Nicholas

Bucheleres Finance 380

Forward Arbitrage (w/ Dividend)
1+ r T ( EAY ) = S e(r )(T ) F = So o (d )(T ) (1+ d )T e EAY rEAY=Domestic Risk Free, dEAY=Foreign Risk Free $Goal * = Units F PV (S0 ) *Discount quantity sold if asset returns dividend*

Black-Scholes
( 2 * T ) Years S ln( X ) + rCC / year * TYears + 2 d1 = TYears

d2 = d1 TYears
European Put w/o Dividends

$Put = S [ N(d1 ) 1] Xe(r)(T ) N ( d2 ) 1

Replicating Portfolio Sell Shares of Underlying Stock = [ N(d1 ) 1] Invest B dollars in Treasuries

Invest in Treasuries to finance longs

PV (UnitsSold ) = UnitsSold (r )(T )

PV UnitsBought ($$ ) = $ X

[(

) ]

(r)(T )

B = Xe(r)(T ) N ( d2 ) 1

Foreign Amount*Rate=$Amount Calculate U.S. Borrowing Cost

Synthetic Borrowing

European Call w/o Dividends

$ Amount(1+ rEAY )T = FV ($ Amount)

Short Foreign Forward to Repay Loan

(qShort )(F) = FV ($ Amount) FV ($ Amount) qShort = F

Lower Cost Loan: Compare Rates

Replicating Portfolio Buy Shares of Underlying Stock = N(d1 ) Borrow B dollars Risk Free B = Xe(r)(T )N(d2 ) European Options w/ Known Cash Dividend Modify asset price and asset volatility by subtracting present value dividends before calculating Black-Scholes values.

$Call = SN(d1 ) Xe(r )(T )N(d2 )

qInitial (1+ r)T = qShort rSynthetic rDirect

N-Period Binomial Pricing

Use backward induction to price todays option from final outcomes whose option price equals S minus X.

= (Div1 )e(rcc )(TYear ) + (Div 2 )e(rcc )(TYear ) S S PV (Divs) S PV (Divs) = S (PVDiv1 + PVDiv 2 ) SModified = S (PVDiv1 + PVDiv 2 ) S S Modified = S S PV (Divs) Modified
European Options w/ Dividends Paid as Perfectly Predictable Number of Units of the Underlying (EAY)

N (1+ rPeriod ) p = rEAY P = T

h = e( )(T *) 1 T* = h = (h% +1)
T N annual

l =e

( )(T *)

1 = stdev CC returns

l = (1 l%)

stdev returns = Length

1 1 Length = {(weekly) 52 ;(monthly) 12 ;etc}

Compounded weekly means

1 52

in the denominator

S S T (1+ dEAY ) NoChange

Put-Call Parity: European Options on Dividend-Paying Stock Case 1Cash level of Future Dividends is Know for Certain: p c S + PV (x) + PV (Divs), X = Strike = Case 2The Stock Pays a Know EAY Dividend Yield of d per year:

C Cl = h Sh Sl C = S + B S C S C h l l h B = (1+ r period )(S h S l

European Call Portfolio w/o Dividends at t=0 Long shares of underlying; borrow B at repo rate. Put-Call Parity based on the Law of One Price Put=(owning -1 shares of stock)+(investing PV(X) + B Dollars risk-free). Call=(owning shares of stock)+(investing B dollars risk- free)

S p = c + PV (X), X = Strike (1+ d)T

American Options on Dividend-Paying Stock Must use N-Period Tree, Black-Scholes cannot be adjusted. 1) Calculate value of option if not exercised at this node. 2) Calculate value of the option if exercised (S-X or zero).

Subtract cash dividend from S at Nodes of Dividend yield 3) At this node, value of the option is the greater of the two. Start at the end and work toward the frontbackward induction.

C = S + B S X = C

OR

Conversions Continuously Compounded (CC)

Xe(rCC )(T ) PVCC (X) = Xe(rCC )(T )

Annual Percentage Rate (APR)

Straddle Short Volatility=Sell Straddle Long Volatility=Buy Straddle Sell/Buy equal number of calls and puts where So=X

PCall + PPut = P*,(P)(X) = DesiredGain

)

X(1+

rAPR (K Freq )(T ) K Freq

PVAPR (X) = X(1+

rAPR ( K Freq )(T ) K Freq

X* X *Calls & X * Puts

Effective Annual Yield (EAY)

If nothing happens, we keep all premiums

Open InterestSum of only net long positions. Dollar Gain/Return=(Change in Price)(Quantity) Initial Dollar Investment is only the amount of margin one needed to put down.

X(1+ rEAY )TYears PVEAY (X) = X(1+ rEAY ) TYears

NetGain = (P *Cumulative )(X *QuantForCallsandPuts )

If price moves up, we must pay the call buyers

NetGain = (P *Cumulative )(X *QuantForCallsandPuts ) (X * )(ST So )

If price moves down, we must pay the put buyers

NetGain = (P *Cumulative )(X *QuantForCallsandPuts ) (X * )(S S ) o T

DollarGain Return On Investment = InitialDollarInvestmnet

To Borrow $X From Spot Market Short $X worth of spot

which will be more than $X if forwards trade at a premium. To Lend $X To Spot Market Buy $X of the underlying on spot market and short the same amount of forwards. Will receive # ofUnits(F $ST ) , which will be more than $X if forwards trade at premium. Determining Markets Expectation of Future Dividend

$X =# ofUnits and go long same So number of forward units. Will repay # ofUnits($ST F) ,

F = So

# ofContracts =

Expertise Transfer 1) Create new stock fund 2) Short futures of expertise 3) Long futures of broader market

(1+r )T (1+d )T

PortfolioSize MarketValueOfPosition

Portfolio Beta

New = Old +

ValueIndex(PositionNeeded ) ValueStock(Portfolio)

Expected Spot Price FV(NIB), then plug that into Expected Spot Price formula

F = So (1+ rEAY ) FV (NetInterimBenefitso,T ) Solve for

ES = S (1+ r )T FV (NIB) and solve for Expected T o return
Spot. Backwardation=Spot>Future & Contango=Spot<Future Zero Cost Collar 1) (Desired Quantity of Protection)(Price of option at high threshold)=$Cost of upward protection 2) Must raise ($Cost) through selling puts, giving up benefits from low prices below low threshold 3) (Price received for puts at low threshold)(quantity)=$Cost of call protection

Slope =

PutsSold is the amount of cost saving that would CallsBought

occur if price goes below low threshold but does not.