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Peter Ouwehand
Department of Mathematical Sciences University of Stellenbosch
November 2010
Basic Finance
November 2010
1 / 30
What is Finance?
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time.
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts;
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages;
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages; Pension funds;
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages; Pension funds; Annuities;
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages; Pension funds; Annuities; Stock market;
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages; Pension funds; Annuities; Stock market;
The outcomes the costs and benets of nancial decisions are usually:
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages; Pension funds; Annuities; Stock market;
The outcomes the costs and benets of nancial decisions are usually:
spread over time;
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages; Pension funds; Annuities; Stock market;
The outcomes the costs and benets of nancial decisions are usually:
spread over time; uncertain, i.e. subject to risk;
Basic Finance
November 2010
2 / 30
What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages; Pension funds; Annuities; Stock market;
The outcomes the costs and benets of nancial decisions are usually:
spread over time; uncertain, i.e. subject to risk;
To make intelligent investment and consumption decisions, individuals must be able to value and compare dierent risky cashows over time.
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 2 / 30
Basic Finance
November 2010
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Basic Finance
November 2010
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Basic Finance
November 2010
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Basic Finance
November 2010
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Basic Finance
November 2010
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Basic Finance
November 2010
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Which do you prefer? R1000 in hand today, or the promise of R1000 in one years time. Why?
Basic Finance
November 2010
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Which do you prefer? R1000 in hand today, or the promise of R1000 in one years time. Why?
Opportunity cost: You can invest the R1000 now, with the expectation of receiving a greater sum in the future.
Basic Finance
November 2010
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Which do you prefer? R1000 in hand today, or the promise of R1000 in one years time. Why?
Opportunity cost: You can invest the R1000 now, with the expectation of receiving a greater sum in the future. Ination: R1000 in one years time may buy fewer goods than R1000 today.
Basic Finance
November 2010
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Which do you prefer? R1000 in hand today, or the promise of R1000 in one years time. Why?
Opportunity cost: You can invest the R1000 now, with the expectation of receiving a greater sum in the future. Ination: R1000 in one years time may buy fewer goods than R1000 today. Risk/Uncertainty: You cant be sure that you will actually receive the R1000 in one years time.
Basic Finance
November 2010
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Which do you prefer? R1000 in hand today, or the promise of R1000 in one years time. Why?
Opportunity cost: You can invest the R1000 now, with the expectation of receiving a greater sum in the future. Ination: R1000 in one years time may buy fewer goods than R1000 today. Risk/Uncertainty: You cant be sure that you will actually receive the R1000 in one years time.
So borrowing isnt free: The borrower must pay a premium to induce the lender to part temporarily with his/her money the interest.
Basic Finance
November 2010
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Which do you prefer? R1000 in hand today, or the promise of R1000 in one years time. Why?
Opportunity cost: You can invest the R1000 now, with the expectation of receiving a greater sum in the future. Ination: R1000 in one years time may buy fewer goods than R1000 today. Risk/Uncertainty: You cant be sure that you will actually receive the R1000 in one years time.
So borrowing isnt free: The borrower must pay a premium to induce the lender to part temporarily with his/her money the interest. The interest rate depends on many factors, e.g. ination, money supply, credit rating, etc.
Basic Finance
November 2010
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Basic Finance
November 2010
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Interest rate modelling is a complex part of mathematical nance, but we are going to keep things simple:
Denition
If an amount A0 is deposited in a bank account at a simple rate r for one timeperiod, it will grow to A1 = A0 (1 + r ).
Basic Finance
November 2010
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Interest rate modelling is a complex part of mathematical nance, but we are going to keep things simple:
Denition
If an amount A0 is deposited in a bank account at a simple rate r for one timeperiod, it will grow to A1 = A0 (1 + r ). If the interest is compounded twice per year, then an amount A0 will be worth:
Basic Finance
November 2010
5 / 30
Interest rate modelling is a complex part of mathematical nance, but we are going to keep things simple:
Denition
If an amount A0 is deposited in a bank account at a simple rate r for one timeperiod, it will grow to A1 = A0 (1 + r ). If the interest is compounded twice per year, then an amount A0 will be worth:
r ) after 0.5 yr.. . . A0 (1 + 2
Basic Finance
November 2010
5 / 30
Interest rate modelling is a complex part of mathematical nance, but we are going to keep things simple:
Denition
If an amount A0 is deposited in a bank account at a simple rate r for one timeperiod, it will grow to A1 = A0 (1 + r ). If the interest is compounded twice per year, then an amount A0 will be worth:
r ) after 0.5 yr.. . . A0 (1 + 2 r r . . . and thus to A0 (1 + 2 )(1 + 2 ) after 1 yr.
Basic Finance
November 2010
5 / 30
Interest rate modelling is a complex part of mathematical nance, but we are going to keep things simple:
Denition
If an amount A0 is deposited in a bank account at a simple rate r for one timeperiod, it will grow to A1 = A0 (1 + r ). If the interest is compounded twice per year, then an amount A0 will be worth:
r ) after 0.5 yr.. . . A0 (1 + 2 r r . . . and thus to A0 (1 + 2 )(1 + 2 ) after 1 yr.
