So, I am working through some schweser problems and in one of the problems explanations it says that in the TB model we do not use put options only index funds, stocks and the RfR. I looked in the notes it does not say this anywhere. However, it does say that in the actively managed portfolio we put stocks with large positive and negative alphas. I am guessing this means we can short stocks but not buy put options on them? Is this true, if so why? Why would we not buy put options on stocks negative beta’s as oppose to shorting, shouldn’t our return be more or less the same?
Can you post the problem? I’d like to get the context. I agree with you: IMHO, any asset should be allowed in the active portfolio, long or short.
Hope this helps. And I could be wrong, but here is how i think about this. The “Index fund” is your “market proxy” (a.k.a. passive portion) the RFR is there just like in your CAPM or SML e.t.c., and your short/long stocks is your “alpha generating” portion of the portfolio (a.k.a. active portion). You can use options on stocks, but you are really just approximating the number of shares of stock you would long or short through the option by matching the deltas (If you don’t know what delta matching is, don’t worry about it). The problem with that is that if the stock price changes, which is what you expect, then your delta changes, meaning your exposure to the stock is now different. Thats what I am thinking for the reason why you don’t use options. Now that I re read that, I think a simpler explanation is that an option’s response to price convergence in the underlying (i.e. the stock) is nonlinear. Since you expect prices to change in the active part of your portfolio, you wouldn’t use options.
It was part of a vignette, this dude Zeller bought a bunch of puts on the 50 largest cap stocks in the index. Which of Zeller’s actions is least compatible with the use of the Treynor-Black model? His: A) purchase of put options. B) support of the efficient market hypothesis. C) use of index funds. Your answer: B was incorrect. The correct answer was A) purchase of put options. Index funds appeal to efficient market theorists in part because they offer a low-cost way of investing in the market without trying to exploit infrequent mispricing. While active management of any sort may seem incongruous against the efficient market backdrop, it is active management, or the search for alpha, that clears up mispricings and theoretically leads to market equilibrium. The Treynor-Black model is an optimization framework that assumes markets are nearly efficient but does allow for some active management. The Treynor-Black model assumes a portfolio consisting of index funds, stocks, and the risk-free return. Put options have no place in that model. (Study Session 18, LOS 69.b)
BostonBoy Wrote: ------------------------------------------------------- > Hope this helps. And I could be wrong, but here > is how i think about this. > > The “Index fund” is your “market proxy” (a.k.a. > passive portion) the RFR is there just like in > your CAPM or SML e.t.c., and your short/long > stocks is your “alpha generating” portion of the > portfolio (a.k.a. active portion). > > You can use options on stocks, but you are really > just approximating the number of shares of stock > you would long or short through the option by > matching the deltas (If you don’t know what delta > matching is, don’t worry about it). The problem > with that is that if the stock price changes, > which is what you expect, then your delta changes, > meaning your exposure to the stock is now > different. Thats what I am thinking for the > reason why you don’t use options. Now that I re > read that, I think a simpler explanation is that > an option’s response to price convergence in the > underlying (i.e. the stock) is nonlinear. Since > you expect prices to change in the active part of > your portfolio, you wouldn’t use options. BB, delta’s only come into the picture if you trying to build a delta-neutral portfolio and have an underlying position in the stock and then you buy/sell options. I am just saying, if you think a stock has negative alpha in the active management portfolio, why not buy options, why only sell short. They both accomplish the same and granted with put options you have to pay premium, but you have to pay interest on selling short, right? Plus, I am not 100% sure but pretty sure the TB assumptions don’t say anything about markets being frictionless. I don’t know, it just seems odd. I suppose I could just remember the answer and move on.
How would mispricings for options be corrected if you’re not allowed to have them in your portfolio? Can’t make sense of this.
naze_duck Wrote: ------------------------------------------------------- > How would mispricings for options be corrected if > you’re not allowed to have them in your portfolio? > Can’t make sense of this. the TB is not suited / silent on options pricing efficiency
Hey, delta’s are there for delta hedging, but the delta is your “stock exposure”. The delta’s change as the stock price changes (and you expect the stock to change). So if you were to buy options, your “exposure” to the stock would change as prices changed. I think treynor black is based on CAPM stuff (i could be wrong, i need to review) which is a linear relationship. The options don’t give you that exposure. Also, while you wait for prices to change, option time value decays, and if prices don’t converge within a specific time period, you need to buy another set. For those reasons, I am guessing you wouldn’t use options.