Financial Markets I

Notes
 Page 2

Table of Contents

Financial Markets Overview...........................................................................................................4

Financial and Depository Institutions .............................................................................................6
Financial Markets and Non-Depository Institutions ........................................................................7
Adverse Selection ..........................................................................................................................8
Moral Hazard .............................................................................................................................. 10
Regulatory Framework ................................................................................................................ 11
Central Banks .............................................................................................................................. 13
Regulatory Framework (Part 2) .................................................................................................... 15
Introduction to Debt Markets ...................................................................................................... 17
Term Structure ............................................................................................................................ 18
Term Structure (Part 2) ................................................................................................................ 21
Yield Curve with Credit Spread..................................................................................................... 24
Bond Returns .............................................................................................................................. 25
Bond Returns—Yield to Maturity .............................................................................................. 26
Interest Rate Risk Duration .......................................................................................................... 27
Duration ..................................................................................................................................... 28
Debt and Coupons ....................................................................................................................... 30
Debt Market Institutions ............................................................................................................. 31
Introduction to Primary Equity Markets ....................................................................................... 32
Primary Equity Markets ............................................................................................................... 33
Venture Capital and Public Offerings ............................................................................................ 34
Public Offerings ........................................................................................................................... 36
Secondary Equity Markets ........................................................................................................... 37
Secondary Equity Markets (Part 2) ............................................................................................... 39
Equity Market Institutions ........................................................................................................... 40
Introduction to Commodity Markets ............................................................................................ 41
Commodities Markets ................................................................................................................. 43
Commodities Markets (Part 2) ..................................................................................................... 45
No-Arbitrage Principle ................................................................................................................. 46
Pricing by No-Arbitrage ............................................................................................................... 47
Commodity Market Institutions ................................................................................................... 49
Interest Rate Parity ..................................................................................................................... 50
Interest Rate Parity (Part 2) ......................................................................................................... 51
Covered Interest Arbitrage .......................................................................................................... 53
Triangular Arbitrage .................................................................................................................... 55
Triangular Arbitrage (Part 2) ........................................................................................................ 57
Carry Trade .................................................................................................................................58
Options Overview ....................................................................................................................... 60
Option Payoffs Equation .............................................................................................................. 61
Options Payoffs—P ut O ptio n s .................................................................................................. 63
Option Strategies ........................................................................................................................ 65
 Page 3

Greek Letters .............................................................................................................................. 68

Theta, Vega, and Rho .................................................................................................................. 70
Black-Scholes Model.................................................................................................................... 72
Black-Scholes Model (Part 2) ....................................................................................................... 74
Dynamic Delta Hedging ............................................................................................................... 76
Binomial Option Pricing Model .................................................................................................... 80
Binomial Option Pricing ............................................................................................................... 81
 Page 4

Financial Markets Overview

Financial markets are markets in which financial assets, such as stocks, bonds,
foreign exchange, commodities, and their derivatives, are traded. Financial
markets consist of capital markets, commodity markets, money markets, and
foreign exchange markets.

Financial markets serve the following purposes:

1. They facilitate the transfer of capital from where it is in surplus to where it

is lacking.

2. They enable price discovery of the financial assets by bringing buyers and
sellers together.

a. By enabling discovery of the fair market price of an asset, financial

markets help to determine the return on that asset, as well as the
capital allocation among different assets.

3. They provide liquidity for financial assets so that an investor can buy or sell
a financial asset at any time.

a. Without liquidity, investors would be forced to hold fixed-income

instruments until maturity or to hold equity investments until the
company in question buys back the stock or goes insolvent.

4. They transfer risk from low-risk appetite to high-risk appetite.

 Page 5

5. They provide a place in which financial instruments can be traded to

transfer risk.

Capital markets include equity markets and debt markets, in which equity and
debt instruments and their derivatives are traded. Commodity markets facilitate
the trading of commodities. Money markets facilitate short-term debts and
financing. Foreign exchange markets provide a facility through which foreign
exchange and their derivatives can be traded.

Transactions in financial markets can occur via an exchange or directly between

two counterparties in what is known as an over-the-counter (OTC) transaction.
 Page 6

Financial and Depository Institutions

Depository institutions, such as banks and credit unions, collect money from
depositors and lend this money out to borrowers. There is information
asymmetry between the lender and the borrower because borrowers know much
more about their ability and willingness to pay than lenders. Depository
institutions mitigate this risk by evaluating the creditworthiness of potential
borrowers, monitoring the borrowers after the loan, and collecting on defaulter
accounts.

