Module-1

Time Value of Money

4-0
 Key Concepts and Skills
• Be able to compute the future value and/or present
value of a single cash flow or series of cash flows
• Be able to compute the return on an investment
• Understand perpetuities and annuities

4-1
 The One-Period Case
If you were to invest $10,000 at 5-percent interest for one year,
your investment would grow to $10,500.

$500 would be interest ($10,000 × .05)

$10,000 is the principal repayment ($10,000 × 1)
$10,500 is the total due. It can be calculated as:

$10,500 = $10,000×(1.05)

❑The total amount due at the end of the investment is call the
Future Value (FV).

4-2
 Future Value

• In the one-period case, the formula for FV can be

written as:
FV = C0×(1 + r)

Where C0 is cash flow today (time zero), and

r is the appropriate interest rate.

4-3
 Present Value
• If you were to be promised $10,000 due in one year
when interest rates are 5-percent, your investment
would be worth $9,523.81 in today’s dollars.
$10,000
$9,523.81 =
1.05
The amount that a borrower would need to set aside
today to be able to meet the promised payment of
$10,000 in one year is called the Present Value (PV).
 that $10,000 = $9,523.81×(1.05).
Note

4-4
 Present Value
• In the one-period case, the formula for PV can be
written as:

C1
PV =
1+ r
Where C1 is cash flow at date 1, and
r is the appropriate interest rate.


4-5
Net Present Value

• The Net Present Value (NPV) of an investment is the

present value of the expected cash flows, less the cost
of the investment.
• Suppose an investment that promises to pay $10,000 in
one year is offered for sale for $9,500. Your interest
rate is 5%. Should you buy?

4-6
Net Present Value
$10,000
NPV = −$9,500 +
1.05
NPV = −$9,500 + $9,523.81
NPV = $23.81

The present value of the cash inflow is greater

than the cost. In other words, the Net Present
Value is positive, so the investment should be
purchased.

4-7
 Net Present Value
In the one-period case, the formula for NPV can be
written as:
NPV = –Cost + PV

If we had not undertaken the positive NPV project

considered on the last slide, and instead invested our
$9,500 elsewhere at 5 percent, our FV would be less
than the $10,000 the investment promised, and we
would be worse off in FV terms :

$9,500×(1.05) = $9,975 < $10,000

4-8
The Multiperiod Case

The general formula for the future value of an

investment over many periods can be written as:
FV = C0×(1 + r)T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.

4-9
Future Value
• Suppose a stock currently pays a dividend of $1.10,
which is expected to grow at 40% per year for the
next five years.
• What will the dividend be in five years?

FV = C0×(1 + r)T

$5.92 = $1.10×(1.40)5

4-10
 Future Value and Compounding
• Notice that the dividend in year five, $5.92, is
considerably higher than the sum of the original
dividend plus five increases of 40-percent on the
original $1.10 dividend:

$5.92 > $1.10 + 5×[$1.10×.40] = $3.30

This is due to compounding.

4-11
Future Value and Compounding
$ 1 . 1 0  (1 . 4 0 ) 5
$ 1 . 1 0  (1 . 4 0 ) 4
$ 1 . 1 0  (1 . 4 0 ) 3
$ 1 . 1 0  (1 . 4 0 ) 2

$ 1 . 1 0  (1 . 4 0 )

$ 1 .1 0 $ 1 .5 4 $ 2 .1 6 $ 3 .0 2 $ 4 .2 3 $ 5 .9 2

0 1 2 3 4 5

4-12
 Present Value and Discounting
• How much would an investor have to set aside today in
order to have $20,000 five years from now if the
current rate is 15%?

PV $20,000

0 1 2 3 4 5
$ 20 , 000
$ 9 ,943 . 53 =
(1 . 15 ) 5

4-13
Finding the Number of Periods
If we deposit $5,000 today in an account paying 10%, how
long does it take to grow to $10,000?
F V = C 0  (1 + r ) T $ 1 0 , 0 0 0 = $ 5 , 0 0 0  (1 . 1 0 ) T
$ 10 , 000
(1 . 10 ) =
T
=2
$ 5 , 000
ln ( 1 . 1 0 ) = ln ( 2 )
T

ln( 2 ) 0 . 6931
T = = = 7 . 27 years
ln( 1 . 10 ) 0 . 0953

4-14
What Rate Is Enough?
Assume the total cost of a college education will be
$50,000 when your child enters college in 12 years. You
have $5,000 to invest today. What rate of interest must
you earn on your investment to cover the cost of your
child’s education?
About 21.15%.
F V = C 0  (1 + r ) T
$ 5 0 , 0 0 0 = $ 5 , 0 0 0  (1 + r ) 12

$ 50 , 000
(1 + r ) =
12
= 10 (1 + r ) = 1 0 1 1 2
$ 5 , 000

r = 10 1 12
− 1 = 1 .2 1 1 5 − 1 = .2 1 1 5

4-15
Multiple Cash Flows

• Consider an investment that pays $200 one year

from now, with cash flows increasing by $200 per
year through year 4. If the interest rate is 12%, what
is the present value of this stream of cash flows?
• If the issuer offers this investment for $1,500,
should you purchase it?

4-16
Multiple Cash Flows
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93
Present Value < Cost → Do Not Purchase

4-17
Compounding Periods

Compounding an investment m times a year for T years

provides for future value of wealth:

m T
 r 
F V = C 0  1 + 
 m

4-18
Compounding Periods

❑ For example, if you invest $50 for 3 years at 12%

compounded semi-annually, your investment will
grow to:

23
 .1 2 
F V = $50  1 +  = $ 5 0  (1 . 0 6 ) 6 = $ 7 0 . 9 3
 2 

4-19
Continuous Compounding
• The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = C0×erT
Where
C0 is cash flow at date 0,
r is the stated annual interest rate,
T is the number of years, and
e is a transcendental number approximately equal
to 2.718. ex is a key on your calculator.
4-20
Simplifications
Perpetuity
A constant stream of cash flows that lasts forever
Growing perpetuity
A stream of cash flows that grows at a constant rate
forever
Annuity
A stream of constant cash flows that lasts for a fixed
number of periods
Growing annuity
A stream of cash flows that grows at a constant rate for a
fixed number of periods

4-21
Perpetuity
A constant stream of cash flows that lasts forever
C C C
…
0 1 2 3

C C C
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

C
PV =
r
4-22
 Perpetuity: Example
What is the value of a British consol that promises to
pay £15 every year for ever?
The interest rate is 10-percent.

£15 £15 £15

…
0 1 2 3

£ 15
PV = = £ 15 0
.1 0
4-23
Growing Perpetuity
A growing stream of cash flows that lasts forever
C C×(1+g) C ×(1+g)2
…
0 1 2 3
C C  (1 + g ) C  (1 + g ) 2
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

C
PV =
r−g
4-24
Growing Perpetuity: Example
The expected dividend next year is $1.30, and
dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this
promised dividend stream?

$1.30 $1.30×(1.05) $1.30 ×(1.05)2

…
0 1 2 3
$ 1 .3 0
PV = = $ 2 6 .0 0
.1 0 − .0 5
4-25
Annuity
A constant stream of cash flows with a fixed maturity
C C C C

0 1 2 3 T

C C C C
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) T

C  1 
PV = 1 − (1 + r ) T 
r  
4-26
Annuity: Example
If you can afford a $400 monthly car payment, how
much car can you afford if interest rates are 7% on 36-
month loans?

$400 $400 $400 $400

0 1 2 3 36

$ 400  1 
PV = 1 − (1 + . 07 12 ) 3 6  = $ 12 ,954 . 59
. 07 / 12  
4-27
 What is the present value of a four-year annuity of
$100 per year that makes its first payment two years
from today if the discount rate is 9%?
4
$100 $100 $100 $100 $100
P V1 = 
t =1 (1 . 0 9 ) t
= 1
+
(1 . 0 9 ) (1 . 0 9 ) 2
+ 3
+
(1 . 0 9 ) (1 . 0 9 ) 4
= $ 3 2 3 .9 7

$297.22 $323.97 $100 $100 $100 $100

0 1 2 3 4 5
$ 327 . 97
PV = = $ 297 . 22
0 1 . 09 4-28
 Growing Annuity
A growing stream of cash flows with a fixed maturity

C C×(1+g) C ×(1+g)2 C×(1+g)T-1

0 1 2 3 T
T −1
C C  (1 + g) C  (1 + g)
PV = + +L+
(1 + r) (1 + r) 2
(1 + r) T

C   1+ g  
T

PV = 1 −   
r − g   (1 + r )  
 
4-29
 Growing Annuity: Example
A defined-benefit retirement plan offers to pay
$20,000 per year for 40 years and increase the annual
payment by 3% each year. What is the present value at
retirement if the discount rate is 10%?
$20,000 $20,000×(1.03) $20,000×(1.03)39

0 1 2 40

$ 20 , 000   1 . 03  
40

PV = 1 −    = $ 265 ,121 . 57
. 10 − . 03   1 . 10  
4-30
What Is a Firm Worth?

• Conceptually, a firm should be worth the present

value of the firm’s cash flows.

• The tricky part is determining the size, timing, and

risk of those cash flows.

4-31
Disclaimer: This study material given in the slides have
been taken from Ross, Westerfield, Jaffe, Jordan (TMH,
11e) and Corporate Finance: Theory and Practice (2nd ed.)
authored by A. Damodaran for the classroom discussion at
BITS Pilani only.

4-32
Risk & Return
 Dollar Returns
the sum of the cash received and Dividends
the change in value of the asset,
in dollars.
Ending
market value

Time 0 1
Percentage Returns
–the sum of the cash received and the
Initial change in value of the asset, divided
investment by the initial investment.

