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Basic Finance

Peter Ouwehand
Department of Mathematical Sciences University of Stellenbosch

November 2010

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Basic Finance

November 2010

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What is Finance?

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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What is Finance?
Finance: The study of how people allocate scarce resources over time.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts;

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages;

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages; Pension funds;

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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What is Finance?
Finance: The study of how people allocate scarce resources over time. Individuals and corporations use
Savings accounts; Mortgages; Pension funds; Annuities;

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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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;

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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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:

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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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;

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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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;

P. Ouwehand (Stellenbosch Univ.)

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.
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The Three Pillars of Finance

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Basic Finance

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The Three Pillars of Finance

To make investment decisions, individuals must consider the following:

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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The Three Pillars of Finance

To make investment decisions, individuals must consider the following:


I. Time value of money: Individuals must compare the value of dierent payments at dierent times R100 today is worth more than R100 next year.

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Basic Finance

November 2010

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The Three Pillars of Finance

To make investment decisions, individuals must consider the following:


I. Time value of money: Individuals must compare the value of dierent payments at dierent times R100 today is worth more than R100 next year. II. Risk management: Individuals must be able to assess and manage the riskiness of investments.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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The Three Pillars of Finance

To make investment decisions, individuals must consider the following:


I. Time value of money: Individuals must compare the value of dierent payments at dierent times R100 today is worth more than R100 next year. II. Risk management: Individuals must be able to assess and manage the riskiness of investments. III. Asset valuation: Individuals must be able to determine and compare asset prices.

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Basic Finance

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The Time Value of Money

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

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The Time Value of Money

Which do you prefer? R1000 in hand today, or the promise of R1000 in one years time. Why?

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Basic Finance

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The Time Value of Money

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.

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Basic Finance

November 2010

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The Time Value of Money

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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The Time Value of Money

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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The Time Value of Money

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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The Time Value of Money

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.

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Basic Finance

November 2010

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Time Value of Money

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Time Value of Money

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 ).

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

5 / 30

Time Value of Money

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:

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

5 / 30

Time Value of Money

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

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

5 / 30

Time Value of Money

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

5 / 30

Time Value of Money

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Time Value of Money

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Time Value of Money

If the interest is compounded continuously, an amount A0 will grow r n to limn A0 (1 + n ) = A0 e r after one yr.. . . ,

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Time Value of Money

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Time Value of Money

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

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Basic Finance

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Returns

P. Ouwehand (Stellenbosch Univ.)

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)

P. Ouwehand (Stellenbosch Univ.)

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

P. Ouwehand (Stellenbosch Univ.)

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?

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.

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.
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

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Basic Finance

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Returns

II

Fundamental relationship in nance: E[Return] = f (Risk) where f is an increasing function.

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Basic Finance

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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.

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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.

P. Ouwehand (Stellenbosch Univ.)

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

Final Price + Interim Cashows Initial Price Initial Price

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Basic Finance

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Returns

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Basic Finance

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Returns

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Shares with a higher expected return are therefore riskier than shares with a low expected return.

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Basic Finance

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Returns

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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).

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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.

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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.

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Basic Finance

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Markets and Instruments

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

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Markets and Instruments

Traders in a nancial market exchange securities for money.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
shares

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
shares bonds

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

Traders in a nancial market exchange securities for money. Securities are contracts for future delivery of goods or money, e.g.
shares bonds derivatives

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

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.

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Basic Finance

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Markets and Instruments

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Markets and Instruments

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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.

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Basic Finance

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Markets and Instruments

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.)

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

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.

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Basic Finance

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Markets and Instruments

III

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Basic Finance

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Markets and Instruments

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Equity: Stocks, shares. Ownership of a small piece of a company.

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Basic Finance

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Markets and Instruments

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Equity: Stocks, shares. Ownership of a small piece of a company.


Shareholders own a corporation. Directors act in the shareholders best interest.

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Basic Finance

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Markets and Instruments

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Equity: Stocks, shares. Ownership of a small piece of a company.


Shareholders own a corporation. Directors act in the shareholders best interest. Public limited companies are listed on a stock exchange. Ownership is easily transferred. The shareholders share the prots of the company, but have limited liability: At most, they can lose their investment.

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Basic Finance

November 2010

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Markets and Instruments

III

Equity: Stocks, shares. Ownership of a small piece of a company.