If the interest is compounded n times per year, an amount A0 will r n grow to A0 (1 + n ) after one yr.
Basic Finance
November 2010
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Basic Finance
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If the interest is compounded continuously, an amount A0 will grow r n to limn A0 (1 + n ) = A0 e r after one yr.. . . ,
Basic Finance
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If the interest is compounded continuously, an amount A0 will grow r n to limn A0 (1 + n ) = A0 e r after one yr.. . . , . . . and thus to A0 e rT after T yr.
Basic Finance
November 2010
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If the interest is compounded continuously, an amount A0 will grow r n to limn A0 (1 + n ) = A0 e r after one yr.. . . , . . . and thus to A0 e rT after T yr. We are now able to compare dierent payments at dierent times: To obtain an amount A in n years time, you must deposit Ae rT in the bank today, i.e. the present value of the amount A in T years time is = Ae rT A A = A (1 + r )T etc. . . . continuous rate OR . . . simple rate
Basic Finance
November 2010
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Returns
Basic Finance
November 2010
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Returns
Returns are similar to interest rates. The main dierence is that an interest rate is a promised return on a deposit, whereas the returns on other assets are generally uncertain (i.e. risky)
Basic Finance
November 2010
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Returns
Returns are similar to interest rates. The main dierence is that an interest rate is a promised return on a deposit, whereas the returns on other assets are generally uncertain (i.e. risky) Example: You bought one share of Xcor one year ago for R123.45. Today the share pays a dividend of R12.00 and the share price is now R135.40. The net income provided by the share is 135.40 + 12.00 123.45 = 23.95 The investment cost R123.45, so the rate of return is 23.95 = 19.4%. 123.45
Basic Finance
November 2010
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Returns
Returns are similar to interest rates. The main dierence is that an interest rate is a promised return on a deposit, whereas the returns on other assets are generally uncertain (i.e. risky) Example: You bought one share of Xcor one year ago for R123.45. Today the share pays a dividend of R12.00 and the share price is now R135.40. The net income provided by the share is 135.40 + 12.00 123.45 = 23.95 The investment cost R123.45, so the rate of return is 23.95 = 19.4%. 123.45 Example: You deposited R123.45 in a bank one year ago. Today, you withdraw R12.00, and R135.40 remains in your bank account. What was the simple rate of interest?
Basic Finance
November 2010
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Returns
Returns are similar to interest rates. The main dierence is that an interest rate is a promised return on a deposit, whereas the returns on other assets are generally uncertain (i.e. risky) Example: You bought one share of Xcor one year ago for R123.45. Today the share pays a dividend of R12.00 and the share price is now R135.40. The net income provided by the share is 135.40 + 12.00 123.45 = 23.95 The investment cost R123.45, so the rate of return is 23.95 = 19.4%. 123.45 Example: You deposited R123.45 in a bank one year ago. Today, you withdraw R12.00, and R135.40 remains in your bank account. What was the simple rate of interest?
Before withdrawal, total was R147.40.
Basic Finance
November 2010
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Returns
Returns are similar to interest rates. The main dierence is that an interest rate is a promised return on a deposit, whereas the returns on other assets are generally uncertain (i.e. risky) Example: You bought one share of Xcor one year ago for R123.45. Today the share pays a dividend of R12.00 and the share price is now R135.40. The net income provided by the share is 135.40 + 12.00 123.45 = 23.95 The investment cost R123.45, so the rate of return is 23.95 = 19.4%. 123.45 Example: You deposited R123.45 in a bank one year ago. Today, you withdraw R12.00, and R135.40 remains in your bank account. What was the simple rate of interest?
Before withdrawal, total was R147.40. Thus 123.45(1 + r ) = 147.40.
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 7 / 30
Returns
Returns are similar to interest rates. The main dierence is that an interest rate is a promised return on a deposit, whereas the returns on other assets are generally uncertain (i.e. risky) Example: You bought one share of Xcor one year ago for R123.45. Today the share pays a dividend of R12.00 and the share price is now R135.40. The net income provided by the share is 135.40 + 12.00 123.45 = 23.95 The investment cost R123.45, so the rate of return is 23.95 = 19.4%. 123.45 Example: You deposited R123.45 in a bank one year ago. Today, you withdraw R12.00, and R135.40 remains in your bank account. What was the simple rate of interest?
Before withdrawal, total was R147.40. Thus 123.45(1 + r ) = 147.40. And so r = 19.4%
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 7 / 30
Returns
II
Basic Finance
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Returns
II
Basic Finance
November 2010
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Returns
II
Fundamental relationship in nance: E[Return] = f (Risk) where f is an increasing function. Shares are riskier investments than deposits. Thus the expected return on a share should be greater than the interest oered by a bank account.
