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Peter Ouwehand

Department of Mathematical Sciences University of Stellenbosch

November 2010

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

1 / 30

What is Finance?

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

2 / 30

What is Finance?

Finance: ”The study of how people allocate scarce resources over time.”

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

2 / 30

” Individuals and corporations use P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 2 / 30 .What is Finance? Finance: ”The study of how people allocate scarce resources over time.

) Basic Finance November 2010 2 / 30 .What is Finance? Finance: ”The study of how people allocate scarce resources over time. P.” Individuals and corporations use Savings accounts. Ouwehand (Stellenbosch Univ.

) Basic Finance November 2010 2 / 30 . Ouwehand (Stellenbosch Univ.What is Finance? Finance: ”The study of how people allocate scarce resources over time.” Individuals and corporations use Savings accounts. Mortgages. P.

What is Finance? Finance: ”The study of how people allocate scarce resources over time.) Basic Finance November 2010 2 / 30 . Ouwehand (Stellenbosch Univ. Mortgages. Pension funds. P.” Individuals and corporations use Savings accounts.

” Individuals and corporations use Savings accounts. Pension funds.What is Finance? Finance: ”The study of how people allocate scarce resources over time.) Basic Finance November 2010 2 / 30 . Mortgages. Ouwehand (Stellenbosch Univ. Annuities. P.

Mortgages. Stock market. P.) Basic Finance November 2010 2 / 30 . Pension funds. Ouwehand (Stellenbosch Univ.What is Finance? Finance: ”The study of how people allocate scarce resources over time.” Individuals and corporations use Savings accounts. Annuities.

” Individuals and corporations use Savings accounts. Pension funds. Ouwehand (Stellenbosch Univ. Annuities. The outcomes — the costs and beneﬁts — of ﬁnancial decisions are usually: P. Mortgages.What is Finance? Finance: ”The study of how people allocate scarce resources over time.) Basic Finance November 2010 2 / 30 . Stock market.

Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 2 / 30 . The outcomes — the costs and beneﬁts — of ﬁnancial decisions are usually: spread over time. Annuities. P. Pension funds. Stock market.” Individuals and corporations use Savings accounts. Mortgages.What is Finance? Finance: ”The study of how people allocate scarce resources over time.

Ouwehand (Stellenbosch Univ.What is Finance? Finance: ”The study of how people allocate scarce resources over time.) Basic Finance November 2010 2 / 30 .e. P. Mortgages. subject to risk. Pension funds. Annuities. i. Stock market. The outcomes — the costs and beneﬁts — of ﬁnancial decisions are usually: spread over time. uncertain.” Individuals and corporations use Savings accounts.

Mortgages. i. subject to risk. uncertain. P.) Basic Finance November 2010 2 / 30 . individuals must be able to value and compare diﬀerent risky cashﬂows over time.” Individuals and corporations use Savings accounts.e. Annuities. Stock market. To make intelligent investment and consumption decisions.What is Finance? Finance: ”The study of how people allocate scarce resources over time. The outcomes — the costs and beneﬁts — of ﬁnancial decisions are usually: spread over time. Pension funds. Ouwehand (Stellenbosch Univ.

) Basic Finance November 2010 3 / 30 . Ouwehand (Stellenbosch Univ.The Three Pillars of Finance P.

individuals must consider the following: P. Ouwehand (Stellenbosch Univ.The Three Pillars of Finance To make investment decisions.) Basic Finance November 2010 3 / 30 .

individuals must consider the following: I.) Basic Finance November 2010 3 / 30 . Time value of money: Individuals must compare the value of diﬀerent payments at diﬀerent times — R100 today is worth more than R100 next year. Ouwehand (Stellenbosch Univ. P.The Three Pillars of Finance To make investment decisions.

II. Ouwehand (Stellenbosch Univ. Time value of money: Individuals must compare the value of diﬀerent payments at diﬀerent times — R100 today is worth more than R100 next year. Risk management: Individuals must be able to assess and manage the riskiness of investments.) Basic Finance November 2010 3 / 30 . individuals must consider the following: I.The Three Pillars of Finance To make investment decisions. P.

Risk management: Individuals must be able to assess and manage the riskiness of investments. II.) Basic Finance November 2010 3 / 30 .The Three Pillars of Finance To make investment decisions. Asset valuation: Individuals must be able to determine and compare asset prices. Ouwehand (Stellenbosch Univ. individuals must consider the following: I. P. Time value of money: Individuals must compare the value of diﬀerent payments at diﬀerent times — R100 today is worth more than R100 next year. III.

Ouwehand (Stellenbosch Univ.The Time Value of Money 1 P.) Basic Finance November 2010 4 / 30 .

Why? P.The Time Value of Money 1 Which do you prefer? R1000 in hand today. Ouwehand (Stellenbosch Univ. or the promise of R1000 in one year’s time.) Basic Finance November 2010 4 / 30 .

Ouwehand (Stellenbosch Univ. P. with the expectation of receiving a greater sum in the future. or the promise of R1000 in one year’s time.The Time Value of Money 1 Which do you prefer? R1000 in hand today. Why? Opportunity cost: You can invest the R1000 now.) Basic Finance November 2010 4 / 30 .

Inﬂation: R1000 in one year’s time may buy fewer goods than R1000 today. or the promise of R1000 in one year’s time. Why? Opportunity cost: You can invest the R1000 now. P.The Time Value of Money 1 Which do you prefer? R1000 in hand today.) Basic Finance November 2010 4 / 30 . with the expectation of receiving a greater sum in the future. Ouwehand (Stellenbosch Univ.

Why? Opportunity cost: You can invest the R1000 now. Inﬂation: R1000 in one year’s time may buy fewer goods than R1000 today. or the promise of R1000 in one year’s time. with the expectation of receiving a greater sum in the future.The Time Value of Money 1 Which do you prefer? R1000 in hand today. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 4 / 30 . P. Risk/Uncertainty: You can’t be sure that you will actually receive the R1000 in one year’s time.

) Basic Finance November 2010 4 / 30 .The Time Value of Money 1 Which do you prefer? R1000 in hand today. Ouwehand (Stellenbosch Univ. P. with the expectation of receiving a greater sum in the future. Inﬂation: R1000 in one year’s time may buy fewer goods than R1000 today. Risk/Uncertainty: You can’t be sure that you will actually receive the R1000 in one year’s time. Why? Opportunity cost: You can invest the R1000 now. or the promise of R1000 in one year’s time. So borrowing isn’t free: The borrower must pay a premium to induce the lender to part temporarily with his/her money — the interest.

The Time Value of Money 1 Which do you prefer? R1000 in hand today. credit rating. or the promise of R1000 in one year’s time. Why? Opportunity cost: You can invest the R1000 now. money supply. with the expectation of receiving a greater sum in the future. The interest rate depends on many factors. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 4 / 30 . P. etc. Risk/Uncertainty: You can’t be sure that you will actually receive the R1000 in one year’s time. inﬂation. e. So borrowing isn’t free: The borrower must pay a premium to induce the lender to part temporarily with his/her money — the interest.g. Inﬂation: R1000 in one year’s time may buy fewer goods than R1000 today.

Time Value of Money 2 P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 5 / 30 .

Ouwehand (Stellenbosch Univ. P.) Basic Finance November 2010 5 / 30 . it will grow to A1 = A0 (1 + r ). but we are going to keep things simple: Deﬁnition If an amount A0 is deposited in a bank account at a simple rate r for one time–period.Time Value of Money 2 Interest rate modelling is a complex part of mathematical ﬁnance.

Time Value of Money 2 Interest rate modelling is a complex part of mathematical ﬁnance. it will grow to A1 = A0 (1 + r ). If the interest is compounded twice per year. Ouwehand (Stellenbosch Univ. but we are going to keep things simple: Deﬁnition If an amount A0 is deposited in a bank account at a simple rate r for one time–period. then an amount A0 will be worth: P.) Basic Finance November 2010 5 / 30 .

Ouwehand (Stellenbosch Univ. If the interest is compounded twice per year..Time Value of Money 2 Interest rate modelling is a complex part of mathematical ﬁnance. then an amount A0 will be worth: r ) after 0. A0 (1 + 2 P.) Basic Finance November 2010 5 / 30 . it will grow to A1 = A0 (1 + r ). .5 yr. but we are going to keep things simple: Deﬁnition If an amount A0 is deposited in a bank account at a simple rate r for one time–period. .

. . but we are going to keep things simple: Deﬁnition If an amount A0 is deposited in a bank account at a simple rate r for one time–period. .5 yr.) Basic Finance November 2010 5 / 30 . If the interest is compounded twice per year.. A0 (1 + 2 r r .Time Value of Money 2 Interest rate modelling is a complex part of mathematical ﬁnance. . it will grow to A1 = A0 (1 + r ). and thus to A0 (1 + 2 )(1 + 2 ) after 1 yr. Ouwehand (Stellenbosch Univ. then an amount A0 will be worth: r ) after 0. P.

