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FIN1 - Sammanfattning
FIN1 - Sammanfattning
Valuing decisions
The rst step in decision making is to identify the costs and bene ts of a decision. The
next step is to quantify these costs and bene ts. In order to compare the costs and
bene ts we need to evaluate them in the same terms - cash today.
A competitive market is a market in which goods can be bought and sold at the same
price - that price determines the cash value of the said goods. By evaluating costs and
bene ts using competitive market prices we can determine whether a decision will make
the rm and its investors wealthier. In extension, the valuation principle means that the
value of an asset to the rm or its investors is determined by its competitive market price.
The bene ts and costs of a decision should be evaluated using these market prices, and
when the value of the bene ts exceeds the value of the costs the decision will increase
the market value of the rm.
r = interest rate
Present value (PV) = the value in terms of SEK today
Future value (FV) = the value in terms of dollars in the future
Interest rate factor = 1+r
Discount factor = 1/1+r one year discount factor
Discount rate = the risk free interest rate is also referred to as the discount rate for a risk
free investment
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Present value and the NPV rule
One should always accept all NPV with value of 0 or higher when the possibility arises.
Regardless of our preferences for cash today versus cash in the future, one should always
maximise NPV rst. We can then borrow or lend to shift cash ows through time and nd
our most preferred pattern of cash ow.
Important to note is that the risk free interest rate equals the percentage gain that you
earn from investing in the bond, which is called a bond return. When assets trade at no-
arbitrage prices the cost and bene t are equal in a normal market and so the NPV of
buying an asset is zero.
In a competitive market, if a trade o ers a positive NPV to one party it must give a
negative NPV to the other party, because all trades are voluntary they must occur at
prices at which neither party is losing value and therefor for which the trade of zero NPV
(no value created). Instead, value is created by real investment projects in which a rm
engages in developing new products, opening news stores or creating more e cient
production methods.
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The separation principle = asset transactions in a normal market neither create nor
destroy value on their own, therefore we can evaluate the NPV of an investment decision
separately from the decision the rm makes regarding how to nance the investment
(borrowing or add stocks) or any other asset transactions the rm is considering
Portfolio = collection of assets/securities. Because asset C is equivalent to the portfolio
of A and B, by the Law of One Price, they must have the same price. This idea leads to
the relationship known as value additivity
Value additivity = the price of C must equal the price of the portfolio, which is the
combined price of A and B. The cash ows of the rm are equal to the total cash ows of
all projects and investments within the rm, therefore, value addivity, the price or value of
the entire rm is equal to the sum of the values of all projects and investments within it. To
maximize the value of the entire rm managers should make decisions that maximize NPV
Risk premium = the risk premium of an asset represents the additional return that
investors expect to earn to compensate for the asset/security risk. Because investors are
risk averse the price of a risky asset cannot be calculated by simply discounting its
expected cash ow at the risk-free interest rate, they want their risk premium. Rather,
when a cash ow is risky, to compute its present value we must discount the cash ow
we expect on average at a rate that equals the risk free interest rate plus an appropriate
risk premium. To eliminate any arbitrage opportunity, the highest bid-price should be
lower than the lowest ask price
An investor shall always draw a timeline with a stream of cash ows. There are 3 rules for
time travel:
- it is only possible to compare or combine values at the same point in time
- rule 1 can be applied with compounding (moving a value or cash ow forward in time)
by Cx(1+r)^n where n is the number of years in the future. This may lead to the e ect of
earning interest on interest which is known as compound interest
- the process of moving a value or cash ow backward in time is known as discounting,
and it’s done with PV=C/(1+r)^n
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The present value of a cash ow stream is the summation of the discounted values:
The NPV of an investment opportunity is also the present value of the stream of cash
ows.
Sometimes, we know the present value or future value but do not know one of the
variables we have previously been given as an input. In such situations. We use the
present and/or future values as inputs then solve for the variable we are interested in.
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Internal rate of return (IRR) = the interest rate that assets the net present value of the
cash ows equal to zero. In a few cases it is impossible to solve the IRR directly. One
other approach is to use trial and error to nd the IRR or other variables than the IRR
One interpretation of the internal rate of return is the average return earned by taking on
the investment opportunity. The IRR investment rule is based on this idea.