Basic Finance
November 2010
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Returns
II
Fundamental relationship in nance: E[Return] = f (Risk) where f is an increasing function. Shares are riskier investments than deposits. Thus the expected return on a share should be greater than the interest oered by a bank account. Note that returns can be negative, whereas interest rates must be positive.
Basic Finance
November 2010
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Returns
II
Fundamental relationship in nance: E[Return] = f (Risk) where f is an increasing function. Shares are riskier investments than deposits. Thus the expected return on a share should be greater than the interest oered by a bank account. Note that returns can be negative, whereas interest rates must be positive. The return on an investment is roughly the percentage by which its value has increased in one year, i.e.
Return
Basic Finance
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Returns
III
Basic Finance
November 2010
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Returns
III
Shares with a higher expected return are therefore riskier than shares with a low expected return.
Basic Finance
November 2010
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Returns
III
Shares with a higher expected return are therefore riskier than shares with a low expected return.
If two shares had the same risk, but dierent expected returns, everyone would buy the share with the higher return (and short the share with the lower return).
Basic Finance
November 2010
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Returns
III
Shares with a higher expected return are therefore riskier than shares with a low expected return.
If two shares had the same risk, but dierent expected returns, everyone would buy the share with the higher return (and short the share with the lower return). This would drive the price of the high return share up, thus lowering its return.
Basic Finance
November 2010
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Returns
III
Shares with a higher expected return are therefore riskier than shares with a low expected return.
If two shares had the same risk, but dierent expected returns, everyone would buy the share with the higher return (and short the share with the lower return). This would drive the price of the high return share up, thus lowering its return.
The riskiness of a share is measured by a quantity called volatility: It is the standard deviation of annualized returns.
Basic Finance
November 2010
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Returns
III
Shares with a higher expected return are therefore riskier than shares with a low expected return.
If two shares had the same risk, but dierent expected returns, everyone would buy the share with the higher return (and short the share with the lower return). This would drive the price of the high return share up, thus lowering its return.
The riskiness of a share is measured by a quantity called volatility: It is the standard deviation of annualized returns. Returns may also be measured as discretely or continuously compounded.
Basic Finance
November 2010
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Returns
III
Shares with a higher expected return are therefore riskier than shares with a low expected return.
If two shares had the same risk, but dierent expected returns, everyone would buy the share with the higher return (and short the share with the lower return). This would drive the price of the high return share up, thus lowering its return.
The riskiness of a share is measured by a quantity called volatility: It is the standard deviation of annualized returns. Returns may also be measured as discretely or continuously compounded. Returns on bonds are called yields.
Basic Finance
November 2010
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Basic Finance
November 2010
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Basic Finance
November 2010
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Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
Basic Finance
November 2010
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Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
shares
Basic Finance
November 2010
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Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
shares bonds
Basic Finance
November 2010
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Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
shares bonds derivatives
Basic Finance
November 2010
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Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
shares bonds derivatives
Basic Finance
November 2010
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Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
shares bonds derivatives
One distinguishes between underlying (primary) and derivative (secondary) instruments. Examples of underlying instruments are shares, bonds, currencies, interest rates, and indexes.
Basic Finance
November 2010
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Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
shares bonds derivatives
One distinguishes between underlying (primary) and derivative (secondary) instruments. Examples of underlying instruments are shares, bonds, currencies, interest rates, and indexes. A derivative is a nancial instruments whose value is derived from an underlying asset.
Basic Finance
November 2010
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Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
shares bonds derivatives
One distinguishes between underlying (primary) and derivative (secondary) instruments. Examples of underlying instruments are shares, bonds, currencies, interest rates, and indexes. A derivative is a nancial instruments whose value is derived from an underlying asset. Examples of derivatives are forward contracts, futures, options, swaps and bonds.
Basic Finance
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II
Basic Finance
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II
One also distinguishes between primary and secondary markets. Securities are issued for the rst time on the primary market, and then traded on the secondary market. The secondary market provides important liquidity.
Basic Finance
November 2010
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II
One also distinguishes between primary and secondary markets. Securities are issued for the rst time on the primary market, and then traded on the secondary market. The secondary market provides important liquidity. Borrowing and lending is done in xedincome markets. The money market is for very shortterm debt (maturities 1 yr.)
Basic Finance
November 2010
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II
One also distinguishes between primary and secondary markets. Securities are issued for the rst time on the primary market, and then traded on the secondary market. The secondary market provides important liquidity. Borrowing and lending is done in xedincome markets. The money market is for very shortterm debt (maturities 1 yr.) Finally, we distinguish between the spot market and the forward market.
Basic Finance
November 2010
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II
One also distinguishes between primary and secondary markets. Securities are issued for the rst time on the primary market, and then traded on the secondary market. The secondary market provides important liquidity. Borrowing and lending is done in xedincome markets. The money market is for very shortterm debt (maturities 1 yr.) Finally, we distinguish between the spot market and the forward market.
Most transactions are spot transactions: Pay now, and receive goods now.
Basic Finance
November 2010
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II
One also distinguishes between primary and secondary markets. Securities are issued for the rst time on the primary market, and then traded on the secondary market. The secondary market provides important liquidity. Borrowing and lending is done in xedincome markets. The money market is for very shortterm debt (maturities 1 yr.) Finally, we distinguish between the spot market and the forward market.