5 yr. .Time Value of Money 2 Interest rate modelling is a complex part of mathematical ﬁnance. . an amount A0 will r n grow to A0 (1 + n ) after one yr. A0 (1 + 2 r r . . P. Ouwehand (Stellenbosch Univ. it will grow to A1 = A0 (1 + r ). and thus to A0 (1 + 2 )(1 + 2 ) after 1 yr. If the interest is compounded n times per year.. If the interest is compounded twice per year. but we are going to keep things simple: Deﬁnition If an amount A0 is deposited in a bank account at a simple rate r for one time–period. then an amount A0 will be worth: r ) after 0. .) Basic Finance November 2010 5 / 30 .

Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 6 / 30 .Time Value of Money 3 P.

P. .) Basic Finance November 2010 6 / 30 . .Time Value of Money 3 If the interest is compounded continuously. Ouwehand (Stellenbosch Univ. .. an amount A0 will grow r n to limn→∞ A0 (1 + n ) = A0 e r after one yr.

an amount A0 will grow r n to limn→∞ A0 (1 + n ) = A0 e r after one yr. . . and thus to A0 e rT after T yr. Ouwehand (Stellenbosch Univ. P.. .Time Value of Money 3 If the interest is compounded continuously. .) Basic Finance November 2010 6 / 30 . . .

e. . . an amount A0 will grow r n to limn→∞ A0 (1 + n ) = A0 e r after one yr. the present value of the amount A in T years’ time is ¯ = Ae −rT A A ¯= A (1 + r )T etc.. . .Time Value of Money 3 If the interest is compounded continuously. . i. . . . simple rate P. We are now able to compare diﬀerent payments at diﬀerent times: To obtain an amount A in n years time. continuous rate OR . . Ouwehand (Stellenbosch Univ. .) Basic Finance November 2010 6 / 30 . and thus to A0 e rT after T yr. you must deposit Ae −rT in the bank today. .

) Basic Finance November 2010 7 / 30 . Ouwehand (Stellenbosch Univ.Returns I P.

Ouwehand (Stellenbosch Univ. risky) P.e. whereas the returns on other assets are generally uncertain (i.) Basic Finance November 2010 7 / 30 .Returns I Returns are similar to interest rates. The main diﬀerence is that an interest rate is a promised return on a deposit.

risky) Example: You bought one share of Xcor one year ago for R123.40 + 12.40.45 P. so the rate of return is 23.00 and the share price is now R135.45.95 = 19. The net income provided by the share is 135. The main diﬀerence is that an interest rate is a promised return on a deposit. Today the share pays a dividend of R12.4%.45.00 − 123. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 7 / 30 . whereas the returns on other assets are generally uncertain (i.e. 123.95 The investment cost R123.45 = 23.Returns I Returns are similar to interest rates.

Returns

I

Returns are similar to interest rates. The main diﬀerence is that an interest rate is a promised return on a deposit, whereas the returns on other assets are generally uncertain (i.e. risky) Example: You bought one share of Xcor one year ago for R123.45. Today the share pays a dividend of R12.00 and the share price is now R135.40. The net income provided by the share is 135.40 + 12.00 − 123.45 = 23.95 The investment cost R123.45, so the rate of return is 23.95 = 19.4%. 123.45 Example: You deposited R123.45 in a bank one year ago. Today, you withdraw R12.00, and R135.40 remains in your bank account. What was the simple rate of interest?

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

7 / 30

Returns

I

Returns are similar to interest rates. The main diﬀerence is that an interest rate is a promised return on a deposit, whereas the returns on other assets are generally uncertain (i.e. risky) Example: You bought one share of Xcor one year ago for R123.45. Today the share pays a dividend of R12.00 and the share price is now R135.40. The net income provided by the share is 135.40 + 12.00 − 123.45 = 23.95 The investment cost R123.45, so the rate of return is 23.95 = 19.4%. 123.45 Example: You deposited R123.45 in a bank one year ago. Today, you withdraw R12.00, and R135.40 remains in your bank account. What was the simple rate of interest?

Before withdrawal, total was R147.40.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

7 / 30

Returns

I

Returns are similar to interest rates. The main diﬀerence is that an interest rate is a promised return on a deposit, whereas the returns on other assets are generally uncertain (i.e. risky) Example: You bought one share of Xcor one year ago for R123.45. Today the share pays a dividend of R12.00 and the share price is now R135.40. The net income provided by the share is 135.40 + 12.00 − 123.45 = 23.95 The investment cost R123.45, so the rate of return is 23.95 = 19.4%. 123.45 Example: You deposited R123.45 in a bank one year ago. Today, you withdraw R12.00, and R135.40 remains in your bank account. What was the simple rate of interest?

Before withdrawal, total was R147.40. Thus 123.45(1 + r ) = 147.40.

P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 7 / 30

whereas the returns on other assets are generally uncertain (i.40 remains in your bank account. total was R147.e. risky) Example: You bought one share of Xcor one year ago for R123.Returns I Returns are similar to interest rates.00 − 123.45.40 + 12.45 = 23. And so r = 19.95 The investment cost R123.40. What was the simple rate of interest? Before withdrawal.45 in a bank one year ago. you withdraw R12.40.45 Example: You deposited R123. The main diﬀerence is that an interest rate is a promised return on a deposit. so the rate of return is 23.00.4% P. The net income provided by the share is 135. Thus 123.4%. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 7 / 30 . 123.45(1 + r ) = 147.45.00 and the share price is now R135.95 = 19. Today. and R135.40. Today the share pays a dividend of R12.

Ouwehand (Stellenbosch Univ.Returns II P.) Basic Finance November 2010 8 / 30 .

P. Ouwehand (Stellenbosch Univ.Returns II Fundamental relationship in ﬁnance: E[Return] = f (Risk) where f is an increasing function.) Basic Finance November 2010 8 / 30 .

Thus the expected return on a share should be greater than the interest oﬀered by a bank account. P.Returns II Fundamental relationship in ﬁnance: E[Return] = f (Risk) where f is an increasing function. Ouwehand (Stellenbosch Univ. Shares are riskier investments than deposits.) Basic Finance November 2010 8 / 30 .

) Basic Finance November 2010 8 / 30 . Shares are riskier investments than deposits. Note that returns can be negative. whereas interest rates must be positive. Ouwehand (Stellenbosch Univ. Thus the expected return on a share should be greater than the interest oﬀered by a bank account.Returns II Fundamental relationship in ﬁnance: E[Return] = f (Risk) where f is an increasing function. P.

e.Returns II Fundamental relationship in ﬁnance: E[Return] = f (Risk) where f is an increasing function. Thus the expected return on a share should be greater than the interest oﬀered by a bank account. whereas interest rates must be positive. Return = Final Price + Interim Cashﬂows – Initial Price Initial Price P. Note that returns can be negative.) Basic Finance November 2010 8 / 30 . i. Shares are riskier investments than deposits. The return on an investment is roughly the percentage by which its value has increased in one year. Ouwehand (Stellenbosch Univ.

Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 9 / 30 .Returns III P.

) Basic Finance November 2010 9 / 30 . P. Ouwehand (Stellenbosch Univ.Returns III Shares with a higher expected return are therefore riskier than shares with a low expected return.

If two shares had the same risk. Ouwehand (Stellenbosch Univ. but diﬀerent expected returns.) Basic Finance November 2010 9 / 30 . everyone would buy the share with the higher return (and short the share with the lower return).Returns III Shares with a higher expected return are therefore riskier than shares with a low expected return. P.

thus lowering its return. Ouwehand (Stellenbosch Univ. If two shares had the same risk. P. but diﬀerent expected returns. This would drive the price of the “high return” share up. everyone would buy the share with the higher return (and short the share with the lower return).Returns III Shares with a higher expected return are therefore riskier than shares with a low expected return.) Basic Finance November 2010 9 / 30 .

If two shares had the same risk.Returns III Shares with a higher expected return are therefore riskier than shares with a low expected return. This would drive the price of the “high return” share up. everyone would buy the share with the higher return (and short the share with the lower return). thus lowering its return. but diﬀerent expected returns. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 9 / 30 . P. The riskiness of a share is measured by a quantity called volatility: It is the standard deviation of annualized returns.

everyone would buy the share with the higher return (and short the share with the lower return). Returns may also be measured as discretely– or continuously compounded.) Basic Finance November 2010 9 / 30 . Ouwehand (Stellenbosch Univ. but diﬀerent expected returns. If two shares had the same risk. P. The riskiness of a share is measured by a quantity called volatility: It is the standard deviation of annualized returns. This would drive the price of the “high return” share up.Returns III Shares with a higher expected return are therefore riskier than shares with a low expected return. thus lowering its return.

If two shares had the same risk. thus lowering its return. Returns may also be measured as discretely– or continuously compounded. but diﬀerent expected returns.) Basic Finance November 2010 9 / 30 . everyone would buy the share with the higher return (and short the share with the lower return). The riskiness of a share is measured by a quantity called volatility: It is the standard deviation of annualized returns.Returns III Shares with a higher expected return are therefore riskier than shares with a low expected return. Ouwehand (Stellenbosch Univ. This would drive the price of the “high return” share up. P. Returns on bonds are called yields.

Markets and Instruments I P.) Basic Finance November 2010 10 / 30 . Ouwehand (Stellenbosch Univ.

) Basic Finance November 2010 10 / 30 .Markets and Instruments I Traders in a ﬁnancial market exchange securities for money. P. Ouwehand (Stellenbosch Univ.

