Options, a gentle introduction

Options are traded both on exchanges and in the OTC markets. There are two
types of option: calls and puts.

A call gives the holder the right to buy an asset by a certain date for a certain
price.
Options, a gentle introduction

Options are traded both on exchanges and in the OTC markets. There are two
types of option: calls and puts.

A call gives the holder the right to buy an asset by a certain date for a certain
price.

A put option gives the holder the right to sell an asset by a certain date for a
certain price. The price in the contract is known as the exercise price or the
strike price; the date in the contract is known as the expiration date or the
maturity date.
Options, a gentle introduction

Options are traded both on exchanges and in the OTC markets. There are two
types of option: calls and puts.

A call gives the holder the right to buy an asset by a certain date for a certain
price.

A put option gives the holder the right to sell an asset by a certain date for a
certain price. The price in the contract is known as the exercise price or the
strike price; the date in the contract is known as the expiration date or the
maturity date.

A European option can be exercised only on the maturity date; an American

option can be exercised at any time during its life.
An example
In June, an investor instructs a broker to purchase one call option contract on Google
with a strike price of $580, set to expire in December.
An example
In June, an investor instructs a broker to purchase one call option contract on Google
with a strike price of $580, set to expire in December.

The broker communicates these instructions, and the transaction is completed with an
offer price of $35.30 per option.

Transaction Details:

The price per contract is $35.30.

Each contract typically covers 100 shares.
bid $561.32
Prices of put options on Google, June 25, 2012; stock price:
offer $561.51
An example
In June, an investor instructs a broker to purchase one call option contract on Google
with a strike price of $580, set to expire in December.

The broker communicates these instructions, and the transaction is completed with an
offer price of $35.30 per option.

Transaction Details:

The price per contract is $35.30.

Each contract typically covers 100 shares.
bid $561.32
Prices of put options on Google, June 25, 2012; stock price:
offer $561.51
An example, continued
The investor must remit $3,530 to the exchange via the broker for the option contract.
An example, continued
The investor must remit $3,530 to the exchange via the broker for the option contract.

Outcome Scenarios:

If the price of Google stock does not rise above $580 by December, the option
expires worthless, and the investor’s loss is the cost of the option premium, $3,530.
If Google’s stock price rises above $580, say to $650, the investor can exercise the
option to buy 100 shares at $580 each and could potentially sell immediately at
$650 each. This results in a gross profit of $7,000, or a net profit of $3,470 after
accounting for the option premium.

Note:

The net profit calculation assumes immediate sale at the higher price and does
not account for transaction fees or taxes.
Understanding the Pay-off Function
The net gain is derived from two actions: (a) acquiring a contract that encompasses 100 call
options for Google, set to expire in December, with an exercise price of $580 each, and (b)
disposing of a contract that includes 100 put options for Google, due in September, with an
exercise price of $540 each.
Understanding the Pay-off Function
The net gain is derived from two actions: (a) acquiring a contract that encompasses 100 call
options for Google, set to expire in December, with an exercise price of $580 each, and (b)
disposing of a contract that includes 100 put options for Google, due in September, with an
exercise price of $540 each.

The pay-off function graphically represents the potential profit and loss of an options
position at expiration.
Understanding the Pay-off Function
The net gain is derived from two actions: (a) acquiring a contract that encompasses 100 call
options for Google, set to expire in December, with an exercise price of $580 each, and (b)
disposing of a contract that includes 100 put options for Google, due in September, with an
exercise price of $540 each.

The pay-off function graphically represents the potential profit and loss of an options
position at expiration.
For a call option, the pay-off is positive if the underlying asset’s price exceeds the
strike price by more than the option premium paid.
Understanding the Pay-off Function
The net gain is derived from two actions: (a) acquiring a contract that encompasses 100 call
options for Google, set to expire in December, with an exercise price of $580 each, and (b)
disposing of a contract that includes 100 put options for Google, due in September, with an
exercise price of $540 each.

The pay-off function graphically represents the potential profit and loss of an options
position at expiration.
For a call option, the pay-off is positive if the underlying asset’s price exceeds the
strike price by more than the option premium paid.
For a put option, the pay-off is positive if the underlying asset’s price is below the
strike price by more than the option premium paid.
Understanding Fixed Income/Bonds

Nature of Bonds:

Bonds are units of debt issued by entities such as governments and corporations,
converted into tradeable assets.
Classified as fixed-income instruments due to their traditional fixed interest
payments, though variable-rate bonds are also common.

