Lecture 1: Optimal Risky Portfolios - Risk reduction depends on the correlation:
 𝜌 = +1.0 → no risk reduction is possible
I. Diversification and Portfolio Risk:
1. The investment decision:
- Top-down process with 3 steps
 Capital allocation between the risky portfolio
and risk-free asset
 Asset allocation across broad asset classes
 Security selection of individual assets within
each asset class
2. Diversification and portfolio risk:
- Market risk:
 Risk attributable to market-wide risk sources
and remains even after extensive
diversification
 Also call systematic or nondiversifiable
- Firm-specific risk:
 Risk that can be eliminated by diversification
 Also call diversifiable or nonsystematic
- Portfolio standard deviation falls as the number of
securities increases, but cannot reduce to zero.
II. Portfolios of two risky assets:
1. Return:
- Portfolio return: 𝑟𝑝 = 𝑤𝐷 𝑟𝐷 + 𝑤𝐸 𝑟𝐸
𝐸(𝑟𝑝 ) = 𝑤𝐷 . 𝐸(𝑟𝐷 ) + 𝑤𝐸 . 𝐸(𝑟𝐸 )
2. Risk:
- Portfolio variance:
𝜎𝑝2 = 𝑤𝐷2 𝜎𝐷2 + 𝑤𝐸2 𝜎𝐸2 + 2𝑤𝐷 𝑤𝐸 𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 )
𝜎𝑝2 = 𝑤𝐷 𝑤𝐷 𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐷 ) + 𝑤𝐸 𝑤𝐸 𝐶𝑜𝑣(𝑟𝐸 , 𝑟𝐸 )
+ 2𝑤𝐷 𝑤𝐸 𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 )
𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 ) = 𝜌𝐷𝐸 . 𝜎𝐷 . 𝜎𝐸
3. Correlation coefficients:
- Range of values for 𝜌1,2: −1.0 ≤ 𝜌1,2 ≤ 1.0
 𝜌1,2 = 1.0 → perfectly positive correlated
securities
 𝜌1,2 = 0 → uncorrelated securities
 𝜌1,2 = −1.0 → perfectly negatively correlated
securities
- When 𝜌𝐷𝐸 = 1.0, there is no diversification
 𝜎𝑝2 = (𝑤𝐷 𝜎𝐷 + 𝑤𝐸 𝜎𝐸 )2
 𝜎𝑝 = 𝑤𝐷 𝜎𝐷 + 𝑤𝐸 𝜎𝐸
- When 𝜌𝐷𝐸 = −1.0, a perfect hedge is possible
 𝜎𝑝2 = (𝑤𝐷 𝜎𝐷 − 𝑤𝐸 𝜎𝐸 )2
 𝜎𝑝 = 𝑤𝐷 𝜎𝐷 − 𝑤𝐸 𝜎𝐸 (in absolute)
 When 𝜎𝑝 = 0, 𝑤𝐷 𝜎𝐷 − 𝑤𝐸 𝜎𝐸 = 0
𝜎𝐷 𝜎𝐸
o 𝑤𝐸 = 𝜎 and 𝑤𝐷 = 𝜎
𝐷 +𝜎𝐸 𝐷 +𝜎𝐸
4. Minimum variance portfolio:
𝜎 2 −𝐶𝑜𝑣(𝑟 ,𝑟 )
 𝐸
𝑤𝑚𝑖𝑛 (𝐷) = 𝜎2 +𝜎 𝐷 𝐸
2 −2𝐶𝑜𝑣(𝑟 ,𝑟
𝐷 𝐸 𝐷 𝐸)
 𝜌 = 0 → 𝜎𝑝 less than standard deviation of
either component asset
 𝜌 = −1.0 → a riskless hedge is possible
 risk reduction through diversification depends
on correlation
 risk reduction potential increases as the
correlation approaches -1
III. Asset allocation with stocks, bonds, and
bills
1. Asset allocation with two risky assets
- Mean-variance criterion
 If 𝐸(𝑟𝐴 ) ≥ 𝐸(𝑟𝐵 ) and 𝜎𝐴 ≤ 𝜎𝐵 , then portfolio
A dominates portfolio B
2. Sharpe ratio
- Maximize the slope of the CAL for any possible
portfolio, P
- Slope of CAL is Sharpe ratio of risky portfolio
𝐸(𝑟𝑝 ) − 𝑟𝑓
𝑆𝑝 =
𝜎𝑝
3. Optimal risky portfolio with a risk-free asset:
𝐸(𝑅𝐷 )𝜎𝐸2 − 𝐸(𝑅𝐸 )𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )
𝑤𝐷 =
𝐸(𝑅𝐷 )𝜎𝐸2 + 𝐸(𝑅𝐸 )𝜎𝐷2 − (𝐸(𝑅𝐷 ) + 𝐸(𝑅𝐸 ))𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )
𝑤𝐸 = 1 − 𝑤𝐷
4. Sharpe ratio maximizing portfolio weights with
two risky assets D and E and risk-free asset
[𝐸(𝑟𝐷 ) − 𝑟𝑓 ]. 𝜎𝐸2 − [𝐸(𝑟𝐸 ) − 𝑟𝑓 ]. 𝜌𝐷𝐸 . 𝜎𝐷 . 𝜎𝐸
𝑤𝐷 =
[𝐸(𝑟𝐷 ) − 𝑟𝑓 ]. 𝜎𝐸2 + [𝐸(𝑟𝐸 ) − 𝑟𝑓 ]. 𝜎𝐷2 − [𝐸(𝑟𝐷 ) − 𝑟𝑓 + 𝐸(𝑟𝐸 ) − 𝑟𝑓 ]. 𝜌𝐷𝐸 . 𝜎𝐷 . 𝜎𝐸
𝑤𝐸 = 1 − 𝑤𝐷
5. Determination of the optimal overall portfolio:
- Investor types: with A: coefficient of risk aversion
 Risk averse investors: 𝐴 > 0
 Risk neutral investors: 𝐴 = 0
 Risk lover investors: 𝐴 < 0
- Utility as function of allocation to the risky asset y
1
 𝑀𝑎𝑥𝑈 = 𝑟𝑓 + 𝑦. [ 𝐸(𝑟𝐷 ) − 𝑟𝑓 ] − 2 𝐴𝑦 2 𝜎𝑝2
𝐸(𝑟𝑝 )−𝑟𝑓
o 𝑦∗ = 𝐴𝜎𝑝2
IV. The Markowitz portfolio optimization
model:
1. Optimal portfolio construction:
a. Step 1: determine the risk-return opportunities
- Security selection:
 All portfolios lie on the minimum-variance
frontier
- Efficient diversification with many risky assets
 Three methods:
o Maximize risk premium for any
standard deviation
o Minimize standard deviation for any
risk premium
o Maximize Sharpe ratio for any
standard deviation or risk premium
b. Step 2: identify risky optimal portfolio by
finding portfolio weights that resulting in the
steepest CAL
 Search for CAL with highest reward-to-
variability ratio → optimal risky portfolio
 Optimal portfolio CAL tangent to efficient
frontier
 Invest in P regardless of their degree of risk
aversion
o More risk averse, put less in P
o Less risk averse, put more in P
c. Step 3: choose an appropriate complete portfolio
by mixing risk-free asset with optimal risky
portfolio
- Separate portfolio into two independent tasks
- Capital allocation line with various portfolios
from efficient set
d. Power of diversification
- Portfolio variance as
 Irreducible risk of diversified portfolio
depends on covariance of returns
1 𝑛−1 2
𝜎𝑝2 = 𝜎̅ 2 + 𝜌𝜎
𝑛 𝑛
o 𝜌 = 0, diversifiable against firm-
specific risk
o 𝜌 > 0, portfolio variance remain
positive
o 𝜌 = 1, non-diversifiable any firm-
specific risk
 Standard deviation is a good measure of risk
when returns are symmetric
 Mean and standard deviation estimate the
future scenarios
Diversification: Spreading a portfolio over many investments to
avoid excessive exposure to any one source of risk
Indifference curve: equally preferred portfolios will lie in
the mean-standard deviation plane on an indifference
curve, which connects all portfolio points with the same
utility value
Insurance principle: risk reduction by spreading exposure across
many independent risk sources
Minimum-variance portfolio: The portfolio of risky assets
with lowest possible variance
Portfolio opportunity set: The expected return–standard
deviation pairs of all portfolios that can be constructed from a given set
of assets
Sharpe ratio: Reward-to-volatility ratio; ratio of excess
return to portfolio standard deviation
Optimal risky portfolio: An investor’s best combination of risky
assets; the combination that maximizes the Sharpe ratio
Minimum-variance frontier: Graph of the lowest possible
portfolio standard deviation corresponding to each value of portfolio