Most transactions are spot transactions: Pay now, and receive goods now. To hedge/speculate on future market movements, it is possible to sell goods for delivery in the future. Forward and futures contracts are derivatives which make this possible.
Basic Finance
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III
Basic Finance
November 2010
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III
Basic Finance
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III
Basic Finance
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III
Basic Finance
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III
Most shares pay regular dividends, whose amount varies according to protability and opportunities for growth.
Basic Finance
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III
Most shares pay regular dividends, whose amount varies according to protability and opportunities for growth.
A share may be bought cum or exdividend.
Basic Finance
November 2010
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III
Most shares pay regular dividends, whose amount varies according to protability and opportunities for growth.
A share may be bought cum or exdividend. On the ex-dividend date, the share price decreases by the amount of the dividend.
Basic Finance
November 2010
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III
Most shares pay regular dividends, whose amount varies according to protability and opportunities for growth.
A share may be bought cum or exdividend. On the ex-dividend date, the share price decreases by the amount of the dividend.
Occasionally a company announces a stock split: Suppose, for example, that you own a single stock whose current price is R600.00. After a 3for1 stock split you will own 3 shares each valued at R200.00.
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 12 / 30
IV
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IV
Short selling: Selling a share you dont own, hoping to pick them up more cheaply later on.
Basic Finance
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IV
Short selling: Selling a share you dont own, hoping to pick them up more cheaply later on.
Your broker borrows the share from a client.
Basic Finance
November 2010
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IV
Short selling: Selling a share you dont own, hoping to pick them up more cheaply later on.
Your broker borrows the share from a client. You may now sell these shares, even though you dont own them.
Basic Finance
November 2010
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IV
Short selling: Selling a share you dont own, hoping to pick them up more cheaply later on.
Your broker borrows the share from a client. You may now sell these shares, even though you dont own them. Later, you buy the shares in the market and return them to your broker, who returns them to the other client. You also pay any dividends that were issued in the interim.
Basic Finance
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IV
Short selling: Selling a share you dont own, hoping to pick them up more cheaply later on.
Your broker borrows the share from a client. You may now sell these shares, even though you dont own them. Later, you buy the shares in the market and return them to your broker, who returns them to the other client. You also pay any dividends that were issued in the interim.
Commodities: Raw materials such as metals, oil, agricultural products, etc. These are often traded by people who have no need for the material, but are speculating on the direction of the commodity. Most of this trading is done in the futures market, and contracts are closed out before the delivery date.
Basic Finance
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IV
Short selling: Selling a share you dont own, hoping to pick them up more cheaply later on.
Your broker borrows the share from a client. You may now sell these shares, even though you dont own them. Later, you buy the shares in the market and return them to your broker, who returns them to the other client. You also pay any dividends that were issued in the interim.
Commodities: Raw materials such as metals, oil, agricultural products, etc. These are often traded by people who have no need for the material, but are speculating on the direction of the commodity. Most of this trading is done in the futures market, and contracts are closed out before the delivery date. Currencies: FOREX.
Basic Finance
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Basic Finance
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Indices: An index tracks the changes in a hypothetical portfolio of instruments (S&P500, DIJA, FTSE100, DAX30, NIKKEI225, NASDAQ100, ALSI40, INDI25, EMBI+, GSCI). A typical index consists of a weighted sum of a basket of representative stocks. These representatives and their weights may change from time to time.
Basic Finance
November 2010
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Indices: An index tracks the changes in a hypothetical portfolio of instruments (S&P500, DIJA, FTSE100, DAX30, NIKKEI225, NASDAQ100, ALSI40, INDI25, EMBI+, GSCI). A typical index consists of a weighted sum of a basket of representative stocks. These representatives and their weights may change from time to time. Fixed income securities:
Basic Finance
November 2010
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Indices: An index tracks the changes in a hypothetical portfolio of instruments (S&P500, DIJA, FTSE100, DAX30, NIKKEI225, NASDAQ100, ALSI40, INDI25, EMBI+, GSCI). A typical index consists of a weighted sum of a basket of representative stocks. These representatives and their weights may change from time to time. Fixed income securities:
Bonds, notes, bills. These are debt instruments, and promise to pay a certain rate of interest, which may be xed or oating.
Basic Finance
November 2010
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Indices: An index tracks the changes in a hypothetical portfolio of instruments (S&P500, DIJA, FTSE100, DAX30, NIKKEI225, NASDAQ100, ALSI40, INDI25, EMBI+, GSCI). A typical index consists of a weighted sum of a basket of representative stocks. These representatives and their weights may change from time to time. Fixed income securities:
Bonds, notes, bills. These are debt instruments, and promise to pay a certain rate of interest, which may be xed or oating. Example: A 10year, 5% semiannual coupon bond with a face value of $1m promises to pay $25 000 every six months for 10 years, and a balloon of $1m at maturity.