Characteristics of Bonds:

There’s an inverse relationship between interest rates and bond prices: as rates
rise, bond prices typically fall, and vice versa.
The principal amount, also known as face value or par, is the amount that will
be repaid at maturity. Failure to repay can lead to default.
Market price factors include the issuer’s creditworthiness, time to maturity, and
how the coupon rate stacks up against the current interest rate environment.

.
Understanding Bond Terminology

Face Value (Par Value): The principal amount of the bond that the issuer agrees
to repay the bondholder at maturity. It’s the initial investment lent to the issuer.

Maturity Date: The date on which the bond’s principal (Face Value) is repaid to
the investor, marking the end of the bond’s life. The term from issuance to
maturity indicates the bond’s duration.

Coupon Rate: Represents the bond’s interest payment, typically an annual fixed
percentage of the bond’s face value. For instance, a 4% coupon rate on a $1000 bond
would yield annual interest payments of $40 ($0.04 x $1000).

Yield: Reflects the bond’s annual interest payment relative to its current market
price, not the face value. The yield can vary over the bond’s life due to market
price changes.

Example: The bond’s price to $500 in the first year (for example, due to a change in
interest rates). The yield would then be 10%. Since a bond’s yield is the coupon payment
as a % of its current value, the coupon ($50) would be 10% of the current value ($500).
An example of a bond
youtu.be/oHcOlcTFzKA
Bonds valuation
Bonds valuation
Bonds valuation

F face value N number of payments

iF contractual interest rate i market interest rate
C = F · iF coupon payment M value at maturity, usually face value
Bonds valuation

F face value N number of payments

iF contractual interest rate i market interest rate
C = F · iF coupon payment M value at maturity, usually face value

 
C C C M
market price of a bond P = 1+i + (1+i)2 + ... + (1+i)N +(1+i)N
1−(1+i)−N
P  
N
= C M
n=1 (1+i)n + (1+i)N = C i + M(1 + i)−N .

If the bond is not valued precisely on a coupon date, the calculated price will incorporate
accrued interest – the interest that has accumulated since the previous coupon date and
is owed to the bond’s current owner.
The price of a bond that includes accrued interest is known as the dirty price. This price
is also referred to as the full price, all in price, or cash price.
In contrast, the clean price is the price of the bond excluding any interest that has
accrued. The clean price reflects the bond’s value without the added interest.
Efficient Market Hypothesis (EMH): Overview

Concept of Market Efficiency:

Market efficiency describes how well prices in financial markets reflect all available
and relevant information.
In an efficient market, securities are priced accurately, reflecting their true value
based on current information.
This implies no consistent opportunity to achieve higher returns through stock
selection or market timing based on publicly available information.

Eugene Fama and EMH:

Proposed by Eugene Fama in 1970, the Efficient Market Hypothesis suggests that
it’s impossible to ‘beat the market’ consistently on a risk-adjusted basis since
market prices incorporate all known information.
EMH classifies markets into three forms of efficiency: weak, semi-strong, and
strong, each differing by the level of information reflected in stock prices.
EMH Implications and Regulatory Impact

Implications of EMH:

The hypothesis challenges the usefulness of technical analysis and fundamental

analysis to outperform the market.
EMH proponents argue for a passive investment strategy, such as buying and
holding a diversified portfolio.

Sarbanes–Oxley Act of 2002:

In response to corporate scandals (e.g., Enron, WorldCom), the Sarbanes–Oxley

Act imposed stringent regulations on corporate governance and financial disclosure.
The Act aimed to enhance transparency and accountability, thereby potentially
increasing market efficiency by ensuring that investors have access to reliable
information.
Post-SOX, some studies observed a reduction in stock market volatility, suggesting
an increase in investor confidence and market stability.
EMH and the Absence of Arbitrage

Arbitrage and Efficient Markets:

The Efficient Market Hypothesis implies that arbitrage opportunities—risk-free

profits arising from price discrepancies—are quickly exploited and corrected,
making them rare in efficient markets.
While in theory, efficient markets should be free of arbitrage, in practice, transient
opportunities can appear due to market frictions and delays in information
dissemination.