expected return.
Efficient frontier of risky assets: The portion of the
minimum-variance frontier that lies above the global minimum-
variance portfolio
Separation property: The property that portfolio choice can be
separated into two independent tasks: (1) determination of the optimal
risky portfolio, which is a purely technical problem, and (2) the
personal choice of the best mix of the risky portfolio and the risk-free
asset.
Risk pooling: Adding uncorrelated, risky investments to the
portfolio
Risk sharing: Spreading risk across many investors so that each
investor bears only a fraction of the total risk
Expected return: the expected return on the portfolio is a
weighted average of expected returns on the component
securities with portfolio proportions as weights
Portfolio risk: variance depends on the variance/
correlation between the returns of the assets in the
portfolio
Covariance and correlation coefficient: provide a
measure of the way returns of two assets move together
----------------------------------------------------------------------  Risk premium on the market depends on
average risk aversion of all market
Lecture 2: The capital asset pricing model
participants
I. Review of portfolio theory:  Risk premium on an individual security is a
- Portfolio risk depends primarily on covariance, function of its covariance with the market
not stocks’ individual volatility III. Market risk premium
- Diversification reduces risk - Risk premium on the market portfolio will be
- Hold the tangency portfolio M: the tangency proportional to its risk and the degree of risk
portfolio has the highest expected return for a aversion of the investor
given level of risk 𝐸(𝑅𝑀 ) = 𝐴̅ 𝜎 2 𝑀
II. Capital asset pricing model CAPM:  𝜎 2 𝑀 : variance of market portfolio
- It is equilibrium model that underlies all modern  𝐴̅: average degree of risk aversion across
financial theory investors
- Derived using principles of diversification with IV. Return and risk for individual securities
simplified assumptions - Risk premium on individual securities is a
1. Assumptions: function of the individual security’s contribution
- Investors optimize portfolios based on Markowitz to the risk of market portfolio
model - An individual security’s risk premium is a
- Investors use identical input list for efficient function of the covariance of returns with the
frontier assets that make up the market portfolio
- Same risk-free rate, tangent CAL, and risky 1. Reward-to-risk ratio for investment in market
portfolio portfolio (market price of risk)
- Market portfolio is aggregation of all risky 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝐸(𝑅𝑀 )
= 2
portfolios and has same weights 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝜎 𝑀
- Individuals: 𝐸(𝑟𝑖 ) = 𝑟𝑓 + 𝛽𝑖 [𝐸(𝑟𝑀 ) − 𝑟𝑓 ]
 Mean-variance optimizers - Security market line: cx
 Homogeneous expectations
 All assets are publicly traded
- Markets:
 All assets are publicly held
 All information is available
 No taxes
 No transaction costs
2. Resulting equilibrium conditions:
- Market portfolio: all investors will hold the same  𝐸(𝑟𝑖 ): expected return of security
portfolio for risky assets
 𝑟𝑓 : risk-free rate → compensation for
- Market portfolio contains all securities and
postponing consumption: time preference
proportion of each security is its market value as a
percentage of total market value  𝛽𝑖 [𝐸(𝑟𝑀 ) − 𝑟𝑓 ] → compensation for bearing
systematic risk: risk aversion
 𝛽𝑖 : beta of security
 𝐸(𝑟𝑀 ) − 𝑟𝑓 : market risk premium
- Interpreting betas

V. CML and SML

- Market risk premium:
𝐸(𝑟𝑀 ) − 𝑟𝑓 = 𝐸(𝑅𝑀 )

1. Capital market line CML
- CLM depicts portfolios combining risk-free
investment and efficient portfolio
- CLM shows the highest expected return that can
attain for each level of volatility
- According to CAPM, market portfolio is on the
CML and all other stocks and portfolios contain
diversifiable risk and lie to the right of the CML
2. Security market line
- SML shows expected return for each security as a
function of its beta with the market
- According to CAPM, market portfolio is efficient,
all stocks and portfolios should lie on the SML
- If a stock is perceived to be a good buy or
underprice, it will provide an expected return in
excess of the fair return stipulated by the SML
 Underprice => plot above SML
 Overprice => plot below SML
 The stock’s alpha ∝: the difference between
the fair and actually expected rate of return on
a stock
VI. Stock’s alpha
1. Identifying stock’s alpha
- To improve performance of their portfolios,
investors will compare expected return of security
with its required return from security market line
𝑟𝑠 = 𝑟𝑓 + 𝛽𝑠 [𝐸(𝑅𝑀𝑘𝑡 ) − 𝑟𝑓 ]
- Difference between stock’s expected return and its
required return according to security market line is
call stock’s alpha
𝛼𝑠 = 𝐸(𝑅𝑠 ) − 𝑟𝑠
 When market portfolio is efficient, all stocks
are on the security market line and have an
alpha of zero
2. Profiting from non-zero alpha stocks
- Investors can improve performance of their
portfolios by buying stocks with positive alphas
and by selling stocks with negative alphas
VII. Single-index model and realized returns
- To move from expected to realized returns, use
index model in excess return form:
𝑅𝑖 = 𝛼𝑖 + 𝛽𝑖 . 𝑅𝑀 + 𝑒𝑖
 each firm-specific, zero-mean residual, 𝑒𝑖
uncorrelated across stocks and uncorrelated
with the market factor, 𝑅𝑀
 index model beta coefficient is same as beta
of the CAPM expected return-beta
relationship
key terms:
homogeneous expectations: The assumption that all
investors agree on the probability distribution of future
returns, so they all use the same input list.