Depository institutions have a banking license and are governed by the country’s
banking laws. They transform liquid liabilities, such as savings accounts, into
relatively illiquid assets such as home mortgages, car loans, business loans, and
credit card balances. Depository institutions also operate the payment systems
through which bank balances are transferred between parties. This occurs
through checks, wire transfers, and credit and debit card transactions, eliminating
the risk of carrying cash. They also offer foreign exchange services, such as the
conversion of one currency into another, thereby facilitating international trade.
 Page 7

Financial Markets and Non-Depository

Institutions
Non-depository or non-banking financial institutions include insurance
companies, pension funds, hedge funds, securities firms, and finance companies.

Insurance companies collect premiums from many businesses and

individuals and pool them together to provide protection from the
potential financial impact of unforeseen events.

Pension funds collect contributions and invest them to provide pension

income for retirees.

Finance companies sell commercial paper and lend the proceeds to

individuals and businesses for higher interest rates than those they have
paid.

Hedge funds accumulate capital from a small number of sophisticated

investors and invest it in securities or other instruments.

o The amount of leverage that a hedge fund can take is not controlled
by the regulators.

o The performance of a hedge fund is measured using alpha, which is

the excess return of the fund relative to the return of the benchmark
index.
 Page 8

Adverse Selection
Adverse selection is an instance of market failure that is rooted in the asymmetry
of information between the buyers and sellers that exist in the market.

Adverse selection occurs when a seller has more information on the value of the
object being sold than the buyer and is unwilling to sell it at a lower price than the
value they know it holds. The buyer, however, does not have enough information
to accurately assess the value of the object. As such, he or she undervalues it due
to the possibility that it is defective. This asymmetry of information prevents the
transaction from taking place. If both the seller and the buyer had similar
information, they would be willing to trade at a mutually agreed price. If both had
insufficient information, they would trade at the expected price, in which case
both parties would consider the possibility of the item being defective. When
there is an imbalance of information between the buyer and the seller, they are
unable to arrive at a mutually acceptable price.

An example of this can be seen in the securities market, in which many

companies, both healthy and sick, offer stock. If there is a lack of information
about companies’ financial health, a buyer will not be able to distinguish between
those with low risk and those with high risk. The buyer will, therefore, offer an
average price that lies between the price of good and bad firms.
 Page 9

While the good firms will not accept the offer because it undervalues their stock,
the bad firms will readily accept it as it overvalues their stock. This adverse
selection inappropriately inflates poor stock while deflating quality stock and is,
thus, considered a failure in the market.
 Page 10

Moral Hazard
Moral hazard, like adverse selection, is another instance of market failure that is
rooted in the asymmetry of information between buyers and sellers in the
market.

Moral hazard describes a market failure situation in which one of the parties
involved in a transaction undertakes excessive risk knowing that they do not have
to pay the consequences of that risk.

When lending to a customer, a bank expects the money to be paid back with
interest. Moral hazard is the risk that the borrower will not use the money as
intended, take unnecessary risks, or fail to take adequate steps to reduce risk.
Similarly, a company that sells stock to investors is expected to use the money in
the shareholders’ interests. If the shareholders do not have sufficient information
about or control over how the company spends funds, the management is free to
use the money as it pleases. The management may use the money in risky
activities or wasteful expenditure since any consequences will be borne by the
shareholders.
 Page 11

Regulatory Framework
A financial institution can become insolvent if it suffers a large sudden loss or a
sustained period of smaller losses. A seemingly solvent bank can turn out to be
insolvent if examiners find hidden losses (assets that have been overvalued or
liabilities that have not been recognized). Solvency regulations seek to prevent
financial institutions from becoming insolvent. That is, they protect depositors
against losses when normal regulations fail to prevent a financial institution’s
insolvency. This is achieved by the means of deposit insurance, which protects
depositors against losing all their savings in the event that an institution fails.
Deposit insurance assures depositors of the safety of their deposits in the event of
an adverse shock to the system and, thereby, prevents “bank runs.” This
guarantee of government protection, however, also carries a risk of “moral
hazard.” That is, the insured or guaranteed institution may make higher-risk bets
because severe losses from losing bets will fall on taxpayers, while profits from
winning bets will go to the owners and managers.