Basic Finance
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Derivative Securities
Basic Finance
November 2010
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Derivative Securities
Individuals and corporations face risks, and many of these risks entail nancial gain or loss. Often, gain or loss is a simple result of a change in the value of a market variable, such as a price or rate:
Basic Finance
November 2010
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Derivative Securities
Individuals and corporations face risks, and many of these risks entail nancial gain or loss. Often, gain or loss is a simple result of a change in the value of a market variable, such as a price or rate:
Commodity prices: Oil, maize, wheat, wool, etc.
Basic Finance
November 2010
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Derivative Securities
Individuals and corporations face risks, and many of these risks entail nancial gain or loss. Often, gain or loss is a simple result of a change in the value of a market variable, such as a price or rate:
Commodity prices: Oil, maize, wheat, wool, etc. Interest rates.
Basic Finance
November 2010
15 / 30
Derivative Securities
Individuals and corporations face risks, and many of these risks entail nancial gain or loss. Often, gain or loss is a simple result of a change in the value of a market variable, such as a price or rate:
Commodity prices: Oil, maize, wheat, wool, etc. Interest rates. The prices of stocks that make up a pension portfolio.
Basic Finance
November 2010
15 / 30
Derivative Securities
Individuals and corporations face risks, and many of these risks entail nancial gain or loss. Often, gain or loss is a simple result of a change in the value of a market variable, such as a price or rate:
Commodity prices: Oil, maize, wheat, wool, etc. Interest rates. The prices of stocks that make up a pension portfolio. Foreign currency exchange rates.
Basic Finance
November 2010
15 / 30
Derivative Securities
Individuals and corporations face risks, and many of these risks entail nancial gain or loss. Often, gain or loss is a simple result of a change in the value of a market variable, such as a price or rate:
Commodity prices: Oil, maize, wheat, wool, etc. Interest rates. The prices of stocks that make up a pension portfolio. Foreign currency exchange rates. ...
Basic Finance
November 2010
15 / 30
Derivative Securities
Individuals and corporations face risks, and many of these risks entail nancial gain or loss. Often, gain or loss is a simple result of a change in the value of a market variable, such as a price or rate:
Commodity prices: Oil, maize, wheat, wool, etc. Interest rates. The prices of stocks that make up a pension portfolio. Foreign currency exchange rates. ...
A derivative security is a nancial instrument whose value is derived from another, underlying or primary, variable, such as a stock price, an interest rate, a commodity price, a forex rate, etc.
Basic Finance
November 2010
15 / 30
Derivative Securities
Individuals and corporations face risks, and many of these risks entail nancial gain or loss. Often, gain or loss is a simple result of a change in the value of a market variable, such as a price or rate:
Commodity prices: Oil, maize, wheat, wool, etc. Interest rates. The prices of stocks that make up a pension portfolio. Foreign currency exchange rates. ...
A derivative security is a nancial instrument whose value is derived from another, underlying or primary, variable, such as a stock price, an interest rate, a commodity price, a forex rate, etc. Derivatives are used to transfer risk:
Basic Finance
November 2010
15 / 30
Derivative Securities
Individuals and corporations face risks, and many of these risks entail nancial gain or loss. Often, gain or loss is a simple result of a change in the value of a market variable, such as a price or rate:
Commodity prices: Oil, maize, wheat, wool, etc. Interest rates. The prices of stocks that make up a pension portfolio. Foreign currency exchange rates. ...
A derivative security is a nancial instrument whose value is derived from another, underlying or primary, variable, such as a stock price, an interest rate, a commodity price, a forex rate, etc. Derivatives are used to transfer risk:
They can be used to hedge i.e. as insurance against adverse risk.
Basic Finance
November 2010
15 / 30
Derivative Securities
Individuals and corporations face risks, and many of these risks entail nancial gain or loss. Often, gain or loss is a simple result of a change in the value of a market variable, such as a price or rate:
Commodity prices: Oil, maize, wheat, wool, etc. Interest rates. The prices of stocks that make up a pension portfolio. Foreign currency exchange rates. ...
A derivative security is a nancial instrument whose value is derived from another, underlying or primary, variable, such as a stock price, an interest rate, a commodity price, a forex rate, etc. Derivatives are used to transfer risk:
They can be used to hedge i.e. as insurance against adverse risk. They can be used to speculate to take on extra risk in the hope of greater returns.
Basic Finance
November 2010
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Call Options
An option gives the holder the right, but not the obligation to buy or sell an asset. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a specied future date T (maturity or expiry).
Basic Finance
November 2010
16 / 30
Call Options
An option gives the holder the right, but not the obligation to buy or sell an asset. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a specied future date T (maturity or expiry). The party who undertakes to deliver the asset is called the writer of the option.
Basic Finance
November 2010
16 / 30
Call Options
An option gives the holder the right, but not the obligation to buy or sell an asset. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a specied future date T (maturity or expiry). The party who undertakes to deliver the asset is called the writer of the option. The buyer of a European call would exercise at time T only if K < S (T ), for a prot of S (T ) K .