market portfolio: The portfolio encompassing all assets
in which each asset is held in proportion to its market
value
mutual fund theorem: A result associated with the
CAPM, asserting that investors will choose to invest their
entire risky portfolio in a market-index mutual fund.
market price of risk: A measure of the extra return, or
risk premium, that investors demand to bear risk. The ratio
of the risk premium of the market portfolio to the variance
of its return
expected return – beta relationship: Implication of the
CAPM that security risk premiums (expected excess
returns) will be proportional to beta
security market line SML: Graphical representation of
the expected return–beta relationship
zero beta portfolio: The minimum-variance portfolio
uncorrelated with a chosen efficient portfolio
liquidity: The speed and ease with which an asset can be  There are sufficient securities to diversify
converted to cash. away idiosyncratic risk
 Well-functioning security markets don’t allow
Lecture 3: Arbitrage pricing theory and
for persistence of arbitrage oppoturnities
multifactor models of risk and return and
 Arbitrage oppoturnity arises when investor
efficient market hypothesis
earns riskless profit without making a net
I. Review modern portfolio theory investment
- MPT emphasizes statistical measures to develop  Law of one price states that if 2 assets are
portfolio plan equal in all economic aspects, they should
- Focus on: expected returns, standard deviation of have the same market price
returns, correlation between returns  Law of one price is enforced by arbitrageurs’
- Combines securities that have negative or low behaviors. Buying asset when it is cheap and
positive correlations between each other’s rates of selling when it is expensive
return IV. Single factor model
II. Summary CAMP - Returns on a security come from two sources:
- Capital asset pricing model CAPM allows to  Common macro-economic factor
identify efficient portfolio of risky assets without  Firm specific events
having any knowledge of expected return of each - Possible common macro-economic factors
security  Gross domestic product growth
- Market portfolio is efficient portfolio  Interest rates
- Risk premium for any security is proportional to - Realized excess return
its beta with the market
III. Arbitrage pricing theory 𝑅𝑖 = 𝐸(𝑅𝑖 ) + 𝛽𝑖 𝐹 + 𝑒𝑖
1. Assumptions of APT are less restrictive than
 𝑅𝑖 : excess return on security
CAPM:
- Capital markets are competitive  𝛽𝑖 : factor sensitivity = factor loading = factor
- Investors prefer more wealth to less beta
- Stochastic process that generates security returns  𝐹: Surprise in macro-economic factor. It
can be expressed as a linear function of K risk could be positive or negative, but it has
factors expected value of zero
- There are many securities traded, such that “well  𝑒𝑖 : firm-specific events (0 expected value)
diversified factor portfolios” can be formed with V. Efficient market hypothesis EMH
only one source of risk - EMH says stock prices reflect all available
2. Compare CAPM and APT: information
- EMH deals with informational efficiency (how
CAPM APT quickly and accurately the market reacts to new
+ Exactly one + one ore many information)
systematic risk factor: systematic risk factors: - Stock price changes follow random walk
market index factor inflation, oil prices, 1. Version of EMH:
+ Security prices change unemployment - Weak form hypothesis asserts that stock prices
due to market factor + expected security
reflect all information that can be derived by
changes and firm return determined by
specific news exposure to each risk examining market trading data such as history of
+ Expected security factor and their risk past prices, trading volume, short interest
return determined by premia - Semi-strong form hypothesis states that all
exposure to market risk publicly in stock price. Such information includes
factor and market risk past prices, fundamental data on firm’s product
premium line, quality of management, balance sheet
3. APT: composition, patents held, earnings forecasts
- APT predicts a security market line in accordance - Strong form version of efficient market hypothesis
with the intuition of expectedd return to risk states that stock prices reflect all information
- APT relies on three main propositions: relevant to firm, including information available
 Security returns can be described by a factor only to company insiders
model 2. Active and passive management:
 - Active management: buying a well-diversified
portfolio without searching for mispriced
securities
 Expensive strategy: costs for decision-making
 Market timing: from T-bills to stock
 Stock selection: undervalued stocks
 Suitable only for very large portfolios
- Passive management: buying mispriced securities
that are expected to outperform and sell or short
those that are expected to underperform
 No attempt to outsmart market
 Accept EMH
 Index fund
 Very low costs
 Buy/sell only for liquidity reasons
Key terms:
Single-factor model: A model of security returns that
decomposes the sources of return variability into one
systematic economywide factor and firm-specific factors.
Single-index model: A model of stock returns that
decomposes influences on returns into a systematic factor,
as measured by the return on a broad market index, and
firmspecific factor
Scatter diagram: Plot of returns of one security versus
returns of another security. Each point represents one pair
of returns for a given holding period
Residuals: Parts of stock returns not explained by the
explanatory variable (the market-index return). They
measure the impact of firm-specific events during a
particular period.