P.) Basic Finance November 2010 10 / 30 . Ouwehand (Stellenbosch Univ.g.Markets and Instruments I Traders in a ﬁnancial market exchange securities for money. e. Securities are contracts for future delivery of goods or money.

Markets and Instruments I Traders in a ﬁnancial market exchange securities for money.g.) Basic Finance November 2010 10 / 30 . e. shares P. Securities are contracts for future delivery of goods or money. Ouwehand (Stellenbosch Univ.

Ouwehand (Stellenbosch Univ.g. Securities are contracts for future delivery of goods or money.) Basic Finance November 2010 10 / 30 . shares bonds P. e.Markets and Instruments I Traders in a ﬁnancial market exchange securities for money.

Markets and Instruments I Traders in a ﬁnancial market exchange securities for money. Ouwehand (Stellenbosch Univ. Securities are contracts for future delivery of goods or money.g. e. shares bonds derivatives P.) Basic Finance November 2010 10 / 30 .

Markets and Instruments I Traders in a ﬁnancial market exchange securities for money. shares bonds derivatives One distinguishes between underlying (primary) and derivative (secondary) instruments. P.g. e. Securities are contracts for future delivery of goods or money.) Basic Finance November 2010 10 / 30 . Ouwehand (Stellenbosch Univ.

e.) Basic Finance November 2010 10 / 30 . bonds. and indexes.Markets and Instruments I Traders in a ﬁnancial market exchange securities for money. P. interest rates. Examples of underlying instruments are shares. shares bonds derivatives One distinguishes between underlying (primary) and derivative (secondary) instruments. currencies.g. Securities are contracts for future delivery of goods or money. Ouwehand (Stellenbosch Univ.

and indexes. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 10 / 30 . A derivative is a ﬁnancial instruments whose value is derived from an underlying asset. e. bonds. P.g. Securities are contracts for future delivery of goods or money. currencies.Markets and Instruments I Traders in a ﬁnancial market exchange securities for money. Examples of underlying instruments are shares. interest rates. shares bonds derivatives One distinguishes between underlying (primary) and derivative (secondary) instruments.

P. bonds. Examples of underlying instruments are shares. interest rates. currencies. Securities are contracts for future delivery of goods or money. Examples of derivatives are forward contracts. and indexes.) Basic Finance November 2010 10 / 30 . A derivative is a ﬁnancial instruments whose value is derived from an underlying asset. swaps and bonds.Markets and Instruments I Traders in a ﬁnancial market exchange securities for money. Ouwehand (Stellenbosch Univ. e. futures. shares bonds derivatives One distinguishes between underlying (primary) and derivative (secondary) instruments.g. options.

Ouwehand (Stellenbosch Univ.Markets and Instruments II P.) Basic Finance November 2010 11 / 30 .

P. Securities are issued for the ﬁrst time on the primary market.Markets and Instruments II One also distinguishes between primary and secondary markets. The secondary market provides important liquidity.) Basic Finance November 2010 11 / 30 . and then traded on the secondary market. Ouwehand (Stellenbosch Univ.

The secondary market provides important liquidity. Securities are issued for the ﬁrst time on the primary market. The money market is for very short–term debt (maturities ≤ 1 yr. and then traded on the secondary market. Ouwehand (Stellenbosch Univ.Markets and Instruments II One also distinguishes between primary and secondary markets. Borrowing and lending is done in ﬁxed–income markets.) P.) Basic Finance November 2010 11 / 30 .

and then traded on the secondary market. The money market is for very short–term debt (maturities ≤ 1 yr. Securities are issued for the ﬁrst time on the primary market. The secondary market provides important liquidity. we distinguish between the spot market and the forward market. P.Markets and Instruments II One also distinguishes between primary and secondary markets.) Finally.) Basic Finance November 2010 11 / 30 . Ouwehand (Stellenbosch Univ. Borrowing and lending is done in ﬁxed–income markets.

P. and receive goods now. Borrowing and lending is done in ﬁxed–income markets.Markets and Instruments II One also distinguishes between primary and secondary markets. Securities are issued for the ﬁrst time on the primary market. Most transactions are spot transactions: Pay now. we distinguish between the spot market and the forward market. The money market is for very short–term debt (maturities ≤ 1 yr. The secondary market provides important liquidity. and then traded on the secondary market.) Basic Finance November 2010 11 / 30 . Ouwehand (Stellenbosch Univ.) Finally.

P.) Basic Finance November 2010 11 / 30 . Ouwehand (Stellenbosch Univ. Borrowing and lending is done in ﬁxed–income markets. The money market is for very short–term debt (maturities ≤ 1 yr. and then traded on the secondary market. The secondary market provides important liquidity.) Finally. Securities are issued for the ﬁrst time on the primary market.Markets and Instruments II One also distinguishes between primary and secondary markets. we distinguish between the spot market and the forward market. and receive goods now. Forward and futures contracts are derivatives which make this possible. Most transactions are spot transactions: Pay now. To hedge/speculate on future market movements. it is possible to sell goods for delivery in the future.

Markets and Instruments III P.) Basic Finance November 2010 12 / 30 . Ouwehand (Stellenbosch Univ.

Ownership of a small piece of a company. shares.Markets and Instruments III Equity: Stocks.) Basic Finance November 2010 12 / 30 . P. Ouwehand (Stellenbosch Univ.

P.Markets and Instruments III Equity: Stocks. shares. Ouwehand (Stellenbosch Univ. Shareholders own a corporation. Ownership of a small piece of a company. Directors act in the shareholders’ best interest.) Basic Finance November 2010 12 / 30 .

Public limited companies are listed on a stock exchange. but have limited liability: At most. Directors act in the shareholders’ best interest. shares.) Basic Finance November 2010 12 / 30 . they can lose their investment. The shareholders share the proﬁts of the company. Ouwehand (Stellenbosch Univ. P. Shareholders own a corporation. Ownership is easily transferred.Markets and Instruments III Equity: Stocks. Ownership of a small piece of a company.

Public limited companies are listed on a stock exchange. but have limited liability: At most. Ownership is easily transferred. shares. whose amount varies according to proﬁtability and opportunities for growth. Ouwehand (Stellenbosch Univ. they can lose their investment.Markets and Instruments III Equity: Stocks. Directors act in the shareholders’ best interest. Shareholders own a corporation.) Basic Finance November 2010 12 / 30 . P. The shareholders share the proﬁts of the company. Ownership of a small piece of a company. Most shares pay regular dividends.

) Basic Finance November 2010 12 / 30 . shares. Most shares pay regular dividends. but have limited liability: At most. they can lose their investment. A share may be bought cum– or ex–dividend.Markets and Instruments III Equity: Stocks. Ouwehand (Stellenbosch Univ. Public limited companies are listed on a stock exchange. P. Directors act in the shareholders’ best interest. Ownership of a small piece of a company. The shareholders share the proﬁts of the company. whose amount varies according to proﬁtability and opportunities for growth. Shareholders own a corporation. Ownership is easily transferred.

the share price decreases by the amount of the dividend. but have limited liability: At most. P. whose amount varies according to proﬁtability and opportunities for growth. Directors act in the shareholders’ best interest.) Basic Finance November 2010 12 / 30 . A share may be bought cum– or ex–dividend. Shareholders own a corporation. Ownership is easily transferred. Ownership of a small piece of a company. The shareholders share the proﬁts of the company.Markets and Instruments III Equity: Stocks. Public limited companies are listed on a stock exchange. Ouwehand (Stellenbosch Univ. they can lose their investment. Most shares pay regular dividends. shares. On the ex-dividend date.

whose amount varies according to proﬁtability and opportunities for growth. Shareholders own a corporation. Ownership is easily transferred.Markets and Instruments III Equity: Stocks. the share price decreases by the amount of the dividend.00. On the ex-dividend date. P. but have limited liability: At most. The shareholders share the proﬁts of the company.) Basic Finance November 2010 12 / 30 . Directors act in the shareholders’ best interest. for example. A share may be bought cum– or ex–dividend.00. Ouwehand (Stellenbosch Univ. shares. they can lose their investment. Occasionally a company announces a stock split: Suppose. After a 3–for–1 stock split you will own 3 shares each valued at R200. that you own a single stock whose current price is R600. Public limited companies are listed on a stock exchange. Most shares pay regular dividends. Ownership of a small piece of a company.

Markets and Instruments

IV

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

13 / 30

Markets and Instruments

IV

Short selling: Selling a share you don’t own, hoping to pick them up more cheaply later on.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

13 / 30

Markets and Instruments

IV

**Short selling: Selling a share you don’t own, hoping to pick them up more cheaply later on.
**

Your broker borrows the share from a client.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

13 / 30

Your broker borrows the share from a client. P.Markets and Instruments IV Short selling: Selling a share you don’t own. You may now sell these shares. Ouwehand (Stellenbosch Univ. hoping to pick them up more cheaply later on.) Basic Finance November 2010 13 / 30 . even though you don’t own them.