10-1
Dollar Return = Dividend + Change in Market Value
dollar return
percentage return =
beginning market value

dividend + change in market value

=
beginning market value

= dividend yield + capital gains yield

10-2
 18%

Small-Company Stocks
16%
Annual Return Average

14%

12% Large-Company Stocks

10%

8%

6%
T-Bonds
4% T-Bills
2%
0% 5% 10% 15% 20% 25% 30% 35%

Annual Return Standard Deviation

10-3
 There is no universally agreed-upon definition of
risk.
 The measures of risk that we discuss are variance and
standard deviation.
◦ The standard deviation is the standard statistical measure of
the spread of a sample, and it will be the measure we use
most of this time.
◦ Its interpretation is facilitated by a discussion of the normal
distribution.

10-4
 A large enough sample drawn from a normal
distribution looks like a bell-shaped curve.
Probability

The probability that a yearly return

will fall within 20.1 percent of the
mean of 12.1 percent will be
approximately 2/3.

– 3s – 2s – 1s 0 + 1s + 2s + 3s
Return on
large company common
68.26% stocks
95.44%

99.74%
10-5
Year Actual Average Deviation from the Squared
Return Return Mean Deviation
1 .15 .105 .045 .002025

2 .09 .105 -.015 .000225

3 .06 .105 -.045 .002025

4 .12 .105 .015 .000225

Totals .00 .0045

Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873

10-6
Consider the following two risky asset world. There
is a 1/3 chance of each state of the economy, and
the only assets are a stock fund and a bond fund.

Rate of Return
Scenario Probability Stock Fund Bond Fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

10-7
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

10-8
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

E (rS ) = 1 3  (−7%) + 1 3  (12%) + 1 3  (28%)

E (rS ) = 11%
10-9
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

(−7% − 11% ) = .0324

2

10-10
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

1
.0205 = (.0324 + .0001 + .0289)
3

10-11
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

14.3% = 0.0205

10-12
 Stock Bond
Scenario Deviation Deviation Product Weighted
Recession -18% 10% -0.0180 -0.0060
Normal 1% 0% 0.0000 0.0000
Boom 17% -10% -0.0170 -0.0057
Sum -0.0117
Covariance -0.0117

“Deviation” compares return in each state to the expected return.

“Weighted” takes the product of the deviations multiplied by the
probability of that state.

10-13
 Cov(a,b)
=
s as b
−.0117
= = −0.998
(.143)(.082)

10-14
 Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

Note that stocks have a higher expected return than bonds

and higher risk. Let us turn now to the risk-return tradeoff
of a portfolio that is 50% invested in bonds and 50%
invested in stocks.

10-15
 Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:
rP = w B rB + w S rS
5 % = 5 0 %  ( − 7 % ) + 5 0 %  (1 7 % )
10-16
 Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The expected rate of return on the portfolio is a weighted
average of the expected returns on the securities in the
portfolio.
E (rP ) = w B E (rB ) + w S E (rS )

9% = 50%  (11% ) + 50%  (7% )

10-17
 Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The variance of the rate of return on the two risky assets

portfolio is
? = (w B ? B ) + (w S ? S ) + 2(w B ? B )(w S ? S )? BS
2
P
2 2

where BS is the correlation coefficient between the returns

on the stock and bond funds.

 10-18
 Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than either stocks or bonds held
in isolation. This is not always the case.

10-19
retur

100%
 = -1.0 stocks
n

 = 1.0
100%
 = 0.2
bonds

 Relationship depends on scorrelation coefficient

-1.0 <  < +1.0
 If  = +1.0, no risk reduction is possible
 If  = –1.0, complete risk reduction is possible

10-20
 return

Individual
Assets

sP
Consider a world with many risky assets; we can still identify
the opportunity set of risk-return combinations of various
portfolios.

10-21
 return minimum
variance
portfolio

Individual Assets

sP

The section of the opportunity set above the minimum

variance portfolio is the efficient frontier.

10-22
 Diversification can substantially reduce the variability
of returns without an equivalent reduction in expected
returns.
 This reduction in risk arises because worse than
expected returns from one asset are offset by better
than expected returns from another.
 However, there is a minimum level of risk that cannot
be diversified away, and that is the systematic
portion.

10-23
 In a large portfolio the variance terms are
s effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n

10-24
 A systematic risk is any risk that affects a large number of
assets, each to a greater or lesser degree.
 An unsystematic risk is a risk that specifically affects a single
asset or small group of assets.
 Unsystematic risk can be diversified away.
 Examples of systematic risk include uncertainty about general
economic conditions, such as GNP, interest rates or inflation.
 On the other hand, announcements specific to a single
company are examples of unsystematic risk.

10-25
 Total risk = systematic risk + unsystematic risk
 The standard deviation of returns is a measure of total
risk.
 For well-diversified portfolios, unsystematic risk is
very small.
 Consequently, the total risk for a diversified portfolio
is essentially equivalent to the systematic risk.

10-26
 return 100%
stocks

rf
100%
bonds

s
In addition to stocks and bonds, consider a world that also
has risk-free securities like T-bills.

10-27
 return 100%
stocks
Balanced
fund

rf
100%
bonds
s
Now investors can allocate their money across the T-
bills and a balanced mutual fund.

10-28
 return

rf

sP

With a risk-free asset available and the efficient frontier

identified, we choose the capital allocation line with the
steepest slope.

10-29
 return
M

rf

sP
With the capital allocation line identified, all investors choose a point
along the line—some combination of the risk-free asset and the market
portfolio M. In a world with homogeneous expectations, M is the same
for all investors.

10-30
 return
100%
stocks
Balanced
fund

rf
100%
bonds

s
Where the investor chooses along the Capital Market Line depends
on her risk tolerance. The big point is that all investors have the
same CML.

10-31
 Researchers have shown that the best measure of the
risk of a security in a large portfolio is the beta (b) of
the security.
 Beta measures the responsiveness of a security to
movements in the market portfolio (i.e., systematic
risk).
Cov(Ri,RM )
bi =
s (RM )
2

10-32
Security Returns

Slope = bi
Return on
market %

Ri = a i + biRm + ei

10-33
 Cov (R i,R M ) s (R i )
bi = =
s (R M )
2
s (R M )

Clearly, your estimate of beta will depend

upon your choice of a proxy for the market

portfolio.

10-34
 Expected Return on the Market:
R M = R F + M arket Risk Premium
• Expected return on an individual security:

R i = RF + βi (R M − RF )

Market Risk Premium

This applies to individual securities held within
well-diversified portfolios.
10-35
 This formula is called the Capital Asset Pricing
Model (CAPM):

R i = R F + b i  (R M − R F )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security

• Assume bi = 0, then the expected return is RF.

• Assume bi = 1, then R i = R M

10-36
 Expected return

R i = R F + b i  (R M − R F )

RM

 RF

1.0 b

10-37
 13.5%
Expected
return

3%
 1.5 b

b i = 1.5 R F = 3% R M = 10%
 R i = 3 % + 1 . 5  (1 0 % − 3 % ) = 1 3 . 5 %
10-38
Disclaimer: The content given in the slides
have been collected from Corporate Finance by
Ross, Westerfield, Jaffe, Jordan and Kakani
(11Ed.) McGrawHill Education. This is pure
prepared for the classroom discussions at BITS
Pilani.

10-39
Introduction to Financial Markets
and Derivatives
What is a Derivative?
 A derivative is an instrument whose value depends on,
or is derived from, the value of another asset.
 Examples: futures, forwards, swaps, options, exotics…

1
Derivative Markets
 OTC vs. Exchanges
 Cash market (or spot market) – market
where underlying is delivered immediately
or shortly thereafter
Concepts of Financial and
Derivative Markets
 Risk Preference
◦ Risk aversion vs. risk neutrality
◦ Risk seeker
 Short Selling
 Repurchase agreements (repos)
 Return and Risk
◦ Risk defined
◦ The risk-return tradeoff

4
Forward Price
 The forward price for a contract is the
delivery price that would be applicable
to the contract if were negotiated
today (i.e., it is the delivery price that
would make the contract worth
exactly zero)
 The forward price may be different
for contracts of different maturities

6
Terminology

 The party that has agreed to buy

has what is termed a long position
 The party that has agreed to sell
has what is termed a short
position

7
Example
 On January 5, 2019, a firm enters into a
long forward contract to buy GBP of 1
million in six months at an exchange rate
of 1.4561 for USD
 This obligates the corporation to pay
$1,456,100 for GBP 1 million on June 5,
2019
 What are the possible outcomes?

8
Profit from a Long Forward Position
(K= delivery price=forward price at time contract is
entered into)

Profit

Price of Underlying at
K Maturity, ST

9
Profit from a Short Forward Position
(K= delivery price=forward price at time contract is entered
into)

Profit

Price of Underlying
K at Maturity, ST

10
Futures Contracts

 Agreement to buy or sell an asset for a

certain price at a certain time
 Similar to forward contract
 Whereas a forward contract is traded
OTC, a futures contract is traded on an
exchange

11
Options
 Premium – price paid to buy an option
 Call – right to buy
 Put – right to sell
 Exercise or strike price – fixed price to
option buyer and buy (call) or sell (put)
 Expiration date – options have finite lives
 European – exercise only on expiration date
 American – exercise anytime before or on
expiration date
12
Long Call (Call Holder)
Profit from buying one European call option: option
price = Rs. 5, strike price = Rs. 100, option life = 2
months
30 Profit (Rs.)

20

10 Terminal
70 80 90 100 stock price (Rs.)
0
-5 110 120 130

12
Short Call (Call Writer)
Profit from writing one European call option: option
price = Rs. 5, strike price = Rs.100
Profit (Rs.)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price (Rs.)

-20

-30

13
 Long Put (Put Holder)
Profit from buying a European put option: option
price = Rs.7, strike price = Rs. 70

30 Profit (Rs.)

20

10 Terminal
stock price (Rs.)
0
40 50 60 70 80 90 100
-7

14
Short Put (Put Writer)
Profit from writing a European put option: option
price = Rs. 7, strike price = Rs. 70
Profit (Rs.)
Terminal
7
40 50 60 stock price (Rs.)
0
70 80 90 100
-10

-20

-30

15
Payoffs from Options
What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity
Payoff Payoff

K
K ST ST
Payoff
Payoff
K
K ST ST

16
Options vs Futures/Forwards
 A futures/forward contract gives the
holder the obligation to buy or sell at a
certain price
 An option gives the holder the right to
buy or sell at a certain price

14
Types of Traders
 Trade on price movements (Hedgers)
 Contain risks and uncertainties
(Speculators)
 Profit from short term mispricing
(Arbitrageurs)

15
Hedging
 One of the most important and practical
applications of Futures and Options is
‘Hedging’. In the event of any adverse
market movements, hedging is a simple
work around to protect your trading
positions from making a loss.