Regression equation: An equation that describes the
average relationship between a dependent variable and one
or more explanatory variables
Security characteristics line: A plot of the excess
return on a security over the risk-free rate as a function of
the excess return on the market.
Information ratio: Ratio of alpha to the standard
deviation of diversifiable risk.
Factor portfolio: A well-diversified portfolio constructed
to have a beta of 1.0 on one factor and a beta of 0 on any
other factor.
Well diversified portfolio: A portfolio spread out over
many securities in such a way that the weight in any
security is close to zero, resulting in negligible
diversifiable risk.
Arbitrage pricing theory APT: An asset pricing theory
that is derived from a factor model, using diversification
and arbitrage arguments. The theory describes the
relationship between expected return and factor exposure
that follows from the absence of risk-free arbitrage
opportunities
Arbitrage: A zero-risk, zero-net investment strategy that
still generates profits
Risk arbitrage: Speculation on perceived security
mispricing, often in connection with merger and
acquisition targets
Factor beta: Sensitivity of security returns to the
realization of a systematic factor. Also called factor
loading and factor sensitivity.
Multifactor model: Model of security returns positing
that returns respond to several systematic risk factors as
well as firm-specific influences
Lecture 4: bond prices and yields
I. Bond characteristics
1. What is bond?
- Bond: interest bearing loan issued by corporations
or governments
- bond certificate: interest bearing loan issued by
corporations or governments states that terms of a
bond as well as amounts and dates of all payments
to be made
- Maturity date: final repayment date of the bond.
Payments continue until this date
𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 . 𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
- Coupons: the promised interest payments of a
bond. Usually paid semiannually, but the
frequency is specified in the bond certificate. They
are determined by the coupon rate, which is stated
on the bond certificate.
- Principal = face value = par value: notional
amount used to compute the interest payment. It is
usually repaid on the maturity date
- Term: the time remaining until the repayment date
- Coupon rate, maturity date, par value are bond
indenture which is the contract between the
issuer and the bondholder
2. Zero-coupon bond:
- Doesn’t make coupon payment
- Always sells at a discount (price lower than face
value), so they are also called pure discount bonds
- Treasury bills are U.S. government zero-coupon
bonds with a maturity of up to one year
- Although bond pays no interest, compensation is - Foreign bonds: issued by a borrower from a
the difference between the initial price and face country other than the one in which bond is sold
value - Eurobonds: denominated in one currently, usually
3. Coupon bonds: that of issue, but sold in other national markets
- Coupon bonds: 7. Innovation in the bond market:
 Pay face value at maturity - Inverse floaters
 Pay regular coupon interest payments  Floater pays coupon = libor(t): London
- Treasury notes: interbank offered rate (at time of coupon
 US treasury coupon security with original payment)
maturities of 1-10 years  Inverse floater pays
- Treasury bonds: - Catastrophe bonds: coupon reduced to zero after
 US treasury coupon security with original heavy earthquake
maturities over 10 years - Indexed bonds: treasury inflation protected
 Bid price is the price at which you can sell securities TIPS: protection against inflation
bond to dealer II. Bond pricing
 Ask price is higher at which you can buy bond 1. Coupon bond:
from dealer 𝑇
4. Corporate bonds (default is possible ) 𝐶𝑡 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒
𝑃𝐵 = ∑ +
- Corporate bonds are issued with call provisions (1 + 𝑟)𝑡 (1 + 𝑟)𝑇
𝑡=1
allowing issuer to repurchase bond at a specified
call price before maturity date - Zero coupon bond:
- Callable bond gives issuer the right option to 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒
𝑃𝐵 =
repurchase bond before maturity date (at par (1 + 𝑟)𝑇
value)  𝑃𝐵 : price of bond
 Callable bonds come with a period of call  𝐶𝑡 : interest or coupon payments
protection, an initial time during which bonds  𝑇: number of periods to maturity
are not callable = deferred callable bonds  𝑟: yield to maturity
 Callable bonds are issued with higher coupons -
𝐶𝑃𝑁1
+
𝐶𝑃𝑁2
+ ⋯+
𝐶𝑃𝑁𝑁
: annuity
(1+𝑌𝑇𝑀)1 (1+𝑌𝑇𝑀)2 (1+𝑌𝑇𝑀)𝑁
and promised yields to maturity than non- 𝐶𝑃𝑁1 𝐶𝑃𝑁2 𝐶𝑃𝑁𝑁 𝐹𝑉𝑁
𝑃= + + ⋯+ +
callable bonds (1 + 𝑌𝑇𝑀)1 (1 + 𝑌𝑇𝑀)2 (1 + 𝑌𝑇𝑀)𝑁 (1 + 𝑌𝑇𝑀)𝑁

- Refunding: if a company issues bond with high
coupon rate when market interest rates are high
and interest rates later fall, firm may retire the
high-coupon debt and issue new bonds at lower
coupon rate to reduce interest payment
- Convertible bonds give bondholder the option to
exchange bond for shares of the firm’s common
stock (at conversion date)
- Puttable bonds give bondholder the option to
retire or extend the bond
- Floating rate bonds have an adjustable coupon rate
5. Preferred stock:
- Shares characteristics of fixed income and equity
 Like fixed income
o Payments are typically fixed
o Preferred dividends are paid before
common
 Like equity:
o Dividends are paid in perpetuity
o Nonpayment doesn’t mean
bankruptcy
o No tax break
6. International bonds:
2. Dynamic behavior of bond prices
- Discount: a bond is selling at a discount if the
price is less than face value
- Par: a bond is selling at par if price is equal to face
vale
- Premium: a bond is selling at a premium of the
price is greater than face value
3. Bond pricing between coupon rate:
𝑖𝑛𝑣𝑜𝑖𝑐𝑒 𝑝𝑟𝑖𝑐𝑒 = 𝑓𝑙𝑎𝑡 𝑝𝑟𝑖𝑐𝑒 + 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑑𝑎𝑦𝑠 𝑠𝑖𝑛𝑐𝑒 𝑙𝑎𝑠𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
= 𝑥
2 𝑑𝑎𝑦𝑠 𝑠𝑒𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
III. Bond yields
1. Why is discount rate r called “YTM”:
- YTM is discount rate that sets the present value of
the promised bond payments equal to the current
market price of bond
- Interest rate is interpreted as a measure of average