Shareholders own a corporation. Directors act in the shareholders best interest. Public limited companies are listed on a stock exchange. Ownership is easily transferred. The shareholders share the prots of the company, but have limited liability: At most, they can lose their investment.

Most shares pay regular dividends, whose amount varies according to protability and opportunities for growth.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

III

Equity: Stocks, shares. Ownership of a small piece of a company.


Shareholders own a corporation. Directors act in the shareholders best interest. Public limited companies are listed on a stock exchange. Ownership is easily transferred. The shareholders share the prots of the company, but have limited liability: At most, they can lose their investment.

Most shares pay regular dividends, whose amount varies according to protability and opportunities for growth.
A share may be bought cum or exdividend.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

III

Equity: Stocks, shares. Ownership of a small piece of a company.


Shareholders own a corporation. Directors act in the shareholders best interest. Public limited companies are listed on a stock exchange. Ownership is easily transferred. The shareholders share the prots of the company, but have limited liability: At most, they can lose their investment.

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Markets and Instruments

III

Equity: Stocks, shares. Ownership of a small piece of a company.


Shareholders own a corporation. Directors act in the shareholders best interest. Public limited companies are listed on a stock exchange. Ownership is easily transferred. The shareholders share the prots of the company, but have limited liability: At most, they can lose their investment.

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.
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Markets and Instruments

IV

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

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Markets and Instruments

IV

Short selling: Selling a share you dont own, hoping to pick them up more cheaply later on.

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Basic Finance

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Markets and Instruments

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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.

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Markets and Instruments

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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.

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Basic Finance

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Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

13 / 30

Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

13 / 30

Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

13 / 30

Markets and Instruments

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

14 / 30

Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

14 / 30

Markets and Instruments

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:

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

14 / 30

Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

14 / 30

Markets and Instruments

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

14 / 30

Derivative Securities

P. Ouwehand (Stellenbosch Univ.)

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:

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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. ...

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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:

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

15 / 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).

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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 .

P. Ouwehand (Stellenbosch Univ.)

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 ?

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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

P. Ouwehand (Stellenbosch Univ.)

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 .

P. Ouwehand (Stellenbosch Univ.)

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 .

P. Ouwehand (Stellenbosch Univ.)

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.

P. Ouwehand (Stellenbosch Univ.)

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. 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.

P. Ouwehand (Stellenbosch Univ.)

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. 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. . .

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

17 / 30

Hedging with Options


Example

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

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Hedging with Options


Example
An investor owns 1 000 shares of Anglo, with value R60.00 per share.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

18 / 30

Hedging with Options


Example
An investor owns 1 000 shares of Anglo, with value R60.00 per share. If the share price drops to R50.00, this will lead to a loss of R10 000.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

18 / 30

Hedging with Options


Example
An investor owns 1 000 shares of Anglo, with value R60.00 per share. If the share price drops to R50.00, this will lead to a loss of R10 000. To hedge against possible loss, the investor buys a put option to sell 1 000 shares in 3 months time at a price of R55.00 per share.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

18 / 30

Hedging with Options


Example
An investor owns 1 000 shares of Anglo, with value R60.00 per share. If the share price drops to R50.00, this will lead to a loss of R10 000. To hedge against possible loss, the investor buys a put option to sell 1 000 shares in 3 months time at a price of R55.00 per share. This limits the losses to R5000 + option premium.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

18 / 30

Hedging with Options


Example
An investor owns 1 000 shares of Anglo, with value R60.00 per share. If the share price drops to R50.00, this will lead to a loss of R10 000. To hedge against possible loss, the investor buys a put option to sell 1 000 shares in 3 months time at a price of R55.00 per share. This limits the losses to R5000 + option premium. If the stock price rises to R63.00, the investor will not exercise the option.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

18 / 30

Hedging with Options


Example
An investor owns 1 000 shares of Anglo, with value R60.00 per share. If the share price drops to R50.00, this will lead to a loss of R10 000. To hedge against possible loss, the investor buys a put option to sell 1 000 shares in 3 months time at a price of R55.00 per share. This limits the losses to R5000 + option premium. If the stock price rises to R63.00, the investor will not exercise the option. In that case the investors prot will be R3000 - option premium.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

18 / 30

Hedging with Options


Example
An investor owns 1 000 shares of Anglo, with value R60.00 per share. If the share price drops to R50.00, this will lead to a loss of R10 000. To hedge against possible loss, the investor buys a put option to sell 1 000 shares in 3 months time at a price of R55.00 per share. This limits the losses to R5000 + option premium. If the stock price rises to R63.00, the investor will not exercise the option. In that case the investors prot will be R3000 - option premium. The investor thus has put a cap on possible losses without restraining the possible gains.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