Basic Finance
November 2010
16 / 30
Call Options
An option gives the holder the right, but not the obligation to buy or sell an asset. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a specied future date T (maturity or expiry). The party who undertakes to deliver the asset is called the writer of the option. The buyer of a European call would exercise at time T only if K < S (T ), for a prot of S (T ) K . If the spot price is less than the strike, the holder would discard the option: Why pay K if you can pay S (T ) < K ?
Basic Finance
November 2010
16 / 30
Call Options
An option gives the holder the right, but not the obligation to buy or sell an asset. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a specied future date T (maturity or expiry). The party who undertakes to deliver the asset is called the writer of the option. The buyer of a European call would exercise at time T only if K < S (T ), for a prot of S (T ) K . If the spot price is less than the strike, the holder would discard the option: Why pay K if you can pay S (T ) < K ? Thus the payo to the holder is max{S (T ) K , 0} 0.
Basic Finance
November 2010
16 / 30
Call Options
An option gives the holder the right, but not the obligation to buy or sell an asset. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a specied future date T (maturity or expiry). The party who undertakes to deliver the asset is called the writer of the option. The buyer of a European call would exercise at time T only if K < S (T ), for a prot of S (T ) K . If the spot price is less than the strike, the holder would discard the option: Why pay K if you can pay S (T ) < K ? Thus the payo to the holder is max{S (T ) K , 0} 0. Unlike forward contracts, options cost money. You have to pay the writer of an option a premium upfront to enter into the contract.
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 16 / 30
More Options
Basic Finance
November 2010
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More Options
A European put option confers the right to sell an asset S for an agreed amount K at a specied future date T .
Basic Finance
November 2010
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More Options
A European put option confers the right to sell an asset S for an agreed amount K at a specied future date T . Similarly, an American call (put) option confers the right to buy (sell) an asset S for an agreed amount K , but at any time at or before maturity T .
Basic Finance
November 2010
17 / 30
More Options
A European put option confers the right to sell an asset S for an agreed amount K at a specied future date T . Similarly, an American call (put) option confers the right to buy (sell) an asset S for an agreed amount K , but at any time at or before maturity T . An Asian option has a payo that depends on the average stock price over a certain time period.
Basic Finance
November 2010
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More Options
A European put option confers the right to sell an asset S for an agreed amount K at a specied future date T . Similarly, an American call (put) option confers the right to buy (sell) an asset S for an agreed amount K , but at any time at or before maturity T . An Asian option has a payo that depends on the average stock price over a certain time period. A knockout barrier call will pay the same as a European call, but only if the underlying asset price hasnt crossed a predetermined barrier level.
Basic Finance
November 2010
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More Options
A European put option confers the right to sell an asset S for an agreed amount K at a specied future date T . Similarly, an American call (put) option confers the right to buy (sell) an asset S for an agreed amount K , but at any time at or before maturity T . An Asian option has a payo that depends on the average stock price over a certain time period. A knockout barrier call will pay the same as a European call, but only if the underlying asset price hasnt crossed a predetermined barrier level. The list of examples of derivatives is endless: Interest rate swaps, interest rate caps and oors, forward rate agreements, credit default swaps. . .
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A call option to buy 100 PharmCor shares at strike R53.00 costs R200.
Basic Finance
November 2010
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A call option to buy 100 PharmCor shares at strike R53.00 costs R200.
If Investor X buys 50 call options and the share price rises to 60.00, she will exercise the options and buy 5 000 shares at R53.00 per share.
Basic Finance
November 2010
19 / 30
A call option to buy 100 PharmCor shares at strike R53.00 costs R200.
If Investor X buys 50 call options and the share price rises to 60.00, she will exercise the options and buy 5 000 shares at R53.00 per share. She will immediately sell these at R60.00 per share.
Basic Finance
November 2010
19 / 30
A call option to buy 100 PharmCor shares at strike R53.00 costs R200.
If Investor X buys 50 call options and the share price rises to 60.00, she will exercise the options and buy 5 000 shares at R53.00 per share. She will immediately sell these at R60.00 per share. Her prot is therefore 5 000 60 5 000 53 50 200 = 25 000 i.e. a prot of R25 000, instead of just R2 000.
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 19 / 30
A call option to buy 100 PharmCor shares at strike R53.00 costs R200.
If Investor X buys 50 call options and the share price rises to 60.00, she will exercise the options and buy 5 000 shares at R53.00 per share. She will immediately sell these at R60.00 per share. Her prot is therefore 5 000 60 5 000 53 50 200 = 25 000 i.e. a prot of R25 000, instead of just R2 000. BUT: Should the share price remain below R53.00, she will lose all.
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 19 / 30
OTC Derivatives Notional OTC Derivatives Value World GDP USA GDP RSA GDP Derivatives gures: BIS 2007 GDP gures: IMF 2007
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November 2010
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November 2010
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Because the value of a derivative is derived from another asset or market variable, it is sometimes possible to nd a mathematical formula for the price.
