can say if a market is semi strong efficient then it should also be weak form efficient.
According to this form of efficiency investors or managers cannot earn superior returns by analyzing publicly available information such as earnings, sales, economic growth. Thus fundamental analysis is useless.
Strong Form Efficiency: A market which is strong form efficient is also weak and semi strong form efficient. A strong form efficient market reflects all public and privately held information (information held by insiders of the company). Hence, no form of analysis will be helpful in beating the market.
Thus from above points we can say that a weak form efficient market is not strong form efficient, but a strong form efficient market is also weak form efficient.
c) No the option is not a better buy. An option premium consists of both intrinsic value and time value. Assuming intrinsic value of call option (stock price-strike price) to be the same a decline in option premium is then reflective of decrease in time value. As the option is closer to expiration and out of the money the time value component will decline rapidly leading to overall decrease in the option premium. Time value component will decline more rapidly for out of the money than in the money option.
d) The five variables often to as Option Greeks are:
Delta: Change in the value of the call option for every 1$ change in the value of the stock price. For e.g a delta of 0.60 would suggest that every 1$ change in stock price will lead to $ 0.60 change in call option price. Delta is the first derivate with respect to the underlying security’s price. Delta of a call option is always between 0 and 1. In the money options will have delta close to 1, while out of the money options will have delta close to 0.
Gamma: Gamma is the rate of change of delta. That is at what rate will delta change for every 1$ change in the stock price. Gamma is highest for the at the money call options. Gamma is the second derivative with respect to the underlying security’s price.
Vega: Vega is the change in the call option prices for change in underlying security’s volatility. Vega does not affect intrinsic value of an option it affects only the time value. For buyers of call and put option vega is positive, while for seller of call and put option vega is negative.
Theta: Theta is the amount by which both call and put option premiums will decrease as time to maturity nears. It is also referred to as “time decay.” For option buyers theta is negative, while for option sellers theta is positive. Theta is highest for at the money options. Time decay will be highest for options which are at the money and closest to expiration.
Rho: Rho is change in value of call and put option for every 1 basis point change in interest rates. Rho is positive for call option and negative for put option.
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