18 / 30

Speculating with Options


Example

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

19 / 30

Speculating with Options


Example
Investor X believes that the shares of pharmaceuticals will rise sharply.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

19 / 30

Speculating with Options


Example
Investor X believes that the shares of pharmaceuticals will rise sharply. She is willing to speculate with a capital of R10 000.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

19 / 30

Speculating with Options


Example
Investor X believes that the shares of pharmaceuticals will rise sharply. She is willing to speculate with a capital of R10 000. Today, the shares of PharmCor trade at R50.00.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

19 / 30

Speculating with Options


Example
Investor X believes that the shares of pharmaceuticals will rise sharply. She is willing to speculate with a capital of R10 000. Today, the shares of PharmCor trade at R50.00.
If Investor X buys 200 shares and the share price rises to R60.00, she will make a prot of $2 000.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

19 / 30

Speculating with Options


Example
Investor X believes that the shares of pharmaceuticals will rise sharply. She is willing to speculate with a capital of R10 000. Today, the shares of PharmCor trade at R50.00.
If Investor X buys 200 shares and the share price rises to R60.00, she will make a prot of $2 000. If the price drops to R40.00, her loss will be $2 000.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

19 / 30

Speculating with Options


Example
Investor X believes that the shares of pharmaceuticals will rise sharply. She is willing to speculate with a capital of R10 000. Today, the shares of PharmCor trade at R50.00.
If Investor X buys 200 shares and the share price rises to R60.00, she will make a prot of $2 000. If the price drops to R40.00, her loss will be $2 000.

A call option to buy 100 PharmCor shares at strike R53.00 costs R200.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

19 / 30

Speculating with Options


Example
Investor X believes that the shares of pharmaceuticals will rise sharply. She is willing to speculate with a capital of R10 000. Today, the shares of PharmCor trade at R50.00.
If Investor X buys 200 shares and the share price rises to R60.00, she will make a prot of $2 000. If the price drops to R40.00, her loss will be $2 000.

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

19 / 30

Speculating with Options


Example
Investor X believes that the shares of pharmaceuticals will rise sharply. She is willing to speculate with a capital of R10 000. Today, the shares of PharmCor trade at R50.00.
If Investor X buys 200 shares and the share price rises to R60.00, she will make a prot of $2 000. If the price drops to R40.00, her loss will be $2 000.

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

19 / 30

Speculating with Options


Example
Investor X believes that the shares of pharmaceuticals will rise sharply. She is willing to speculate with a capital of R10 000. Today, the shares of PharmCor trade at R50.00.
If Investor X buys 200 shares and the share price rises to R60.00, she will make a prot of $2 000. If the price drops to R40.00, her loss will be $2 000.

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

Speculating with Options


Example
Investor X believes that the shares of pharmaceuticals will rise sharply. She is willing to speculate with a capital of R10 000. Today, the shares of PharmCor trade at R50.00.
If Investor X buys 200 shares and the share price rises to R60.00, she will make a prot of $2 000. If the price drops to R40.00, her loss will be $2 000.

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

World Derivatives Markets

OTC Derivatives Notional OTC Derivatives Value World GDP USA GDP RSA GDP Derivatives gures: BIS 2007 GDP gures: IMF 2007

Value in $ trillion 516 11 54 14 0.283

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

20 / 30

Pricing Derivative Securities

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

21 / 30

Pricing Derivative Securities

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

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

21 / 30

Pricing Derivative Securities

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

21 / 30

Pricing Derivative Securities

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:

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

21 / 30

Pricing Derivative Securities

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

21 / 30

Pricing Derivative Securities

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

21 / 30

Pricing Derivative Securities

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?

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

21 / 30

Pricing Derivative Securities

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

Pricing Derivative Securities


Example
(Continued)

II

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

22 / 30

Pricing Derivative Securities


Example
(Continued) Suppose the market price of the ticket is P .

II

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

22 / 30

Pricing Derivative Securities


Example
(Continued) Suppose the market price of the ticket is P .

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

22 / 30

Pricing Derivative Securities


Example
(Continued) Suppose the market price of the ticket is P .

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:

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

22 / 30

Pricing Derivative Securities


Example
(Continued) Suppose the market price of the ticket is P .