Governments also seek to prevent any liquidity crises, such as bank runs, on
otherwise solvent banks by using the central bank as a lender of last resort. That
is, the central bank is ready to lend to an illiquid bank when no one else will,
provided the bank has collateral in the form of high-quality assets.
 Page 12

To control risk taking, regulations limit the amount of high-risk assets financial
institutions can hold. Banking regulations also encourage the diversification of
assets as a means of reducing risk.

Asymmetric information problems, such as moral hazard and adverse selection,

can cause market failure and adversely impact the financial system. To counter
this, the government empowers the central bank to exert control over financial
institutions through financial regulations.

The basic goals of regulations are:

To protect depositors and account-holders from losses arising from the

insolvency of financial institutions,

to protect individuals from unfair dealing in the financial markets,

and to ensure general stability within the financial system.

Central banks are financial institutions that determine the money supply and key
interest rates. They also regulate and monitor other financial institutions,
especially banks.
 Page 13

Central Banks
Central banks issue currency and are found in almost every country. They monitor
credit conditions and create money to keep the market fluid and deter difficulties
in performing basic transactions.

Central banks attempt to control the key interest rates of very liquid markets.
They trade their deposits back and forth with the Federal Reserve banks. The
Federal banks will add or drain liquidity to keep the interest rates in line with
target levels.

The central bank may ration credit or encourage loans. They regulate and monitor
financial institutions. They may not always have full authority, but they work
closely to ensure they are solvent.

A central bank’s goal is to keep currency stable; however, they will reduce or
increase the value of their currency to stimulate or restrain the economy. They
also accomplish this by managing the foreign exchange market, which can be
extremely large in some countries.
 Page 14

Central banks, along with other regulators, help stabilize the bank system. They
accomplish this by:

Providing deposit insurance,

acting as the lender of last resort,

regulating capital,

enforcing the diversification of assets,

monitoring examinations and disclosures,

and maintaining good internal controls.

As a lender of last resort, the central bank may offer loans to institutions that are
having difficulties or close to failing. International central banks have agreed upon
how much capital they should have and have established a specific amount they
must maintain. They enforce diversification of assets to protect against a shock
causing a crash.
 Page 15

Regulatory Framework (Part 2)

Central banks ensure the solvency and liquidity of financial institutions through
capital regulation. Financial institutions are required to maintain a positive capital
position equal to at least a certain portion of their assets. The Basel Accord, to
which all central banks are signatories, recommends that banks must hold a
certain percentage of their risk-weighted assets as capital.

While central banks regularly inspect the financial health of banks through
examination and disclosures, a bank’s financial health may rapidly decline in the
case of rapid trading losses. To monitor this, banks are required to implement
stringent internal controls and robust risk management processes to ensure live
monitoring of any mounting risks. Stress testing and VaR calculations are also
adopted to calculate the worst possible losses under adverse scenarios.

In the U.S., the Federal Reserve is the regulator for banks and bank holding
companies. The Federal Deposit Insurance Corporation (FDIC) provides deposit
insurance, guaranteeing the safety of a depositor's accounts in each insured bank.
 Page 16

The National Association of Insurance Commissioners (NAIC), which is composed

of chief insurance regulators from all U.S. states, is the standard-setting and
regulatory body for insurance companies. The U.S. Securities and Exchange
Commission (SEC) is responsible for enforcing the federal securities laws,
proposing securities rules, and regulating the securities industry, the stock
exchanges, and the electronic securities markets in the United States. The U.S.
Commodity Futures Trading Commission (CFTC) regulates the futures and options
markets. The Consumer Financial Protection Bureau (CFPB) is responsible for
consumer protection in the financial sector, which includes banks, credit unions,
securities firms, payday lenders, mortgage-servicing operations, and other
financial companies that operate in the United States.
 Page 17

Introduction to Debt Markets

Bonds are fixed-income instruments that are denominated in a certain currency.
These are considered fixed income because the fixed or floating-rate interest is
specified in advance. Bonds are issued by the central government, local
governments, and corporations.

Treasury bills are short-term debt obligations that are backed by the U.S.
government and have a maturity of less than one year. Treasury notes are debt
securities, and they mature between 1 and 10 years. Treasury bonds are
marketable debt securities that have a fixed interest and a maturity of more than
10 years.

Government bonds are considered riskless because the government has the
option to increase taxes or print the money required to repay bonds.
 Page 18

Term Structure

Yield Curves

Based on the spread between maturities, the yield curve can be classified as one
of the following:

Normal yield curve

Inverted yield curve

Steep yield curve

Flat yield curve

Humped yield curve

Figure 1: Yield curve shapes

 Page 19

1. Normal yield curve

A normal yield curve results when the short-term interest rates are lower than
the long-term interest rates. The normal yield curve is the most commonly
observed of all yield curve shapes. It has a positive slope, which implies that
the market expects growth in the economy and a rise in inflation in the future.
Under normal conditions, long-term interest rates are kept higher to
compensate for future market uncertainty and the potential of increased
inflation rates.

