Finance: Explanation for Answers

Posted: August 27th, 2021

Student’s Name

Instructor’s Name

Course

Date

Finance: Explanation for Answers

Pros and Cons of Assuming that Stock Prices follows Geometric Brownian Motion

The geometric Brownian motion (GBM) is a commonly used model for simulating stock prices. The model assumes that stock prices are taking a constant drift that is accompanied by random shocks. Although the GBM model is characterized by normally distributed periods, subsequent multi-period, for instance, ten days and more, are assumed to experience lognormal distribution. The GBM model assumptions have both pros and cons. On the pros’ side, the expected returns calculated by the model are independent of the stock price. This is true in reality. Also, the assumptions of positive values in the GBM process masks the reality in the actual stock prices. It has independent increments implying that forecasted stock prices are dependent on current prices, which is a useful feature for the efficiency of market prices. However, the assumptions prescribed by the GBM model have some limitations or cons. The immediate ones include the model assuming constant stock price volatility, which is not the case in reality as stock price volatility is assumed to change over time. Also, the GBM assumption of a continuous path without discontinuity is untrue since stocks are assumed to experience jumps in reality. Thus, despite being one of the mostly used model for simulating  stock prices, these challenges limits the GBM from achieving proper predictions of prices. Hence, the assumptions in the model should be applied alongside other models to ensure accuracy.

Investment in Underlying Stocks-Government Securities that Hedges Long and Short Position

Hedging is a strategy that investors use to help reduce the investment’s risk if there is a potential decline in prices. Hence, investment in government securities that hedges the long and short call at each strike price reduces price uncertainties besides limiting possible losses. However, this still maintains anticipated returns rates. In this case, investors develop portfolios with a mix of less volatility. Thus, this helps to counter the adverse changes in market prices hence limiting potential losses on their investments.

Why Hedging Position must be adjusted daily

The hedge position is an extreme definition of reducing the risks and the adverse price movements in assets. It is also based on the decisions made to ensure that offset positions taken by the assets’ adverse price movements are related to securities. Hedging positions must be adjusted daily because daily investors do not depend on hedging to play their financial activities. As such, the fluctuations in the short-term period are extremely critical since the growth of investments is influenced by small but rapidly changing margins of the overall market. Hence, investors with long term strategies have to pay attention to the given security’s day-to-day fluctuations.

Implied Range Of Put Prices at Each Strike Price

The implied range will depend majorly on the stock prices that have been put in place. The determination is based on the monetizing of the prices for the specific stock price outcomes. These outcomes determine various implicating strategies used in the observation of the distribution of the specific outcomes. They are also dependent on a complex options pricing model issued in determining various categories of maximum payouts. Likewise, the distribution shows only the dominant calculating aspects used to determine the overall pricing indices used in the analysis.