Example
Basic Finance
November 2010
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Because the value of a derivative is derived from another asset or market variable, it is sometimes possible to nd a mathematical formula for the price.
Example
Tomorrow, Allegra and Darcy will face each other in the nals at Wimbledon.
Basic Finance
November 2010
21 / 30
Because the value of a derivative is derived from another asset or market variable, it is sometimes possible to nd a mathematical formula for the price.
Example
Tomorrow, Allegra and Darcy will face each other in the nals at Wimbledon. Tickets are available to gamble on the outcome of the game:
Basic Finance
November 2010
21 / 30
Because the value of a derivative is derived from another asset or market variable, it is sometimes possible to nd a mathematical formula for the price.
Example
Tomorrow, Allegra and Darcy will face each other in the nals at Wimbledon. Tickets are available to gamble on the outcome of the game:
If Allegra wins, the holder of a ticket gets R10 000.
Basic Finance
November 2010
21 / 30
Because the value of a derivative is derived from another asset or market variable, it is sometimes possible to nd a mathematical formula for the price.
Example
Tomorrow, Allegra and Darcy will face each other in the nals at Wimbledon. Tickets are available to gamble on the outcome of the game:
If Allegra wins, the holder of a ticket gets R10 000. If Darcy wins, the holder gets nothing.
Basic Finance
November 2010
21 / 30
Because the value of a derivative is derived from another asset or market variable, it is sometimes possible to nd a mathematical formula for the price.
Example
Tomorrow, Allegra and Darcy will face each other in the nals at Wimbledon. Tickets are available to gamble on the outcome of the game:
If Allegra wins, the holder of a ticket gets R10 000. If Darcy wins, the holder gets nothing.
Because the payo is nonnegative, such a ticket cannot be free. What would you be willing to pay for such a ticket?
Basic Finance
November 2010
21 / 30
Because the value of a derivative is derived from another asset or market variable, it is sometimes possible to nd a mathematical formula for the price.
Example
Tomorrow, Allegra and Darcy will face each other in the nals at Wimbledon. Tickets are available to gamble on the outcome of the game:
If Allegra wins, the holder of a ticket gets R10 000. If Darcy wins, the holder gets nothing.
Because the payo is nonnegative, such a ticket cannot be free. What would you be willing to pay for such a ticket? Mathematics cannot be used to determine the price of this ticket. It is determined by punters combined views on who is likely to win, as well as their risk preferences.
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 21 / 30
II
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November 2010
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II
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November 2010
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II
Suppose also that there is a second type of ticket available: This ticket pays R10 000 if Darcy wins, and R0 if Allegra wins.
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November 2010
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II
Suppose also that there is a second type of ticket available: This ticket pays R10 000 if Darcy wins, and R0 if Allegra wins. We can determine the price of the second ticket mathematically:
Basic Finance
November 2010
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II
Suppose also that there is a second type of ticket available: This ticket pays R10 000 if Darcy wins, and R0 if Allegra wins. We can determine the price of the second ticket mathematically: If you own one of each kind, you will denitely get R10 000. So the price of both tickets must be R10 000, and hence the price of the second ticket is 10 000 P .
Basic Finance
November 2010
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II
Suppose also that there is a second type of ticket available: This ticket pays R10 000 if Darcy wins, and R0 if Allegra wins. We can determine the price of the second ticket mathematically: If you own one of each kind, you will denitely get R10 000. So the price of both tickets must be R10 000, and hence the price of the second ticket is 10 000 P . The second ticket is a derivative of the rst ticket once the market decides the price of the rst ticket, the price of the second ticket is determined, independent of views and risk preferences of punters.
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November 2010
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p 10 1p STOCK
11
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Pricing by Expectation: (HuygensBernoulli) The fair price is the expected (discounted) payo: C0 = E CT 1+r =p 11 0 + (1 p ) 1.1 1.1
Basic Finance
November 2010
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Pricing by Expectation: (HuygensBernoulli) The fair price is the expected (discounted) payo: C0 = E CT 1+r =p 11 0 + (1 p ) 1.1 1.1
Basic Finance
November 2010
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Pricing by Expectation: (HuygensBernoulli) The fair price is the expected (discounted) payo: C0 = E CT 1+r =p 11 0 + (1 p ) 1.1 1.1
Basic Finance
November 2010
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Pricing by Expectation: (HuygensBernoulli) The fair price is the expected (discounted) payo: C0 = E CT 1+r =p 11 0 + (1 p ) 1.1 1.1
Supply and demand: The correct price is the one at which the supply is equal to the demand.
Basic Finance
November 2010
25 / 30
Pricing by Expectation: (HuygensBernoulli) The fair price is the expected (discounted) payo: C0 = E CT 1+r =p 11 0 + (1 p ) 1.1 1.1
Supply and demand: The correct price is the one at which the supply is equal to the demand.
If demand goes up(down), so must the price: Higher prices will make it more attractive to sell(buy).
Basic Finance
November 2010
25 / 30
Pricing by Expectation: (HuygensBernoulli) The fair price is the expected (discounted) payo: C0 = E CT 1+r =p 11 0 + (1 p ) 1.1 1.1
Supply and demand: The correct price is the one at which the supply is equal to the demand.