19
Example
 Imagine you have bought 250 shares of
Infosys at Rs.2,284/- per share. The
quarterly results are expected [Link]
are worried Infosys may announce a not
so favorable set of numbers, as a result of
which the stock price may decline
considerably. To avoid making a loss in the
spot market you decide to hedge the
position.

20
 In order to hedge the position in spot, we simply
have to enter a counter position in the futures
market. Since the position in the spot is ‘long’, we
have to ‘short’ in the futures market.
Future price = Rs.2,285/-
Lot size= 250
Infosys Price Long Spot P&L Short Futures P&L Net P&L

2200 2200 – 2284 = – 84 2285 – 2200 = +85 -84 + 85 = +1

2290 2290 – 2284 = +6 2285 – 2290 = -5 +6 – 5 = +1

2500 2500 – 2284 = +216 2285 – 2500 = -215 +216 – 215 = +1

21
 Hedging using options
Assume that the following information is given for
a put option on Infosys stock.
Option price = Rs.1/-
Strike price= Rs.2,286/-
Lot size= 250
Infosys Price Long Spot P&L Put option P&L Net P&L

2200 2200 – 2284 = – 84 2285 – 2200 = +85 -84 + 85 = +1

2290 2290 – 2284 = +6 -1 +6 – 1 = +5

2500 2500 – 2284 = +216 -1 +216 – 1 = +215

22
Speculators
 A speculator is an individual or firm that, as the
name suggests, speculates – or guesses – that the
price of securities will go up or down and trades
the securities based on their speculation.
 Example: You would like to speculate on a rise in
the price of a certain stock. The current stock
price is $29 and a 3-month call with a strike price
of $30 costs $[Link] have $5,800 to invest.
Identify two alternative investment strategies, one
in the stock and the other in an option on the
stock. What are the potential gains and losses
from each?

23
Strategy 1: Buy 200 shares from market for $29 each
Strategy 2: Buy 2,000 call options from derivative market for
option price $2.90
At time “T” the following scenario may occur:
Scenario 1: Underlying stock price becomes $40
Gain from spot market: 200  ($40 − $29) = $2 200
Gain from option market: [2 000  ($40 − $30)] − $5 800 = $14 200

Scenario 2: If the share price goes down to $25, the first

strategy leads to a loss of 200  ($29 − $25) = $800 whereas the
second strategy leads to a loss of the whole $5,800
investment. This example shows that options contain built in
leverage.
Arbitrage
 Arbitrage is the strategy of taking advantage of price differences in
different markets for the same asset. For it to take place, there
must be a situation of at least two equivalent assets with differing
prices.
 In essence, arbitrage is a situation where a trader can profit from
the imbalance of asset prices in different markets. The simplest
form of arbitrage is purchasing an asset in the market where the
price is lower and simultaneously selling the asset in the market
where the asset’s price is higher.
Example
 Explain the arbitrage opportunity when
the price of a dually listed mining
company stock is $50 (USD) on the New
York Stock Exchange and $60 (CAD) on
the Toronto Stock Exchange. Assume that
the exchange rate is such that 1 USD
equals 1.21 CAD. Explain what is likely to
happen to prices as traders take
advantage of this opportunity.
 In this case, traders can buy shares on the
TSX and sell them on the NYSE to lock in
a USD profit of 50-60/1.21=0.41 per
share.
 As they do this the NYSE price will fall
and the TSX price will rise so that the
arbitrage opportunity disappears
Example (Arbitrage)
 The price of gold is currently $1,200 per
ounce. The forward price for delivery in 1
year is $1,300 per ounce. An arbitrageur
can borrow money at 3% per annum.
What should the arbitrageur do? Assume
that the cost of storing gold is zero and
that gold provides no income.

28
 The arbitrageur should borrow money to
buy a certain number of ounces of gold
today and short forward contracts on the
same number of ounces of gold for
delivery in one year. This means that gold
is purchased for $1,200 per ounce and
sold for $1,300 per ounce. Interest on the
borrowed funds will be 0.03×$1,200 or
$36 per ounce. A profit of $64 per ounce
will therefore be made.

29
Note: Basis is the difference between futures and spot price. Future prices are
5-minute snapshot prices.
Practice Question
 A stock price is $29. An investor buys one
call option contract on the stock with a
strike price of $30 and sells a call option
contract on the stock with a strike price
of $32.50. The market prices of the
options are $2.75 and $1.50, respectively.
The options have the same maturity date.
Describe the investor's position.
Swaps
 Swap is a commitment between two
parties to do a series of transactions in
the future
 Similar to forward contract, but involves
multiple future transactions
 Swaps can involve a variety of underlyings
◦ Interest rates
◦ Equity
◦ Currency
◦ Commodities
32
Derivative Market in India
 Exchange traded derivatives were
permitted in the year 2000,
 In the last two decades the derivative
market has grown rapidly.
 The equity derivative turnover to GDP
ratio for the year 2017-18 - 985%.
 National Stock Exchange of India (NSE)
ranked as the second largest stock
exchange worldwide in terms of the
number of contracts traded.
Dangers
 Traders can switch from being hedgers to
speculators or from being arbitrageurs to
speculators
 It is important to set up controls to
ensure that trades are using derivatives in
for their intended purpose
Thank You
Futures
Markets

1
 Futures Contracts
Available on a wide range of assets

Exchange traded

What can be delivered,

Specifications need to be Where it can be delivered, &
defined: When it can be delivered

Settled daily

2
 ➢ Equity Index Futures
Futures ➢Single Stock Futures
➢Interest Rate Futures
Products ➢Commodity Futures
in India ➢Currency Futures
➢Volatility Futures

3
Future Trading

4
Future Price Quotation

5
Source: [Link]
 Intraday Future Price

6
Source: [Link]
Margins and M2M

➢A margin is cash or marketable securities deposited by an

investor with his or her broker
➢The balance in the margin account is adjusted to reflect daily
settlement
➢Margins minimize the possibility of a loss through a default on a
contract

7
Margin Cash Flows

• A trader has to bring the balance in the margin account

up to the initial margin when it falls below the
maintenance margin level
• A member of the exchange clearing house only has an
initial margin and is required to bring the balance in its
account up to that level every day.
• These daily margin cash flows are referred to as
variation margin
• A member is also required to contribute to a default
fund

8
Example of a Futures Trade
• An investor takes a long position in 2 December
gold futures contracts on June 5
• contract size is 100 oz.
• futures price is US$1,250
• initial margin requirement is US$6,000/contract
(US$12,000 in total)
• maintenance margin is US$4,500/contract
(US$9,000 in total)

9
A Possible Outcome
Day Trade Settle Daily Cumul. Margin Margin
Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)

1 1,250.00 12,000

1 1,241.00 −1,800 − 1,800 10,200

2 1,238.30 −540 −2,340 9,660

….. ….. ….. ….. ……

6 1,236.20 −780 −2,760 9,240

7 1,229.90 −1,260 −4,020 7,980 4,020

8 1,230.80 180 −3,840 12,180

….. ….. ….. ….. ……

16 1,226.90 780 −4,620 15,180

10
11
Margin Cash Flows When Futures Price
Increases

Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

12
Margin Cash Flows When Futures Price Decreases

Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

13
Intriguing Questions???

1. How to decide the initial margin requirement for a contract?

2. What are the factors influence the decision of initial margin level?
3. What are the components of initial margin?

14
 Types of Orders
➢ Market - A market order is an order to buy or sell scrips at the current best
available price.
➢Limit: A limit order allows you to buy or sell a stock at the price you have
set or a better price.
• In other words, if you place a buy limit order at Rs 92, you want to buy the
stock from the exchange only at Rs 92 or lower. You don't want to pay more
than Rs 92. Similarly, if you place a sell limit order at Rs 95, you want to sell
the stock at Rs 95 or higher.
• The advantage of placing a limit order is that you can place buy/sell order
at the desired price. However, there is a chance that your order may not get
filled partially or completely depending upon if a counter order is available
for some quantity or none at the price you’ve specified.
➢Stop-loss order: A stop-loss order is a buy/sell order placed to limit the
losses when you fear that the prices may move against your trade. For
instance, if you have bought a stock at Rs 100 and you want to limit the loss
at 95, you can place an order in the system to sell the stock as soon as the
stock comes to 95. Such an order is called 'Stop Loss', as you are placing it
to stop a loss more than what you are ready to risk.
15
➢ Stop-Loss Limit Order (SL):
• Case 1 > if you have a buy position, then you will keep a sell SL
• Case 2 > if you have a sell position, then you will keep a buy SL
In Case 1, if you have a buy position at 100 and you wish to place
an SL at 95.
You will place a Sell SL order with price and trigger price. Since
your order needs to be triggered first, the (trigger price ≥ price.)
Here, this order type gives you a range of the Stop-Loss.
Let's assume a range of Rs 0.10 (10 paise). Here, you can keep
trigger price = 95 and price = 94.90.
When the price of 95 is triggered, the sell limit order is sent to the
exchange and your order will be squared off at the next available
bid above 94.90. So, your SL order may get executed at 96 or
94.95 but not below 94.90.

16
• You will place a Buy SL order with price and trigger
price. Since your order needs to be triggered first,
(the trigger price ≤ price.) Here, this order type
gives you a range of the stop-loss.

• Let's assume a range of Rs.0.10 (10 paise). Here,

you can keep trigger price = 105 and price = 105.10.
When the price of 105 is triggered, the buy limit
order is sent to the exchange and your order will be
squared off at the next available offer below
105.10. So, your SL order may get executed at
105.05 or 105 but not above 105.10.