IRR Investment Rule = an investor skall take any opportunity where the IRR exceeds the
opportunity cost of capital. Turn also down any opportunity where IRR is less than the
opportunity cost of capital
NPV Decision Rule = when making an investment decision you shall always choose the
alternative with the highest NPV due to choosing this alternative being equivalent to
receiving its NPV in cash today
NPV pro le = a graph of the project’s NPV over a range of discount rates
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Pitfalls with the IRR rule
There are several situations in which the IRR fails:
- during delayed investments
- when there are multiple IRRs present
- when there exists no IRR
Delayed investments
Imagine someone o ers you a million SEK upfront to write a book that takes 4 years to
write which would mean having to stop working in order to write the book, which would in
turn mean you forgo a certain amount of money as alternative income. For most
investment opportunities the expenses occur initially and cash is received later, but in this
case you receive cash upfront which incurs the costs of producing the book later. It is as
if you borrowed money, receiving money today for a future liability (and when you borrow
money you prefer as low a rate as possible. In this case IRR better represents the rate
that you are paying rather than earning - the optimal choice is then to borrow money so
long as this rate is less than the cost of capital.
Multiple IRRs
Imagine that you would like the publisher to sweeten the deal before accepting to write
the book. In response, the publisher o ers to give you a royalty payment when the book
is published in exchange for taking a smaller upfront payment. This deal would entail that
you get one million SEK in 4 years after publishing the book and only 500K SEK as
upfront payment. In this case there exist multiple IRRs, which leads us to relying on the
NPV rule instead.
Nonexistent IRR
Imagine after your latest negotiations that the publisher is willing to increase your initial
payment to 750K SEK in addition to the 1 million SEK royalty when the book is published
in 4 years. With these cash ows there exists no IRR which means that there is no
discount rate that makes NPV equal to zero, thus the IRR rule provides no guidance
whatsoever.
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Equivalent Annual Annuity (EAA) = is a method of evaluating projects with di erent life
durations used as a metric for determining how nancially e cient projects are. It
smoothes out all cash ows and generates a single average cash ow for all periods that
(when discounted) equal the project’s NPV which means that a high EEA is more
attractive
The result is that Project A has a higher EAA which implies that it also has a higher NPV,
therefore should the investor choose Project A.
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The Payback Rule = states that you should only accept a project if its cash ow pay
back its initial investment within a pre-speci ed time period. To apply the rule we must
rst calculate the amount of time it takes to pay back the initial investment (called the
payback period) and then accept the project if the payback period is less than a pre-
speci ed length of time (usually a few years)
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INTEREST RATES
Interest rates are generally stated a an annual rate, thought the payments themselves
may occur at di erent intervals such as monthly or quarterly. When evaluating cash ows
however, we must use a discount rate that matches the time period of our cash ows -
this discount rate should re ect the annual return we could earn over that time period.
Adjusting the discount rate to di erent periods is important since we want to know
what the total interest earnings for these 2 years look like. With this, we could also
calculate the interest earnings for periods shorter than a year, for example half year.
By raising the interest rate factor (1+3) to the appropriate power, we can compute an
equivalent interest rate for a desired time period, in this case half a year:
Since the APR doesn't itself re ect the true amount that we earn over one year it is
important to remember that we then cannot use APR itself as a discount rate, instead the
APR with a k amount of compounding periods is a way of quoting actual interest earned
each compounding period.
Once we computed the interest earned per compounding period we can then compute
the EAR by compounding using the rst formula on this page. The e ective annual rate
corresponding to an APR with k compounding periods per year is given by the following
conversion formula:
This means that when working with APR we must rst divide the APR by the number of
compounding periods per year to the determine the actual interest rate per compounding
period, and then compute the appropriate discount rate by compounding the rst formula
on this page. Once these step are completed, we can then use the discount rate to
evaluate the present or future values of a set cash ows.
Nominal interest rate = indicates the rate at which your money will grow if invested for a
certain period of time
Real interest rate = indicates the growth of your purchasing power after adjusting for
in ation
Growth in purchasing power is therefore calculated by dividing the growth of money with
the grow of prices!