rate of return that will be earned on a bond of it is
bought now and held until maturity
- YTM of a bond is the internal rate of return IRR
earned by an investor who buys the bond today at
 the market price, assuming that the bond will be  𝐸(𝑃1 ): expected ending price
held until maturity  𝐸(𝐷1 ): expected coupon during period one
- Assumption: all coupons are reinvested at an - Holding period returns when yields change
interest rate equal to yield-to-maturity  No change → HPR = yield at bond purchase
2. Zero coupon bond: date
𝐹𝑉  Rising yields → yield increase cause a loss
𝑃=
(1 + 𝑌𝑇𝑀𝑛 )𝑛
 → HPR < initial yield
- Yield to maturity of n-year zero coupon bond is
 Falling yields → yield decrease cause a price
𝐹𝑉 1
𝑌𝑇𝑀𝑛 = ( )𝑛 − 1 gain → HPR > initial yield
𝑃
3. Coupon bonds: VI. Default risk on bond pricing
- YTM is single discount rate that equates the 1. Protection against default
present value of the bond’s remaining cash flows - Sinking funds: issuer is required to buy back x%
to its current price of bonds in market before maturity
- Dividend restrictions: force firm to retain earnings
rather than paying them out to shareholders
- Collateral: bondholders receive proceeds from
liquidation of particular asset if firm defaults
- Yield to maturity of a coupon bond - Subordination of future debt: restrict additional
1 1 𝐹𝑉 borrowing
𝑃 = 𝐶𝑃𝑁 × (1 − )+
𝑦 (1 + 𝑦) 𝑁 (1 + 𝑦)𝑁 2. YTM and default risk
IV. Bond prices and yield - Capital market requires different yields from
- Prices and yields (required rates of return) have an issuers with different credit ratings
inverse relationship - Yield spread measures the extra yield that capital
- Bond price curve is convex markets demands from issuers with high credit
- Longer maturity, more sensitive bond’s price to risk
changes in market interest rates - Credit spread = default spread: difference between
- Lower coupon, more sensitive bond price yield on corporate bonds and treasury yields
V. Bond prices over time - Spread is highly cyclical and can increase in times
- Holding all other things constant, a bond’s yield to of a financial crises
maturity will not change over time 3. Credit default swaps CDS
- Holding all other things constant, price of discount - Credit default swaps CDS acts like an insurance
or premium bond will move toward par value over policy on default risk of corporate bond or loan
time - CDS buyer pays annual premiums
- If bond’s yield to maturity hasn’t changed, IRR of - CDS issuer agrees to buy bond in default at face
an investment in bond equals its yield to maturity value or pay difference between par and market
even if you sell the bond early values to CDs buyer
1. Compare YTM and HPR:
Premium bonds (Price > Par): Coupon rate > Current
YTM HPR
yield > Yield to maturity
+ YTM is bond’s + HPR is the realized
internal rate of return rate of return over Discount bonds (Price < Par): Coupon rate < Current
and corresponds to the particular investment yield < Yield to maturity
average expected period
return if bond is held + HPR depends on Par value bonds (Price = Par): Coupon rate = Current
to maturity bond’s price at the yield = Yield to maturity
+ YTM assumes that end of holding period,
all coupons can be an unknown future Key terms:
reinvested at YTM value
Debt securities: Bonds; also called fixed-income
rate
securities.
2. Risk and risk premiums
- Rate of return: single period Bond: A security issued by a borrower that obligates
𝐸(𝑃1 ) − 𝑃0 + 𝐸(𝐷1 ) the issuer to make specified payments to the holder
𝐻𝑃𝑅 =
𝑃0 over a specific period
 𝐻𝑃𝑅: holding period return
 𝑃0 : beginning price
Par value: The face value of the bond. The payment I. Yield curve
to the bondholder on the bond’s maturity date. - Yield curve is a graph that displays relationship
between YTM and time to maturity
Face value: The maturity value of a bond.
 Inverted yield curve: downward sloping, short
Coupon rate: A bond’s interest payments per dollar rate > long rate
of par value  Normal yield curve: upward sloping
- Information on expected future short term rates
Bond indenture: The contract between the issuer and can be implied from yield curve
the bondholder 1. Bond pricing:
Zero-coupon bond: A bond paying no coupons that - Yields on different maturity bonds aren’t all equal
sells at a discount and provides only payment of face - Each bond can be considered as portfolio of stand-
value at maturity. alone zero-coupon bonds
- Value of bond should be sum of values of its parts
Callable bond: A bond that the issuer may repurchase - Bond stripping and bond reconstitution offer
at a given call price in some specified period opportunities for arbitrage
Convertible bond: A bond with an option allowing 2. Two types of yield curves:
the bondholder to exchange the bond for a specified Pure yield curve zero On the run yield curve
number of shares of common stock in the firm. (higher coupon curve
price because bondholder owns bond) + pure yield curve uses + on-the-run yield curve
stripped or zero coupon uses recently issued
Floating rate bonds: A bond whose interest rate is
yields coupon bonds selling at
reset periodically according to a specified market rate. + pure yield curve may or near par
Yield to maturity YTM: A measure of the average differ significantly from + financial press
rate of return that will be earned on a bond if held to the on-the-run yield typically publishes on
curve of coupon bonds the run yield curves
maturity
Current yield: A bond’s annual coupon payment
II. Yield curve and future interest rates
divided by its price. Differs from yield to maturity
1. Future interest rates:
Premium bonds: A bond selling above par value. - Yield curve under uncertainty
 Bond yield YTM is the internal rate of return
Discount bond: A bond selling below par value.
of a bond
Realized compound return: Compound rate of return  Spot rate = zero coupon rate: rate prevails
assuming that coupon payments are reinvested until today for given maturity. Spot rate is
maturity geometric average of its component short
rates
Horizon analysis: Forecasting the realized compound  Short rate: short term interest rate for given
yield over various holding periods or investment maturity at different points in time
horizons.
