Kevin NAJJAR HEC Paris | 1

Financial Markets
Holding Period Return is composed of capital gain and dividend yield, r is the return on equity.

Expected Dividend Yield

Constant growth dividend discount model CGDDM, T periods, V is the intrinsic value:

Dividend discount model

We assume DDM, the intrinsic value of perpetuity, Gordon formula, g is the growth rate of the firm

Market capitalization

Present Value of Growth opportunities, E is the earning per share

Plow back (retention) ratio

Growth rate of the stock

Total Earnings from assets in place and the new project

Price Earnings Ratio

Kevin NAJJAR HEC Paris | 2

Flexbolt is trading at 15 times its next year earnings

Bonds
Determined by Maturity T, Coupon C , Face Value N, Frequency k and Coupon Rate i

1. Zero-coupon bonds = Pure discount bonds

2. Perpetual bonds, T->
3. Coupon bonds
4. Floating rate bonds, coupon is not constant
5. Convertible bonds, convertible into shares
6. Callable bonds, can be bought back

Current Yield,

y is yield-to-maturity so that following equation is satisfied: CALCULATOR

Properties:
AT PAR
AT PREMIUM
AT DISCOUNT
Zero coupon bond:

Kevin NAJJAR HEC Paris | 3

Discount factor

Forward rates

The following relationship holds

With
Notation

Price of a bound

COUPONS ARE ALSO PAID AT THE END, WITH FACE VALUE!!!

No arbitrage opportunity, system of equations as function of years and situations. Find n i

Forwards and Futures

Buyer of a future (buys asset in future) has a long position
Seller of the future has a short position (has to sell the asset)
Forward price = delivery price in future, fixed at t=0 = P0

Kevin NAJJAR HEC Paris | 4

Spot price = actual price of underlying asset

Forwards are traded in Over The Counter markets (OTC), Futures are traded on an exchange
|

| at date t=T are |

Value of a forward at date t

Price adjustment of a forward

Forward with income

Price of a forward with income

at date t
(

Price of a forward with incomes C every month and none -flat term structure
(

])

Arbitrage opportunities
Basics
OVERVALUED

Tu achtes lasset sur credit de la banque et en m me temps tu short-sell un forward (en gros tu te
prends pour un vendeur de forward alors que tu ne les pas).
CF0

CF1

1. short the forward

F0-S T

2. short riskless asset (borrow):

S0

-S o

3. buy underlying security:

-S 0

ST

1. Buy the forward

-(F0-S T)

2. Borrow the underlying asset

S0

-S T

3. Invest in riskless asset for T years

-S 0

So

UNDERVALUED

Kevin NAJJAR HEC Paris | 5

Elaborated
Forward on coupon paying bond
OVERVALUED
CF0

CF1

CF2

CF3

CF4

FO,overvalued-

2.1 Borrow C1

-C1

2.2 Borrow C2

-C2

2.3 Borrow C3

-C3

2.4 Borrow C4

-C4

2.5 Borrow Face V

- FO,fair

C1

C2

C3

C4+

1. Sell forward

3. Buy the bond

-Po

Futures on stock index with dividends (1 Stage)

UNDERVALUED
CF0
1. Buy Index futures

CF1

2. Short-Sell the Index

3.1 Invest riskless
3.2 Invest riskless

Futures on stock with dividends (2 Stages) (UNDERVALUED) Problem 7 p.24

Forward on exchange rates (OVERVALUED) Problem 3 p.23
Forward on animal with income and cost (OVERVALUED & UNDERVALUED) Problem 6 p.23

Kevin NAJJAR HEC Paris | 6

Options
Option premium = price of an option (Slide 13)
Strike or exercise price = predetermined price = K

Call option gives the right to purchase the underlying asset at date T for European Option and at
date t
for the American Option.

Put option gives the right to sell

Possible positions: long on call, short on call, long on put, short on put
Traded on Exchanges or OTC Markets
Out, at, in the money if S T is smaller, equal or greater than K
Payoffs (t=T) or intrinsic value (t<T) are either 0 or |

Spread trading strategy = buy options for same stock but with different K
Bull 1 long call, 1 short call
bear 1 short put, 1 long put,
butterfly 1 long call, 1 long call, 2 short call
straddle long call and long put on same strike price

Kevin NAJJAR HEC Paris | 7

is the state price under state of world i, or the PV of 1$ delivered at time T of world state i.
Price of a call option at date 0, useful to obtain no-arbitrage bounds for price

Kevin NAJJAR HEC Paris | 8

Result for European Call option, Lower Boundary

{

Put-call parity relationship, if options are bought on same asset with same maturity and strike price

A synthetic call is composed of a long position in stock, a short position in the discount bond with face
value K (borrow at risk free rate) and a long position in a European put with face value K.
Everything holds only for non-dividend paying stocks. For dividend paying stocks it might be optimal to
exercise American before maturity.

Binomial trees
State Price method
the PV of $1 to be received in state up of the world. Stock price :
the PV of $1 to be received in state down of the world.

Risk free zero-coupon bond B that sells today for

and pays a risk free rate

(

From the system of equations we get the two state prices:

under both states

Kevin NAJJAR HEC Paris | 9

Law of one price = Replicating portfolio : Crer un systme dequation avec:

{
Solve for

Works for options with maturity 1 year

In case of dividends:
{
In case of an American Call Option arbitrage can be made at t=0 if Option price is lower than the
difference between the asset price and the exercise pr ice.

Options Arbitrage
Replicating Portfolio Method
Create a portfolio composed of

stocks and

zero-coupon bonds

If n is negative, we short-sell

If several periods self-financed dynamic arbitrage strategy

Kevin NAJJAR HEC Paris | 10

Arbitrage portfolio is composed of Replicating portfolio and an option position ,

Regarder les arbres comme des arbres de probabilit

Two period model

Properties do not necessarily hold for puts. (Slide 44), n-period model Pb10

Exercises
Can you build an arbitrage portfolio?
Compare effects of Options between them and see if one can be built with the others in terms of payoffs.
If yes, compare the prices. They should be the same .

Recognize Arbitrage:
1. Draw every single Payoff graph independently
(long & shorts, so 2 graph per possible derivative/asset, dont forget the asset itself)
2. Try to find combinations (curve additions) that end up giving another derivatives graphs
Or try to have a 0- Payoff line
3. Once such a combination is found, compare the prices
-> Do Arbitrage (Table with payoffs)
If Put is undervalued: Sell Put, Buy Call, Sell Stock, invest at risk-free
CF0

CF1 (St<K)

CF1(St>K)

St-K

Sell Put

St-K

Short-sell Stock

-St

-St

Buy call

Invest risk free

-Rest

Kevin NAJJAR HEC Paris | 11

If Put is overvalued: Buy Put, Sell Call, Buy Stock, borrow at risk-free (Dividends included)
CF0

CF1 (St<K)

CF1(St>K)

Sell call

K-St

Buy Put

K-St

Buy Stock

St+FV(D)

St+FV(D)

Borrow risk free

Rest