Derivative Securities Coursework Example | Topics and Well Written Essays - 6000 words

Derivative Securities - Coursework Example Particularly, stock price depends on 3 factors: annual dividends, stock sale price and interest rate for discounting. All these factors are undefined. If our security is a bond, only one factor is undefined, - interest rate. In the primary market, state emits securities to cover state expenses. Dealers create a secondary market, offering to sell or buy these securities between the dates of issue and maturity. Apart of marketable securities state on behalf of government sells several types of non-marketable securities, which can't be sold or given any other person. Gonchar, M. (2002, p. 28) pointed out that the holder (for instance, in the USA) has a right to repay them in a commercial bank, in Federal Reserve System banks, in a public treasury. Private investors own a significant part (75% in the USA) of government securities. Public institutions and Federal Reserve banks own about 25% of these securities. Securities price drop, generated with interest rates increasing, can cause problems for those, who bought them during the period of high price. Financial institution, which bought securities in the time of low interest rate, will experience losses, if it sells them after the rate uprising. If the rate is falling, financial institutions have an opportunity to attract necessary finances with securities selling. During the interest rate uprising we observe converse effect - financial institutions try not to sell government securities, avoiding capital losses. As security buyers don't know the way, in which interest rates will change, they can't avoid the risk of their securities price drop. This is interest-rate risk. Government securities with short repayment period have a little interest-rate risk, as their prices don't fall much during interest rate increasing. The situation with long-term securities is quite another. Their prices plummet during interest rate increasing. It testifies about a considerable risk, due to holding securities with low annual interest bearing over a long period. Another kind of risk aligned with dividend policy of a company, which emitted securities, for instance, stocks. There are some other accidental causes, which influence on security price, which are called psychological by analysts. So, as we've noticed, the price behavior such an asset as stock is a random value. Finances theory and financial mathematics has a task of building veridical models of stock value evolution and calculating on their base fair option price and investor strategy (investment portfolio) in the security market with the help of statistical data. Simple models are important. Let's analyze here discrete models of asset value evolution and related questions of fair option price calculating and hedging strategies. The development of calculating fair option price researches development started with famous Black-Sholes theory. The Black Scholes Model The seminal work of Fischer Black and Myron Scholes in 1973 produced an elegant closed form solution for pricing European style call options on stock. The standard Black-Scholes equation and its derivatives have dominated the derivatives markets for 25 years. According to F. Black and M. Scholes (1973, pp. 637-659), firstly, it is useful to examine the assumptions underlying the mathematical alchemy used to derive the Black-Scholes equation for the pricing of options: The price of the underlying asset follows a Markov process with an average m and volatility s. The short