Role of Financial Markets: 1) Allocation of capital (Stocks, Bonds, Loans); Sharing of risk (Insurance,

Derivatives (Futures, Options or Credit default swaps). Correct prices ensure both
Importance of equity valuation New Business: How much is the start up worth? (from Angels, VCs, PEs
perspective); Mature Businesses: IPO, FPO; Acquisition; Divestitures:
Several methods to value equity
• Based on projections
• Dividend discount model

• Total Payout model

• Discounted free cash flow model (least assumptions)

Note: Downside for a short position in a put option is limited to the strike price because stock price cannot
fall below zero. A short position in a call option has no limits.

Option Moneyness

Call Option Put option

At-the-money K=S K=S K=S

In-the money +ve value, if exercised S>K S<K

• Based on comparable firms: We can adjust the diff in scale b/w firms by expressing value in terms of Out-of-the-money –ve value, if exercised S<K S>K
valuation multiples. Deep in-the-money Large +ve S >>> K S <<< K
• P/E Ratio:
Deep in-the-money Large -ve S <<< K S >>> K
*where Div1 is Dividend Per Share in year 1
• EV Multiples: EV/EBIIDTA is useful when comparing firms with diff. amt. of leverage NOTE:
1) For a stock or Call/ Put Option; When buying : Use Ask Price; When selling : Use Bid Price
2) Total Purchase Price = # Contracts x # Shares # Ask Price; Option prices are quoted on a per share basis

*This valuation multiple is higher for firms with high growth rates and low capital Profits for Holding an Option to Expiration
requirements (so that free cash flow is high in proportion to EBITDA) • Payouts on a long position in an option contract are never negative
• However the profit from purchasing an option and holding it to expiration could be negative because the
payout at expiration might be less than the initial cost of the option
• Valuation Multiples # Multiples of Sales can be useful if it is reasonable to assume margins would be • Break Even for Long Call: S – K = Ask Price
similar going forward in future. # P/B or Price to Book value of equity can be used for firms with
substantial tangible assets.; Industry specific multiples # Enterprise value per subscriber Used in cable
TV industry # Average revenue per user (ARPU) used in Telecom industry.
Limitations of Relative Valuation :
• Firms are never identical&
• Usefulness of a valuation multiple depends on nature of differences &sensitivity of multiples to diff.
• Diff. in multiples can be related to diff. in Expected future growth rate or Cost of Capital i.e., Risk
• No clear guidance on how to adjust the multiple for these differences
• Comparables only provide information regarding the value of a firm relative to other firms in the Remember to convert
Days to Years
comparison set # Using multiples will not help us if an entire industry is overvalued (dot com bubble is
a common example)
Comparison – RV vs DCF : Advantage of RV is that it is based on real prices and not hypothetical
projections. But valuation multiple does not consider material differences between firms. #Talented
managers # More efficient manufacturing processes # Patents on new technology. Discounted cash flow
methods allow us to incorporate specific information about cost of capital or future growth. Therefore, has
greater potential to be more accurate in some situations. DCF also allows for sensitivity analysis.

Information, Competition, and Stock Prices Information in

Stock Prices # A valuation model links the firm’s future cash
flows, its cost of capital, and its share price. # Given accurate
information about any two of these variables, a valuation
model allows us to make inferences about the third variable.

Competition and Efficient Markets Efficient Markets Hypothesis: Competition among investors drive away
all positive NPV trading opportunities. This implies that securities will be fairly priced, based on their future
cash flows, given all information that is available to investors.
• Public, Easily Interpretable Information: Stock price to react immediately to such news
• Private or Difficult-to-Interpret: Efficient markets hypothesis will not hold. However, as these
informed traders begin to trade, they will tend to move prices --> prices will begin to reflect their info;
degree of “inefficiency” in the market will be limited by the costs of obtaining the pvt. info.