2. Inverted yield curve

An inverted yield curve results when the long-term interest rates are lower
than the short-term interest rates. This negatively sloped curve is observed
when the market expects the economy to slow down and perform poorly in
the future. So, instead of demanding a higher rate of interest in long-term
securities, investors prefer to lock their returns on short-term securities,
expecting that the central bank will reduce interest rates to stimulate the
economy.

3. Steep yield curve

The steep yield curve is a normal yield curve with a wide spread between the
short-term and long-term interest rates. This curve is usually observed during
an expansion phase of an economy, during which the demand for credit is
likely to be high.
 Page 20

4. Flat yield curve

The flat yield curve is a yield curve that tracks similar yields for different
maturities. The spread in a flat yield is almost negligible. The flat yield curve is
a transitional stage between the normal and inverted curves. It is normally
observed when the market is unsure about the movement of the economy and
the future of inflation.

5. Humped yield curve

The humped yield curve, also known as the bell-shaped curve, is observed
when medium-term interest rates are higher than both short-term and long-
term maturities. The humped yield curve is a transitional state between a
normal yield curve and an inverted yield curve. Not all humped yield curves
result in the onset of an inverted yield curve.
 Page 21

Term Structure (Part 2)

Investors watch the maturity yield curve closely because it gives them an idea of
what future interest rate changes and economic activity may emerge. The yield
curve is a line that plots interest rates from a set time between bonds that have
the same credit quality, but different maturity dates. Generally, it compares U.S.
Treasury bonds of 3 months, 2 years, 5 years, and 30 years. This creates a
benchmark that can be used to monitor other areas of debt in the markets, such
as lending rates.

The spread is a summary measure of the yield curve. It can be defined as the
difference between the strike price and the market value.

The normal yield curve has an upward slope and is the most common yield curve.
It is defined as a short-term debt security that has a lower yield than the long-
term debt securities of the same credit worth. This is referred to, and considered
to be, “normal” because investors generally expect more compensation for
greater risk. Long-term bonds are riskier. The normal yield curve is seen as growth
and trend inflation.

The inverted yield curve is basically the exact opposite of the normal yield curve.
It is defined as identifying an environment in which long-term debt security has a
lower yield than short-term debt (of the same credit worth).
 Page 22

This is the rarest of the yield curve types and investors know it typically means a
recession or slowdown in the economy.

The flat yield curve is just that: A flat line with no difference between investing in
short-term or long-term securities and no difference in the interest rates of the
same credit worth. It is usually seen in the transition time between a normal and
an inverted curve. This is unfavorable because the investor doesn’t stand to
benefit from holding the bond for 30 years; as such, he or she may as well sell it
immediately rather than incurring risk by holding it for a longer period of time.

The humped yield curve follows a very similar path to the flat yield; however, it
will drop at some point in the future. If an investor holds a 30-year bond, the
closer he sells the bond during the up time of the hump, the better. Holding on to
the bond to maturity is very risky. The humped yield curve indicates a slowdown
in the economy.

A spot yield curve is a graphical depiction of a set of yields of zero-coupon bonds

of varying maturities.

Credit spread is the difference in the yield amount between two bonds that have
similar maturity but different credit quality. For instance, the Treasury is expected
to be able to pay its bonds. An A-rated industrial company that offers a bond has
a chance of going out of business or otherwise not being able to pay. Therefore,
they must offer greater returns on their bonds to make the risk worthwhile to
investors. The credit spread measures the difference between what investors are
 Page 23

willing to pay for a riskless bond and a bond that is associated with risks. The
higher the credit rating, the lower the credit spread.
 Page 24

Yield Curve with Credit Spread

The spot rate curve plots the zero-coupon yield of Treasury instruments across
different maturities. It is plotted with yields of zero-coupon Treasury instruments
(bill, notes, and bonds) on the y-axis and their corresponding maturities on the x-
axis. If the zero-coupon rate is not available for a required maturity,
bootstrapping is used to calculate the rate. The spot rate curve is used to value
debt instruments.