 Forward rate: interest rate between two future
Reinvestment rate risk: The uncertainty surrounding time points as inferred by current term
the cumulative future value of reinvested bond coupon structure
payments - Compare short rate and yield curve slope
+ when next year’s + when next year’s
Junk bond: A bond rated Ba or lower by Moody’s or short rate, 𝑟2 > 𝑟1 , short rate, 𝑟2 < 𝑟1 ,
BB or lower by Standard & Poor’s, or an unrated yield curve slopes up yield curve slopes
bond. Also called a speculative-grade bond + may indicate rates down
rise + may indicate rates
Original issue discount bond: A bond issued with a fa;;
low coupon rate that sells at a discount from par value. 2. Forward rates:
Puttable bond: A bond that the holder may choose (1 + 𝑦𝑛 )𝑛
(1 + 𝑓𝑛 ) =
either to exchange for par value at some date or to (1 + 𝑦𝑛−1 )𝑛−1
extend for a given number of years.  𝑓𝑛 : one-year forward rate for period n
 𝑦𝑛 : yield for a security with maturity of n
Lecture 5: The term structure of interest rate
 - Forward interest rate is forecast of future short
rate
III. Interest rates uncertainty and forward
rates
- Investor require risk premium to hold longer term
bond
- Liquidity premium compensates short term
investors for uncertainty about future prices
IV. Theories of term structure
1. Expectations hypothesis theory
- Observed long-term rate is a function of today’s
short term rate and expected future short term
rates
- 𝑓𝑛 = 𝐸(𝑟𝑛 ) and liquidity premiums are zero
- Function holds if
 Investors are risk neutral
 Investors don’t prefer short term bonds
2. Liquidity preference theory
- Long-term bonds are more risky when 𝑓𝑛 > 𝐸(𝑟𝑛 )
- Excess of 𝑓𝑛 over 𝐸(𝑟𝑛 ) is liquidity premium
- Yield curve has upward bias built into long term
rates because of liquidity premium
V. Interpreting term structure
- The yield curve reflects expectations of future
interest rates
- The forecasts are clouded by liquidity premiums
- An upward sloping curve could indicate:
 Rates are expected to rise
 Investors require large liquidity premiums to
- The yield curve is a good predictor of the business
cycle
 Long term rates tend to rise in anticipation of
economic expansion
Inverted yield curve may indicate that interest rates are
expected to fall and signal a recession
Key terms:
Term structure of interest rate: The pattern of interest
rates appropriate for discounting cash flows of various
maturities. The relation between yield to maturity and time
to maturity.
Yield curve: A measure of the average rate of
return that will be earned on a bond if held to maturity
Bond stripping: Selling bond cash flows (either coupon
or
principal payments) as stand-alone zero-coupon securities
Bond reconstitution: Combining zero-coupon stripped
securities to re-create the original cash flows of a coupon
bond. (bond stripping and bond reconstitution offer
opportunities for arbitrage can occur if law of one price is
violated)
Pure yield curve: The relationship between yield to
maturity and time to maturity for zero-coupon bonds.
On the run yield curve: Relationship between yield to
maturity and time to maturity for newly issued bonds
selling at or near par value.
Spot rate: The current interest rate appropriate for
discounting a cash flow of some given maturity.
Short rate: A one-period interest rate
Forward interest rate: Rate of interest for a future period
that would equate the total return of a long-term bond with
that of a strategy of rolling over shorter-term bonds.
Liquidity premium: Forward rate minus expected future
short interest rate
Expectations hypothesis: Theory that
forward interest rates are unbiased estimates of expected
future interest rates
Liquidity preference theory: Theory that investors
demand a risk premium on long-term bonds. Implies that
the forward
Lecture 6: Future markets
I. Futures contract:
1. Basics of futures contracts:
- Futures price is paid at contract maturity
- Require daily setting up of contracts gains or
losses
- Long position commits to purchase commodity on
delivery date = buy contract
 Profit to long = spot price at maturity –
original futures price
 Profit from price increase
- Short position commits to deliver commodity on
delivery date = sell contract
 Profit to short = original futures price – spot
price at maturity
 Profit from price decrease
o Spot price: actual market price of
commodity at time of delivery
2. Forward contract:  when contract begins trading, open interest is
- Agreement to buy or sell an asset for a forward zero
price at a certain time  time passes, open interest increase as more
 Each party must lock in ultimate delivery contract entered
price 2. Margin account and marking to market:
 Protect each party from future price - Marking to market: process by which profits or
fluctuations losses accrue to traders
 No money changes hands until delivery date  At initial execution of trade, each trader
 Party that agrees to sell has what is termed a establishes margin account
short position  Contracts written on assets with more volatile
 Party that agrees to buy has what is termed a prices require higher margin
long position  Margin account fall below a critical value:
- Forward contract is traded OTC maintenance margin
3. Compare forwards and futures contracts:  Margin account:
o More volatile price, higher margins
forwards futures o Ensure trader satisfy obligation of
+ private contract + exchange traded
futures contracts
between 2 parties
+ non-standard contract + standard contract  Convergence property: futures price and spot
+ 1 specified delivery + range of delivery dates price must converge at maturity
date  Margin call: when maintenance margin is
+ settled at end of + settled daily reached, broker will ask for additional margin
contract funds
+ delivery or final cash + contract closed out III. Futures Markets strategies:
settlement occurs prior to maturity 1. Hedging and speculation:
+ some credit risk + no credit risks - Hedge uses future contract to protect against price
movement
4. Existing contracts: - Speculator uses futures contract to profit from
- Futures and forward contracts are traded in four movement in futures price
categories:  Speculator believe price increase, they take
 Agricultural commodities long position for expected profits and take
 Metals and minerals short position for decreasing expected profit
- Speculators: seek to profit from price movement
 Foreign currencies
 Short – believe price fall
 Financial futures
II. Trading mechanics:  Long – believe price rise
1. Clearinghouse and open interest: - Arbitrageurs: seek to profit from arbitrage
- Clearinghouse becomes seller of contract for long opportunities
position and buyer of contract for short position  Short – future overvalued
- Clearinghouse becomes an intermediary  Long – future undervalued
- Clearinghouse’s position nets to zero - Hedgers: seek protection from price movement
 Traders liquidate position easily  Short – protect against a fall in selling price
 Reversing trade  Long – protect against rise in purchase price
2. Basis risk and hedging:
- Basis is difference between futures price and spot
price
 On maturity, basis is zero.