Implications for Pricing Theory:

The assumption of no arbitrage is fundamental in financial mathematics for the

pricing of derivatives and other financial instruments.
It leads to models that provide a theoretical framework for determining the fair
prices of derivatives, based on the prices of underlying assets.
Pricing, Hedging, and Fundamental Theorems

Unique Price Determination:

The absence of arbitrage opportunities in efficient markets contributes to the

unique determination of prices for certain derivative instruments.
This uniqueness is crucial for developing hedging strategies that mitigate risk by
offsetting potential losses in investments.

Risk-Neutral Valuation:
"In the absence of arbitrage, the market imposes a risk-neutral measure on all
possible market scenarios, determining prices through discounted expectations."

Fundamental Theorem of Asset Pricing:

This theorem formalises the relationship between arbitrage, market efficiency, and
derivative pricing.
It underpins much of modern financial theory, providing a foundation for the
pricing of assets in a no-arbitrage context.
FToAP in a finite-state universe.
FToAP in a finite-state universe.
Consider a market with K assets, A1 , . . . , AK freely traded and one of these, say
A1 , is riskless, that is, its value at t = 1 does not depend on the market scenario.
FToAP in a finite-state universe.
Consider a market with K assets, A1 , . . . , AK freely traded and one of these, say
A1 , is riskless, that is, its value at t = 1 does not depend on the market scenario.
The share price of Aj at t = 0 is S0j , WLOG S10 = 1.
FToAP in a finite-state universe.
Consider a market with K assets, A1 , . . . , AK freely traded and one of these, say
A1 , is riskless, that is, its value at t = 1 does not depend on the market scenario.
The share price of Aj at t = 0 is S0j , WLOG S10 = 1.
Uncertainty of the market is encapsulated in a finite set Ω of N possible market
scenarios, ω1 , . . . , ωN .
FToAP in a finite-state universe.
Consider a market with K assets, A1 , . . . , AK freely traded and one of these, say
A1 , is riskless, that is, its value at t = 1 does not depend on the market scenario.
The share price of Aj at t = 0 is S0j , WLOG S10 = 1.
Uncertainty of the market is encapsulated in a finite set Ω of N possible market
scenarios, ω1 , . . . , ωN .
A portfolio is a vector θ = (θ1 , . . . , θK ) ∈ RK . Its value at t = 0 is
K
θj S0j .
X
V0 (θ) =
j=1
FToAP in a finite-state universe.
Consider a market with K assets, A1 , . . . , AK freely traded and one of these, say
A1 , is riskless, that is, its value at t = 1 does not depend on the market scenario.
The share price of Aj at t = 0 is S0j , WLOG S10 = 1.
Uncertainty of the market is encapsulated in a finite set Ω of N possible market
scenarios, ω1 , . . . , ωN .
A portfolio is a vector θ = (θ1 , . . . , θK ) ∈ RK . Its value at t = 0 is
K
θj S0j .
X
V0 (θ) =
j=1

PK j
The value at t = 1 depends on ωi : V0 (θ; ωi ) = j=1 θj S1 (ωi ).
FToAP in a finite-state universe.
Consider a market with K assets, A1 , . . . , AK freely traded and one of these, say
A1 , is riskless, that is, its value at t = 1 does not depend on the market scenario.
The share price of Aj at t = 0 is S0j , WLOG S10 = 1.
Uncertainty of the market is encapsulated in a finite set Ω of N possible market
scenarios, ω1 , . . . , ωN .
A portfolio is a vector θ = (θ1 , . . . , θK ) ∈ RK . Its value at t = 0 is
K
θj S0j .
X
V0 (θ) =
j=1

PK j
The value at t = 1 depends on ωi : V0 (θ; ωi ) = j=1 θj S1 (ωi ).

