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