ALTRUISM

It is often alleged that altruism is inconsistent with economic rationality, which assumes that people behave selfishly. Certainly, much economic analysis is concerned with how individuals behave, and homo economicus (economic man) is usually assumed to act in his or her self-interest. However, self-interest does not necessarily mean selfish. Some economic models in the field of behavioural economics assume that self-interested individuals behave altruistically because they get some benefit, or utility, from doing so. For instance, it may make them feel better about themselves, or be a useful insurance policy against social unrest, say. Some economic models go further and relax the traditional assumption of fully rational behaviour by simply assuming that people sometimes behave altruistically, even if this may be against their self-interest. Either way, there is much economic literature about charity, international aid, public spending and redistributive taxation.

ABSOLUTE ADVANTAGE

This is the simplest yardstick of economic performance. If one person, firm or country can produce more of something with the same amount of effort and resources, they have an absolute advantage over other producers. Being the best at something does not mean that doing that thing is the best way to use your scarce economic resources. The question of what to specialise in–and how to maximise the benefits from international trade–is best decided according to comparative advantage. Both absolute and comparative advantage may change significantly over time.


The Economist

GROWTH STOCKS

Growth stocks are shares of companies investors believe are poised to grow faster than the industry norm. These stocks present a chance for higher gains but come with higher risks. They also tend to rise quickly when the market is on an upswing and fall fast when the market falters. In addition, because these companies are looking to grow, they often don’t hand out dividends.

Note that a growth company’s stock is not always classified as growth stock. In fact, a growth company’s stock is often overvalued.

AMERICAN OPTION

An American option is a financial contract that gives its holder a choice to purchase or sell a financial asset at a specified exercise price at any time before the specified expiry date.

American option entitles its holder to discretion not only in exercising his option, but also in the timing of such exercise. European option on the other hand, does not allow flexibility in timing of exercise.

Reference to America and Europe in option names is just by convention and there is no connection between the options and any geographical location.

Formula

Since an American option is more flexible than a European option, it has higher value. In practice, value of an American option is taken as at least equal to the value of equivalent European option.

Value of American Option ≥ Value of European Option

Examples

Example 1: American Call Option

On 23 July 20Y3, Dona Amati, a trader with a large brokerage house bought 100 American call options (or simply American calls) on BP Plc (NYSE:BP) stock. The option has an exercise price of $42 and expiry date of 27 July 20Y3. She believes that BP price on 24th, 25th and 26th of July is expected to be $43.5, $44.5 and $43. Assuming she is very confident in her projections, what is the maximum she can gain on the options and when should she exercise them? Hint: ignore time value of money, call option value = max [0, price of the underlying stock – the option’s exercise price].

Solution

Since Dona bought American options, she can exercise them at any time before 27th. Based on the projections:

Value on 24th = max [0, $43.5 – $42] = $1.5

Value on 25th = max [0, $44.5 – $42] = $2.5

Value on 26th = max [0, $43 – $42] = $1

She should exercise the options on 25th and gain $2.5 per option.

Had she bought European options, she would have been able to exercise them only on 26th July 20Y3 for a gain of $1 per option.

Example 2: American put option

Dona also bought 50 American put options with exercise price of $60 on Discover Financial Services (NYSE: DFS) stock. They are due to expire in 2 days. If BP share price is expected to be $58 and $61 tomorrow and day after tomorrow respectively, when it would be profitable to exercise the options?

Hint: gain on a put option = max [0, exercise price – price of the underlying stock].

Solution

Gain when exercised tomorrow = max [0, $60 – $58] = $2

Loss when exercised day after tomorrow = max [0, $60 – $61] = 0

If Dona is correct in her projections, the best strategy is to cash out $2 per option gain tomorrow. The options will be worthless day after tomorrow.

REBALANCING

The process of buying or selling securities over time in order to maintain your desired asset allocation. For example, if your target allocation is 60 percent stocks, 20 percent bonds and 20 percent cash, and the stock market has performed particularly well over the past year, your allocation may now have shifted to 70 percent stocks, 10 percent bonds and 20 percent cash.

To rebalance your portfolio, you could sell some of your stocks and reinvest the proceeds in bonds, or invest new money in bonds to bring the portfolio back to the original balance.