 Convergence property implies 𝐹𝑇 − 𝑃𝑇 = 0
3. Long hedge for purchasing of asset:

- open interest on contract is number of contracts

outstanding
- 𝐹1 : futures price at time hedge is set up Forward contract: agreement calling for future delivery
- 𝐹2 : futures price at time asset is purchased of asset at an agreed-upon price
- 𝑆2 : asset price at time of purchase
Futures price: price at which futures trader commits to
- 𝑏2 : basis at time of purchase
make or take delivery of underlying asset
4. Short hedge for sale of an asset
Long position: futures trader commit to purchase
underlying asset
Short position: futures trader committing to deliver
underlying asset
Clearinghouse: established by exchanges to facilitate
- 𝐹1 : futures price at time hedge is set up transfer of securities resulting from traders. For options
- 𝐹2 : futures price at time asset is sold and futures contracts, clearinghouse interpose as
- 𝑆2 : asset price at time of sale intermediate between 2 traders
- 𝑏2 : basis at time of sale
IV. Futures prices: Open interest: number of futures contracts outstanding
1. Spot-futures parity theorem: Marking to market: daily settlement of obligation on
- Rate of return on hedged stock portfolio: futures positions
(𝐹0 + 𝐷) − 𝑆0
𝑆0 Maintenance margin: an established value below trader’s
2. Optimal hedge ratio: margin may not fall. Reaching maintenance margin
- Proportion of exposure that should optimally be triggers a margin call
hedged:
Convergence property: convergence of futures prices
- Cross hedging: hedging position using futures on
and spot prices at maturity of futures contract
another asset
𝜎𝑆 Cash settlement: provision of some futures contracts that
ℎ∗ = 𝜌.
𝜎𝐹 requires not delivery of underlying asset but settlement
 𝜎𝑆 : standard deviation of ∆𝑆, change in spot according to cash value of the asset
price during hedging period
Basis: difference between futures price and spot price
 𝜎𝐹 : standard deviation of ∆𝐹, change in spot
price during hedging period Basis risk: risk attributable to uncertain movement in the
 𝜌: coefficient of correlation between ∆𝑆 and spread between futures price and spot price
∆𝐹
- Optimal hedge ratio: Spot-futures parity theorem: describes correct
relationship between spot and future prices. Violation
̂𝑆
𝜎 cause arbitrage opportunity. Also called: cost-of-carrying
ℎ̂ = 𝜌̂.
𝜎
̂𝐹 relationship
- Optimal number of contracts: Lecture 7: Option markets
 Optimal number of contracts if adjustment for
𝑄𝐴 I. Option contract:
daily settlement = ℎ∗ 1. Call option:
𝑄𝐹
 Optimal number of contracts after “tailing - Call option gives holder right to purchase an asset
adjustment” to allow or daily settlement of for specified price: exercise price = strike price
𝑉
futures = ℎ̂ 𝐴  Exercise option to buy only if share price >
𝑉𝐹
strike price
o 𝑄𝐴 : size of position being hedged
 Profit on call options increase when asset
(units)
price increase
o 𝑄𝐹 : size of one futures contract (units)
 Share price < strike price → option left
o 𝑉𝐴 : value of position being hedged
unexercised → unexercised before expiration
(= spot price times 𝑄𝐴 )
date, call option: expire and valueless
o 𝑉𝐹 : value of one futures contract (=
 On expiration date, stock price > exercise
futures price times 𝑄𝐹 )
price → call value = stock price – exercise
Key terms:
price
  Stock price < exercise price → call expire
worthless
 Net profit = option value – original
investment
- Premium is purchase price of option
 Premium represents compensation call buyer
pays for right to exercise only when exercise
is desirable
2. Put option:
- Sellers write calls
2. Put option: 0 𝑖𝑓 𝑆𝑇 ≥ 𝑋
𝑝𝑎𝑦𝑜𝑓𝑓 𝑡𝑜 𝑝𝑢𝑡 ℎ𝑜𝑙𝑑𝑒𝑟 = {
- Put option gives holder right to sell an asset for 𝑆𝑇 − 𝑋 𝑖𝑓 𝑆𝑇 < 𝑋
specified exercise price = strike price on or before
expiration date
 Put is exercised only if price of asset <
exercise price and only if holder delivers
exercise price asset with lesser market value
 Profit on put option increase when asset price
decrease
 Value at expiration = exercise price – stock
price
- In the money when its exercise produce positive
cash flow
 Asset price > exercise price → call option III. Option strategies:
 Asset price < exercise price → put option 1. Protective put:
- Out of the money when asset price < exercise - Want to invest but unwilling to bear losses(own
price stock and buy put option)
 Exercise price < asset price → put option
- At the money when exercise price = asset price
- On expiration date = European options
- On or before the expiration date = American
options
II. Values of options at expiration:
1. Call option:
𝑆 − 𝑋 𝑖𝑓 𝑆𝑇 > 𝑋
𝑝𝑎𝑦𝑜𝑓𝑓 𝑡𝑜 𝑐𝑎𝑙𝑙 ℎ𝑜𝑙𝑑𝑒𝑟 = { 𝑇
0 𝑖𝑓 𝑆𝑇 ≤ 𝑋
 𝑆𝑇 : value of stock at expiration
 𝑋: exercise price
- Formula emphasizes option property because
payoff cannot be negative
 Option is exercised when 𝑆𝑇 exceeds X
 No negative option, just have 0 2. Covered calls:
 Loss = original paid for option - Purchase a share of stock with simultaneous sale
 Profit = option payoff – original purchase call option on that stock (own stock and write call)
price
−(𝑆𝑇 − 𝑋) 𝑖𝑓 𝑆𝑇 > 𝑋
𝑝𝑎𝑦𝑜𝑓𝑓 𝑡𝑜 𝑐𝑎𝑙𝑙 𝑤𝑟𝑖𝑡𝑒𝑟 = {
0 𝑖𝑓 𝑆𝑇 ≤ 𝑋

 Call writer has losses if stock price increase

and is willing to bear risk in return for option
premium

3. Straddle:
- Buy call and put on stock with same exercise price
and same expiration date
4. Spreads:
- Spread is combination of more than 2 call options
or put options on same stock with differing
exercise prices or time to maturities
- Money spread involves purchase of one option
and simultaneous sale of anther with different
exercise price
- Time spread is sale and purchase of options with
differing expiration dates
IV. Put-call parity relationship
Put – call parity theorem:
𝑋 stockholders. Slips can increase or decrease shares.
𝐶+ = 𝑆0 + 𝑃
(1 + 𝑟𝑓 )𝑇
 If parity relation is violated, arbitrage
opportunity arises
𝑃 = 𝐶 − 𝑆0 + 𝑃𝑉(𝑋) + 𝑃𝑉(𝐷)
Key terms:
Call option: buy one option and write another with
different expiration date
Covered call: combination of selling a call option
together with buying underlying asset
Exercise price: price set for calling (buying) an asset or
putting (selling) an asset
Premium: purchases price of an option (seller of option at
time of sale receive premium)
Put option: right to sell asset at specified exercise price
on or before specified expiration date
In the money: an option whose exercise produce positive
cash flow.