This in turn means that the greater the risk, the greater the possibility of return. The
potential gap between what you're willing to pay for the bond and what you're going to
get determines the amount of risk involved with the trade.
BONDS
A bond is a security sold by governments and corporations to raise money from investors
today in exchange for promised future payments. A bond certi cate shows the terms of
the bond, for example:
- maturity date (the time remaining until the repayment date, also known as the term of
the bond)
- coupons (the promised interest payments of a bond)
- coupon rate (the amount of each payment)
- face value (the notional amount used to compute interest payments)
Zero-Coupon Bonds
This is the simplest type of bond, which does not make coupon payments. The only cash
payment the investor receives is the face value of the bond on the maturity date. Zero-
Coupon bonds generally trade at a discount, aka a price lower than the face value, which
is why they're also called pure discount bonds.
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YTM = yield to maturity, which is the IRR of an investment in a bond
Coupon Bonds
Coupon bonds also pay investors their face value at maturity, but in addition to that they
also make regular coupon interest payments. These can be treasury notes (original
maturities from 1 to 10 years) and treasury bonds (original maturities of more than 10
years).
The YTM of a coupon bond can also be computed. Remember than the YTM of a bond is
the IRR of investing in it and holding it to maturity - it is the single discount rate that
equates the present value of a bond's remaining cash ows to its current price, as below:
Because the coupon payments represent an annuity, the YTM is the interest rate y that
solves the formula:
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Here is an example for the price of a coupon bond:
The risk-free interest rate for an investment until date n equals the YTM of a risk-free
zero-coupon bond that matures on date n. A plot of these rates against maturity is called
the zero-coupon yield curve. The YTM of a coupon bond is the discount rate y, which
equates the present value of the bond's future cash ows with its price:
When a bond issuer does not make a bond payment in full, the issuer has defaulted (the
risk that default can occur is called default/credit risk).
Constant dividend growth model = states that the value of the rm depends on the
dividend level for the coming year divided by the equity cost of capital adjusted by the
expected growth rate of dividends
Dividend = a distribution of cash or stock to a class of shareholders in a company
(dividends are drawn from a company's retained earnings and therefore based on them
for the most part)
STOCK VALUATION
The Law of One Price implies that to value any security we must rst determine the
expected cash ows an investor will receive from owning it, thus we begin our analysis of
stock valuation by considering the cash ows for an investor with a one-year investment
horizon. We then consider the perspective of investors with longer investment horizons.
Imagine buying a stock for 50SEK. One year later you sell the stock for 50,50SEK, but
before that you managed to get a dividend as well, worth 1,50SEK. In this case, your total
return is worth 2SEK, which is a 4% return on the investment. Of these 4%, the dividend
yield stands for 3% and the increase in stock price stands for 1%. You invest now (period
0) into a stock with the current price p0, only to sell it a year later (period 1) ,where your
total return amounts to dividend1+p1 (where p1 represents the price of the stock in
period 1).
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These are the results of someone investing one year into the future. For a multiyear
investor the calculations are di erent. For example, if we planned to hold the stock for 2
years, we would receive dividends in both year 1 and year 2 before selling the stock, as
shown below:
Of course, the future dividend payment and stock price in the timeline above are not
known with certainty, rather these values are based on the investor’s expectations at the
time the stock is purchased. Given these expectations, the investor will be willing to buy
the stock at today’s price as long as the NPV of the transaction is not negative - aka as
long as the current price does not exceed the present value of the expected future
dividend and sale price. Because these cash ows are risky, we can’t compute their
present value using the risk-free interest rate, instead we must discount them based on
the equity cost of capital, rE, for the stock, which is the expected return of other
investments available on the market with equivalent risk to the rm’s shares. The investor
is willing to then buy the stock under these conditions:
For an investor to be willing to sell the stock, she must receive at least as much today as
the present value she would receive if she waited to sell next year:
But because for every buyer of a stock there must a seller, both equations must then
hold, therefore the stock price should satisfy:
Setting the stock price equal to the present value of the future cash ows in this case
implies:
As a two-year investor, in this case, we care about the dividend and stock price in year 2,
which would imply that if you’re a one-year investor you would then not care about these
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numbers for year 2. While a one-year investor doesn’t really directly care about the
dividend and stock price in year 2, she has to care about them indirectly since they will
a ect the price for which the investor can sell the stock for at the end of year 1. This
means that the formula for the stock price for a two-year investor is the same as the one
for a sequence of two one-year investors!
