Question

1. (a)what constitutes the price of a straddle?

(b) supposed you sold a straddle. What would cause your sale to be a profitable one?

2. (a) In selecting a measure of portfolio performance, why do we want a measure that is insensitive to the risk of the investment?

(b) what does it mean to say the "the market portfolio is efficient"? What approach have studies like that of Black, Jensen, and Scholes taken to test whether the market portfolio is efficient?

Answer 1

1-a) A straddle is a trading strategy in which you are expecting high volatility but not sure as to whether the price will fall or rise so you can buy long straddle. Long straddle is one where you buy along call option and buy a long-put option. The price of setting up the strategy is the cost of premium paid on buying long call and long put.

b) A short straddle is a strategy in which you will sell a call option and sell a put option. When you will sell both of these options you will receive premium. The total amount of premium is the range for you. If the price either fell or rose within the range your position will be profitable.

2-a) In selecting a measure of portfolio performance we look for a measure which is insensitive to the risk so that we can compare it across with different asset classes. Here the logic is if an asset risk is being measured in beta but it can not be measured in standard deviation (Just in case) then the asset return can compare with an asset class. We look for a measure which is risk adjusted so that we can compare the performance of the asset class to see how it is doing.

b) When we say that the market portfolio is efficient that means given the amount of risk the portfolio is generating the highest return. When the asset returns are plotted on a graph with respect to the risk then the market portfolio is the portfolio where you are generating highest return with the least amount of risk in a portfolio. The studies which have been performed by these authors focuses on the approach of measuring risk and return of different portfolio in the market. Some focus on managing risk in terms of beta, some with respect to standard deviation but the motive is to create an efficient portfolio in such a way that the highest return can be achieved at lowest return in a portfolio.