17
Forward Contracts vs Futures Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk

18
Disclaimer: The content in the slides have been taken from various
sources such as Options, Future, and Other Derivative by Hull and Basu
(10 Ed. Pearson Publication), official website of National Stock
Exchange of India, Zerodha and Motilal Oswal. This material is purely
created for classroom discussions at BITS Pilani and do not possess any
right to these contents.

19
 Session-6
Hedging Using
Futures

1
 A long futures hedge is
appropriate when you
know you will purchase
an asset in the future and
Long & Short want to lock in the price
Hedges
A short futures hedge is
appropriate when you
know you will sell an
asset in the future and
want to lock in the price

2
Example of Hedging

•Imagine you have bought 250 shares of

Infosys at Rs.2,284/- per share. The quarterly
results are expected soon. You are worried
Infosys may announce a not so favorable set
of numbers, as a result of which the stock
price may decline considerably. To avoid
making a loss in the spot market you decide
to hedge the position.

3
In order to hedge the position in spot, we simply have to
enter a counter position in the futures market. Since the
position in the spot is ‘long’, we have to ‘short’ in the
futures market.
Future price = Rs.2,285/-
Lot size= 250

Infosys Price Long Spot P&L Short Futures P&L Net P&L

2200 2200 – 2284 = – 84 2285 – 2200 = +85 -84 + 85 = +1

2290 2290 – 2284 = +6 2285 – 2290 = -5 +6 – 5 = +1

2500 2500 – 2284 = +216 2285 – 2500 = -215 +216 – 215 = +1

4
Example (Exporter)
ADITYA EXPORT has an inward remittance of USD 50,000 after
one month. The company has been advised by its bank that the
rupee is likely to be strengthened due to heavy inflow of FDI
inflows in recent months. To hedge against any rupee appreciation
against dollar, the export house is considering using one-month
USDINR futures, quoted at USD/INR 74.5675. The current spot
rate is USD/INR 74.4577. The lot size of USD-INR futures is
1000 USD.
(a) What will be the hedging strategy of the exporter?
(b) What will be the hedging outcome after one month under the
following scenarios?
Scenario-1: Rupee appreciates to USD/INR 73.4077 and futures
contract price moves to USD/INR 73.5175.
Scenario-2: Rupee depreciates further to USD/INR 75.5040 and
futures contract price reaches USD/INR 75.6138.
5
 a) Hedging strategy:
Since the exporter is holding a long position of receivables, it will short
(i.e. sell) USDINR futures at USD/INR 74.5675.
The lot size of USD-INR futures is 1000 USD. So, the exporter will short
50 lots, which is computed as follows:
Hedge ratio= (Exposure value/lot size)= 50000/1000=50
b) Hedge outcomes
Loss/gain from spot position Loss/gain from futures

Scenario-1 (rupee appreciation)

Cash Loss= (74.4577-73.5077)*50000= Cash Gain= (74.5675-

52500 73.5175)*50*1000= 52500
Scenario-2 (rupee depreciation)

Cash Gain= (75.5040-74.4577)*50000= Cash Loss= (75.6138-74.5675)*50*1000=

52315 52315

6
Example (Importer)
SUNIL Enterprise has imported spare parts from Germany and
the total value of the shipment is EUR 75,000 payable after 3
months. The current spot rate EUR/INR 80.25. Apprehending
that EUR may become weak during the intervening period, the
importing is planning to hedge his position with EURINR
futures quoting at EUR/INR 80.65
(a) What will be the hedging strategy of the importer?
(b) Determine hedging outcome after 3 months if (i) rupee
appreciates to EUR/INR 79.50 with futures quoting at 79.90;
and (ii) rupee depreciates to EUR/INR 81.75 with futures
quoting at 82.15.

7
 (a) Hedging strategy:
Since the importer is holding a short position of receivables, it will long
(i.e. buy) EURINR futures at EUR/INR 80.65.
The lot size of EUR-INR futures is 1000 EUR. So, the exporter will
long 75 lots, which is computed as follows:
Hedge ratio= (Exposure value/lot size)= 75000/1000=75
b) Hedge outcomes

Loss/gain from cash position Loss/gain from futures

Scenario-1 (rupee appreciation)

Cash Gain = (80.25- Cash Loss = (80.65-

79.50)*75000= 56250 79.90)*75*1000= 56250
Scenario-2 (rupee depreciation)

Cash Loss = (81.75- Cash Gain= (82.15-

80.25)*75000= 112500 80.65)*75*1000= 112500
8
Example
An exporter of castor oil received an export order of 1000 MT on 3 April,
delivery due by the end of May (roughly after two month). Due to quality and
logistical concerns, she is planning to buy 1000 MT castor seed from the
physical market in May, process it into castor oil, and then export. However,
she is anticipating significant increase in price in the spot market at the time of
purchase in May. The lot size is 10 MT per contract.
(a) How can she hedge price risk using castor seed futures? The current spot
price of castor seed is Rs. 3,825 per 100 kg, and 20 May futures is quoted
at Rs. 3,910 per 100 kg.
(b) What will be the pay-off from the hedge position by the end of May under
the following two situations?
(i) Spot price and May futures price go up to Rs. 4,150 and Rs. 4,230
respectively
(ii) Spot price and May futures price decline to Rs. 3,700 and Rs. 3,780
respectively

9
The exporter will hedge its position by going long (i.e. buy) 100 castor seed futures
contracts.
Hedge ratio = 1,000/10 =100 lots
Scenario 1
Cash loss in spot market = (4,150 - 3,825) x 10 x1000 = Rs. 32,50,000
Gains from futures closure = (4,230 - 3,910) x 10 x 100 x 10 = Rs. 32,00,000
Net cash loss = (32,50,000 - 32,00,00) = Rs. 50,000
The gains from futures has offset the cash loss to a large extent, but hedging is not
perfect. Why? This is because basis has narrowed down from (3910 - 3825 =) 85 on
3rd April to 80 by the time of closure of May futures. Thus, whether hedge pay-off
would be perfect or not would depend on what happens to basis. This what is
called basis risk. In the process of hedging price risk, we get exposed to basis risk.
Scenario 2
Cash gain in spot market = (3,825 - 3,700) x 10 x1000 = Rs. 12,50.000
Loss from futures closure = (3780 - 3910) x 10 x 100 x 10 = (-) Rs. 13,00,000
The gains from fall in commodity price in may has been eroded by loss from closure
of futures. The loss has exceeded gains because of decrease in basis.

10
Basis Risk

BASIS IS USUALLY DEFINED AS THE SPOT BASIS RISK ARISES BECAUSE OF THE
PRICE MINUS THE FUTURES PRICE UNCERTAINTY ABOUT THE BASIS WHEN
THE HEDGE IS CLOSED OUT

11
Short Hedge for Sale of an Asset

Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is sold
S1 : Asset price at time of hedge is set up
S2 : Asset price at time of sale
b2 : Basis at time of sale

Price of asset S2
Gain on Futures F1 −F2
Net amount received S2 + (F1 −F2) =F1 + b2

12
Variation of Basis Over Time

13
Source of Basis

•The assets whose price to be hedged may not

be exactly the same as the asset underlying
the futures contract
•There may be uncertainty as to the exact
date when the assets will be bought or sold
•The hedge may require the futures contract
to be closed out before its delivery month

14
Choice of Contract

•Choose a delivery month that is as close as

possible to, but later than, the end of the life
of the hedge
•When there is no futures contract on the
asset being hedged, choose the contract
whose futures price is most highly correlated
with the asset price. This is known as cross
hedging.

15
Optimal Hedge Ratio

Proportion of the exposure that should optimally be

hedged is
sS
h* = r
where sF
sS is the standard deviation of DS, the change in the
spot price during the hedging period,
sF is the standard deviation of DF, the change in the
futures price during the hedging period
r is the coefficient of correlation between DS and DF.

16
Example

• Airline will purchase 2 million gallons of jet fuel

in one month and hedges using heating oil
futures
• Size of the heating oil contract is 42000 gallons
• Find out the hedge ratio and optimal number of
future contracts
• From historical data sF =0.0313, sS =0.0263, and
r= 0.928

0.0263
h = 0.928 
*
= 0.78 17
0.0313
Example continued
• The size of one heating oil contract is 42,000 gallons
• Optimal number of contracts is
= 0.78  2, 000, 000 42, 000

18
 Optimal Number of Contracts

QA Size of position being hedged (units)

QF Size of one futures contract (units)
VA Value of position being hedged (=spot price time QA)
VF Value of one futures contract (=futures price times QF)

Optimal number of contracts if

adjustment for daily settlement

h *Q A
=
QF

19
Hedging Using Index Futures

To hedge the risk in a portfolio the number of contracts

that should be shorted is

VA
b
VF

where VA is the value of the portfolio, b is its beta, and VF

is the value of one futures contract

20
Example
Suppose that a future contract with 4-month maturity is used to hedge
the value of a portfolio over the next 3 months in the following
situations:
Index level= 1000
Index futures price=1010
Value of the portfolio= 5050000
Risk-free rate= 4% per annum
Dividend yield on index= 1% per annum
Beta of the portfolio= 1.5
Lot size= 250 times of the index

21
An investor has invested Rs. 95.5 lacs in a portfolio of stocks as shown in
the table below. The investor is worried about fall in portfolio value in near
futures and intend to hedge the position with Nifty 50 futures currently
quoted at 9,025. [Lot size = 75]

Stock Amount invested Portfolio weight Stock beta

(Rs.)
ACC 3,00,000 3.14% 1.22
Axis Bank 12,50,000 13.09% 1.40
BPCL 18,00,000 18.85% 1.42
Cipla 6,50,000 6.81% 0.59
DLF 10,00,000 10.47% 1.86
Infosys 7,50,000 7.85% 0.43
L&T 8,50,000 8.90% 1.43
Maruti Suzuki 14,00,000 14.66% 0.95
Reliance 3,00,000 3.14% 1.22
SBI Limited 12,50,000 13.09% 1.40
Total 95,50,000 1.25 22
Changing Beta

• What position is necessary to reduce the beta of the

portfolio to 0.75?
• What position is necessary to increase the beta of the
portfolio to 2.0?