This process can be continued for any number of years by replacing the nal stock price
with the value that the next holder of the stock would be willing to pay. Doing so leads to
the general dividend-discount model for the stock price where the horizon N is arbitrary
and dependent on the speci c exercise done:
In the end, investors do this to earn money, therefore what we’re looking for is the
maximum amount of total return, calculated by:
Because the expected dividends are a constant growth perpetuity, we can calculate their
present value and then obtain the following formula for the stock price:
Constant dividend growth model = a model that shows that the value of the rm
depends on the dividend level for the coming year divided by the equity cost of capital
adjusted by the expected growth rate of dividends
The total payout model instead values all of the rm’s equity rather than a single share. To
do so we discount the total payouts that the rm makes to shareholders, which is the
total amount spent on both dividends and share repurchases, then we divide by the
current number of shares outstanding to determine the share price.
Enterprise value = the value of the rm’s underlying business, unencumbered by debt
and separate from any cash or marketable securities. We can interpret the enterprise
value as the net cost of acquiring the rm’s equity, taking its cash, paying o all debt and
thus owning the unlevered business
The advantage of the discounted FCF model is that it allows us to value a rm without
explicitly forecasting its dividends, share repurchases or its use of debt. To value an
enterprise we compute the present value of the free cash ow that the rm has available
to pay all investors, both debt and equity holders. FCF measures the cash generated by
the rm before any payments to debt or equity holders are considered. Just as we can
determine the value of a project by calculating the NPV of its free cash ow, so can we
estimate a rm’s current enterprise value V0 by computing the present value of the rm’s
free cash ow:
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When we are looking at the entire rm, it is natural to de ne the rm’s net investment as
its capital expenditures in excess of depreciation:
Net investment = investment intended to suppor the rm’s growth, above and beyond
the level needed to maintain the rm’s existing capital
Depreciation = a way to calculate the reduction in value of an asset due to use, wear and
tear or obsolescence (used for intangible assets)
Amortization = paying o a debt over time (used for tangible assets)
Net working capital = how much cash we have “stuck” in for example inventory (an
increase here would a ect cash ow negatively)
Capital expenditures = money that the rm outlays in order to expand or maintain its
operations, upgrade/replace its machines/property etc
WACC = stands for weighted average of cost of capital and is the average cost of capital
the rm must pay to all its investors, both debt and equity holders (if the rm has no debt
then rwacc=rE but if the farm has debt then rwacc is an average of the rm’s debt and equity
cost of capital). WACC is then interpreted as re ecting the average risk of all of the rm’s
investments
FCF = stands for free cash ow and is calculated by EBIT(1- taxes) - depreciation -
capital expenditure - the increase in working capital)
Expected Return
Given the probability distribution of returns, we can now compute the expected return.
We calculate the expected return as a weighted average of the possible returns where the
wrights correspond to the probabilities.
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Expected Value
The expected value of an investment can also be called “the mean of a random variable
x” where the variable x represents in this case a random stock or any other kind of
investment. This is our expectation of x. The expected value corresponds to the average
outcome if we invest in x many times over, therefore if we invest in x once then the
expected value cannot be the outcome.
If the return is risk-free and never deviates from its mean then the variance is zero.
Otherwise, the variance increases with the magnitude of the deviations from the mean,
therefore the variance is a measure of how “spread out” the distribution of the return is.
In nance, we refer to the standard deviation of a return as its volatility aka how much an
investment deviates from its expected returns.
In nance, we would also like to diversify our investments, so as to not put all of our eggs
in the same basket. For that we have to compute the covariance of investments,
meaning how similarly investments move (if two stocks move almost the same then
investing in both does not achieve diversi cation). Covariance stands for co-movement.
Since the covariance between X and Y can take any value, it is hard to interpret the
resulting number. Instead, we may use a correlation coe cient for X and Y. The coe cient
Pxy is always between 1 and -1.
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The formula for covariance is:
Historical Returns
Out of all possible returns, the realised return is the return that actually occurs over a
particular time period.