Ouwehand (Stellenbosch Univ. Later. P.Markets and Instruments IV Short selling: Selling a share you don’t own. you buy the shares in the market and return them to your broker. who returns them to the other client. Your broker borrows the share from a client. You also pay any dividends that were issued in the interim. You may now sell these shares. hoping to pick them up more cheaply later on. even though you don’t own them.) Basic Finance November 2010 13 / 30 .

you buy the shares in the market and return them to your broker. hoping to pick them up more cheaply later on. P. Commodities: Raw materials such as metals. Your broker borrows the share from a client. oil.) Basic Finance November 2010 13 / 30 . You also pay any dividends that were issued in the interim. You may now sell these shares. Later. who returns them to the other client. Most of this trading is done in the futures market. agricultural products. even though you don’t own them.Markets and Instruments IV Short selling: Selling a share you don’t own. Ouwehand (Stellenbosch Univ. These are often traded by people who have no need for the material. but are speculating on the direction of the commodity. and contracts are closed out before the delivery date. etc.

you buy the shares in the market and return them to your broker. hoping to pick them up more cheaply later on. Your broker borrows the share from a client. Currencies: FOREX. Most of this trading is done in the futures market. etc. Ouwehand (Stellenbosch Univ. You may now sell these shares. These are often traded by people who have no need for the material. You also pay any dividends that were issued in the interim. oil. Later. agricultural products. who returns them to the other client. P.) Basic Finance November 2010 13 / 30 . and contracts are closed out before the delivery date. but are speculating on the direction of the commodity. even though you don’t own them. Commodities: Raw materials such as metals.Markets and Instruments IV Short selling: Selling a share you don’t own.

) Basic Finance November 2010 14 / 30 . Ouwehand (Stellenbosch Univ.Markets and Instruments V P.

EMBI+. ALSI40. GSCI). FTSE100. A typical index consists of a weighted sum of a basket of representative stocks. INDI25.Markets and Instruments V Indices: An index tracks the changes in a hypothetical portfolio of instruments (S&P500. NASDAQ100. P.) Basic Finance November 2010 14 / 30 . DAX–30. Ouwehand (Stellenbosch Univ. DIJA. NIKKEI225. These representatives and their weights may change from time to time.

NIKKEI225. These representatives and their weights may change from time to time. NASDAQ100. Fixed income securities: P. EMBI+. ALSI40. INDI25. A typical index consists of a weighted sum of a basket of representative stocks. Ouwehand (Stellenbosch Univ.Markets and Instruments V Indices: An index tracks the changes in a hypothetical portfolio of instruments (S&P500. DIJA. GSCI).) Basic Finance November 2010 14 / 30 . FTSE100. DAX–30.

INDI25. These representatives and their weights may change from time to time. ALSI40. These are debt instruments. NASDAQ100. bills. Fixed income securities: Bonds. which may be ﬁxed or ﬂoating. Ouwehand (Stellenbosch Univ. DIJA. NIKKEI225. GSCI). and promise to pay a certain rate of interest.Markets and Instruments V Indices: An index tracks the changes in a hypothetical portfolio of instruments (S&P500. FTSE100. P. EMBI+. DAX–30. A typical index consists of a weighted sum of a basket of representative stocks.) Basic Finance November 2010 14 / 30 . notes.

and a balloon of $1m at maturity. 5% semi–annual coupon bond with a face value of $1m promises to pay $25 000 every six months for 10 years. which may be ﬁxed or ﬂoating. P. INDI25. and promise to pay a certain rate of interest. EMBI+. A typical index consists of a weighted sum of a basket of representative stocks. DAX–30. ALSI40. GSCI). These representatives and their weights may change from time to time. NIKKEI225. Example: A 10–year. Fixed income securities: Bonds.) Basic Finance November 2010 14 / 30 . FTSE100. notes.Markets and Instruments V Indices: An index tracks the changes in a hypothetical portfolio of instruments (S&P500. NASDAQ100. DIJA. These are debt instruments. bills. Ouwehand (Stellenbosch Univ.

Derivative Securities P.) Basic Finance November 2010 15 / 30 . Ouwehand (Stellenbosch Univ.

Derivative Securities Individuals and corporations face risks. gain or loss is a simple result of a change in the value of a market variable. and many of these risks entail ﬁnancial gain or loss. such as a price or rate: P. Often. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 15 / 30 .

such as a price or rate: Commodity prices: Oil. Often. gain or loss is a simple result of a change in the value of a market variable. wool. P. Ouwehand (Stellenbosch Univ. and many of these risks entail ﬁnancial gain or loss. wheat.) Basic Finance November 2010 15 / 30 .Derivative Securities Individuals and corporations face risks. maize. etc.

) Basic Finance November 2010 15 / 30 . Often. gain or loss is a simple result of a change in the value of a market variable. maize. Interest rates. and many of these risks entail ﬁnancial gain or loss. such as a price or rate: Commodity prices: Oil. Ouwehand (Stellenbosch Univ. P. wheat. wool. etc.Derivative Securities Individuals and corporations face risks.

Ouwehand (Stellenbosch Univ. maize. gain or loss is a simple result of a change in the value of a market variable. The prices of stocks that make up a pension portfolio.) Basic Finance November 2010 15 / 30 . Often. etc. P. such as a price or rate: Commodity prices: Oil. wool. wheat.Derivative Securities Individuals and corporations face risks. and many of these risks entail ﬁnancial gain or loss. Interest rates.

Ouwehand (Stellenbosch Univ. and many of these risks entail ﬁnancial gain or loss. wool.Derivative Securities Individuals and corporations face risks. The prices of stocks that make up a pension portfolio. wheat. P. Often. gain or loss is a simple result of a change in the value of a market variable. such as a price or rate: Commodity prices: Oil. Interest rates. etc. maize. Foreign currency exchange rates.) Basic Finance November 2010 15 / 30 .

Foreign currency exchange rates.) Basic Finance November 2010 15 / 30 .Derivative Securities Individuals and corporations face risks... . and many of these risks entail ﬁnancial gain or loss. Ouwehand (Stellenbosch Univ. The prices of stocks that make up a pension portfolio. gain or loss is a simple result of a change in the value of a market variable. such as a price or rate: Commodity prices: Oil. P. wheat. Interest rates. Often. wool. maize. etc.

P. A derivative security is a ﬁnancial instrument whose value is derived from another. a commodity price. maize.. etc.) Basic Finance November 2010 15 / 30 . gain or loss is a simple result of a change in the value of a market variable. Often. such as a price or rate: Commodity prices: Oil. wool.Derivative Securities Individuals and corporations face risks.. and many of these risks entail ﬁnancial gain or loss. . a forex rate. Ouwehand (Stellenbosch Univ. The prices of stocks that make up a pension portfolio. an interest rate. underlying or primary. etc. variable. Foreign currency exchange rates. wheat. such as a stock price. Interest rates.

etc. Ouwehand (Stellenbosch Univ. gain or loss is a simple result of a change in the value of a market variable. a commodity price.) Basic Finance November 2010 15 / 30 . wool. Foreign currency exchange rates. Derivatives are used to transfer risk: P. a forex rate. Often.. The prices of stocks that make up a pension portfolio. . A derivative security is a ﬁnancial instrument whose value is derived from another. such as a price or rate: Commodity prices: Oil. variable. such as a stock price.Derivative Securities Individuals and corporations face risks.. etc. underlying or primary. wheat. and many of these risks entail ﬁnancial gain or loss. maize. an interest rate. Interest rates.

such as a price or rate: Commodity prices: Oil. maize. variable. wool. The prices of stocks that make up a pension portfolio. Interest rates. a forex rate. as insurance against adverse risk. A derivative security is a ﬁnancial instrument whose value is derived from another. an interest rate. P..Derivative Securities Individuals and corporations face risks. Ouwehand (Stellenbosch Univ. a commodity price. etc. underlying or primary.) Basic Finance November 2010 15 / 30 .. such as a stock price.e. gain or loss is a simple result of a change in the value of a market variable. . etc. Often. Foreign currency exchange rates. Derivatives are used to transfer risk: They can be used to hedge — i. and many of these risks entail ﬁnancial gain or loss. wheat.

gain or loss is a simple result of a change in the value of a market variable. and many of these risks entail ﬁnancial gain or loss. The prices of stocks that make up a pension portfolio. underlying or primary. Often. Interest rates. maize. Foreign currency exchange rates.e.Derivative Securities Individuals and corporations face risks. . variable. as insurance against adverse risk.) Basic Finance November 2010 15 / 30 . P. such as a price or rate: Commodity prices: Oil. Derivatives are used to transfer risk: They can be used to hedge — i. etc. etc.. They can be used to speculate — to take on extra risk in the hope of greater returns. a forex rate. Ouwehand (Stellenbosch Univ. A derivative security is a ﬁnancial instrument whose value is derived from another. a commodity price. wool. such as a stock price.. an interest rate. wheat.

A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a speciﬁed future date T (maturity or expiry). Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 16 / 30 . P. but not the obligation to buy or sell an asset.Call Options An option gives the holder the right.

P. but not the obligation to buy or sell an asset. Ouwehand (Stellenbosch Univ. The party who undertakes to deliver the asset is called the writer of the option.) Basic Finance November 2010 16 / 30 .Call Options An option gives the holder the right. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a speciﬁed future date T (maturity or expiry).

