Investment Theory and Risk Management, + Website

Summary

There are several excellent texts on option theory. This chapter serves as an introduction to that theory as it pertains to our understanding of portfolio management and risk, but not as a substitute. My intention here was to provide an introduction to this important class of securities as investments in their own right but primarily as instruments to hedge risk. In Chapter 17, I cover mathematical models of stock price dynamics, which will lay the groundwork for conducting Monte Carlo simulations that serve to model the dynamics in asset prices and also to price various options. Chapter 18 will then return to the concept of hedging with options.

Real options are too important to leave out of an introductory course in options theory. The gold mine example used here is from Luenberger's Investment Science text but gold prices and discount rates are actual. Real options open up a treasure trove of thinking and conceptualization about the world around us; indeed, we find that options in many forms have always been an integral part of our everyday lives.