Suppose that you invest in a stock on date t for price Pt. If the stock pays dividend Divt
on the date of t+1 and you sell the stock at that time for the price of Pt+1 then the
realised return from your investment in the stock from t to t+1 is:
The portfolio weights add up to 1, so that they represent the way we divided our money
between the di erent individual investments in the portfolio. Think of it as percentage of
the total value of portfolio, where 1 represents 100% and likewise 0,2 represents 20%
etc. Consider a portfolio with 200 shares of the stock D and 100 shares of the stock C.
The corresponding portfolio weights are as follows:
Given the portfolio weights we can calculate the return on the portfolio. Suppose x1, x2
etc are the portfolio weights of the n investments in a portfolio, and these investments
have returns R1, R2 etc, then the return on the portfolio RP is the weighted average of the
returns on the investments in the portfolio where the weights correspond to portfolio
weights:
After understanding how to calculate expected return and volatility of a portfolio, we can
now try and create an e cient portfolio. Generally, an e cient portfolio will have
maximised return and minimised volatility.
Short Sales
So far we have only considered portfolios in which we invest a positive amount in each
stock, thus we refer to a positive investment in a security as a long position in the
security. It is though also possible to invest a negative amount in a stock, called a short
position, by engaging in short sales (a transaction in which you sell a stock today that
you do not own, with the obligation of buying it back in the future).
Risk vs Return
Variations in the risk associated with or the price of an individual stock are mainly of two
types, rm-speci c (risks and variations speci c to the rm) and market-speci c (risks
and variations speci c to all rms in a market). Important to note is that rm-speci c risk
does not lead to higher expected return, thus the term “high risk, high return” should
instead be “high systematic risk, high expected return”!
You can also borrow money to invest. Borrowing money to invest in stocks is referred to
as buying stocks on margin or using leverage. A portfolio that consists of a short
position in the risk-free investment is known as a levered portfolio.
The Sharpe ratio measures the ratio of reward-to-volatility provided by a portfolio where
the optimal portfolio to combine with the risk-free asset will be the one with the highest
Sharpe ratio, where the line with the risk-free investment just touches (and so is tangent
to) the e cient frontier of risky investments. The portfolio that generates this tangent line
is known as the tangent portfolio.
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Another type of portfolio is the market portfolio, which is a portfolio created out of all
available risky nancial assets in an economy. The market portfolio uses weights as
relative market value of each one of these nancial assets. According to CAPM, the
forces of nancial marktes will make the market portfolio and tangent portfolio equal.
The required return is the expected return that is necessary to compensate for the risk
that our investment will contribute to the portfolio. The required return for an investment is
equal to the risk-free interest rate plus the risk premium of the current portfolio, scaled by
the investment’s sensitivity to the portfolio.
The beta of investment i with portfolio P is de ned with the help of combining the
volatility and correlation terms of the following equation:
When the CAPM assumptions hold, the market portfolio is e cient, so the tangent
portfolio then becomes the market portfolio. When the tangent line goes through the
market portfolio it is called the capital market line (CML). According to CALM, all
investors should choose a portfolio on the capital market line, by holding some
combination of risk-free security and the market portfolio.
Since the market portfolio in this case is the e cient portfolio, if we don’t know the
expected return of a security or the cost of capital of an investment, we can use the
CAPM to nd it by using the market portfolio as a benchmark.
Knowing that there is a linear relationship between a stock’s beta and its expected return,
we can see (in the picture below) that there is a line going through the risk-free investment
with a beta of 0 and the market with a beta of 1 - that is called the security market line
(SML). Under the CAPM assumptions, the security market line is the line along which all
individual securities should lie when plotted according to their expected return and beta.
Because the security market line applies to all tradable investment opportunities, we can
apply it to portfolios as well. Consequently, the expected return of a portfolio depends on
the portfolio’s beta, which we can calculate as follows:
In other words, the beta of a portfolio is the weighted average beta of the securities in the
portfolio!
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OPTIONS
A nancial option contract gives its owner the right to purchase or sell an asset at a xed
price at some future date. These can be split into 2 types of contracts, call options and
put options. A call option gives the owner the right to buy the asset, while a put option
gives the owner the right to sell the asset. Since an option is a contract between two
parties, there is also an option writer aka the person who takes the other side of the
contract.