Call Options An option gives the holder the right.) Basic Finance November 2010 16 / 30 . The party who undertakes to deliver the asset is called the writer of the option. P. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a speciﬁed future date T (maturity or expiry). for a proﬁt of S (T ) − K . Ouwehand (Stellenbosch Univ. but not the obligation to buy or sell an asset. The buyer of a European call would exercise at time T only if K < S (T ).

If the spot price is less than the strike. Ouwehand (Stellenbosch Univ. for a proﬁt of S (T ) − K . The buyer of a European call would exercise at time T only if K < S (T ).Call Options An option gives the holder the right. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a speciﬁed future date T (maturity or expiry). the holder would discard the option: Why pay K if you can pay S (T ) < K ? P.) Basic Finance November 2010 16 / 30 . The party who undertakes to deliver the asset is called the writer of the option. but not the obligation to buy or sell an asset.

Ouwehand (Stellenbosch Univ. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a speciﬁed future date T (maturity or expiry). for a proﬁt of S (T ) − K . P.) Basic Finance November 2010 16 / 30 .Call Options An option gives the holder the right. The party who undertakes to deliver the asset is called the writer of the option. 0} ≥ 0. If the spot price is less than the strike. The buyer of a European call would exercise at time T only if K < S (T ). the holder would discard the option: Why pay K if you can pay S (T ) < K ? Thus the payoﬀ to the holder is max{S (T ) − K . but not the obligation to buy or sell an asset.

If the spot price is less than the strike. The buyer of a European call would exercise at time T only if K < S (T ). options cost money. The party who undertakes to deliver the asset is called the writer of the option. 0} ≥ 0. for a proﬁt of S (T ) − K . but not the obligation to buy or sell an asset.) Basic Finance November 2010 16 / 30 . Unlike forward contracts.Call Options An option gives the holder the right. P. You have to pay the writer of an option a premium upfront to enter into the contract. A European call option gives the holder the right to buy an asset S (the underlying) for an agreed amount K (the strike price or exercise price) on a speciﬁed future date T (maturity or expiry). Ouwehand (Stellenbosch Univ. the holder would discard the option: Why pay K if you can pay S (T ) < K ? Thus the payoﬀ to the holder is max{S (T ) − K .

Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 17 / 30 .More Options P.

Ouwehand (Stellenbosch Univ.More Options A European put option confers the right to sell an asset S for an agreed amount K at a speciﬁed future date T . P.) Basic Finance November 2010 17 / 30 .

) Basic Finance November 2010 17 / 30 . P. Ouwehand (Stellenbosch Univ.More Options A European put option confers the right to sell an asset S for an agreed amount K at a speciﬁed future date T . Similarly. an American call (put) option confers the right to buy (sell) an asset S for an agreed amount K . but at any time at or before maturity T .

P. An Asian option has a payoﬀ that depends on the average stock price over a certain time period.) Basic Finance November 2010 17 / 30 . but at any time at or before maturity T . an American call (put) option confers the right to buy (sell) an asset S for an agreed amount K .More Options A European put option confers the right to sell an asset S for an agreed amount K at a speciﬁed future date T . Similarly. Ouwehand (Stellenbosch Univ.

) Basic Finance November 2010 17 / 30 . an American call (put) option confers the right to buy (sell) an asset S for an agreed amount K . Similarly. Ouwehand (Stellenbosch Univ. but only if the underlying asset price hasn’t crossed a predetermined barrier level. but at any time at or before maturity T .More Options A European put option confers the right to sell an asset S for an agreed amount K at a speciﬁed future date T . P. An Asian option has a payoﬀ that depends on the average stock price over a certain time period. A knock–out barrier call will pay the same as a European call.

but only if the underlying asset price hasn’t crossed a predetermined barrier level. forward rate agreements. P. .More Options A European put option confers the right to sell an asset S for an agreed amount K at a speciﬁed future date T . An Asian option has a payoﬀ that depends on the average stock price over a certain time period. credit default swaps. The list of examples of derivatives is endless: Interest rate swaps.) Basic Finance November 2010 17 / 30 . . interest rate caps and ﬂoors. Ouwehand (Stellenbosch Univ. Similarly. A knock–out barrier call will pay the same as a European call. but at any time at or before maturity T . an American call (put) option confers the right to buy (sell) an asset S for an agreed amount K .

Ouwehand (Stellenbosch Univ.Hedging with Options Example P.) Basic Finance November 2010 18 / 30 .

Ouwehand (Stellenbosch Univ.00 per share. P.Hedging with Options Example An investor owns 1 000 shares of Anglo.) Basic Finance November 2010 18 / 30 . with value R60.

00 per share.00.) Basic Finance November 2010 18 / 30 . this will lead to a loss of R10 000. P. Ouwehand (Stellenbosch Univ. with value R60.Hedging with Options Example An investor owns 1 000 shares of Anglo. If the share price drops to R50.

P.00 per share. the investor buys a put option to sell 1 000 shares in 3 months time at a price of R55.00 per share.) Basic Finance November 2010 18 / 30 .00. If the share price drops to R50.Hedging with Options Example An investor owns 1 000 shares of Anglo. Ouwehand (Stellenbosch Univ. To hedge against possible loss. this will lead to a loss of R10 000. with value R60.

Hedging with Options Example An investor owns 1 000 shares of Anglo. To hedge against possible loss.00 per share.00 per share.00. If the share price drops to R50. the investor buys a put option to sell 1 000 shares in 3 months time at a price of R55. Ouwehand (Stellenbosch Univ. P. This limits the losses to R5000 + option premium. with value R60. this will lead to a loss of R10 000.) Basic Finance November 2010 18 / 30 .

Ouwehand (Stellenbosch Univ.00.Hedging with Options Example An investor owns 1 000 shares of Anglo.00 per share.) Basic Finance November 2010 18 / 30 . To hedge against possible loss. If the share price drops to R50. with value R60.00. the investor will not exercise the option.00 per share. this will lead to a loss of R10 000. This limits the losses to R5000 + option premium. P. the investor buys a put option to sell 1 000 shares in 3 months time at a price of R55. If the stock price rises to R63.

To hedge against possible loss.00 per share.00 per share. In that case the investor’s proﬁt will be R3000 . this will lead to a loss of R10 000. Ouwehand (Stellenbosch Univ.00. If the stock price rises to R63.) Basic Finance November 2010 18 / 30 . P.Hedging with Options Example An investor owns 1 000 shares of Anglo. with value R60. This limits the losses to R5000 + option premium. the investor will not exercise the option.00.option premium. the investor buys a put option to sell 1 000 shares in 3 months time at a price of R55. If the share price drops to R50.

00 per share. To hedge against possible loss. this will lead to a loss of R10 000. If the share price drops to R50.00 per share. the investor will not exercise the option.00. If the stock price rises to R63. with value R60. Ouwehand (Stellenbosch Univ. The investor thus has put a cap on possible losses without restraining the possible gains. the investor buys a put option to sell 1 000 shares in 3 months time at a price of R55.option premium.) Basic Finance November 2010 18 / 30 .00. In that case the investor’s proﬁt will be R3000 .Hedging with Options Example An investor owns 1 000 shares of Anglo. P. This limits the losses to R5000 + option premium.

Speculating with Options Example P.) Basic Finance November 2010 19 / 30 . Ouwehand (Stellenbosch Univ.

P.Speculating with Options Example Investor X believes that the shares of pharmaceuticals will rise sharply.) Basic Finance November 2010 19 / 30 . Ouwehand (Stellenbosch Univ.

Speculating with Options Example Investor X believes that the shares of pharmaceuticals will rise sharply. Ouwehand (Stellenbosch Univ. She is willing to speculate with a capital of R10 000.) Basic Finance November 2010 19 / 30 . P.

Ouwehand (Stellenbosch Univ. Today.Speculating with Options Example Investor X believes that the shares of pharmaceuticals will rise sharply.) Basic Finance November 2010 19 / 30 .00. She is willing to speculate with a capital of R10 000. the shares of PharmCor trade at R50. P.

If Investor X buys 200 shares and the share price rises to R60. the shares of PharmCor trade at R50.00. P.) Basic Finance November 2010 19 / 30 . she will make a proﬁt of $2 000.Speculating with Options Example Investor X believes that the shares of pharmaceuticals will rise sharply. Ouwehand (Stellenbosch Univ. She is willing to speculate with a capital of R10 000.00. Today.

) Basic Finance November 2010 19 / 30 . If Investor X buys 200 shares and the share price rises to R60. she will make a proﬁt of $2 000.00.00.00. P.Speculating with Options Example Investor X believes that the shares of pharmaceuticals will rise sharply. the shares of PharmCor trade at R50. Ouwehand (Stellenbosch Univ. her loss will be $2 000. If the price drops to R40. Today. She is willing to speculate with a capital of R10 000.

00. the shares of PharmCor trade at R50. she will make a proﬁt of $2 000.00. If Investor X buys 200 shares and the share price rises to R60. P.) Basic Finance November 2010 19 / 30 . Ouwehand (Stellenbosch Univ.00. If the price drops to R40. her loss will be $2 000. A call option to buy 100 PharmCor shares at strike R53.Speculating with Options Example Investor X believes that the shares of pharmaceuticals will rise sharply. She is willing to speculate with a capital of R10 000.00 costs R200. Today.

