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0 S T
F F
1 2
Sold forwards
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ADVANCED FINANCIAL THEORY
Futures: Marking-to-market
Exchang
rate Mark-to-market
t+1 Mark-to-market
EUR / t+2
100 USD
Profit
90
• Expectations theory :
F t,T = E ( S T)
• Price given by a no-arbitrage condition,
Extended Cost-of-Carry
F t,T = S t + I + C - B
where
Ft,T = price now(at time t) for a forward contract with maturity T
St = today's spot rate
I = interest gained (during T-t) if we buy using a forward contract (instead of
now)
C = other costs saved by a forward transaction (e.g. storage costs during T-t)
B = gain which is lost if a forward transaction is made instead of a spot
• lost dividend (stock and index futures)
• lost interest coupon payment (bond futures)
• lost currency deposit rate as compared to buying at once, in which case you
@ EVA LILJEBLOM 61
ADVANCED FINANCIAL THEORY
could depositing foreign currency and earn an interest rate (currency futures)
• Convenience yield (futures on physical assets) => the gain from "having oil".
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ADVANCED FINANCIAL THEORY
FRA-interest rate forwards are forward contracts based on forward rates on the
money market (which can be Computed from existing money market spot
rates).
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ADVANCED FINANCIAL THEORY
N
2. F t,T = S t - PV(Divi ) * (1 + r )T-t =>
i=1
N
Divi
F t,T = S t - * (1 + r )T-t
i=1 (1 + rti )ti
• Currency forwards
Covered interest parity (a no-arbitrage condition) gives:
@ EVA LILJEBLOM 64
ADVANCED FINANCIAL THEORY
6. Options
An option gives a right, but no obligation, to buy (a call
option) or sell (a put option)
- a fixed amount (contract size) of the underlying asset
- at a settled price (strike price, excercise price)
- during a time (American options) or at maturity (on expiration
day=> Euroopean options).
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ADVANCED FINANCIAL THEORY
X1 S S
X2 T X X T
1 2
X1 X2
X1 X2 S S
T T
Calls Puts
S>X In-the-money Out-of-the-money
S=X At-the-money At-the-money
S<X Out-of-the-money In-the-money
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ADVANCED FINANCIAL THEORY
Value Value
now now
S S
t t
Time value
Intrinsic value
@ EVA LILJEBLOM 67
ADVANCED FINANCIAL THEORY
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ADVANCED FINANCIAL THEORY
) )
Value Value
now now
S S
t t
( )
)
),
)
) )
) )
@ EVA LILJEBLOM 69
ADVANCED FINANCIAL THEORY
• American options
Example 1: Two dividend days t1 and t2 during the life of an American call
option.
• Since time always increases the value of a call option if no dividends are paid
out, we can eliminate many of these alternative European options to value. What
will be left is the options used just before an ex-dividend day, and the one held
t1- t2- T
to expiration, i.e. C E,t , C E,t , and :C E,t :
• CA,t Max 0
S - X /(1+r)t1
S - Div1/(1+r)t1 - X /(1+r)t2
S - Div1/(1+r)t1 - Div1/(1+r)t2- X /(1+r)T
Example 2: Two ex-dividend days during the life of an American put. Div1
is the lowest possible dividend.
• PA, t Max 0
X-S
X /(1+r)t1 - S + Div1/(1+r)t1
X/(1+r)t2 - S + Div1/(1+r)t1+ Div1/(1+r)t2
@ EVA LILJEBLOM 70
ADVANCED FINANCIAL THEORY
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ADVANCED FINANCIAL THEORY
Since cash flows at maturity are equal => both strategies must cost the
same now, initially.
(Otherwise arbitrage!)
90
80
70
60 C
50
X
40
30 Kok.pos.
20
10
0
50 60 70 80 90
90
80
70
60 P
50
S
40
30 Kok.pos.
20
10
0
50 60 70 80 90
@ EVA LILJEBLOM 72
ADVANCED FINANCIAL THEORY
- Bad to buy at high cost for calls (X, C), good to sell at high
cost for puts (X, P)
=> you save the time value of money for the strike price X
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ADVANCED FINANCIAL THEORY
=> Option would dominate spot deal unless the saved interest
rate on X would be included in its price
=> no-arbitrage restriction requires that the call is worth more,
by an amount equaling the time value of money otherwise
saved!
• Puts => you sell, but obtain the price X later => loose the
time value of money on X => puts worth less.
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ADVANCED FINANCIAL THEORY
Calls
25
20 std. 0.1
std. 0.3
15
std. 0.5
10
std. 0.7
5
std. 0
0
50 60 70 80 90
Puts
25
20 std. 0.1
std. 0.3
15
std. 0.5
10
std. 0.7
5 std. 0
0
50 60 70 80 90
@ EVA LILJEBLOM 75
ADVANCED FINANCIAL THEORY
Time
t0 t1 t2 t3
If the volatility of one period (t0 => t1) is 1, the volatility of two
periods (t0 => t2) is 1* 2 , and of n periods (t0 => tn) is 1 * n.
=> If the volatility per unit of time stays the same => when
longer time passes, even large stock price changes can occur
with higher probabilities
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ADVANCED FINANCIAL THEORY
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ADVANCED FINANCIAL THEORY
Osto-optiot
30
25 aika 3 kk
20 aika 6 kk
15 aika 9 kk
10 aika 12 kk
5 aika 0
0
50 60 70 80 90
Myynti-optiot
20
18
16 aika 3 kk
14
aika 6 kk
12
10 aika 9 kk
8
aika 12 kk
6
4 aika 0
2
0
50 60 70 80 90
@ EVA LILJEBLOM 78