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Portfolio risk; Derivatives

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1. The derivatives market is complex because derivative buying and selling includes many things like financial contracts, including debt and structured debts and deposits, swaps, other obligations, futures, options, floors, caps, and forwards, and various combinations of these. Reporting may be hard to understand because derivatives are often forward looking and there can be many parts to the statement. They also have no real value themselves.

To improve the methods for valuing derivatives so that the reporting becomes more transparent. make the value of these available as soon as they change on financial websites open to the public.
Question: Don't we have useful models for valuing derivatives?

2. Since options have no value, there is no way one can truly figure out his Alpha or Beta number for risk. The standard deviation model needs to be modified to allow for derivatives (based on type, contract length and how purchased). This could help calculate a more correct estimate of portfolio risk.

One of the circumstances is based on structured debt (bonds) during times of interest rates rising will likely lose value, so this is risk. Put based in an account of a young investor with not too much equity before a market/stock(s) rally if the derivative is covered or uncovered. That will decrease the risk.

Question: Isn't an options risk already measured by its volatility? Is the answer perhaps to adjust for leverage in the portfolio? Isn't portfolio insurance (buying puts) a rather expensive long-term strategy?

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1. The derivatives market is complex because derivative buying and selling includes many things like financial contracts, including debt and structured debts and deposits, swaps, other obligations, futures, options, floors, caps, and forwards, and various combinations of these. Reporting may be hard to understand because derivatives are often forward looking and there can be many parts to the statement. They also have no real value themselves.

To improve the methods for valuing derivatives so that the reporting becomes more transparent: make the value of these available ...

Solution Summary

The improved methods for valuing derivatives for the reporting to become more transparent are given.

$2.19
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Call Option - Using derivatives to manage risk and enhance returns in a stock portfolio

So far, things have gone well with Dr. Washington. Before you wrap up your meetings with Dr. Washington and he begins investing, you decide to spend a little time sharing information with him about using derivatives to manage risk and enhance returns in his stock portfolio.

You decide the best way to illustrate this is via a call option that Dr. Washington can use on a stock that might have some upside potential. If the stock does not reach the potential, the option minimizes the risk. The stock is LVO Enterprise, a high tech firm that did well during the Internet boom but declined when the boom turned into a bust. If the company's new portal software is adopted by a large number of consumers over the next few months, you believe the stock can go much higher. The 6-month options are priced at US$1, the strike price is 22, and the current price for LVO stock is 20.

Put a slide presentation together with graphs inserted that illustrate what advice you would give Dr. Washington on the options if the price of the stock was either 18, 21, 24, or 28 at the end of six months. Be sure the graphs tell him at what price he should exercise the call option.

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