When a holder of an option enforces the agreement and buys or sells a share of stock at
the agreed-upon price, he is exercising the option. The price at which the holder buys or
sells the share of stock when the option is exercises is called a strike/exercise price.
There are 2 kinds of options - American options and European options. American
options, the most common kind, allow their holders to exercise the option on any date up
to and including a nal date called the expiration date. European options though only
allow their holders to exercise the option on the expiration date exactly. The option buyer,
also called the option holder, has then a long position in the contract, while the option
seller, also called the option writer, has a short position in the contract.
The reason selling options is lucrative is because options always have positive prices,
thus if you sell an option you get paid for it. The market price of the option is also called
the option premium. This upfront payment compensates the seller for the risk of loss in
the event that the option holder chooses to exercise the option.
The total number of outstanding contracts of a speci c option is called open interest.
When the exercise price of an option is equal to the current price of the stock, the option
is said to be at-the-money. If the payo from exercising an option immediately is
positive, the option is said to be in-the-money. Call options with strike prices below the
current stock price are in-the-money. Conversely, if the payo from exercising the option
immediately is negative, the option is out-of-the-money.
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Options where the strike price and the stock price are far apart as referred to as deep-in-
the-money or deep-out-of-the-money. Important to remember is that stock option
contracts are always written on 100 shares of stock.
The holder of a put option will exercise the option if the stock price S is below the strike
price of K. Because the holder receives K when the stock is worth S, the holder’s gain is
equal to K-S, thus the value of a put at expiration is:
An investor holding a short position in an option has an obligation - this investor takes the
opposite side of the contract to the investor who is long, thus the short position’s cash
ows are the negative of the long position’s cash ows. Because the investor who is long
an option can only receive money at expiration, aka the investor will not exercise an
option that is out-of-the-money since a short investor can only pay money.
Assume you have a short position in a call option with an exercise pice of 20SEK. If the
stock price is greater than the strike price of the call, say 25SEK, the holder will exercise
the option, which means that you then have the obligation to sell the stock for the strike
price of 20SEK. Since you must purchase the stock at the market price of 25SEK you
then lose the di erence of 5SEK. However, if the stock price is less than the strike price at
the expiration date then the holder will not exercise the option. In this case, you lose
nothing, you have no obligation.
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Combination of Options
Sometimes investors combine option positions by holding a portfolio of options. In this
case, we describe the most common combinations. Imagine at expiration you have both
a put option and a call option at the same strike price - that is a straddle.
By combining a call option and a put option you will receive cash so long as the options
do not expire at-the-money. The farther away from the money the options are, the more
money you will make. However, to construct the combination requires purchasing both
options, so the pro ts after deducting this cost are negative for stock prices close to the
strike price and positive elsewhere. This combination is known as a straddle. This
strategy is used by investors who expect the stock to be very volatile and move up and
down a large amount but who do not necessarily have a view on which direction the stock
will move.
Put-Call Parity
If you imagine K as the strike price of the option, C as the call price, P as the put price
and S as the stock price, then if both positions have the same price we get:
In the following equation, the left side of the equation is the cost of buying the stuck and
a put while the right side is the cost of buying a zero-coupon bond with face value K and
a call option. Recall that the price of a zero-coupon bond is just the present value of its
face value. Rearranging terms gives an expression for the price of a European call option
for a non dividend paying stock as:
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This relationship between the value of the stock, the bond and call and put options is
known as a put-call parity. It says that the price of a European call equals the price of
the stock plus an otherwise identical put minus the price of a bond that matures on the
exercise date of the option.
But what happens if the stock pays a dividend? In that case, the two di erent ways to
construct portfolio insurance do not have the same payout because the stock will pay a
dividend while the zero-coupon bond will not, thus the two strategies will cost the same
to implement only if we add the PV of future dividends to the combination of the bond
and the call:
The left side of the following equation is the value of the stock and a put while the right
side is the value of a zero-coupon bond, a call option, and the future dividends paid by
the stock during the life of the option, denoted by Div. Rearranging terms gives the
general put-call parity fortmula:
ff