FIN 401 Final Exam
Future
- Buyer/Seller work through an exchange desk - desk is the counterparty for all transactions - the exchange desk bears the default risk - market to market every day - Buyer gets Ft - Ft-1 every day from seller
Forward
- Buyer/seller work directly with each other - Buyer/seller has default risk - market-to-market only at expiration - only day cash is exchanged is at T - Buyer gets St- Fo from seller at T
Close out at T
- Cash settlement buyer receives St - F0 - Physical delivery happens only 1% - 3% of the time
Warrant
- a call option issued by the company - often see these as a "sweetener" to a bond issuance - Require the firm to issue new stock - results in a cash inflow to issuing firm
Institutional Features
1) At time 0, only promise is made (no cash changes hands) 2) long(buy) - bet price of the underlying asset or you need to sell the asset in the future
Black Scholes Assumptions
1) Stock pays a consistent dividend (can be zero) 2) Risk-free rate and variance of stock returns are either - Constant or - Change in a similar pattern 3) Stock prices are continuous "perfect certainty"
Why we use a cover call strategy
1) you expect the stock price (S) to be stable. A covered call creates cash flow for the sellers 2) If you plan sell at X, you can still sell at X and also get C (call premium)
Option Strategies
1. Protective Put 2. Covered Call 3. Straddle
Active Bond Management Vs. Passive
1. Substitution Swap 2. Intermediate Spread Swap 3. Rare Anticipation Swap 4. Pure Yield Pickup Swap
Typically, stock is not purchased but it is about
7% of the time
PEG Ration (PEG)
= (PPS/EPS) / Annual EPS Growth %
E(r) = Expected Return
= Dividend Yield + Capital Gain
B (plowback retention)
= reinvested earnings /net incomes
Black-Scholes Model
A mathematical model of a financial market containing certain derivative investment instruments.
Principle of Convergence
At time T, Ft = St - S = Spot price - cost
American Option
Can be exercised anytime before or at maturity - you will almost never exercise an option early. You should sell instead
European Option
Can only be exercised at maturity (though the option can still be sold prior to maturity)
Derivatives
Contingent claim. It's value is dependent on the value of underlying assets
N(d0
Cumulative normal distribution
Po =
D1 / k - g
Static Analysis Call - Stock Price
Delta C / Delta S
Static Analysis Call - Volatility
Delta C / Delta Sigma > 0 (positive)
Static Analysis Call - Time Until Expiration
Delta C / Delta T > 0 (positive)
Static Analysis Call - Exercise Price
Delta C / Delta X < 0 (negative)
Static Analysis Call - Riskless rate
Delta C / Delta r > (positive)
Option Premium
Dollar price of the option contract
Intermediate Spread Swap
Driven by the belief that the spread between two bond segments is not in equilibrium
E1 vs P0
E1 is the prediction of future earnings. In practice, represented as P0 /E0
Rare Anticipation Swap
Exchange bonds with different maturities (duration) due to an anticipated rate change
If D increases
G decreases
Assumption 1
G is constant into perputity
Call Options
Give the holder (buyer) the right (but not the obligation) to purchase the underlying security for a specified price within a specified period of time
Future contract: maintenance margin
If your account balance in your account falls below a set level (maintenance margin) you must add money to the account to bring it back to the initial margin. Otherwise exchange closes your position
Assumption 2
K > g
Black Scholes: European Option
No dividend
Should a company pay all of its net income in dividends?
No, it depends on the company's reinvestment options, which affect g
Pure Yield Pickup Swap
Not due to mispricing (not really active) move from shorter duration bonds with low yields to bonds
Futures/Forwards
Obligations to buy or sell assets at price (F0) sometime specific in the future
E in P/E is accounting based, meaning
Often open to debate to agency cost
Derivative examples
Options, futures/forwards, warrants
PVGO increases, then
P/E Increases
P/E =
PPS /EPS
P/E
Price to earnings ratio
Smaller dividend today results in a greater stock price because..
ROE > k
Options are risky relative to the underlying asset if...
S never exceeds X (for a CALL) and you hold until maturity, you loss 100%
Exercise or strike price (X)
The price that is paid if the call option is exercised to purchase stock
Put Option
The right (but not the obligation) for the option holder (buyer) to sell the underlying asset at the exercise price until expiration.
If funds can be reinvested at a rate of return that exceeds the cost of equity (i.e. positive NPV)
The value of the firm increases
Protective Put Payoff
Total Position: X and St
Straddle Payoff
Total Position: X-St or St-X
Covered Call payoff
Total position: St or X
Substitution Swap
Two bonds seem equivalent except one has a greater YTM. Buy the bond with the greater YTM and sell the bind with the lower yield - at least one of the bonds is mispriced
If you want to find the market price for stock
Use k as the discount rate
Speculative Investing
You do not own a long position in the underlying asset (i.e, you don't own the stock the option is based on)
Company's P/E multiple reflects
a firms growth opportunities
Protective Put
a) long (own) the underlying asset (stock) and b) long (buy) the put option in part A
Straddle: want volatility (no preference for +/-
a) long position in the put and b) long call
Covered Call
a) long stock and b) short (i,e, sell) call option on stock from part A
g is affected by
changes in D
convertiable bond
essentially is a call option
As dividends increase, the price should increase. But this is only true if...
everything else is held constant
Growth rate (g)
g = roe * b
We would expect a smaller start-up company to have a...
greater P/E multiple than an equivalent but more mature company
PEG "Rule of Thumb"
if P/E = growth %, then PEG = 1
P/E multiple varies by
industry
Constant growth is
more appropriate for mature firms
PPS is a
multiple of earnings sales, book value, or many other things
Futures/Forwards: no premium
no cash changes hands on the initial date
Future/Forwards
payoff = profit - payoff can be negative
N(d1) and N(d2)
probabilities called "moneyness ratio" for a call - Chance that a call option will finish in-the-money
Straddle assumptions
same X, same stock, same maturity
As PV of growth opportunities goes up...
should drive up your price-earnings multiple
The positive (or negative) NPV is called
the present value of growth opportunities
k is a market consensus of...
the required return (rs)
b =
the retention (plowback) ratio
If PEG < 1
then pricing represents a bargain (i,e buy)
If you want to find your intrunsic value for a company's stock price...
use your rs as the discount rate