Lessons for Investors and Corporate Managers Consequences for Investors If stocks are fairly priced, then
investors who buy stocks can expect to receive future cash flows that fairly compensate them for the risk of
their investment In such cases, the average investor can invest with confidence, even if he is not fully Returns for Holding an Option to Expiration
informed. Implications for Corporate Managers Focus on NPV and free cash flow. Avoid accounting illusions. • In all cases, max loss is 100% i.e. option expires worthless
Use financial transactions to support investment. Markets should be ready to invest in any positive-NPV • Distribution of returns for out-of the-money options are more extreme
project • E.g. if K ↑ à C↓ (C will be less expensive); Thus R↑

• Financial Option: A contract that gives its owner the right (but not the obligation) to purchase or sell an
asset at a fixed price as some future date. # Options are traded on stocks, indexes such as NIFTY and the
S&P 500, commodities, currencies, etc.
• Call option: A financial option that gives its owner the right to buy an asset.
• Put option: A financial option that gives its owner the right to sell an asset
• Option uses: # Hedging To reduce risk by holding contracts or securities whose payoffs are negatively
correlated with some risk exposure. #Speculation When investors use contracts or securities to place a
bet on the direction in which they believe the market is likely to move
• Exercising an Option: When a holder of an option enforces the agreement and buys or sells a share of
stock at the agreed-upon price.
• Strike Price or Exercise Price: The price at which an option holder buys or sells a share of stock when the
option is exercised.
• Expiration Date: The last date on which an option holder has the right to exercise the option. Combinations of Options
• American Options allow their holders to exercise the option on any date up to, & expiration date. Straddle A portfolio that is long a call option and a put option on the same stock with the same exercise
• European Options allow their holders to exercise the option only on the expiration date. date and strike price. This strategy may be used if investors expect the stock to be very volatile and move up
• Option Writer The seller of an option contract. The option buyer (holder) holds the right to exercise the or down a large amount but do not necessarily have a view on which direction the stock will move.
option & has a long position in the contract. The option seller (writer) sells (or writes) the option and has Strangle A portfolio that is long a call option and a put option on the same stock with the same exercise
a short position in the contract. Because the long side has the option to exercise, the short side has an date but the strike price on the call exceeds the strike price on the put. In this case, you do not receive
obligation to fulfill the contract if it is exercised. The buyer pays the writer a premium (option price). money if the stock price is between the two strike prices
Butterfly Spread A portfolio that is long two call options with differing strike prices and is short two call
Option Payoff at Maturity options with a strike price equal to the average strike price of the first two calls. Although a straddle
• Long Position in a Call Option: C = max (S – K , 0) strategy makes money when the stock and strike prices are far apart, a butterfly spread makes money when
• Short Position in a Call Option: C = - max (S – K , 0) the stock and strike prices are close.
• Long Position in a Put Option : P = max (K – S , 0)
• Short Position in a Put Option : P = - max (K – S , 0)
 Zero-Coupon Bond Usually sells at a discount (i.e., price is less than the face value) so they are also
called pure discount bonds. Example: Treasury Bills (maturity of, say, 91, 184 or 364 days), Cash
Management Bills (maturity less than 91 days).

Yield to Maturity YTM = Discount rate that equates PV of promised payments to today’s price. It is
the expected rate of return for an investor who holds the bond until maturity (assuming all payments
are made). It is determined by the investors and not by the issuer.

Risk-Free Interest Rate A default-free zero-coupon bond that matures on date n provides a risk-free
return over the same period. Thus, the Law of One Price guarantees that the risk-free interest rate
equals the yield to maturity on such a bond.

Spot Interest Rate Another term for a default-free, zero-coupon yield.

Suppose you hold a stock and are worried about its downside. What will you do? Use Protective Put: A long Zero- Coupon Yield Curve A plot of the yield of risk free zero-coupon bonds as a function of the bond’s
position in a put held on a stock you already own. Portfolio Insurance A protective put written on a maturity date.
portfolio rather than a single stock. Portfolio insurance can also be achieved by purchasing a bond and a call
option Coupon bonds

Premium, Discount, or Par?