She is willing to speculate with a capital of R10 000. P.00 costs R200.) Basic Finance November 2010 19 / 30 . Ouwehand (Stellenbosch Univ. she will exercise the options and buy 5 000 shares at R53.00. If Investor X buys 50 call options and the share price rises to 60.00. If Investor X buys 200 shares and the share price rises to R60.Speculating with Options Example Investor X believes that the shares of pharmaceuticals will rise sharply. If the price drops to R40. the shares of PharmCor trade at R50. she will make a proﬁt of $2 000. A call option to buy 100 PharmCor shares at strike R53.00.00 per share. Today. her loss will be $2 000.00.

She is willing to speculate with a capital of R10 000.Speculating with Options Example Investor X believes that the shares of pharmaceuticals will rise sharply. she will exercise the options and buy 5 000 shares at R53. P. If Investor X buys 200 shares and the share price rises to R60. A call option to buy 100 PharmCor shares at strike R53. She will immediately sell these at R60.00.00. Today.00. Ouwehand (Stellenbosch Univ. she will make a proﬁt of $2 000.00 costs R200. If Investor X buys 50 call options and the share price rises to 60. her loss will be $2 000.00.00 per share. the shares of PharmCor trade at R50.00 per share. If the price drops to R40.) Basic Finance November 2010 19 / 30 .

instead of just R2 000. P.00 per share. a proﬁt of R25 000.00 per share.00. If Investor X buys 200 shares and the share price rises to R60. she will make a proﬁt of $2 000. Her proﬁt is therefore 5 000 × 60 − 5 000 × 53 − 50 × 200 = 25 000 i.Speculating with Options Example Investor X believes that the shares of pharmaceuticals will rise sharply. she will exercise the options and buy 5 000 shares at R53. her loss will be $2 000. the shares of PharmCor trade at R50. A call option to buy 100 PharmCor shares at strike R53.00. She will immediately sell these at R60.00. Ouwehand (Stellenbosch Univ. If the price drops to R40.00.e.) Basic Finance November 2010 19 / 30 .00 costs R200. Today. If Investor X buys 50 call options and the share price rises to 60. She is willing to speculate with a capital of R10 000.

Today. If Investor X buys 200 shares and the share price rises to R60. a proﬁt of R25 000. instead of just R2 000.00. Ouwehand (Stellenbosch Univ. If the price drops to R40. She is willing to speculate with a capital of R10 000.Speculating with Options Example Investor X believes that the shares of pharmaceuticals will rise sharply. P. she will lose all.00. she will make a proﬁt of $2 000. Her proﬁt is therefore 5 000 × 60 − 5 000 × 53 − 50 × 200 = 25 000 i. the shares of PharmCor trade at R50. If Investor X buys 50 call options and the share price rises to 60. her loss will be $2 000. She will immediately sell these at R60.00.00 per share. she will exercise the options and buy 5 000 shares at R53.) Basic Finance November 2010 19 / 30 . BUT: Should the share price remain below R53.e.00.00. A call option to buy 100 PharmCor shares at strike R53.00 per share.00 costs R200.

283 P. Ouwehand (Stellenbosch Univ.World Derivatives Markets OTC Derivatives Notional OTC Derivatives Value World GDP USA GDP RSA GDP Derivatives ﬁgures: BIS 2007 GDP ﬁgures: IMF 2007 Value in $ trillion 516 11 54 14 0.) Basic Finance November 2010 20 / 30 .

Ouwehand (Stellenbosch Univ.Pricing Derivative Securities I P.) Basic Finance November 2010 21 / 30 .

Pricing Derivative Securities I Because the value of a derivative is derived from another asset or market variable. Example P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 21 / 30 . it is sometimes possible to ﬁnd a mathematical formula for the price.

Ouwehand (Stellenbosch Univ. Allegra and Darcy will face each other in the ﬁnals at Wimbledon.Pricing Derivative Securities I Because the value of a derivative is derived from another asset or market variable.) Basic Finance November 2010 21 / 30 . it is sometimes possible to ﬁnd a mathematical formula for the price. Example Tomorrow. P.

) Basic Finance November 2010 21 / 30 . Tickets are available to gamble on the outcome of the game: P. Ouwehand (Stellenbosch Univ. Example Tomorrow. it is sometimes possible to ﬁnd a mathematical formula for the price. Allegra and Darcy will face each other in the ﬁnals at Wimbledon.Pricing Derivative Securities I Because the value of a derivative is derived from another asset or market variable.

Allegra and Darcy will face each other in the ﬁnals at Wimbledon. Example Tomorrow. it is sometimes possible to ﬁnd a mathematical formula for the price. Ouwehand (Stellenbosch Univ. Tickets are available to gamble on the outcome of the game: If Allegra wins.Pricing Derivative Securities I Because the value of a derivative is derived from another asset or market variable.) Basic Finance November 2010 21 / 30 . the holder of a ticket gets R10 000. P.

the holder gets nothing. it is sometimes possible to ﬁnd a mathematical formula for the price. Allegra and Darcy will face each other in the ﬁnals at Wimbledon. If Darcy wins. Example Tomorrow. the holder of a ticket gets R10 000.) Basic Finance November 2010 21 / 30 . Tickets are available to gamble on the outcome of the game: If Allegra wins. P. Ouwehand (Stellenbosch Univ.Pricing Derivative Securities I Because the value of a derivative is derived from another asset or market variable.

such a ticket cannot be free.Pricing Derivative Securities I Because the value of a derivative is derived from another asset or market variable. If Darcy wins. the holder gets nothing. Because the payoﬀ is non–negative. What would you be willing to pay for such a ticket? P. Tickets are available to gamble on the outcome of the game: If Allegra wins. Allegra and Darcy will face each other in the ﬁnals at Wimbledon. Ouwehand (Stellenbosch Univ. Example Tomorrow. it is sometimes possible to ﬁnd a mathematical formula for the price. the holder of a ticket gets R10 000.) Basic Finance November 2010 21 / 30 .

) Basic Finance November 2010 21 / 30 . it is sometimes possible to ﬁnd a mathematical formula for the price. If Darcy wins. the holder of a ticket gets R10 000. the holder gets nothing. P. What would you be willing to pay for such a ticket? Mathematics cannot be used to determine the price of this ticket. Example Tomorrow. Ouwehand (Stellenbosch Univ. as well as their risk preferences. Tickets are available to gamble on the outcome of the game: If Allegra wins.Pricing Derivative Securities I Because the value of a derivative is derived from another asset or market variable. It is determined by punters’ combined views on who is likely to win. Because the payoﬀ is non–negative. Allegra and Darcy will face each other in the ﬁnals at Wimbledon. such a ticket cannot be free.

Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 22 / 30 .Pricing Derivative Securities Example (Continued) II P.

Ouwehand (Stellenbosch Univ. II P.) Basic Finance November 2010 22 / 30 .Pricing Derivative Securities Example (Continued) Suppose the market price of the ticket is P .

P. Ouwehand (Stellenbosch Univ. II Suppose also that there is a second type of ticket available: This ticket pays R10 000 if Darcy wins.Pricing Derivative Securities Example (Continued) Suppose the market price of the ticket is P . and R0 if Allegra wins.) Basic Finance November 2010 22 / 30 .

Pricing Derivative Securities Example (Continued) Suppose the market price of the ticket is P . We can determine the price of the second ticket mathematically: P. Ouwehand (Stellenbosch Univ. II Suppose also that there is a second type of ticket available: This ticket pays R10 000 if Darcy wins. and R0 if Allegra wins.) Basic Finance November 2010 22 / 30 .

Pricing Derivative Securities Example (Continued) Suppose the market price of the ticket is P . Ouwehand (Stellenbosch Univ. We can determine the price of the second ticket mathematically: If you own one of each kind. and hence the price of the second ticket is 10 000 − P . P. So the price of both tickets must be R10 000. and R0 if Allegra wins. you will deﬁnitely get R10 000. II Suppose also that there is a second type of ticket available: This ticket pays R10 000 if Darcy wins.) Basic Finance November 2010 22 / 30 .

P.) Basic Finance November 2010 22 / 30 . The second ticket is a derivative of the ﬁrst ticket — once the market decides the price of the ﬁrst ticket. and hence the price of the second ticket is 10 000 − P . independent of views and risk preferences of punters. you will deﬁnitely get R10 000. So the price of both tickets must be R10 000. We can determine the price of the second ticket mathematically: If you own one of each kind. the price of the second ticket is determined. II Suppose also that there is a second type of ticket available: This ticket pays R10 000 if Darcy wins. Ouwehand (Stellenbosch Univ. and R0 if Allegra wins.Pricing Derivative Securities Example (Continued) Suppose the market price of the ticket is P .

Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 23 / 30 .Law of One Price P.

P. Ouwehand (Stellenbosch Univ. we assume only that you can’t make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0.) Basic Finance November 2010 23 / 30 .Law of One Price In order to be able to use mathematics to ﬁnd prices.