23
Why Hedge Equity Returns
• May want to be out of the market for a while. Hedging avoids the
costs of selling and repurchasing the portfolio
• Suppose stocks in your portfolio have an average beta of 1.0, but
you feel they have been chosen well and will outperform the market
in both good and bad times. Hedging ensures that the return you
earn is the risk-free return plus the excess return of your portfolio
over the market.

24
Hedging in India

• Equity market: Futures and Options

• Currency market: Forward and Options
• Interest rate market: Interest Rate Futures, Forward Rate Agreement,
Swaps
• Commodity market: Futures

25
Disclaimer: The content in the slides have been taken from various
sources such as Options, Future, and Other Derivative by Hull and Basu
(10 Ed. Pearson Publication), official website of National Stock
Exchange of India, Zerodha and Motilal Oswal. This material is purely
created for classroom discussions at BITS Pilani and do not possess any
right to these contents.

26
The Future Pricing

1
Consumption vs Investment Assets

 Investment assets are assets held by

significant numbers of people purely
for investment purposes (Examples:
gold, silver)
 Consumption assets are assets held
primarily for consumption (Examples:
copper, oil)

2
Short Selling

 Short selling involves selling

securities you do not own
 Your broker borrows the
securities from another client and
sells them in the market in the
usual way

3
 Short Selling

 At some stage you must buy the

securities so they can be replaced
in the account of the client
 You must pay dividends and other
benefits the owner of the securities
receives
 There may be a small fee for
borrowing the securities

4
5
Notation for Valuing Futures and
Forward Contracts
Assumptions:
• No transaction cost
• Unlimited borrowing and lending at risk free rate
• Avail Arbitrage opportunity

S0: Spot price today

F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for
maturity T

6
An Arbitrage Opportunity?
 Suppose that:
◦ The spot price of a non-dividend-
paying stock is $40
◦ The 3-month forward price is $43
◦ The 3-month risk free interest rate is
5% per annum
 Is there an arbitrage opportunity?

7
Another Arbitrage Opportunity?
 Suppose that:
◦ The spot price of non-dividend-paying
stock is $40
◦ The 3-month forward price is US$39
◦ The 3-month interest rate is 5% per
annum (continuously compounded)
 Is there an arbitrage opportunity?

8
9
 The Forward Price
If the spot price of an investment asset is
S0 and the futures price for a contract
deliverable in T years is F0, then
F0 = S0erT
where r is the T-year risk-free rate of
interest.
In our examples, S0 =40, T=0.25, and
r=0.05 so that
F0 = 40e0.05×0.25 = 40.50

10
When an Investment Asset Provides
a Known Income

F0 = (S0 – I )erT
where I is the present value of the
income during life of forward contract

11
Example
 Consider a coupon bearing bond of
current price Rs.900. Suppose the
forward contract matures at 9 months.
Assume that the coupon payment of
Rs.40 is expected to receive after 4
months. The 4-month and 9-month risk
free rates are 3% and 4% per annum.
Determine the arbitrage opportunity if (i)
forward price is Rs.910 and (ii) Rs. 870

12
13
Example:
 Consider a 10 months forward contract
on a stock when the stock price Rs. 50.
Assume that the risk-free rate of interest
is 8% per annum (continuously
compounded). Also, the stock is expected
to give dividend Rs. 0.75 per share after 3
months, 6 months, and 9 months.
Determine the forward price

14
When an Investment Asset
Provides a Known Yield

F0 = S0 e(r–q )T
where q is the average yield during
the life of the contract (expressed with
continuous compounding)

15
Example:
A 6-month forward contract on an asset
that is expected to provide income equals
to 4% per annum with semi-annual
compounding. The spot price of the asset is
Rs.25. The risk-free rate of interest is 10%
per annum with continuous compounding.
Determine the forward price.

16
Home Assignment
ITC futures with expiration due on 28 May
2020 quoted at Rs.175.50 on 30 April 2020,
while underlying was Rs.181.05. On the
same day, one-moth MIBOR was 4.96%.
Calculate fair value of [Link] may
ignore dividend since ITC would not pay
any interim dividend in May. Is there any
opportunity for earning arbitrage profit?

17
Valuing a Forward Contract
 A forward contract is worth zero when it
is first negotiated
 Later it may have a positive or negative
value
 Suppose that K is the delivery price and F0
is the forward price for a contract that
would be negotiated today

18
 Valuing a Forward Contract

 By considering the difference between a

contract with delivery price K and a
contract with delivery price F0 we can
deduce that:
◦ the value of a long forward contract is
(F0 – K )e–rT
◦ the value of a short forward contract is
(K – F0 )e–rT

19
Example
 A long forward contract on a non-
dividend paying stock was entered into
sometime ago. It has 6 months to
maturity. The risk free rate of interest is
10% per annum (Continuously
compounding), the current stock price is
Rs.25 and delivery price is Rs.24.
Determine the value of forward contract

20
Stock Index
 Can be viewed as an investment asset
paying a dividend yield
 The futures price and spot price
relationship is therefore
F0 = S0 e(r–q )T
where q is the average dividend yield
on the portfolio represented by the
index during life of contract

21
22
23
Example
 A stock index currently stands at Rs.
11250.55. The risk-free rate is 3.69% per
annum and dividend yield on the index is
1.42% per annum. What is the forward
price?

24
25
Home Assignment
 Assume that the risk-free rate 9% per
annum and the dividend yield on the stock s
varies throughout the year. In February, May,
August and November the dividends are
paid at 5% per annum. And, in the remaining
months, it is paid at the rate of 2% per
annum. Suppose that the value of the index
on July 31is Rs.1300. What is the future price
of a contract deliverable on December 31, of
the same year?
26
Index Arbitrage
 When F0 > S0e(r-q)T an arbitrageur buys
the stocks underlying the index and
sells futures
 When F0 < S0e(r-q)T an arbitrageur buys
futures and shorts or sells the stocks
underlying the index

27
 Index Arbitrage
 Index arbitrage involves simultaneous trades
in futures and many different stocks
 Very often a computer is used to generate the
trades
 Occasionally simultaneous trades are not
possible and the theoretical no-arbitrage
relationship between F0 and S0 does not hold

28
Futures and Forwards on
Currencies

 A foreign currency is analogous to a

security providing a yield
 The yield is the foreign risk-free interest
rate
 It follows that if rf is the foreign risk-free
interest rate
( r −rf ) T
F0 = S0e

29
Example
Suppose that the 2-year interest rate in
Australia and the USA are 3% and 1%
respectively, and the spot exchange rate is
0.75 USD per AUD. Determine the forward
price. Is there any arbitrage opportunity If
the forward rate is 0.70?

30
The forward price can be determined as:

Strategy: (i) Borrow 1000 AUD at 3% per

annum for 2 years (
and convert it to 750 USD and invest at1%
(
(ii) Enter into a forward contract to buy
1061.84 AUD for 1061.84x0.70= 743.29
USD.

31
Commodity Futures
F0 = S0 e(r+u )T
where u is the storage cost per unit
time as a percent of the asset value.
Alternatively,
F0 = (S0+U )erT
where U is the present value of the
storage costs.

32
Example:
On 28 April 2020, the price of standard gold (22 carat) in Delhi
was Rs. 45,300 per 10 grams. On the same day, 5 June GOLD
futures closed on MCX at Rs. 46,066. The relevant features of
GOLD futures contract of MCX are as follows

Symbol GOLD
. Trading Unit 1 kg
Quotation Rs. Per 10 gm
Expiry 5th of the Expiry Month

Determine the fair value of 5 June GOLD futures as on 28 April

2020. The yield on 91-day T-Bills averaged 4.09% (Continuously
compounding) during April 2020. The storage cost of gold is Rs.
35 per kg per day.

33
34
Consumption Assets: Storage is
Negative Income
F0  S0 e(r+u )T
where u is the storage cost per unit
time as a percent of the asset value.
Alternatively,
F0  (S0+U )erT
where U is the present value of the
storage costs.

35
 The Cost of Carry

 The cost of carry, c, is the storage cost

plus the interest costs less the income
earned
 For an investment asset F0 = S0ecT
 For a consumption asset F0  S0ecT

36
 Convenience Yield
The convenience yield is the benefit/return of holding
(or owning) the underlying asset till expiration of a
futures contract. In case of a commodity futures, the
benefit of holding inventory of the underlying commodity
may accrue from the ability to profit from temporary
shortage, or the ability to keep the production process
running.

37
 Futures Prices & Expected Future
Spot Prices
 Suppose k is the expected return required by
investors in an asset
 We can invest F0e–r T at the risk-free rate and enter
into a long futures contract to create a cash inflow
of ST at maturity
 This shows that

− rT
F0 e e kT
= E ( ST )
or
F0 = E ( ST )e ( r − k )T
38
Futures Prices & Future Spot Prices

No Systematic Risk k=r F0 = E(ST)

Positive Systematic Risk k>r F0 < E(ST)
Negative Systematic Risk k<r F0 > E(ST)

Positive systematic risk: stock indices

Negative systematic risk: gold (at least for some periods)

39
40
41
Disclaimer: The content in the slides have been taken from various
sources such as Options, Future, and Other Derivative by Hull and
Basu (10 Ed. Pearson Publication), official website of National Stock
Exchange of India, Zerodha and Motilal Oswal. This material is purely
created for classroom discussions at BITS Pilani and do not possess
any right to these contents.