• Discount If a coupon bond trades at a discount, an investor will earn a return both from receiving
the coupons and from receiving a face value that exceeds the price paid for the bond. If a bond
trades at a discount, its yield to maturity will exceed its coupon rate.
• Premium If a coupon bond trades at a premium, it will earn a return from receiving the coupons,
Put-Call Parity but this return will be diminished by receiving a face value less than the price paid for the bond.
• *Most coupon bonds have a coupon rate so that the bonds will initially trade at, or very close to,
par.

Factors Affecting Option Prices

• Impact of Strike Price:

• Impact of Stock Price Important Points:

• Int rate or y ↑ à PV↓
• Arbitrage options on stock prices • Time to Maturity ↓ à PV ↑
• Shorter maturity coupon rates are less sensitive to changes in interest rate
• Option Prices & Exercise Date: For American options, the longer the time to the exercise date, the more • Bond with higher coupon rates are less sensitive to interest rates
valuable the option. An American option with a later exercise date has all the rights and privileges of an • *a coupon with longer maturity but very high coupon rate will have less sensitivity
otherwise identical. American option with an earlier exercise date; hence it is more valuable. However, a • Duration Zero Coupon Bond> Duration Coupon Bond.
European option with a later exercise date can be worth less than an otherwise identical European • Duration Low Coupon Bond> Duration High Coupon Bond
option with an earlier exercise date. Think of a European call on a stock which pays dividend at later dt. • Price of a coupon bond rises between payments but drops on the coupon date, reflecting the
amount of coupon payment
• Volatility

BLACK-SCHOLES FORMULA: Determine Price of a Call Option on a Non-Dividend Paying Stock

1. S is the current price of the stock,

2. K is the exercise price,
3. N(d) is the cumulative normal distribution Cumulative Normal Distribution (the probability that an
outcome from a standard normal distribution will be below a certain value)
4. σ is the annual volatility,
5. T is the number of years left to expiration REMEMBER!
T is in years. So, convert days or
months into year

Black Scholes formula is derived assuming European Call Option. An American call option on a non-dividend
paying stock always has the same price as its European counterpart.

Implied Volatility Of the five required inputs in the Black-Scholes formula, only volatility is not observable
directly. Practitioners use two strategies to estimate the value of σ. 1) Use historical data 2) “Back out” the
implied volatility: The volatility of an asset’s returns that is consistent with the quoted price of an option on
the asset. What σ in the B-S formula will give me the quoted price? Implied volatility is often used a
measure of fear in the market. VIX index
Qs: Suppose you purchase a 30-year, zero-coupon bond with a yield to maturity of 3%. You hold the
Bond Valuation: Why? Risk-free interest rate can be calculated using prices of govt bonds. Acts as input for bond for five years before selling it.a. If the bond's yield to maturity is 3% when you sell it, what is the
valuation of all securities: stocks, interest rates quoted on housing loans. Cost of debt: Input for WACC. internal rate of return of your investment?
Understanding signals about the macro environment.
Bonds are debt. Issuers (sellers) are borrowers and holders (buyers) are creditors. Bonds are issued by
many entities including Governments Companies. We will focus on those bonds that are considered to be
“risk- free” because they are issued by “safe” governments.
• Bond Certificate States the terms of the bond (dates and amounts).
• Maturity Date Final repayment date.
• Term The time remaining until the maturity date.
• Coupon Promised interest payments.
• Face Value Notional amount used to compute the interest payments; also paid back on maturity date.
• Coupon Rate Determines the amount of each coupon payment, expressed as an APR(Annual % Rate)
Qs: What is the maturity of a default-free security with annual coupon payments and a yield to maturity
of ? Why? One year; It must be one year otherwise there will be an arbitrage opportunity.