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 .

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

22 / 30

Pricing Derivative Securities


Example
(Continued) Suppose the market price of the ticket is P .

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

22 / 30

Law of One Price

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

23 / 30

Law of One Price


In order to be able to use mathematics to nd prices, we assume only that you cant make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

23 / 30

Law of One Price


In order to be able to use mathematics to nd prices, we assume only that you cant make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0. For suppose that X , Y are securities, and that XT = YT in all states of the world.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

23 / 30

Law of One Price


In order to be able to use mathematics to nd prices, we assume only that you cant make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0. For suppose that X , Y are securities, and that XT = YT in all states of the world.
If X0 < Y0 , you can buy X and sell Y at time t = 0 for an immediate prot of Y0 X0 .

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

23 / 30

Law of One Price


In order to be able to use mathematics to nd prices, we assume only that you cant make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0. For suppose that X , Y are securities, and that XT = YT in all states of the world.
If X0 < Y0 , you can buy X and sell Y at time t = 0 for an immediate prot of Y0 X0 . At time T , you have XT and you owe YT and these cancel!

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

23 / 30

Law of One Price


In order to be able to use mathematics to nd prices, we assume only that you cant make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0. For suppose that X , Y are securities, and that XT = YT in all states of the world.
If X0 < Y0 , you can buy X and sell Y at time t = 0 for an immediate prot of Y0 X0 . At time T , you have XT and you owe YT and these cancel! So if X0 < Y0 , you can make money from nothing!!!!!

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

23 / 30

Law of One Price


In order to be able to use mathematics to nd prices, we assume only that you cant make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0. For suppose that X , Y are securities, and that XT = YT in all states of the world.
If X0 < Y0 , you can buy X and sell Y at time t = 0 for an immediate prot of Y0 X0 . At time T , you have XT and you owe YT and these cancel! So if X0 < Y0 , you can make money from nothing!!!!! If X0 > Y0 do the opposite.
P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 23 / 30

Option Pricing in a SinglePeriod Model


CAN WE PRICE THIS CALL OPTION? r = 10% K = 11

p 10 1p STOCK

22 C0=? 5.5 CALL

11

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

24 / 30

Option Pricing in a SinglePeriod Model

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

25 / 30

Option Pricing in a SinglePeriod Model

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

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

25 / 30

Option Pricing in a SinglePeriod Model

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

So the price depends on p .

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

25 / 30

Option Pricing in a SinglePeriod Model

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

So the price depends on p . 1 If p = 2 , then C0 = 5.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

25 / 30

Option Pricing in a SinglePeriod Model

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

So the price depends on p . 1 If p = 2 , then C0 = 5.

Supply and demand: The correct price is the one at which the supply is equal to the demand.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

25 / 30

Option Pricing in a SinglePeriod Model

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

So the price depends on p . 1 If p = 2 , then C0 = 5.

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).

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

25 / 30

Option Pricing in a SinglePeriod Model

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

So the price depends on p . 1 If p = 2 , then C0 = 5.

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

25 / 30

Option Pricing in a SinglePeriod Model

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

So the price depends on p . 1 If p = 2 , then C0 = 5.

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.

Both the above methods are WRONG!!


P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 25 / 30

Option Pricing in a SinglePeriod Model

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

26 / 30

Option Pricing in a SinglePeriod Model

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

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

26 / 30

Option Pricing in a SinglePeriod Model

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

at t = T the portfolios value is VT () = 1.10 + 221 1.10 + 5.51 if S 22 if S 5.5

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

26 / 30

Option Pricing in a SinglePeriod Model

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

at t = T the portfolios value is VT () = 1.10 + 221 1.10 + 5.51 if S 22 if S 5.5

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

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

26 / 30

Option Pricing in a SinglePeriod Model

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

27 / 30

Option Pricing in a SinglePeriod Model

As VT () = CT no matter what, the Law of One Price dictates that C0 = V0 () = 10 3 +


2 3

10 =

10 3

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

27 / 30

Option Pricing in a SinglePeriod Model

As VT () = CT no matter what, the Law of One Price dictates that C0 = V0 () = 10 3 +


2 3

10 =

10 3

The probability p of an move is completely IRRELEVANT!!