Out of the money: an option where exercise results in
negative cash flow
At the money: option’s exercise price = price of
underlying assets
Spread: combination of more than two call options or put
options on same stock with differing exercise prices or
times to expiration.
Money spread: a spread with different exercise prices
Time spread: a spread with different expiration dates
Put-call parity theorem: equation represents proper
relation between put and call prices. Violation of parity
implies existence of arbitrage opportunities
Straddle: combination of buying both call and put on
same assets, each with same exercise price and expiration
date. Purpose is to profit from expected volatility
Protective put: purchases of asset combined with put
option on that asset to guarantee proceeds at least equal to
put’s exercise price
American option: can be exercised before and up to its
expiration date. Compare with European option, which
can be exercised only on the expiration date: European
option
Stock split: issued by corporation of given number of
shares in exchange for current number of shares held by
Reverse split decrease number outstanding.
Bullish strategy: investor attitude to optimistic (married
put, short put, long and short call)
Bearish strategy: investor attitude to pessimistic(buy put  present value of exercise price decrease
option)  benefit the call option holder
 option value increase
Lecture 8: Option valuation
- interest rate increase:
I. Option valuation: introduction  call option value increase
1. Intrinsic and time values:  present value of exercise price decrease
- Call is value because there is always a chance that - dividend increase:
stock price rise above exercise price by expiration  lower expected rate of capital gain
date  lower option value
- 𝑆0 − 𝑋: intrinsic value II. Restrictions on option values:
 Intrinsic value = 0 for out-of-money or at-the- 1. Restrictions on value of a call option:
money - The most obvious restriction is that its value
 Time value = actual call price – intrinsic value cannot be negative
- Option to exercise provides insurance against poor - Loan repayment is 𝑋 + 𝐷
stock price performance 𝑋+𝐷
- Purchase one share of stock and borrow
(1+𝑟𝑓 )𝑇
- Stock value is 𝑆𝑇 + 𝐷 (ex-dividend stock value +
dividends received)
 Total payoff to stock-plus-borrowing position
is positive or negative depends on whether 𝑆𝑇
exceeds X
- If option expires in the money and zero, payoff to
call option is 𝑆𝑇 − 𝑋
𝑋+𝐷
- Value of call must be greater than 𝑆0 − (1+𝑟 𝑇
𝑓)
Or 𝐶 ≥ 𝑆0 − 𝑃𝑉(𝑋) − 𝑃𝑉(𝐷)
 𝑃𝑉(𝑋): present value of exercise price
 𝑃𝑉(𝐷): present value of dividends that stock
pays at the expiration
 Stock price is very low, option is worthless
because there is no chance to be exercised
 Stock price is very high, option value
approaches adjusted intrinsic value
 In midrange case, option is appropriately at
the money
2. Determinants of option values:
- Six factors affect value of call option:

 Before expiration, call option value will be

within allowable range, touching neither
upper or lower bound
2. Early exercise and dividends:
- Call option increase in value with stock price - Holder can close out position has 2 options:
- Call option decrease in value with exercise price  Exercise call
 If exercised, payoff to call = 𝑆𝑇 − 𝑋  Sell call
 Expected payoff increases with difference III. Binomial option pricing:
𝑆𝑇 − 𝑋 1. Two states option pricing:
- Volatility: - Stock prices can take only 2 possible values at
 Low volatility yields lower expected payoff expiration:
- Time to expiration lengthens  Stock increase given higher price
  Stock decrease given lower price Implied volatility: standard deviation of stock returns that
- Hedge ratio = ratio of ranges because option and is consistent with an option’s market value
𝐶 −𝐶
stock are perfectly correlated 𝐻 = 𝑢.𝑆𝑢 −𝑑.𝑆
𝑑
Hedge ratio: shares of stocks required to hedge against
0 0
 𝐶𝑢 𝑜𝑟 𝐶𝑑 : call option’s value when stock’s up price risk of writing one option. Also called option’s delta
or down
Portfolio insurance: practice of using options or dynamic
 𝑢. 𝑆0 𝑎𝑛𝑑 𝑑. 𝑆0 : stock prices
hedge strategies to provide protection against investment
 𝐻: ratio of swings in end-of-period values of losses while maintaining upside potential
option and stock
 Example: Dynamic hedging: constant updating of hedge positions
o Stock price range: 𝑢. 𝑆0 − 𝑑. 𝑆0 = 30 as market conditions change
o Option price range 𝐶𝑢 − 𝐶𝑑 = 10.
1
o Hence hedge ratio is 𝐻 = means
3
1
that portfolio made up 3 share with
one written option would have an
end-of-year value of $30 with
certainty
- Option is underpriced, it should be reversed
arbitrage strategy: buy option and sell stock short
to eliminate price risk
IV. Black-Scholes option valuation:
- Black-Scholes pricing formula:
Call option value:
𝐶0 = 𝑆0 . 𝑁(𝑑1 ) − 𝑋. 𝑒 −𝑟𝑇 . 𝑁(𝑑2 )
𝑆 𝜎2
ln ( 𝑋0 ) + (𝑟 + 2 ) . 𝑇
𝑑1 =
𝜎. √𝑇
𝑑2 = 𝑑1 − 𝜎. √𝑇
 C0 : current call option value
 S0 : current stock price
 N(d): probability that random draw from
standard normal distribution will be less than
d
 X: exercise price
Put option value:

𝑃 = 𝑋. 𝑒 −𝑟𝑇 . [1 − 𝑁(𝑑2 )] − 𝑆0 . [1 − 𝑁(𝑑1 )]

𝑃 = 𝐶 + 𝑃𝑉(𝑋) − 𝑆0 = 𝐶 + 𝑋. 𝑒 −𝑟𝑇 − 𝑆0
Key terms:
Intrinsic value: value of option would have if it were
about to expire
Time value: difference between option’s price and
intrinsic value
Binomial model: an option valuation model predicated on
assumption that stock prices can move to only 2 values
over any short time period
Black-Scholes pricing formula: an equation to value an
option that uses stock price, exercise price, risk-free rate,
time to maturity, standard deviation of stock return