Interest:

Simple This is interest you receive based on the amt initially invested
Compound Can be discrete or continious

Discrete If I get m interest payments at a rate r/m per year then (1+r/m)^m
is what I get in 1 year.

Continuous (1+r/m)^m= exp(m log (1+r/m)) ~ e^r for 1 year.

Or (1+r/m)^mt ~ exp(rt) after time t and m approaches infinity

*Assume everything is continuous compounded

Fixed income securities

ex: Depositing money to a bank. There are two types of interest payments
1) Fixed interest Coupon bearing bonds
2) Floating interest interest rate swaps

FORWARDS AND FUTURES

Forward Contract: agreement where 1 party agrees to buy an asset from another party
at some specified date and price. No $ exchanges hands until the delivery or
maturity date of contract.

The asset could be stock, currency , etc.

Delivery Price : Price you pay for asset at the delivery date. The price is at the
time the contract is entered into giving it a value=0 initially and changes to
underlying asset price delivery price.

Futures Contract: traded through a exchange. Profit/loss is calcuated everyday and

the change in this value is paid from 1 party to another. The value of a futures
contract is zero at any given time, but at maturity, the value of it must = asset
your buying.

No Arbitrage Principle Example:

Lets have 1 forward contract that we have to hand over an amount $F at time T
which is when we receive the underlying asset.
Suppose the current date is t and the price of the asset is s(t)= spot price. We
receive s(T)- F at the time of maturity which is unknown.

First we enter in a forward contract where we same time sell the asset called going
short.
We now have s(t) from selling the asset, contract, and a short asset position. But
our net position is zero. We put s(t) in something to receive interest.

At maturity we hand over $F and get the asset. This cancels the short position
regardless of s(T) and at maturity we are left with F in cash + the bank account.
Thus our net position at maturity =s(t)exp(-r(T-t))- F

Thus F= s(t)exp(-r(T-t)) since the value at t=0 is 0.

Options

- gives the holder the right to trade the future at a previous agreed price but
takes away that obligation to do so.

Call Option gives the right to buy an asset for an agreed amount at a specified
time in the future.

Terminology

Exercise or Strike Price: The price we pay for an asset on the expiry date.
Underlying Asset: The asset which we pay for.

Ex: Call option on Microsoft today is 24.5$ and we decide to buy it in 1 months
time for 25$. 25$ is the strike price.

Suppose the stock rose to 29$ at expiry. Then by exercising the call option we make
29$- 25$ = 4$.

Generally let S be the stock price and E be the exercise price then the option is
worth at expiry max(S-E,0). A option does have a cost as well.

Put Option: right to sell an asset for an agreed amount in the future.
Holder on the put option wants to price of the asset to drop so he can sell the
asset for more then its worth. Thus the value is max(E-S,0).
Put/Call options are called Vanilla since they are the simplest.

Necessary Terms:

Premium: price paid for the contract initially

Underlying asset: The financial instrument the option depends on. (Stocks etc)
denoted by S.
Strike Price: amount the underlying can be bought/sold denited by E.
Expiration: Date which the option can be exercised.
Intrinsic Value: Payoff that you would get at the assets current value.
In the Money: An option with a positive intrinsic value.
Out of the Money: An option with a negative intrinsic value.
At the Money: Intrinsic value = Payoff
Long Position: positive amount of a quanitity.
Short Position: negative amount of something or negative exposure to a quantity
like shorting assets.

Payoff Diagrams
Plot of value of an option at expiry vs underlying asset value.

Example
- Note: The premium of the call option was subtracted off the value denoted by S*
Writer of an Option: Person who promises to deliver the underlying asset if the
option is a call or buy it if a put option and receives the premium.

Valuation of an option b4 Expiry:

1) Depends on how high the asset price is.
2) How long there is b4 expiry.
3) Volatility: measure of the fluctuation in the asset price.
To determine fair value of an option:

Denote V(S,t)= mean value of an option depending on asset price S and time t.
V(S, t=T) = max(S-E, 0) = Pay off at expiry time T for a call option.

Variables: quantities that change over time.

Parameters: Dont change like strike price.

Gearing or Leverage:

Buy the Stock: If I buy the stock for $666 and by mid August it is $730 then
investment has increased by (730-680)/680x 100% = 9.6%

Buy the Call Option: I buy the option for 39$ and exercise the option by
paying $680 at xpiry. Then my ROI is

(value of an asset at expiry strike cost of call)/ cost of call x 100% =

(730- 680 39)/39 * 100% = 28%.

This is called gearing or leverage. This out of money option has a high gearing for
a small investment.

European Options: exercise only permitted at expiry.

American Options: allows exercise at anytime before or at expiry.

Put- Call Parity

Suppose you buy 1 euro call option and write 1 euro put option with the same strike
at expiry denoted E.

Payoff at T = max(S(T)-E,0)-max(E-S(T),0) = S(T)-E. It is given below.

Put Call Parity :
A Portfolio of a long call and short put is the same as long asset and short cash
position. The equality of these cashflows are independent of future behavior of
stocks and is model independent:

C P = S E exp(-rt) where C and P are today's value of Call/put options.