Credit spread is the additional yield an investor earns above the risk-free rate
when investing in a risky bond. The additional yield compensates the investor for
the credit risk they bear when investing in a corporate debt. The value of the
spread depends on the credit rating of the corporate issuing the debt. The higher
the credit rating, the lower the credit spread.
 Page 25

Bond Returns
Bond returns are measured by calculating current yield. The yield is the simplest
calculation, and it indicates the return you will get on your investment. This is
calculated as:

yield = coupon amount / price.

Bond investors prefer to calculate this as yield to maturity (YTM). This is a more
advanced calculation than current yield and shows the total of the return you will
receive if you hold on to the bond until its maturity date. However, as bond prices
increase, bond yields fall.
 Page 26

Bond Returns—Yield to Maturity

Yield to maturity (YTM) is the rate of return investors would earn if they were to
buy the bond today at the current market price. It is the discounted rate at which
the sum of all future cash flows equates to the current market price of the bond if
all the cash flows from the bond are made on schedule, the bond is held until
maturity, and the cash flows received are reinvested at YTM.

If the YTM of a bond is equal to its coupon rate, the bond is selling at par.

If the YTM of a bond is less than its coupon rate, the bond is selling at a premium.

If the YTM of a bond is more than its coupon rate, the bond is selling at a
discount.
 Page 27

Interest Rate Risk Duration

Interest rate risk is the risk to the value of a bond posed by a change in interest
rate. The interest rate risk of a bond depends on the extent to which the bond is
sensitive to the changes in interest rates. The sensitivity, in turn, depends on the
time to maturity and coupon rate of the bond.

Interest rates and bond prices have an inverse relationship. When interest rates
go down, new bond issues pay lower coupon rates, thus increasing the demand
and price for the earlier, higher coupon-rate bonds. When interest rates go up,
new bond issues have higher coupon rates, thereby decreasing the demand and
price of earlier bonds.

If an investor has bought a bond with the intention of holding it until maturity,
there is no interest rate risk, as the redemption value and coupon rate are fixed
and, therefore, unaffected by changing interest rates. If, on the other hand, the
investor buys a bond with the intention of selling it before maturity, the rise in
interest rates will adversely affect the price of the bond.
 Page 28

Duration

Duration

Duration, also called “Macaulay Duration,” is a measure of the extent to which a

bond is sensitive to changes in interest rates. It shows changes in the price of a
bond relative to changes in interest rates, and is calculated as a weighted average
of the time until the cash flow of the bond is received, measured in years.

𝑃𝑉
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑡
𝑉

Modified Duration

Modified duration helps to calculate how the price of a bond will change in
response to a change in interest rates. Modified duration is the percentage
change in the price of the bond for every unit (basis point) of change in interest
rate. It is calculated as follows:

𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 (𝑀𝐷) =
𝑌𝑇𝑀
(1 + 𝑛 )

Changes in bond prices can be calculated using modified duration, as follows:

Δ 𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 = 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 ∗ 𝑀𝐷 ∗ Δ 𝑖𝑛 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒

 Page 29

As previously mentioned, the Macaulay duration is measured in years. It helps

assess the risk of an investment in fixed-income instruments; the higher the
duration of a bond, the riskier the bond.

Modified duration helps to calculate the changes in bond prices that result from
changes in the yield curve. A bond with longer maturity and a lower coupon rate
will have a higher duration than one with a shorter maturity and higher coupon
rate. However, duration analysis suffers limitations as it fails to take into
consideration the following:

The yield curve may tilt upward or downward.

Bonds may have call options.

 Page 30

Debt and Coupons

Corporations and governments require funds to finance their ongoing and
upcoming capital-intensive projects. They raise these funds by issuing debt to
individual and institutional investors. The coupon rate of a debt that is issued is
largely dependent on the credit quality of the issuer. Government debts normally
have the lowest coupon rate, as governments are assumed to have insignificant
credit risk. Company-issued debt has a higher coupon rate to compensate for its
associated higher credit risk. Market interest rates are also an important factor in
deciding the coupon rate of the issue.
 Page 31

Debt Market Institutions

Governments and corporations issue debt to individuals and institutional
investors as a means of raising funds. The coupon rate is dependent on the
credibility of the issuer. Governments have the lowest coupon rate because it is
assumed they will be able to repay the debt. Companies will have a higher coupon
rate because of the higher credit risk.

Credit is measured by credit rating agencies. These provide people and investors
with the information necessary to determine if an issuer of debt will be able to
pay what is owed. Credit ratings are issued in ratings; the higher the rating, the
more confidence investors will have. Individual investors generally use credit
rating agencies to get a rating they feel comfortable with; for example, the AAA
rating.

