Mastering Options Pricing and Capital Market Theory Concepts

Understanding Call and Put Options

A call option grants the owner the right to purchase a specified financial instrument for a specified price (the exercise price) within a specified period of time.

Option Moneyness Definitions

The relationship between the market price of the underlying security and the exercise price determines if an option is "in the money" or "out of the money."

• A call option is in the money when the market price of the underlying security exceeds the exercise price.
• A put option is in the money when the exercise price exceeds the market price of the underlying security.
• A put option is out of the money when the market price of the security exceeds the exercise price.

Managing Option Positions

Sellers (writers) of call options can offset their position at any point in time by buying identical call options.

Capital Market Theory (CMT) and Portfolio Risk

The Capital Allocation Line (CAL) and CML

The line depicting the risk and return of portfolio combinations of a risk-free asset and any risky asset is the Capital Allocation Line (CAL).

The portfolio combining a risk-free asset and a risky asset offers a better risk-return tradeoff than investing in only one asset type because the correlation between the risk-free asset and the risky asset is equal to 0.0.

The Capital Market Line (CML)

The Capital Market Line (CML) is the graph of the risk and return of portfolio combinations consisting of the risk-free asset and the Market Portfolio.

• The market portfolio consists of all risky assets.
• The optimal risky portfolio in CMT is the Market Portfolio.
• Relative to portfolios on the CML, any portfolio that plots above the CML is considered unachievable.

Investor Behavior and CML Portfolios

An investor's optimal portfolio is the combination of a risk-free asset and a risky asset that intersects with the highest Indifference Curve.

Highly risk-averse investors will most likely invest the majority of their wealth in risk-free assets.

Portfolios on the CML:

1. A portfolio with returns greater than the returns on the market portfolio represents a borrowing portfolio.
2. A portfolio with returns less than the returns on the market portfolio represents a lending portfolio.

Risk Management and Diversification

Systematic vs. Nonsystematic Risk

The type of risk most likely avoided by forming a diversified portfolio is nonsystematic risk (also known as diversifiable risk).

In capital market theory, systematic risk is priced, meaning investors are compensated for bearing it.

An example of nonsystematic risk is the resignation of a Chief Executive Officer (CEO) at a specific company.

Portfolio Composition and Risk Reduction

Investors should use a portfolio approach primarily to reduce risk.

The best reason for an investor to be concerned with the composition of a portfolio is risk reduction.

With respect to portfolio formation, the most accurate statement is that portfolios affect risk more than returns.

Institutional Quality Needs

Institutions that will, on average, have the greatest need for quality (referring likely to asset or credit quality) are banks.