Law of One Price In order to be able to use mathematics to ﬁnd prices. we assume only that you can’t make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0. Ouwehand (Stellenbosch Univ. Y are securities. P. For suppose that X .) Basic Finance November 2010 23 / 30 . and that XT = YT in all states of the world.

we assume only that you can’t make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0. Ouwehand (Stellenbosch Univ. Y are securities. If X0 < Y0 .) Basic Finance November 2010 23 / 30 . you can buy X and sell Y at time t = 0 — for an immediate proﬁt of Y0 − X0 .Law of One Price In order to be able to use mathematics to ﬁnd prices. For suppose that X . P. and that XT = YT in all states of the world.

For suppose that X . you have XT and you owe YT — and these cancel! P. Ouwehand (Stellenbosch Univ. Y are securities.) Basic Finance November 2010 23 / 30 . you can buy X and sell Y at time t = 0 — for an immediate proﬁt of Y0 − X0 . we assume only that you can’t make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0. At time T .Law of One Price In order to be able to use mathematics to ﬁnd prices. and that XT = YT in all states of the world. If X0 < Y0 .

**Law of One Price
**

In order to be able to use mathematics to ﬁnd prices, we assume only that you can’t make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0. For suppose that X , Y are securities, and that XT = YT in all states of the world.

If X0 < Y0 , you can buy X and sell Y at time t = 0 — for an immediate proﬁt of Y0 − X0 . At time T , you have XT and you owe YT — and these cancel! So if X0 < Y0 , you can make money from nothing!!!!!

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

23 / 30

**Law of One Price
**

In order to be able to use mathematics to ﬁnd prices, we assume only that you can’t make money from nothing: Law of One Price: Two securities that are guaranteed to have the same value at time t = T must have the same value at time t = 0. For suppose that X , Y are securities, and that XT = YT in all states of the world.

If X0 < Y0 , you can buy X and sell Y at time t = 0 — for an immediate proﬁt of Y0 − X0 . At time T , you have XT and you owe YT — and these cancel! So if X0 < Y0 , you can make money from nothing!!!!! If X0 > Y0 do the opposite.

P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 23 / 30

**Option Pricing in a Single–Period Model
**

CAN WE PRICE THIS CALL OPTION? r = 10% K = 11

1

p 10 1p STOCK

22 C0 = ? 5.5 CALL

11

0

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

24 / 30

Option Pricing in a Single–Period Model 2 P.) Basic Finance November 2010 25 / 30 . Ouwehand (Stellenbosch Univ.

Option Pricing in a Single–Period Model

2

Pricing by Expectation: (Huygens–Bernoulli) The “fair” price is the expected (discounted) payoﬀ: C0 = E CT 1+r =p× 11 0 + (1 − p ) × 1.1 1.1

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

25 / 30

Option Pricing in a Single–Period Model

2

Pricing by Expectation: (Huygens–Bernoulli) The “fair” price is the expected (discounted) payoﬀ: C0 = E CT 1+r =p× 11 0 + (1 − p ) × 1.1 1.1

So the price depends on p .

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

25 / 30

Option Pricing in a Single–Period Model

2

Pricing by Expectation: (Huygens–Bernoulli) The “fair” price is the expected (discounted) payoﬀ: C0 = E CT 1+r =p× 11 0 + (1 − p ) × 1.1 1.1

So the price depends on p . 1 If p = 2 , then C0 = 5.

P. Ouwehand (Stellenbosch Univ.)

Basic Finance

November 2010

25 / 30

) Basic Finance November 2010 25 / 30 . then C0 = 5. 1 If p = 2 .1 1.1 So the price depends on p . Supply and demand: The “correct” price is the one at which the supply is equal to the demand.Option Pricing in a Single–Period Model 2 Pricing by Expectation: (Huygens–Bernoulli) The “fair” price is the expected (discounted) payoﬀ: C0 = E CT 1+r =p× 11 0 + (1 − p ) × 1. Ouwehand (Stellenbosch Univ. P.

) Basic Finance November 2010 25 / 30 . Ouwehand (Stellenbosch Univ. 1 If p = 2 . If demand goes up(down). Supply and demand: The “correct” price is the one at which the supply is equal to the demand. P.1 1. then C0 = 5.1 So the price depends on p .Option Pricing in a Single–Period Model 2 Pricing by Expectation: (Huygens–Bernoulli) The “fair” price is the expected (discounted) payoﬀ: C0 = E CT 1+r =p× 11 0 + (1 − p ) × 1. so must the price: Higher prices will make it more attractive to sell(buy).

then C0 = 5. and thus the higher its price. 1 If p = 2 . The higher the probability p of an ↑–move.) Basic Finance November 2010 25 / 30 .1 So the price depends on p .1 1. P. If demand goes up(down). Ouwehand (Stellenbosch Univ. the more attractive the option. Supply and demand: The “correct” price is the one at which the supply is equal to the demand. so must the price: Higher prices will make it more attractive to sell(buy).Option Pricing in a Single–Period Model 2 Pricing by Expectation: (Huygens–Bernoulli) The “fair” price is the expected (discounted) payoﬀ: C0 = E CT 1+r =p× 11 0 + (1 − p ) × 1.

) Basic Finance November 2010 25 / 30 .1 1.Option Pricing in a Single–Period Model 2 Pricing by Expectation: (Huygens–Bernoulli) The “fair” price is the expected (discounted) payoﬀ: C0 = E CT 1+r =p× 11 0 + (1 − p ) × 1. If demand goes up(down). then C0 = 5.1 So the price depends on p . Both the above methods are WRONG!! P. The higher the probability p of an ↑–move. so must the price: Higher prices will make it more attractive to sell(buy). and thus the higher its price. Ouwehand (Stellenbosch Univ. the more attractive the option. Supply and demand: The “correct” price is the one at which the supply is equal to the demand. 1 If p = 2 .

) Basic Finance November 2010 26 / 30 . Ouwehand (Stellenbosch Univ.Option Pricing in a Single–Period Model 3 P.

Option Pricing in a Single–Period Model 3 Consider a portfolio θ := (θ0 .) Basic Finance November 2010 26 / 30 . At t = 0 the portfolio’s value is V0 (θ) = θ0 + 10θ1 P. θ1 ) consisting of an θ0 –many rands in a bank account and θ1 –many shares. Ouwehand (Stellenbosch Univ.

Option Pricing in a Single–Period Model 3 Consider a portfolio θ := (θ0 . Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 26 / 30 .5θ1 if S ↑ 22 if S ↓ 5. At t = 0 the portfolio’s value is V0 (θ) = θ0 + 10θ1 at t = T the portfolio’s value is VT (θ) = 1.1θ0 + 5. θ1 ) consisting of an θ0 –many rands in a bank account and θ1 –many shares.1θ0 + 22θ1 1.5 P.

) Basic Finance November 2010 26 / 30 .1θ0 + 5. Ouwehand (Stellenbosch Univ.5 We choose θ so that VT (θ) = CT . whether the stock price goes ↑ or ↓: ↑: ↓: 1. At t = 0 the portfolio’s value is V0 (θ) = θ0 + 10θ1 at t = T the portfolio’s value is VT (θ) = 1.1θ0 + 22θ1 1. θ1 ) consisting of an θ0 –many rands in a bank account and θ1 –many shares.Option Pricing in a Single–Period Model 3 Consider a portfolio θ := (θ0 .5θ1 = 0 ⇒ θ0 = − 10 3 .1θ0 + 22θ1 = 11 1.5θ1 if S ↑ 22 if S ↓ 5. θ1 = 2 3 P.1θ0 + 5.

) Basic Finance November 2010 27 / 30 .Option Pricing in a Single–Period Model 4 P. Ouwehand (Stellenbosch Univ.

) Basic Finance November 2010 27 / 30 . the Law of One Price dictates that C0 = V0 (θ) = − 10 3 + 2 3 × 10 = 10 3 P. Ouwehand (Stellenbosch Univ.Option Pricing in a Single–Period Model 4 As VT (θ) = CT no matter what.

Option Pricing in a Single–Period Model 4 As VT (θ) = CT no matter what.) Basic Finance November 2010 27 / 30 . the Law of One Price dictates that C0 = V0 (θ) = − 10 3 + 2 3 × 10 = 10 3 The probability p of an ↑–move is completely IRRELEVANT!! P. Ouwehand (Stellenbosch Univ.

Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 27 / 30 .Option Pricing in a Single–Period Model 4 As VT (θ) = CT no matter what. P. the Law of One Price dictates that C0 = V0 (θ) = − 10 3 + 2 3 × 10 = 10 3 The probability p of an ↑–move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument.

) Basic Finance November 2010 27 / 30 .Option Pricing in a Single–Period Model 4 As VT (θ) = CT no matter what. the Law of One Price dictates that C0 = V0 (θ) = − 10 3 + 2 3 × 10 = 10 3 The probability p of an ↑–move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument. Ouwehand (Stellenbosch Univ. An arbitrage is a portfolio θ with the following properties: P.

the Law of One Price dictates that C0 = V0 (θ) = − 10 3 + 2 3 × 10 = 10 3 The probability p of an ↑–move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument.Option Pricing in a Single–Period Model 4 As VT (θ) = CT no matter what.) Basic Finance November 2010 27 / 30 . An arbitrage is a portfolio θ with the following properties: V0 (θ) = 0 P. Ouwehand (Stellenbosch Univ.