Institutional investors want to know how much credit risk they are taking. They
prefer a full investigation to know the risk they are taking before they purchase a
bond. Some investors may not select bonds by type, but by a predetermined
credit rating for the company selling it.

State and local governments sell bonds that are federally tax exempt, giving the
investor more incentive to purchase them. In these cases, investors depend on
credit rating agencies to verify corporate debts. Asset-backed securities are an
alternative method by which investors can invest in corporate debts.
 Page 32

Introduction to Primary Equity Markets

The primary market is the component of the capital market through which
institutions issue securities, such as equity and preference shares, through initial
public offerings. When a new instrument is issued only in the primary market, it is
known as the “new issue market.” The money received from primary investors
goes to the institutions and investors buy and sell the securities through regulated
exchange markets or over-the-counter (OTC) deals. Most of the issues are open to
all types of investors (individual or institutional), but some of the new issues may
be limited to institutional investors only. The prices of these securities are
predetermined and stated in the offer document.

Primary Markets are for investors who want the first chance to exploit new
investments. These companies or individuals may buy up new stock and retain it
as privately held without it ever hitting the public market. The main reason for a
company to issue stock is to:

Raise capital or funds for expansion,

cover rising operating cost,

or to get out of debt.

Some companies prefer the boarder public markets, and some do not. Most
would rather have their share more broadly held, which increases investor
confidence.
 Page 33

Primary Equity Markets

There are several reasons why an institution may issue securities in the primary
market:

To provide funds to form or expand a business.

To pay back outstanding debt and fund it with proceeds from the issue
of equity shares.

To dilute the ownership of a shareholding.

To increase investor confidence and company visibility.

Governments, private sector companies, and public sector companies raise funds
by issuing securities, such as shares and debentures, to both the public at large
and institutional investors.
 Page 34

Venture Capital and Public Offerings

Venture capital is money provided by individuals, groups, banks, or other financial
institutions as start-up funds for small businesses that exhibit great potential.
Venture capitalists may offer their expertise, as well as their funding, in exchange
for equity in the growing company. One downside to agreements of this nature is
that the capitalist will subsequently have a say in how the owners of the business
manage their company. Capitalists may have stakes in several companies at one
time and typically chose to support companies that exhibit long-term
development opportunities.

Venture capital companies and other private companies often choose the public
offering route instead of a private placement investment. A public offering
involves selling themselves or going public and issuing their own shares on the
market. Going public means they issue shares in the company at a predetermined
price and receive funds in return.

Public offerings initially require the securities to be documented with the terms
and conditions. These documents must be registered and approved by the SEC or
other regulating body depending on the country. The rules vary widely from
country to country. The U.S. is considered to be extremely strict in terms of the
requirements that govern a company’s ability to go public, and the SEC is
renowned for being very thorough. This gives investors throughout the world
more confidence in the company’s stock.
 Page 35

New issues and guarantee subscriptions are normally brought to market by an

underwriting organization. Generally, the underwriter will have a large amount of
expertise and an established network of potential investors. In return, they
charge a fee for the risk they are taking and any investment they make in
marketing and advertising the stock. The fee is included in the agreed upon
offering price of the IPO.

After the securities are allocated, trading in the secondary market begins. The first
day of trading can vary greatly from expectations and may require adjustments.
 Page 36

Public Offerings

A public offering arises when a company issues shares or other financial

instruments to the general public. Public offerings can be made by public or
private companies. Equity shares issued by existing publicly traded companies are
called secondary equity offerings.

When a private company “goes public” (offers shares to the public for the first
time) the offering is called an initial public offering (IPO). An IPO gives the
company better access to capital markets and, therefore, to funds at a lower
price. It also allows the promoters to liquidate their holdings directly through the
exchange. When securities other than shares are issued to the public, this is not
classified as an IPO.
 Page 37

Secondary Equity Markets

Secondary equity markets are for trading stocks that have been previously issued
in the primary market. The secondary markets are more for investors trading
stocks back and forth than for the company that issues the stock. Pricing is
affected by new information or the liquidity of stocks. The New York Stock
Exchange and the NASDAQ are secondary markets in the U.S. Regional stock
exchanges are now more national; however, they do have different types of
clients and specialties.

Securities issued in the primary markets are traded in the secondary market. The
issuer of the securities is no longer a party to the transaction, and transactions
involving the purchase or sale of securities are executed between two investors
through a centralized exchange market or through over-the-counter (OTC) deals.
In a small number of cases, trades may be executed through dark pools.

