Damodaran's view on Buffett's view of derivatives!!

Here i go... With the basic understanding of Black-Scholes' option pricing model which under value deep out of the money options and over values the options that are illiquid (as the pricing model assumes continuous prices); (Of course Damodaran too mentions the same), Prof presented a detailed critic of Buffett's recent statement that 'Black-Scholes wildly produces inappropriate values when applied to long-dated-options.

This illustration clarifies many nitty-gritties of B-S option pricing model! [Link]

Covered call strategy explained!

It is a derivative trading strategy. It essentially means that you own a stock and sell call on the stock you owned and collect the premium. This strategy make sense if one wants to keep hold on the stock and thinks that in the short run its price will be either stable or slightly goes down........... but sure that its long term prospects are good. The strategy has been nicely explained by a finance professor. Here is the [link]!!

II. Derivatives and Monetary Policy: Implications for the Transmission Mechanism of Monetary Policy

The goal of the monetary policy is to ensure non-inflationary growth in the economy.  The intentions of the monetary policy are mostly transmitted through the financial sector, mainly through influencing the interest rates, exchange rates and availability of bank credit. Though there are wide variances in the financial structures in various countries, these issues assume greater significance in almost all the institutional arrangements.

Through Interest Rates:

With their low transaction costs and flexibility of product designs, derivatives increase the speed of portfolio adjustments and thus lead to the faster transmission of interest rate changes. On the other hand, financial derivatives are also the perfect instruments for the individuals who now can seperate the interest rate risk of an investment from its production risk at least for a while. The influence of monetary policy will sooner or later will get reflected in the real economy because the insurance obtained through derviatives will eventually expire. Moreover, the monetary policy so heavily influences the cost of such insurance. In a way financial derviatives provide inexpensive and efficient transmission of information to the modern and globalized economy.

Through Exchange Rates:

In the world with financial derivatives, it is much easier to engage in speculative positions on a particular country's currency without having any relationship to that country. It is not posible in the world without such derivative products. These kind of transactions effectively transmits the impulses of monetary policy to other parts of the region.

Through Bank Credit:

Monetary policy influences the volume and structure of bank credit if it were to control credit costs. The availability of financial derivatives in such an economy would likely to undermine the efforts of monetary policy given their capacity for substitution. This implies greater significance for the 'interest rate channel' than a 'credit chennel'.

(The author is greatly benefited from the writings of Gerd Hausler)

Constructive comments and suggestions are encouraged!!

I. Derivatives and Monetary Policy: An Introduction

I deeply regret for the delay in posting my discussion on this issue at the promised time. I really put a lot of effort in gathering and analysing the existing information about this topic.  After a deep thought i have decided to post my arguments on this issue through a series of 5 blogs.  At the outset, here i will provide the framework for such a proposed series. I hope you will receive it with the right spirit.

Introduction:

It is generally perceived that the central banks deal with derivatives exclusively in the context of supervision and regulation. There are few central banks (small) that gained the first hand experience with derivatives when trying to manage their exchange reserves more professionally. Ofcourse, this is a commercial action which may be significant in individual cases, but is not of a core cencern of a central bank. Given the exploding size of derivatives markets today, it is crucial to understand the impact of derivatives on monetary policy in particular and on today's financial environment in general.

The possible issues araising from the interaction of derivatives and monetary policy may be classified into four categories:

1. Impact of derivatives on the various aspects of the transmission mechanism for monetary policy.
2. Influence of derivatives on the targeting of monetary policy.
3. Usefullness of derivatives market in designing the monetary policy especially in providing policy makers with the valuable information about the market expectations.
4. Derivatives as an operational tool for the monetary policy purposes.

The discussion over these issues will be presented through the following series of five blog posts.

Constructive comments and arguments will receive due recognition!!