42
Options Markets

1
Review of Option Types
 A call is an option to buy
 A put is an option to sell
 A European option can be exercised
only at the end of its life
 An American option can be exercised
at any time

2
Option Positions

 Long call
 Long put
 Short call
 Short put

3
Long Call
Profit from buying one European call option: option
price = $5, strike price = $100, option life = 2 months

30 Profit ($)

20

10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130

4
Short Call
Profit from writing one European call option: option
price = $5, strike price = $100
Profit ($)
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30

5
 Long Put
Profit from buying a European put option: option
price = $7, strike price = $70

30 Profit ($)

20

10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7

6
Short Put
Profit from writing a European put option: option
price = $7, strike price = $70
Profit ($)
Terminal
7
40 50 60 stock price ($)
0
70 80 90 100
-10

-20

-30

7
Payoffs from Options
What is the Option Position in Each Case?
K = Strike price, ST = Price of asset at maturity
Payoff Payoff

K
K ST ST
Payoff
Payoff
K
K ST ST

8
Assets Underlying
Exchange-Traded Options

 Stocks
 ETFs (and other ETPs)
 Foreign Currency
 Stock Indices
 Futures

9
Specification of
Exchange-Traded Options

 Expiration date
 Strike price
 European or American
 Call or Put (option class)

10
Terminology

Moneyness :
◦ At-the-money option
◦ In-the-money option
◦ Out-of-the-money option

11
Terminology
(continued)

 Option class
 Option series
 Intrinsic value
 Time value

12
Intrinsic value & Time value
 The intrinsic value of an option represents
the current value of the option, or in
other words how much in the money it is.
When an option is in the money, this
means that it has a positive payoff for the
buyer.
• In the money call options: Intrinsic Value
= Price of Underlying Asset - Strike Price
• In the money put options: Intrinsic Value
= Strike Price - Price of Underlying Asset

13
Time value
 The time value of an option is an
additional amount an investor is
willing to pay over the current intrinsic
value. Investors are willing to pay this
because an option could increase in
value before its expiration date.
• Time Value = Option Premium -
Intrinsic Value
• Option Premium = Intrinsic Value +
Time Value
14
Dividends & Stock Splits

 Suppose you own N options with a

strike price of K :
◦ No adjustments are made to the option
terms for cash dividends
◦ When there is an n-for-m stock split,
 the strike price is reduced to mK/n
 the no. of options is increased to nN/m
◦ Stock dividends are handled similarly to
stock splits

15
Dividends & Stock Splits
 Consider an exchange-traded call option
contract to buy 500 shares with a strike
price of $40 and maturity in four months.
Explain how the terms of the option contract
change when there is
a) A 10% stock dividend
b) A 10% cash dividend
c) A 4-for-1 stock split

16
a) The option contract becomes one to buy 500 11 = 550 shares with an exercise price
40 1.1 = 3636 .
b) There is no effect. The terms of an options contract are not normally adjusted for cash
dividends.
c) The option contract becomes one to buy 500  4 = 2 000 shares with an exercise price of
40 4 = $10 .

17
Market Makers
 Most exchanges use market makers
to facilitate options trading
 A market maker quotes both bid and
ask prices when requested
 The market maker does not know
whether the individual requesting the
quotes wants to buy or sell

18
Warrants

 Warrants are options that are issued

by a corporation or a financial
institution
 The number of warrants outstanding
is determined by the size of the
original issue and changes only
when they are exercised or when
they expire

19
Warrants
(continued)
 The issuer settles up with the holder when a
warrant is exercised
 A call warrant represents a specific number
of shares that can be purchased from the
issuer at a specific price, on or before a
certain date.
 A put warrant represents a certain amount of
equity that can be sold back only to the issuer
at a specified price, on or before a stated
date.

20
Employee Stock Options
 Employee stock options are a form of
remuneration issued by a company to
its executives
 They are usually at the money when
issued
 When options are exercised the
company issues more stock and sells
it to the option holder for the strike
price
 Expensed on the income statement

21
 Convertible Bonds
 Convertible bonds are regular bonds
that can be exchanged for equity at
certain times in the future according to
a predetermined exchange ratio
 Usually a convertible is callable
 The call provision is a way in which the
issuer can force conversion at a time
earlier than the holder might otherwise
choose

22
 Notation

c:
European call C: American call option
option price price
p: P: American put option
European put
price
option price
ST: Stock price at option
S0:
Stock price today maturity
K:
Strike price D: PV of dividends paid
T:
Life of option during life of option
s: r Risk-free rate for
Volatility of stock
maturity T with cont.
price comp.
23
Effect of Variables on Option Pricing

Variable c p C P
S0 + − + −
K − + − +
T ? ? + +
s + + + +
r + − + −
D − + − +

24
25
American vs European Options
An American option is worth at least
as much as the corresponding
European option
Cc
Pp

26
Lower Bound for European Call
Option Prices; No Dividends

c  max(S0 –Ke –rT, 0)

27
Arbitrage

 Suppose that
c= 3
S0= 20
T=1
r = 10%
K =18
D=0
 What are the arbitrage possibility?

28
Lower Bound for European Put
Prices; No Dividends

p  max(Ke -rT–S0, 0)

29
 Put-Call Parity: No Dividends

 Consider the following 2 portfolios:

◦ Portfolio A: European call on a stock + zero-
coupon bond that pays K at time T
◦ Portfolio B: European put on the stock + the
stock

30
Values of Portfolios

ST > K ST < K
Portfolio A Call option ST − K 0
Zero-coupon bond K K
Total ST K
Portfolio C Put Option 0 K− ST
Share ST ST
Total ST K

31
The Put-Call Parity Result
 Both are worth max(ST , K ) at the
maturity of the options
 They must therefore be worth the
same today. This means that
c + Ke -rT = p + S0

32
Arbitrage Opportunities

 Suppose that
c= 3 S0= 31
T = 0.25 r = 10%
K =30 D=0

 What are the arbitrage

possibilities when
p = 2.25 ?
p=1?
33
34
 Early Exercise

 Usually there is some chance that an

American option will be exercised early

 An exception is an American call on a

non-dividend paying stock
 This should never be exercised early

35
 An Extreme Situation

 For an American call option:

S0 = 100; T = 0.25; K = 60; D = 0
Should you exercise immediately?
 What should you do if
◦ You want to hold the stock for the next 3 months?
◦ You do not feel that the stock is worth holding for
the next 3 months?

36
Reasons For Not Exercising a Call
Early (No Dividends)

 No income is sacrificed
 You delay paying the strike price
 Holding the call provides insurance
against stock price falling below strike
price

37
Bounds for European or American Call
Options (No Dividends)

38
Should Puts Be Exercised
Early ?

Are there any advantages to

exercising an American put when

S0 = 60; T = 0.25; r=10%

K = 100; D = 0

39
Bounds for European and American Put
Options (No Dividends)

40
The Impact of Dividends on Lower
Bounds to Option Prices

− rT
c  S 0 − D − Ke
− rT
p  D + Ke − S0

41
Extensions of Put-Call Parity
 American options; D = 0
S0 − K < C − P < S0 − Ke−rT

 European options; D > 0

c + D + Ke −rT = p + S0

 American options; D > 0

S0 − D − K < C − P < S0 − Ke −rT

42
Example
A one-month European put option on a
non-dividend-paying stock is currently
selling for . The stock price is $47, the
strike price is $50, and the risk-free interest
rate is 6% per annum. What opportunities
are there for an arbitrageur?

43
Example
The price of an American call on a non-
dividend-paying stock is $4. The stock price
is $31, the strike price is $30, and the
expiration date is in three months. The risk-
free interest rate is 8%. Derive upper and
lower bounds for the price of an American
put on the same stock with the same strike
price and expiration date.

44
Option Trading Strategy
Payoff profile of buyer of asset: Long asset
• The figure shows the profits/losses from a long position on ABC Ltd.. The investor
bought ABC Ltd. at Rs. 2220. If the share price goes up, he profits. If the share price
falls, he loses.
Payoff profile for seller of asset: Short asset
• The figure shows the profits/losses from a short position on ABC Ltd.. The investor sold
ABC Ltd. at Rs. 2220. If the share price falls, he profits. If the share price rises, he
loses.
Long call
ANALYSIS: This strategy limits the downside risk to the extent of premium paid by Mr.
XYZ (Rs. 36.35). But the potential return is unlimited in case of rise in Nifty. A long call
option is the simplest way to benefit if you believe that the market will make an upward
move and is the most common choice among first time investors in Options. As the stock
price / index rises the long Call moves into profit more and more quickly.
Short call
ANALYSIS: This strategy is used when an investor is very aggressive and has a strong
expectation of a price fall (and certainly not a price rise). This is a risky strategy since as
the stock price / index rises, the short call loses money more and more quickly and losses
can be significant if the stock price / index falls below the strike price. Since the investor
does not own the underlying stock that he is shorting this strategy is also called Short
Naked Call.
Payoff profile for buyer of put options: Long put

• The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put
option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon
expiration, Nifty closes below the strike of 2250, the buyer would exercise his option
and profit to the extent of the difference between the strike price and Nifty-close. The
profits possible on this option can be as high as the strike price. However if Nifty rises
above the strike of 2250, he lets the option expire. His losses are limited to the extent
of the premium he paid for buying the option.
Payoff profile for writer (seller) of put options: Short put

• The figure shows the profits/losses for the seller of a three-month Nifty 2250 put
option. As the spot Nifty falls, the put option is in-the-money and the writer starts
making losses. If upon expiration, Nifty closes below the strike of 2250, the buyer
would exercise his option on the writer who would suffer a loss to the extent of the
difference between the strike price and Nifty close. The loss that can be incurred by
the writer of the option is a maximum extent of the strike price (Since the worst that
can happen is that the asset price can fall to zero) whereas the maximum profit is
limited to the extent of the up-front option premium of Rs.61.70 charged by him.
SYNTHETIC LONG CALL: BUY STOCK, BUY PUT

Mr. XYZ is bullish about ABC Ltd stock. He buys ABC Ltd. at current market price of Rs. 4000 on 4th
July. To protect against fall in the price of ABC Ltd. (his risk), he buys an ABC Ltd. Put option with a
strike price Rs. 3900 (OTM) at a premium of Rs. 143.80 expiring on 31st July.
ANALYSIS: This is a low risk strategy. This is a
strategy which limits the loss in case of fall in
market, but the potential profit remains unlimited
when the stock price rises. A good strategy when
you buy a stock for medium or long term, with the
aim of protecting any downside risk. The pay-off
resembles a Call Option buy and is therefore called
as Synthetic Long Call.
COVERED CALL
The Payoff Schedule
LONG COMBO : SELL A PUT, BUY A CALL
A stock ABC Ltd. is trading at Rs. 450. Mr. XYZ is bullish on the stock. But does not want to invest Rs.
450. He does a Long Combo. He sells a Put option with a strike price Rs. 400 at a premium of Rs.
1.00 and buys a Call Option with a strike price of Rs. 500 at a premium of Rs. 2. The net cost of the
strategy (net debit) is Rs. 1.