Dark pools are a means for brokers to cross-sell stocks among their own
customers. The majority of these are handled away from the central exchanges.
The name dark pool comes from the fact the exchanges are hidden from the
public. The brokers often have their own rules as to who gets to trade what and
how fast. They are required to make the fact that a trade took place public, but
they don’t have to share all the details.
 Page 38

Stock dealers are people or firms who make a business of buying and selling
stocks for their own account, either via a broker or otherwise. They tend to deal
with less liquid stocks that don’t trade frequently. Therefore, if a company
wanted to sell a rare stock they would sell it to the dealer, and the dealer would
hold it until they found someone to buy it.

Fast markets are exchanges that try to compete by bring a sale to the front more
rapidly than other markets. They do this by investing in faster electronic systems.
The main problem with this approach is that a flood of transactions can occur in a
rush with only a few of them being executed. This puts a strain on the systems
and can cause dealers to shut down because they are overwhelmed by the
volumes. The Flash Crash of May 2010 is an example of this phenomenon in
action.
 Page 39

Secondary Equity Markets (Part 2)

Prices in the secondary market are determined by factors such as supply and
demand and are also influenced by available market information and future
market expectations.

The liquidity of a market directly influences the efficiency with which deals take
place. A functional secondary market is a prerequisite for a functional primary
market; investors would not subscribe to new issues in the primary market
without a secondary market in which to liquidate investments.
 Page 40

Equity Market Institutions

An offer document is required to issue securities in the primary market. It

contains the terms and conditions through which the securities are offered to
investors. The offer document must be approved by the governing regulatory
body of the country of issue. The rules and regulations governing the offer
document differ according to the country of issue.

The issue process is undertaken by an underwriter who guarantees the

subscription to the issue at a fixed fee. The securities allocated are then traded on
the secondary markets. Investors and speculators are two major participants in
the secondary equity market. Institutional investors have a much larger trade
volume than retail investors. Institutional investors play an important role in
bringing efficiency to market operations and facilitating the price discovery of
securities.
 Page 41

Introduction to Commodity Markets

Commodity markets are markets in which primary products, such as agricultural

products or mined resources, are traded. Commodity markets help to manage the
price risk of primary products by fixing the price of their products well ahead of
time, thereby eliminating the uncertainty of future commodity prices.

Commodities can broadly be divided into three categories:

Soft commodities are mainly agricultural products such as wheat, coffee,

sugar, cattle, etc.

Hard commodities include metals that are either mined or extracted such
as gold, copper, brass, silver, etc.

Energy commodities include oil and gas.

Commodity markets in the U.S. started out as agricultural markets based in

Chicago due to their proximity to the Midwest and the Erie Canal. These markets
dealt predominantly with the sale, purchase or trade of raw products. Out of this,
futures markets, such as the Chicago Mercantile Exchange (CME), were born.

Derivative contracts are financial instruments that derive their value from an
underlying asset. The most common derivative contracts are forwards, futures,
swaps, and options.
 Page 42

Futures markets buy and sell contracts for delivery on a future date. Those trading
in commodities also trade in commodity derivatives. In the 1980s, people began
to trade financial futures on interest rates, stock indexes, and other key variables.
Today, both commodity and financial products are traded on the futures markets.
 Page 43

Commodities Markets
Commodity markets are markets in which primary products are traded such as
gold, metals, energy, wheat, and corn. Financial products are traded on
exchanges and over-the-counter (OTC) markets. OTCs are flexible in terms of
delivery dates and dealers trade OTC stocks within a network via computer or
phone.

Forwards markets are OTC markets that set the prices for financial instruments,
stocks, bonds, or other assets with a future delivery. The price is set in a contract,
and the contracts are binding on all parties. This type of market is customizable
and carries a high default risk.

In comparison, futures markets have contracts to buy or sell, but are standardized
and have little-to-no default risk. The futures markets have standardization, which
helps to create liquidity in the marketplace. Forwards markets have some credit
risk, but futures markets do not because a clearinghouse guarantees against
default risk. Futures markets are sufficiently well-structured to survive times in
which other markets fail.

A commodity forward contract is a contract to buy or sell a specific commodity on

a future date (called the expiry date) at a price decided today. It eliminates price
risk and fixes the price of the underlying asset to be exchanged in future. Forward
contracts are OTC contracts and are highly customizable, their terms being
mutually decided by the parties. Delivery takes place at the expiry of a forward
 Page 44

contract when the underlying commodity is exchanged at the previously agreed

forward rate.