A probability measure π on Ω is risk-neutral, when for any A, the share price of A at

t = 0 is the discounted expectation under π of the share price at t = 1, that is
N
S0j = e −r π(ωi )S1j (ωi )
X
(j ⩽ K ).
j=1
Example: future contracts
Example: future contracts

Say, there is an equity, whose share price at time t = 0 is known but at time t = 1
is subject to uncertainty.
Example: future contracts

Say, there is an equity, whose share price at time t = 0 is known but at time t = 1
is subject to uncertainty.
There is also a riskless asset (a treasury bond?) whose share price at t = 1 is
certain; the price at t = 0 is 1 and at t = 1 is e r .
Example: future contracts

Say, there is an equity, whose share price at time t = 0 is known but at time t = 1
is subject to uncertainty.
There is also a riskless asset (a treasury bond?) whose share price at t = 1 is
certain; the price at t = 0 is 1 and at t = 1 is e r .
The forward contract calls for one of the stakeholders to pay the other the amount
F (the forward price) at t = 1 in exchange for one share of equity.
Example: future contracts

Say, there is an equity, whose share price at time t = 0 is known but at time t = 1
is subject to uncertainty.
There is also a riskless asset (a treasury bond?) whose share price at t = 1 is
certain; the price at t = 0 is 1 and at t = 1 is e r .
The forward contract calls for one of the stakeholders to pay the other the amount
F (the forward price) at t = 1 in exchange for one share of equity.
The forward price is written at t = 0.
Example: future contracts

Say, there is an equity, whose share price at time t = 0 is known but at time t = 1
is subject to uncertainty.
There is also a riskless asset (a treasury bond?) whose share price at t = 1 is
certain; the price at t = 0 is 1 and at t = 1 is e r .
The forward contract calls for one of the stakeholders to pay the other the amount
F (the forward price) at t = 1 in exchange for one share of equity.
The forward price is written at t = 0.

Mini theorem 1. In an arbitrage-free market, the forward price is F = S0 e r .

Example: future contracts, ctd.
In an arbitrage-free market, the forward price is F = S0 e r .
Assume not.
Example: future contracts, ctd.
In an arbitrage-free market, the forward price is F = S0 e r .
Assume not.

F < S0 e r . At t = 0, sell 1 share of equity. Invest S0 in the bond, and simultaneously

enter into a forward contract to buy 1 share of equity at t = 1 at the forward price F . Use
the share of Equity obtained from the forward contract at t = 1 to settle the short
position.
Example: future contracts, ctd.
In an arbitrage-free market, the forward price is F = S0 e r .
Assume not.

F < S0 e r . At t = 0, sell 1 share of equity. Invest S0 in the bond, and simultaneously

enter into a forward contract to buy 1 share of equity at t = 1 at the forward price F . Use
the share of Equity obtained from the forward contract at t = 1 to settle the short
position.
A locked-in profit of S0 e r − F at t = 1 using 0 assets at t = 0!
Example: future contracts, ctd.
In an arbitrage-free market, the forward price is F = S0 e r .
Assume not.

F < S0 e r . At t = 0, sell 1 share of equity. Invest S0 in the bond, and simultaneously

enter into a forward contract to buy 1 share of equity at t = 1 at the forward price F . Use
the share of Equity obtained from the forward contract at t = 1 to settle the short
position.
A locked-in profit of S0 e r − F at t = 1 using 0 assets at t = 0!
F > S0 e r . How would you hedge here?
Example: future contracts, ctd.
In an arbitrage-free market, the forward price is F = S0 e r .
Assume not.

F < S0 e r . At t = 0, sell 1 share of equity. Invest S0 in the bond, and simultaneously

enter into a forward contract to buy 1 share of equity at t = 1 at the forward price F . Use
the share of Equity obtained from the forward contract at t = 1 to settle the short
position.
A locked-in profit of S0 e r − F at t = 1 using 0 assets at t = 0!
F > S0 e r . How would you hedge here? At t = 0 sell S0 of the bond, buy 1 share of
equity, and simultaneously enter into a forward contract to sell 1 share of equity at t = 1
at the forward price F . Profit: F − S0 e r .
Example: European call options
Example: European call options

European call option gives the Buyer the right to buy one share of an equity
at a pre-specified time t = 1 (the expiration date) for an amount K (called the
strike price) in cash.
Example: European call options

European call option gives the Buyer the right to buy one share of an equity
at a pre-specified time t = 1 (the expiration date) for an amount K (called the
strike price) in cash.
The strike price K is written into the contract at t = 0. Buyer is not obliged to
exercise at expiration.