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Finance review.doc

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Administrative Studies
ADMS 3530
Hernan Humana

Finance review notes: Chapter 24 Hedging Immunization Derivative securities: a financial asset that represents a claim to another financial asset. Volatility Commodity Transaction exposure: 交易风险 Forward contract: set up a price for the future exchange and then finish on that day. Future contract: a forward contract with the feature that gains and losses are realized each day rather than only on the settlement date. Crossing-hedging: 交叉套期保值 Swap contract: an agreement by two parties to exchange, or swap, specified cash flows at specified intervals in the future. The only difference with forward contract is that there are multiple exchanges instead of just one. Swap dealer plays a key role in the swaps market.  Currency swaps: two companies agree to exchange a specific amount of one currency for a specific amount of another at specific dates in the future.  Interest rate swaps: exchange a floating interest rate for a fixed one.  Commodity swaps: an agreement to exchange a fixed quantity of a commodity at fixed times in the future.  Credit default swaps: a contract that pays off when a credit event occurs, default by a particular company termed the reference entity, giving the buyer the right to sell corporate bonds issued by the reference entity at their face value.  Here we already introduced 3 contract, they are conceptually similar. Two parties agree to transact on a future date or dates, but the key is that both parties are obligated to complete the transaction. Option contract: an agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specific price for a set period of time.  Put option卖方期权 an option that gives the owner the right, but not the obligation, to sell an asset at the fixed price for a specified time.  Call option: 买入期权 an option that gives the owner the right, but not the obligation, to buy an asset at a fixed price, called the strike price or exercise price. Compare with forwards option: 1. Obvious. With a forward contract, both parties are obligated to transact and one party delivers the asset, the other party pay for it; with an option contract, the transaction occurs only if the owner of the option chooses to exercise it. 2. The second difference is whereas no money changes hands when a forward contract is created, the buyer of an option contract gains a valuable right and must pay the seller for that right. (the price of the option is frequently called the option premium) Option payoff profiles: a call option is a zero-sum game, so the seller’s payoff profile is exactly the opposite of the buyer’s. An interest rate cap is a call option on an interest rate. A floor is a put option on an interest rate. If a firm buys a cap and sells a floor, the result is a collar. An option on a cap is called a caption and there is a growing market for these instruments. Chapter 25: Option and Corporate Securities Important definitions:  Exercising the option: the act of buying or selling the underlying asset via the option contract.  Striking price or exercise price: the fixed price in the option contract at which the holder can buy or sell the underlying asset.  Expiration date: the last day on which an option can be exercised.  American option: an option that can be exercised at any time until its expiration date.  European option: an option that can be exercised only on the expiration date.  Call option: the right to buy an asset at a fixed price during a particular period of time.  Put option: the right to sell an asset at a fixed price during a particular period of time. The opposite of a call option. The net profit to option sellers= (selling price – exercise price) * #of shares - $you received upfront. One contract= share price*100 You always buy at the asking price and sell at the bid price. Fundamentals of option valuation: 1. Value of a call option at expiration: If the stock price is not more than the exercise price on the expiration date, the call option is worth zero. If the option finishes in money which stock price more than the exercise price, the value of the option at expiration is equal to the difference of them. 2. The upper and lower bounds on a call option’s value: call option= stock price at expiration – exercise price on the option  The upper bound is C (value of the call option today)≤ S (stock price today)  The lower bound: first the call cannot sell for less than zero, so C≥0; furthermore, if the stock price is greater than the exercise price, the call option is worth at least Stock price today – exercise price on the option. So we put these two conditions together: C≥0 if S-E< 0 C≥S-E if S-E≥0  The lower bound also called the intrinsic 内在价值e ( ) of the option which means the lower bound of an option’s value, or what the option would be worth if it were about to expire.  At expiration, an option is worth its intrinsic value; it is generally worth more than that any time before expiration. Stock price/ exercise price Call option Stock price< exercise price 0 Stock price > exercise price S- E Call option= max (0, S-E) Put option= max (0, E-S) 3. Simple model to get call option (part one):  The basic approach: The value of call option is equal to the stock price minus the present value of the exercise price (using the risk free rate to get the present value of the exercise price, exercise price/ (1-R)).  The more complicated case: If the stock price is anything greater than or equal to the exercise price, we can found out that buying a share of stock has exactly the same payoff as buying a call option and investing the present value of the exercise price in the riskless asset. Combine value= riskless asset value + option value Summary the formula of option value: Call option value = stock value- present value of the exercise price (in the money)
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