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

27 / 30

Option Pricing in a SinglePeriod Model

As VT () = CT no matter what, the Law of One Price dictates that C0 = V0 () = 10 3 +


2 3

10 =

10 3

The probability p of an move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

27 / 30

Option Pricing in a SinglePeriod Model

As VT () = CT no matter what, the Law of One Price dictates that C0 = V0 () = 10 3 +


2 3

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:

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

27 / 30

Option Pricing in a SinglePeriod Model

As VT () = CT no matter what, the Law of One Price dictates that C0 = V0 () = 10 3 +


2 3

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

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

27 / 30

Option Pricing in a SinglePeriod Model

As VT () = CT no matter what, the Law of One Price dictates that C0 = V0 () = 10 3 +


2 3

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. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

27 / 30

Option Pricing in a SinglePeriod Model

As VT () = CT no matter what, the Law of One Price dictates that C0 = V0 () = 10 3 +


2 3

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

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

27 / 30

Option Pricing in a SinglePeriod Model

As VT () = CT no matter what, the Law of One Price dictates that C0 = V0 () = 10 3 +


2 3

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

27 / 30

Option Pricing in a SinglePeriod Model

As VT () = CT no matter what, the Law of One Price dictates that C0 = V0 () = 10 3 +


2 3

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

Pricing by Expectation Reprise!

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

28 / 30

Pricing by Expectation Reprise!

Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r

This seems like a good idea, but it went horribly wrong:

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

28 / 30

Pricing by Expectation Reprise!

Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r

This seems like a good idea, but it went horribly wrong:


1 If p = 2 , H-B give a price of C0 = 5,

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

28 / 30

Pricing by Expectation Reprise!

Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r

This seems like a good idea, but it went horribly wrong:


1 If p = 2 , H-B give a price of C0 = 5, . but we know that C0 = 3. 3 (or else there will be arbitrage).

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

28 / 30

Pricing by Expectation Reprise!

Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r

This seems like a good idea, but it went horribly wrong:


1 If p = 2 , H-B give a price of C0 = 5, . but we know that C0 = 3. 3 (or else there will be arbitrage).

However, the stock itself is not priced correctly via H-B.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

28 / 30

Pricing by Expectation Reprise!

Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r

This seems like a good idea, but it went horribly wrong:


1 If p = 2 , H-B give a price of C0 = 5, . but we know that C0 = 3. 3 (or else there will be arbitrage).

However, the stock itself is not priced correctly via H-B.


We ought to have S0 = p 22 5.5 + (1 p ) = 12.5 1.1 1.1 when p =
1 2

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

28 / 30

Pricing by Expectation Reprise!

Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r

This seems like a good idea, but it went horribly wrong:


1 If p = 2 , H-B give a price of C0 = 5, . but we know that C0 = 3. 3 (or else there will be arbitrage).

However, the stock itself is not priced correctly via H-B.


We ought to have S0 = p 22 5.5 + (1 p ) = 12.5 1.1 1.1 when p =
1 2

Instead, we have S0 = 10.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

28 / 30

Pricing by Expectation Reprise!

Consider our rst method for pricing the call option as (discounted) expected payo (HuygensBernoulli): C0 = E CT 1+r

This seems like a good idea, but it went horribly wrong:


1 If p = 2 , H-B give a price of C0 = 5, . but we know that C0 = 3. 3 (or else there will be arbitrage).

However, the stock itself is not priced correctly via H-B.


We ought to have S0 = p 22 5.5 + (1 p ) = 12.5 1.1 1.1 when p =
1 2

Instead, we have S0 = 10.

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

Pricing by Expectation Reprise!

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

29 / 30

Pricing by Expectation Reprise!


We want S0 = p 22 5.5 + (1 p ) 1.1 1.1

p =

1 3

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

29 / 30

Pricing by Expectation Reprise!


We want S0 = p 22 5.5 + (1 p ) 1.1 1.1

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

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

29 / 30

Pricing by Expectation Reprise!


We want S0 = p 22 5.5 + (1 p ) 1.1 1.1

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

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

29 / 30

The Fundamental Theorem of Mathematical Finance

Theorem

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

30 / 30

The Fundamental Theorem of Mathematical Finance

Theorem
A marketmodel is arbitragefree if and only if there exists a riskneutral probability measure.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

30 / 30

The Fundamental Theorem of Mathematical Finance

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

30 / 30

The Fundamental Theorem of Mathematical Finance

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,

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

30 / 30

The Fundamental Theorem of Mathematical Finance

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,

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

30 / 30

The Fundamental Theorem of Mathematical Finance

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.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

30 / 30

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