Solution Different Instruments in Derivative Markets Derivatives or derivative securities are financial arrangements whose payments

Solution Different Instruments in Derivative Markets Derivatives or derivative securities are

in Derivative Markets Derivatives or derivative securities are financial arrangements whose payments are derived from other

Solution Different Instruments in Derivative Markets Derivatives or derivative

securities are financial arrangements whose payments are derived from other

Solution Different Instruments in Derivative Markets Derivatives

Solution Different Instruments

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Expected return on Put OptionIn the example in the attached material, why do you think the put option has a negative expected return (-16.67%), while the call option has a very high positive expected return (42.86%)?Compare the payoff patterns of these two options. When do they pay? Note that one pays when the economy is good, and the other pays when the economy is bad.ONLY COMPLETE ANSWER PROVIDERS TAKEOVER THIS QUESTION.1.1 Different Instruments in Derivative Markets
Derivatives, or derivative securities, are financial arrangements whose payments
are derived from other securities or assets. In other words, derivative markets
are markets for contractual instruments whose performance is determined by
how other securities or assets perform.
Two major types of derivatives include
option-type contracts
and
forward-
type contracts
.
Options
are the right, but not the obligation, to buy or sell an
asset at a
pre
-set price (=exercise price or striking price) over a specified
period.
Forward-type contracts
are the commitment to buy or sell a given asset
at a set price on a future date. Forwards, futures, and swaps are included in this
type. Read pages 2-4 of the textbook for more discussion of these types of
derivative securities.
Now in the rest of this lecture, we'll go over two concepts:
(1) risk and risk aversion and
(2) arbitrage.
1.2. Risk and Risk Aversion
We all know that the expected return on a security is determined by the risk of
the security, i.e., the higher the risk, the higher the expected return. Risk-averse
investors ask for a premium for the risk they are taking. To understand the
concept of risk-aversion, let's consider an imaginary economy where uncertainty
is represented by the two states (good and bad) of the economy in the next
period. In this simple economy, the good and the bad, economy has the same
probabilities of 50%-50%. Let us further assume that the next three securities
exist in an imaginary economy:
T-bill
Common stock
10 Call options written on the same common stock with the strike
price (X) of 100
T-bill is the risk-free asset and will provide certain cash flow of $100 whether
economy is good or bad. (See the table below.)
The common stock pays off $120 and $80 in good and bad economy,

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