A Long Combo is a Bullish strategy. If

an investor is expecting the price of a
stock to move up, he can do a Long
Combo strategy. It involves selling an
OTM (lower strike) Put and buying an
OTM (higher strike) Call. This strategy
simulates the action of buying a stock
(or a futures) but at a fraction of the
stock price. It is an inexpensive trade,
similar in pay-off to Long Stock,
except there is a gap between the
strikes.
PROTECTIVE CALL /SYNTHETIC LONG PUT
Suppose ABC Ltd. is trading at Rs. 4457 in June. An investor Mr. A buys a Rs 4500 call
for Rs. 100 while shorting the stock at Rs. 4457. The net credit to the investor is Rs.
4357 (Rs. 4457 – Rs. 100).
 COVERED PUT
Suppose ABC Ltd. is trading at Rs 4500 in June. An investor, Mr. A, shorts
Rs 4300 Put by selling a July Put for Rs. 24 while shorting an ABC Ltd.
stock. The net credit received by Mr. A is Rs. 4500 + Rs. 24 = Rs. 4524.
LONG STRADDLE
The Payoff Schedule
SHORT STRADDLE
LONG STRANGLE
SHORT STRANGLE
COLLAR
BULL CALL SPREAD STRATEGY
BULL PUT SPREAD STRATEGY
BEAR CALL SPREAD STRATEGY
BEAR PUT SPREAD STRATEGY
LONG CALL BUTTERFLY
SHORT CALL BUTTERFLY
LONG CALL CONDOR
SHORT CALL CONDOR
Example: Nifty is at 3600. Mr. XYZ expects high volatility in the Nifty and expects the market
to break open significantly on any side. Mr. XYZ sells 1 ITM Nifty Call Options with a strike
price of Rs. 3400 at a premium of Rs. 41.25, buys 1 ITM Nifty Call Option with a strike price
of Rs. 3500 at a premium of Rs. 26, buys 1 OTM Nifty Call Option with a strike price of Rs.
3700 at a premium of Rs. 9.80 and sells 1 OTM Nifty Call Option with a strike price of Rs.
3800 at a premium of Rs. 6.00. The Net credit is of Rs. 11.45.
Binomial Option Pricing Models

1
 A Simple Binomial Model

 A stock price is currently $20

 In 3 months it will be either $22 or $18

Stock Price = $22

Stock price = $20
Stock Price = $18

2
 A Call Option

A 3-month call option on the stock has a strike

price of 21.

Stock Price = $22

Option Payoff = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Payoff = $0

3
Setting Up a Riskless Portfolio
 For a portfolio that is long D shares, and a
short 1 call option values are

22D – 1

18D

Portfolio is riskless when 22D – 1

= 18D or D = 0.25
4
 Valuing the Portfolio
(Risk-Free Rate is 4%)

 The riskless portfolio is:

long 0.25 shares
short 1 call option
 The value of the portfolio in 3 months is
22 ×0.25 – 1 = 4.50
 The value of the portfolio today is
4.5e–0.04×0.25 = 4.455

5
Valuing the Option
 The portfolio that is
long 0.25 shares
short 1 option
is worth 4.455
 The value of the shares is
5.00 (= 0.25 × 20 )
 The value of the option is therefore
5.00 – 4.455 = 0.545

6
 Generalization

A derivative lasts for time T and is

dependent on a stock
S0u
ƒu
S0
ƒ
S0d
ƒd

7
Generalization
 Value of a portfolio that is long D shares and short
1 derivative:

S0uD – ƒu

S0dD – ƒd

 The portfolio is riskless when S0uD – ƒu = S0dD – ƒd

or
ƒu − f d
D=
S 0u − S 0 d

8
Generalization
 Value of the portfolio at time T is S0uD
– ƒu
 Value of the portfolio today is (S0uD –
ƒu)e–rT
 Another expression for the portfolio
value today is S0D – f
 Hence
ƒ = S0D – (S0uD – ƒu )e–rT
9
 Generalization
(continued)

Substituting for D we obtain

ƒ = [ pƒu + (1 – p)ƒd ]e–rT

where
e rT − d
p=
u−d

10
p as a Probability
 It is natural to interpret p and 1-p as probabilities of up
and down movements
 The value of a derivative is then its expected payoff in
a risk-neutral world discounted at the risk-free rate
S0u
ƒu
S0
ƒ
S0d
ƒd

11
Risk-Neutral Valuation
 When the probability of an up and down
movements are p and 1-p the expected stock price
at time T is S0erT
 This shows that the stock price earns the risk-free
rate
 Binomial trees illustrate the general result that to
value a derivative we can assume that the
expected return on the underlying asset is the risk-
free rate and discount at the risk-free rate
 This is known as using risk-neutral valuation

12
Original Example Revisited
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

p is the probability that gives a return on the stock equal to the

risk-free rate:
20e 0.04 ×0.25 = 22p + 18(1 – p ) so that p = 0.5503
Alternatively: 0.040.25
e −d e
rT
− 0.9
p= = = 0.5543
u−d 1.1 − 0.9

13
 Valuing the Option Using Risk-Neutral
Valuation

S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

The value of the option is

e–0.04×0.25 (0.5543 ×1 + 0.4497×0)
= 0.545

14
A Two-Step Example

24.2
22

20 19.8

18
16.2

 K=21, r = 4%
 Each time step is 3 months

15
 Valuing a Call Option

24.2
3.2
22
B
20 1.7433 19.8
0.9497 A 0.0
18

0.0 16.2
0.0
Value at node B
= e–0.04×0.25(0.5503×3.2 + 0.4497×0) = 1.7433
Value at node A
= e–0.04×0.25(0.5503×1.7433 + 0.4497×0) = 0.9497

16
17
18
Example: Put Option
 Consider a 2-year put option with strike
price of Rs.52 on a stock whose current
price is Rs.50. Suppose that there are two
times of 1 year, and each time step the
stock price either moves up by 20% or
moves down by 20%. The risk-free rate is
5%.

19
 A Put Option Example

72
0
60
50 1.4147 48
4.1923 4
40
9.4636 32
20

K = 52, time step =1yr

r = 5%, u =1.2, d = 0.8

20
 What Happens When the Put Option
is American

72
0
60

50 1.4147 48
5.0894 4
40
The American feature C
increases the value at node 12.0 32
C from 9.4636 to 12.0000. 20

This increases the value of

the option from 4.1923 to
5.0894.

21
 Delta

 Delta (D) is the ratio of the change

in the price of a stock option to the
change in the price of the
underlying stock
 The value of D varies from node to
node

22
Choosing u and d
One way of matching the volatility is to
set

u = es Dt

d = 1 u = e −s Dt

where s is the volatility and Dt is the

length of the time step. This is the
approach used by Cox, Ross, and
Rubinstein
23
Assets Other than Non-Dividend
Paying Stocks

 For options on stock indices, currencies

and futures the basic procedure for
constructing the tree is the same except
for the calculation of p

24
 The Probability of an Up Move

a−d
p=
u−d

a = e rDt for a nondividen d paying stock

a = e ( r − q ) Dt for a stock index where q is the dividend

yield on the index

( r − r ) Dt
a=e f for a currency where r f is the foreign
risk - free rate

a = 1 for a futures contract

25
Example
 Consider an American put option where
the stock price is Rs.50, the strike price is
Rs.52, the risk-free rate is 5%, the life of
the option is 2 years, and there are two-
time steps. The volatility is 30%.

26
27
28
Example
A stock index is currently 810 and has a
volatility of 20% and dividend yield of 2%.
The risk-free rate of interest is 5%.
Determine the value of the European call
option with a strike price 800 using two
step binomial tree.

29
Wiener Processes and Itô’s
Lemma

1
Stochastic Processes
•Describes the way in which a variable
such as a stock price, exchange rate or
interest rate changes through time
•Incorporates uncertainties

2
Example 1

• Each day a stock price

• increases by $1 with probability 30%
• stays the same with probability 50%
• reduces by $1 with probability 20%

3
Markov Processes
• In a Markov process future movements in a
variable depend only on where we are, not
the history of how we got to where we are
• Is the process followed by the temperature
at a certain place Markov?
• We assume that stock prices follow Markov
processes

4
Weak-Form Market Efficiency
•This asserts that it is impossible to
produce consistently superior returns
with a trading rule based on the past
history of stock prices. In other words
technical analysis does not work.
•A Markov process for stock prices is
consistent with weak-form market
efficiency

5
Variances & Standard Deviations
• In Markov processes changes in successive
periods of time are independent
• This means that variances are additive
• Standard deviations are not additive

6
Wiener Process (Brownian Motion)
• Brownian motion gets its name from the botanist Robert
Brown (1828) who observed in 1827 how particles of pollen
suspended in water moved erratically on a microscopic
scale.
• Louis Bachelier published these ideas in his (1900) doctoral
thesis on speculation in the French bond market.
• Albert Einstein (1905) independently discovered the same
stochastic process and applied it in thermodynamics.
• Norbert Wiener (1923) ultimately proved the existence of
Brownian motion and developed related mathematical
theories, so Brownian motion is often called a Wiener
process.