An arbitrage is a portfolio θ with the following properties: V0 (θ) = 0 VT (θ) ≥ 0 in all states of the world. the Law of One Price dictates that C0 = V0 (θ) = − 10 3 + 2 3 × 10 = 10 3 The probability p of an ↑–move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 27 / 30 .Option Pricing in a Single–Period Model 4 As VT (θ) = CT no matter what. P.

P(VT (θ) > 0) > 0 P. the Law of One Price dictates that C0 = V0 (θ) = − 10 3 + 2 3 × 10 = 10 3 The probability p of an ↑–move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument.) Basic Finance November 2010 27 / 30 . Ouwehand (Stellenbosch Univ. An arbitrage is a portfolio θ with the following properties: V0 (θ) = 0 VT (θ) ≥ 0 in all states of the world.Option Pricing in a Single–Period Model 4 As VT (θ) = CT no matter what.

Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 27 / 30 .Option Pricing in a Single–Period Model 4 As VT (θ) = CT no matter what. An arbitrage is a portfolio θ with the following properties: V0 (θ) = 0 VT (θ) ≥ 0 in all states of the world. P(VT (θ) > 0) > 0 Thus an arbitrage is like a free lottery ticket. the Law of One Price dictates that C0 = V0 (θ) = − 10 3 + 2 3 × 10 = 10 3 The probability p of an ↑–move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument. P.

) Basic Finance November 2010 27 / 30 . P(VT (θ) > 0) > 0 Thus an arbitrage is like a free lottery ticket. An arbitrage is a portfolio θ with the following properties: V0 (θ) = 0 VT (θ) ≥ 0 in all states of the world. The only assumption we make is: There are no arbitrage opportunities in the market P. Ouwehand (Stellenbosch Univ. the Law of One Price dictates that C0 = V0 (θ) = − 10 3 + 2 3 × 10 = 10 3 The probability p of an ↑–move is completely IRRELEVANT!! The call option has been priced using an arbitrage argument.Option Pricing in a Single–Period Model 4 As VT (θ) = CT no matter what.

Ouwehand (Stellenbosch Univ.Pricing by Expectation — Reprise! 1 P.) Basic Finance November 2010 28 / 30 .

Pricing by Expectation — Reprise! 1 Consider our ﬁrst method for pricing the call option as (discounted) expected payoﬀ (Huygens–Bernoulli): C0 = E CT 1+r This seems like a good idea. but it went horribly wrong: P. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 28 / 30 .

P. but it went horribly wrong: 1 If p = 2 .Pricing by Expectation — Reprise! 1 Consider our ﬁrst method for pricing the call option as (discounted) expected payoﬀ (Huygens–Bernoulli): C0 = E CT 1+r This seems like a good idea. H-B give a price of C0 = 5. Ouwehand (Stellenbosch Univ.) Basic Finance November 2010 28 / 30 .

) Basic Finance November 2010 28 / 30 . . 3 (or else there will be arbitrage). but it went horribly wrong: 1 If p = 2 . P. but we know that C0 = 3. H-B give a price of C0 = 5. Ouwehand (Stellenbosch Univ.Pricing by Expectation — Reprise! 1 Consider our ﬁrst method for pricing the call option as (discounted) expected payoﬀ (Huygens–Bernoulli): C0 = E CT 1+r This seems like a good idea.

However. but it went horribly wrong: 1 If p = 2 .Pricing by Expectation — Reprise! 1 Consider our ﬁrst method for pricing the call option as (discounted) expected payoﬀ (Huygens–Bernoulli): C0 = E CT 1+r This seems like a good idea.) Basic Finance November 2010 28 / 30 . Ouwehand (Stellenbosch Univ. . P. the stock itself is not priced correctly via H-B. but we know that C0 = 3. 3 (or else there will be arbitrage). H-B give a price of C0 = 5.

5 1. the stock itself is not priced correctly via H-B.) Basic Finance November 2010 28 / 30 .1 when p = 1 2 P. . 3 (or else there will be arbitrage). H-B give a price of C0 = 5. However. but it went horribly wrong: 1 If p = 2 .5 + (1 − p ) × = 12.1 1. Ouwehand (Stellenbosch Univ.Pricing by Expectation — Reprise! 1 Consider our ﬁrst method for pricing the call option as (discounted) expected payoﬀ (Huygens–Bernoulli): C0 = E CT 1+r This seems like a good idea. but we know that C0 = 3. We ought to have S0 = p × 22 5.

) Basic Finance November 2010 28 / 30 .5 1.1 1.Pricing by Expectation — Reprise! 1 Consider our ﬁrst method for pricing the call option as (discounted) expected payoﬀ (Huygens–Bernoulli): C0 = E CT 1+r This seems like a good idea. P. we have S0 = 10. H-B give a price of C0 = 5. We ought to have S0 = p × 22 5.1 when p = 1 2 Instead. the stock itself is not priced correctly via H-B. but we know that C0 = 3. but it went horribly wrong: 1 If p = 2 . However.5 + (1 − p ) × = 12. 3 (or else there will be arbitrage). . Ouwehand (Stellenbosch Univ.

we have S0 = 10.Pricing by Expectation — Reprise! 1 Consider our ﬁrst method for pricing the call option as (discounted) expected payoﬀ (Huygens–Bernoulli): C0 = E CT 1+r This seems like a good idea.5 + (1 − p ) × = 12. We now ﬁnd a probability p ∗ for which H-B does price the stock correctly.1 when p = 1 2 Instead. However. Ouwehand (Stellenbosch Univ. We ought to have S0 = p × 22 5. 3 (or else there will be arbitrage). the stock itself is not priced correctly via H-B. but we know that C0 = 3.5 1. P.1 1. . H-B give a price of C0 = 5. but it went horribly wrong: 1 If p = 2 .) Basic Finance November 2010 28 / 30 .

) Basic Finance November 2010 29 / 30 . Ouwehand (Stellenbosch Univ.Pricing by Expectation — Reprise! 2 P.

5 + (1 − p ∗ ) × 1.) Basic Finance November 2010 29 / 30 . Ouwehand (Stellenbosch Univ.1 2 ⇒ p∗ = 1 3 P.1 1.Pricing by Expectation — Reprise! We want S0 = p ∗ × 22 5.

Ouwehand (Stellenbosch Univ. we obtain: C0 = E∗ which is correct!! CT 1+r = 11 2 0 10 1 × + × = 3 1.1 3 1.Pricing by Expectation — Reprise! We want S0 = p ∗ × 22 5.1 2 ⇒ p∗ = 1 3 If we use this new risk–neutral probability p ∗ to price the option via H-B.1 3 P.) Basic Finance November 2010 29 / 30 .1 1.5 + (1 − p ∗ ) × 1.

) Basic Finance November 2010 29 / 30 .5 + (1 − p ∗ ) × 1.1 3 P. we obtain: C0 = E∗ which is correct!! Thus H-B yields the correct price. CT 1+r = 11 2 0 10 1 × + × = 3 1. provided we use risk–neutral probabilities.Pricing by Expectation — Reprise! We want S0 = p ∗ × 22 5.1 1. Ouwehand (Stellenbosch Univ.1 3 1.1 2 ⇒ p∗ = 1 3 If we use this new risk–neutral probability p ∗ to price the option via H-B.

The Fundamental Theorem of Mathematical Finance Theorem P.) Basic Finance November 2010 30 / 30 . Ouwehand (Stellenbosch Univ.

Ouwehand (Stellenbosch Univ. P.) Basic Finance November 2010 30 / 30 .The Fundamental Theorem of Mathematical Finance Theorem A market–model is arbitrage–free if and only if there exists a risk–neutral probability measure.

The Fundamental Theorem of Mathematical Finance Theorem A market–model is arbitrage–free if and only if there exists a risk–neutral probability measure. but using risk–neutral probabilities.) Basic Finance November 2010 30 / 30 . Ouwehand (Stellenbosch Univ. P. Prices of derivative securities must be obtained via H-B.

) Basic Finance November 2010 30 / 30 . P.The Fundamental Theorem of Mathematical Finance Theorem A market–model is arbitrage–free if and only if there exists a risk–neutral probability measure. but using risk–neutral probabilities. This theorem is easy to prove for this simple unrealistic model. Ouwehand (Stellenbosch Univ. Prices of derivative securities must be obtained via H-B.

This theorem is easy to prove for this simple unrealistic model.The Fundamental Theorem of Mathematical Finance Theorem A market–model is arbitrage–free if and only if there exists a risk–neutral probability measure. Ouwehand (Stellenbosch Univ. but using risk–neutral probabilities. for all models.) Basic Finance November 2010 30 / 30 . P. But it holds in general. Prices of derivative securities must be obtained via H-B.

And makes it possible to numerically price options in very complicated and realistic models. Prices of derivative securities must be obtained via H-B. But it holds in general. but using risk–neutral probabilities. Ouwehand (Stellenbosch Univ. P.The Fundamental Theorem of Mathematical Finance Theorem A market–model is arbitrage–free if and only if there exists a risk–neutral probability measure. using Monte Carlo Simulation. for all models.) Basic Finance November 2010 30 / 30 . This theorem is easy to prove for this simple unrealistic model.

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