If demand goes up(down), so must the price: Higher prices will make it more attractive to sell(buy). The higher the probability p of an move, the more attractive the option, and thus the higher its price.
Basic Finance
November 2010
25 / 30
Pricing by Expectation: (HuygensBernoulli) The fair price is the expected (discounted) payo: C0 = E CT 1+r =p 11 0 + (1 p ) 1.1 1.1
Supply and demand: The correct price is the one at which the supply is equal to the demand.
If demand goes up(down), so must the price: Higher prices will make it more attractive to sell(buy). The higher the probability p of an move, the more attractive the option, and thus the higher its price.
Basic Finance
November 2010
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Consider a portfolio := (0 , 1 ) consisting of an 0 many rands in a bank account and 1 many shares. At t = 0 the portfolios value is V0 () = 0 + 101
Basic Finance
November 2010
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Consider a portfolio := (0 , 1 ) consisting of an 0 many rands in a bank account and 1 many shares. At t = 0 the portfolios value is V0 () = 0 + 101
Basic Finance
November 2010
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Consider a portfolio := (0 , 1 ) consisting of an 0 many rands in a bank account and 1 many shares. At t = 0 the portfolios value is V0 () = 0 + 101
We choose so that VT () = CT , whether the stock price goes or : : : 1.10 + 221 = 11 1.10 + 5.51 = 0 0 = 10 3 , 1 =
2 3
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November 2010
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10 =
10 3
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November 2010
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10 =
10 3
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November 2010
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10 =
10 3
The probability p of an move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument.
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November 2010
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10 =
10 3
The probability p of an move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument. An arbitrage is a portfolio with the following properties:
Basic Finance
November 2010
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10 =
10 3
The probability p of an move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument. An arbitrage is a portfolio with the following properties:
V0 () = 0
Basic Finance
November 2010
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10 =
10 3
The probability p of an move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument. An arbitrage is a portfolio with the following properties:
V0 () = 0 VT () 0 in all states of the world.
Basic Finance
November 2010
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10 =
10 3
The probability p of an move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument. An arbitrage is a portfolio with the following properties:
V0 () = 0 VT () 0 in all states of the world. P(VT () > 0) > 0
Basic Finance
November 2010
27 / 30
10 =
10 3
The probability p of an move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument. An arbitrage is a portfolio with the following properties:
V0 () = 0 VT () 0 in all states of the world. P(VT () > 0) > 0
Basic Finance
November 2010
27 / 30
10 =
10 3
The probability p of an move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument. An arbitrage is a portfolio with the following properties:
V0 () = 0 VT () 0 in all states of the world. P(VT () > 0) > 0
Thus an arbitrage is like a free lottery ticket. The only assumption we make is: There are no arbitrage opportunities in the market
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 27 / 30
Basic Finance
November 2010
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Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r
Basic Finance
November 2010
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Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r
Basic Finance
November 2010
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Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r
Basic Finance
November 2010
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Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r
Basic Finance
November 2010
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Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r
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November 2010
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Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r
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November 2010
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Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r
We now nd a probability p for which H-B does price the stock correctly.
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 28 / 30
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November 2010
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p =
1 3
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November 2010
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p =
1 3
If we use this new riskneutral probability p to price the option via H-B, we obtain: C0 = E which is correct!! CT 1+r = 11 2 0 10 1 + = 3 1.1 3 1.1 3
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November 2010
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p =
1 3
If we use this new riskneutral probability p to price the option via H-B, we obtain: C0 = E which is correct!! Thus H-B yields the correct price, provided we use riskneutral probabilities. CT 1+r = 11 2 0 10 1 + = 3 1.1 3 1.1 3
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November 2010
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Theorem
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November 2010
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Theorem
A marketmodel is arbitragefree if and only if there exists a riskneutral probability measure.
Basic Finance
November 2010
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Theorem
A marketmodel is arbitragefree if and only if there exists a riskneutral probability measure. Prices of derivative securities must be obtained via H-B, but using riskneutral probabilities.
Basic Finance
November 2010
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Theorem
A marketmodel is arbitragefree if and only if there exists a riskneutral probability measure. Prices of derivative securities must be obtained via H-B, but using riskneutral probabilities. This theorem is easy to prove for this simple unrealistic model,
Basic Finance
November 2010
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Theorem
A marketmodel is arbitragefree if and only if there exists a riskneutral probability measure. Prices of derivative securities must be obtained via H-B, but using riskneutral probabilities. This theorem is easy to prove for this simple unrealistic model, But it holds in general, for all models,
Basic Finance
November 2010
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Theorem
A marketmodel is arbitragefree if and only if there exists a riskneutral probability measure. Prices of derivative securities must be obtained via H-B, but using riskneutral probabilities. This theorem is easy to prove for this simple unrealistic model, But it holds in general, for all models, And makes it possible to numerically price options in very complicated and realistic models, using Monte Carlo Simulation.
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