7
A Wiener Process
• Define f(m,v) as a normal distribution with mean
m and variance v

• A variable z follows a Wiener process if

• The change in z in a small interval of time Dt
is Dz
• Dz =  Dt where  is f(0,1)

• The values of Dz for any 2 different (non-

overlapping) periods of time are independent

8
Properties of a Wiener Process

•Mean of [z (T ) – z (0)] is 0
•Variance of [z (T ) – z (0)] is T
•Standard deviation of [z (T ) – z (0)]
is T

9
Generalized Wiener Processes

• A Wiener process has a drift rate (i.e.

average change per unit time) of 0 and a
variance rate of 1
• In a generalized Wiener process the drift
rate and the variance rate can be set equal
to any chosen constants

10
Generalized Wiener Processes

Dx = a Dt + b  Dt

• Mean change in x per unit time is a

• Variance of change in x per unit time is
b2

11
Taking Limits . . .
• What does an expression involving dz and dt
mean?
• It should be interpreted as meaning that the
corresponding expression involving Dz and Dt is
true in the limit as Dt tends to zero
• In this respect, stochastic calculus is analogous
to ordinary calculus

12
The Example Revisited
• A stock price starts at 40 and has a probability
distribution of f(40,100) at the end of the year
• If we assume the stochastic process is Markov with
no drift then the process is
dS = 10dz
• If the stock price were expected to grow by $8 on
average during the year, so that the year-end
distribution is f(48,100), the process would be
dS = 8dt + 10dz

13
Itô Process
• In an Itô process the drift rate and the
variance rate are functions of time
dx=a(x,t) dt + b(x,t) dz
• The discrete time equivalent
Dx = a( x, t )Dt + b( x, t ) Dt

is true in the limit as Dt tends to

zero

14
An Ito Process for Stock Prices

dS = mS dt + sS dz
where m is the expected return s is the volatility.
The discrete time equivalent is

The process is known as geometric Brownian motion

DS = mSDt + sS Dt

15
Itô’s Lemma
• If we know the stochastic process followed by
x, Itô’s lemma tells us the stochastic process
followed by some function G (x, t ). When
dx=a(x,t) dt+ b(x,t) dz then

 G G  2G 2  G
dG =  a+ +½ b  dt + b dz
 x t x x
2

• Since a derivative is a function of the price of
the underlying asset and time, Itô’s lemma
plays an important part in the analysis of
derivatives

16
Indication of Why Itô’s Lemma is True

• A Taylor’s series expansion of G(x, t) gives

G G  2G
DG = Dx + Dt + ½ 2 Dx 2
x t x
 2G  2G 2
+ Dx Dt + ½ 2 Dt + 
xt t

17
Ignoring Terms of Higher Order
Than Dt

In ordinary calculus we have

G G
DG = Dx + Dt
x t
In stochastic calculus this becomes
G G  2G 2
DG = Dx + Dt + ½ Dx
x t x 2

because Dx has a component which is

of order Dt

18
Substituting for Dx

Suppose
dx = a( x, t )dt + b( x, t )dz
so that
Dx = a Dt + b  Dt
Then ignoring terms of higher order than Dt
G G  2G 2 2
DG = Dx + Dt + ½ 2 b  Dt
x t x

19
The 2Dt Term

Since   f(0,1), E () = 0

E ( 2 ) − [ E ()]2 = 1
E ( 2 ) = 1
It follows that E ( 2 Dt ) = Dt
The variance of Dt is proportion al to Dt 2 and can
be ignored. Hence
G G 1  2G 2
DG = Dx + Dt + b Dt
x t 2 x 2

20
Taking Limits

G G  2G 2
Taking limits : dG = dx + dt + ½ 2 b dt
x t x
Substituting : dx = a dt + b dz
 G G  2G 2  G
We obtain : dG =  a+ + ½ 2 b dt + b dz
 x t x  x
This is Ito' s Lemma

21
Application of Itô’s Lemma
to a Stock Price Process

The stock price process is

d S = mS dt + sS d z
For a function G of S and t
 G G  2G 2 2  G
dG =  mS + + ½ 2 s S dt + sS dz
 S t S  S

22
Examples
1. The forward price of a stock for a contract
maturing at time T
G = S e r (T − t )
dG = (m − r )G dt + sG dz

2. The log of a stock price

G = ln S
 s2 
dG =  m − dt + s dz

 2 

23
The Black-Scholes-Merton
Model

1
The Stock Price Assumption
• Consider a stock whose price is S
• In a short period of time of length Dt, the
return on the stock is normally distributed:

DS
S
(
  mDt , s 2 Dt )

where m is expected return and s is volatility

2
The Lognormal Property

• It follows from this assumption that

 s2  
ln S T − ln S 0    m − T , s T 
2

 2  
or
  s2  

ln S T   ln S 0 +  m − T, s T
2

  2  
• Since the logarithm of ST is normal, ST is lognormally
distributed

3
The Lognormal Distribution

E ( ST ) = S0 emT
2 2 mT s2T
var ( ST ) = S0 e (e − 1)

4
Continuously Compounded Return

If x is the realized continuously compounded return

S T = S 0 e xT
1 ST
x = ln
T S0
 s2 s2 
x    m − , 

 2 T 

5
 The Expected Return
• The expected value of the stock price is S0emT
• The expected return on the stock is

m – s 2/2 not m

This is because
ln[ E ( ST / S0 )] and E[ln( ST / S0 )]

are not the same

6
The Volatility
• The volatility is the standard deviation of the
continuously compounded rate of return in 1 year
• The standard deviation of the return in a short time
period time Dt is approximately

s Dt
• If a stock price is $50 and its volatility is 25% per year
what is the standard deviation of the price change in one
day?

7
 Estimating Volatility from Historical
Data
1. Take observations S0, S1, . . . , Sn at intervals
of t years (e.g. for weekly data t = 1/52)
2. Calculate the continuously compounded
return in each interval as:
 Si 
ui = ln 
 i −1 
S

3. Calculate the standard deviation, s , of the

ui´s s
4. The historical volatility estimate is: s
ˆ =
t

8
Nature of Volatility

• Volatility is usually much greater when the

market is open (i.e. the asset is trading) than
when it is closed
• For this reason time is usually measured in
“trading days” not calendar days when options
are valued
• It is assumed that there are 252 trading days in
one year for most assets

9
Example

• Suppose it is April 1 and an option lasts to April

30 so that the number of days remaining is 30
calendar days or 22 trading days
• The time to maturity would be assumed to be
22/252 = 0.0873 years

10
The Concepts Underlying Black-Scholes-
Merton
• The option price and the stock price
depend on the same underlying source of
uncertainty
• We can form a portfolio consisting of the
stock and the option which eliminates this
source of uncertainty
• The portfolio is instantaneously riskless
and must instantaneously earn the risk-free
rate
• This leads to the Black-Scholes-Merton
differential equation
11
The Derivation of the Black-Scholes-Merton
Differential Equation

DS = mS Dt + sS Dz
 ƒ ƒ 2ƒ 2 2  ƒ
Dƒ =  mS + +½ s S Dt +
 sS Dz
 S t S S
2


We set up a portfolio consisting of

− 1: derivative
ƒ
+ : shares
S
This gets rid of the dependence on Dz.

12
The Derivation of the Black-Scholes-Merton
Differential Equation

The value of the portfolio, , is given by

ƒ
 = −ƒ + S
S
The change in its value in time Dt is given by
ƒ
D = − Dƒ + DS
S

13
The Derivation of the Black-Scholes-Merton
Differential Equation continued

The return on the portfolio must be the risk - free

rate. Hence
D = r Dt
f  f 
- Df + DS = r  − f + S Dt
S  S 
We substitute for Dƒ and DS in this equation
to get the Black - Scholes differenti al equation :
ƒ ƒ  2
ƒ
+ rS +½ σ S 2 2
= rƒ
t S S 2

14
 The Differential Equation

• Any security whose price is dependent on the

stock price satisfies the differential equation
• The particular security being valued is
determined by the boundary conditions of the
differential equation.
• The boundary condition for European call
option is

The boundary condition for European put option

is

15
The Black-Scholes-Merton Formulas for
Options

c = S 0 N (d1 ) − K e − rT N (d 2 )
p = K e − rT N (− d 2 ) − S 0 N (− d1 )
ln( S 0 / K ) + (r + s 2 / 2)T
where d1 =
s T
ln( S 0 / K ) + (r − s 2 / 2)T
d2 = = d1 − s T
s T
16
The N(x) Function
• N(x) is the probability that a normally distributed
variable with a mean of zero and a standard deviation
of 1 is less than x

17
 Properties of Black-Scholes Formula

• As S0 becomes very large c tends to S0 – Ke-rT

and p tends to zero
• As S0 becomes very small c tends to zero and p
tends to Ke-rT – S0
• What happens as s becomes very large?
• What happens as T becomes very large?

18
Understanding Black-Scholes
(
c = e − rT N (d 2 ) S 0 e rT N (d1 ) N (d 2 ) − K )
e − rT : Present value factor
N (d 2 ) : Probability of exercise
S 0 e rT N (d1 )/N (d 2 ) : Expected stock price in a risk - neutral world
if option is exercised
K : Strike price paid if option is exercised

19
Implied Volatility

•The implied volatility of an option is the

volatility for which the Black-Scholes-
Merton price equals the market price
•There is a one-to-one correspondence
between prices and implied volatilities
•Traders and brokers often quote implied
volatilities rather than dollar prices

20
The VIX S&P500 Volatility Index

90
80
70
60
50
40
30
20
10
0

21
An Issue of Warrants & Executive Stock
Options
• When a regular call option is exercised the
stock that is delivered must be purchased in
the open market
• When a warrant or executive stock option is
exercised new Treasury stock is issued by the
company
• If little or no benefits are foreseen by the
market, the stock price will reduce at the time
the issue is announced.

22
The Impact of Dilution

• After the options have been issued it is not necessary to take

account of dilution when they are valued
• Before they are issued we can calculate the cost of each option
as N/(N+M) times the price of a regular option with the same
terms where N is the number of existing shares and M is the
number of new shares that will be created if exercise takes
place

23
Dividends

• European options on dividend-paying stocks are valued by

substituting the stock price less the present value of dividends
into Black-Scholes
• Only dividends with ex-dividend dates during life of option
should be included
• The “dividend” should be the expected reduction in the stock
price expected

24