Binary Option: Options that have a payoff at expiry but has a discontinuous
underlying asset price.
Binary Call pays exactly x$ at expiry if asset price > E.
Binary Put holder gets x$ at expiry if asset price < E.
Put-Call Relationship: Binary Call + Binary Put = exp(-r (T-t))

Option Strategies:

Spread: A strategy involving the same type of options.

Bull Spread: portfolio of call options.

Ex: Buy 1 call option with strike = 100 and write a call option with
strike=120 with the same expiry. Basically

Payoff of a portfolio made up of call options with strikes E1 and E2 is

1/(E2-E1)*(max(S-E1,0)- max(S-E2,0)) where E2>E1.

Put Spread: portfolio of put options.

Ex. Write a put option with strike=100 and buy a put with strike=120.
 Straddle: Consists of a Call and a
Put option with the same strike.

Example: Suppose the stock today

is 35$ and I purchase 1 call and 1
put option with strike 40$ with
same expiry. If the stock goes to
45$ then I make 45$ -40$= 5$ at
most and lose out on the put
option.

Strangle: Consists of a call and put option but not with the same strike.
Note- Straddles/Strangle rarely held to expiry

Combination: Strategies involving both calls and puts.

Risk Reversal: combination of a long call with strike above current spot and a
short put with a strike below the current spot.
 Butterfly:
involving
buying and
sale of
options with
3 different
strikes.
Condor: Like
a butterfly
except
involving 4
strikes and 4
call options
are used.

Note- Useful
when the
market isn't
moving.

Calendar Spread: a strategy involving options with different expiry dates. Use
this to reduce the payoff at asset values and times which are irrelevant and
increasing the payout where you think its relevant.
Chapter 3: Binomial Model

Example: Suppose we have the following

1) A stock and a call option expiring tomorrow

2) The stock can rise/fall a known amount between today and tomorrow.
3) Interest rate=0.

Assume the current stock price S=100. It can be 101 tomorrow with p=0.6 and 99 with
p=0.4. If we buy a call option with expiry tomorrow, then the payoff=1 with p=0.6
and 0 with p=0.4. At the figure below the option payoff is 1 if the stock rises.

The option payoff = 0. Now we want to figure out what the portfolio is worth today.

If the stock rises to 101, the portfolio is with 1-1/2*101 and if it is at 99 then
its it worth 0-99/2 giving in both -99/2. With zero interest rate assumption the
portfolio is worth -99/2$.
Two ways to ensure we have -99/2 $ tomorrow.
1) Buy 1 option and sell of the stock.
2) Put the money in the mattress.

Both these portfolios are worth the same today so

?-1/2x100= option value -1/2x100 = -1/2x99 => ?= option value = .
This brings up 3 questions:
1) Why should the theoretical price be the market price?
Reason: There is risk free $ to be made. If the option costs < then buy it
and hedge it. If it is > , then sell it and hedge.

2) How did I know to sell of the stock for hedging?

: Let delta be the quantity of stock for hedging. Starting with 1 option,
- of the stock which gives a portfolio value of
?- x 100 and tomorrow it is worth 1- x 101 if the stock rises or
0- x 99 if it falls.
Now we make these two equal and get

1- x 101 = 0- x 99 => Solving for we get 0.5.

Based on our assumption that we are trading zero interest we get that
?- x 100 = 0- x 99 => ?= . So the option value = as well.

Delta Hedging: Choosing a such that the value of the portfolio does not
depend on the direction of the stock.

= Range of Option Payoffs/ Range of Stock Prices

Note:

If we have an interest rate, we delta hedge as b4 to create a riskless

portfolio, but we Present value that back in time by multiplying by the discount
factor.

Example:
Suppose r=0.1, then the discount factor going back one day is
1/(1+.10/252)=.9996. Thus the portfolio value today is the present value of the
portfolio tomorrow. Thus

? - 0.5 x 100 = - 0.5 x 99 x .9996 => ?=.51963.

3) Is the stock itself correctly priced?

We usually want to pay less then the expected value because stocks are
volatile, and we want a positive expected return. In this case the expected value
tomorrow is 0.6*101+0.4*99 = 100.2.

Complete Markets: Options are hedgeable and can be priced without knowing
probabilities.
Option Payoffs can be replicated with stocks and cash, so any two points on
the line can be used to get to any other point.

Getting the option price from stock and cash by replication.

Example: Risk Neutral World

Suppose that you know the stock is currently 100$ and that it could rise or
fall 101$ or 99$. Then the risk neutral probabilities p is
 p x 101* (1-p)*99 = 100 => p = .50 which really makes no sense.

Now the option value is 0.5 x 1 + 0.5x 0 = 0.5. Also called risk neutral
expectation.

*2 wrongs make a right. Find a probabilistic from the price and then finding option
pricing via probabilities.

Non-Zero Interest: Allow for present valuing

Ex: If r=0.1 then .9996*(p*101+(1-p)x99)=100 => p=.5184. Then find the expected
option payoff as above with p.

Formal Binomial Model: (pg 102)

Notation:
Let S = initia; value of asset
Let t= time step
where the asset can rise by u x S or fall v x s with 0<v<1<u. Below summarizes what
we are formalizing a.k.a random walk.

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