Some of the biggest beneficiaries of forward markets are the suppliers of

agricultural commodities and metals. Forwards act as a hedging mechanism
against price risk, as the future price is fixed today.

Commodities participants include institutions, individuals, governments, hedge

funds, and speculators. Participants may invest in either the futures or the
forwards markets. Indirect investment in commodities markets can include
investing in those who produce the products sold as commodity stocks, mutual
funds, or exchange-traded funds.
 Page 45

Commodities Markets (Part 2)

Future contracts are standardized contracts traded on exchanges. The trades are
guaranteed by a clearinghouse and this offsets counterparty risk. The OTC
markets have also adopted the use of clearinghouses for trades in certain
products. The terms of a contract, such as the trade date, place of delivery, and
the underlying quality and quantity of a commodity, are all pre-fixed. The only
variable parameter in a future contract is the future price, which converges into
the spot price on the expiry date.

Speculators are the major participants in the commodity markets. They normally
exit their position before the expiry date. Only about 2% of futures contracts
result in delivery at the expiry.
 Page 46

No-Arbitrage Principle
When trade is taking place in different markets, if the prices are lower in one
market than another, the demand will shift and level the prices again. Arbitrage is
defined as two entities purchasing and selling a financial security to profit from a
difference in the price between two markets. The profit on the trade is made by
exploiting the difference between the price of the same (or extremely similar)
financial securities on different markets. Market inefficiencies result in arbitrage.
This offers a means by which traders can make sure prices do not deviate
substantially, for a prolonged period, from the fair value.

The more the market levels, the less money there is to be made. Thus, the no-
arbitrage principle states that when unequal pricing situations arise, the normal
trading of the markets will take care of this situation quickly. These are not
opportunities that are available often; however, arbitrage can take place between
markets and across time.
 Page 47

Pricing by No-Arbitrage

Let us look at the no-arbitrage pricing principle again by considering a commodity

forward contract, using zinc as an example. Suppose that the current price of one
unit of zinc is $10 and the price of a one-year zinc forward is to be determined.
Assume that the zinc can be loaned out at a lease rate of 2% per annum (p.a.),
and the risk-free interest rate is 4% p.a. with annual compounding in both cases.
Also, assume that the price of zinc does not change in one year.

According to the no-arbitrage principle, the price of the one-year zinc forward
must be $10.20.

If the price of the forward was less than $10.20 (say $10.05), then an arbitrageur
could buy a one-year zinc forward (take a long position in the commodity
forward), borrow a unit of zinc from someone today and sell it (short-sell the
commodity), invest the proceedings from the short sale in risk-free deposits for a
year, and make a riskless profit of $0.15. The actual cash flows are given below.
 Page 48

Similarly, if the price of the forward was more than $10.20 (say $10.40), then the
arbitrageur could short-sell the forward, take a loan of $10, use it to buy a unit of
zinc today, and lend out that zinc to make a riskless profit of $0.20.

As we can see, the no-arbitrage principle, therefore, sets the correct price of the
one-year zinc forward at $10.20.
 Page 49

Commodity Market Institutions

Originally, commodity suppliers had no alternative than to sell their products in

the open market at the current price. In the case of commodities that were
perishable or had a shorter shelf life due to lack of proper warehousing facilities,
the prices received would often even lower than the fair market value. This led to
the development of forward markets.

The commodities markets are composed of suppliers, institutional investors, and

speculators. While institutional investors are normally the other party in a
forward contract with the suppliers, speculators are only present in the futures
market.

There are many ways to invest in commodity markets. Investors can directly
invest in commodity markets by entering into futures markets or taking a forward
position. There are also many indirect ways of investing in commodity markets to
help diversify a portfolio. Investors can buy mutual funds, exchange-traded funds,
or invest in the stocks of companies that specialize in agriculture, mining, or
energy.
 Page 50

Interest Rate Parity

According to the theory of interest rate parity, the difference in the interest rate
between two different countries is equal to the differential between the spot
exchange rate and the forward exchange rate. This creates an equilibrium
relationship between two currencies when no arbitrage is possible.

Consider a currency pair of a foreign currency and a domestic currency. Interest

rate parity states that the domestic interest rate equals the foreign interest rate
minus the expected appreciation of the domestic currency. If the domestic
interest rate is higher than the foreign interest rate, there is an expected
appreciation of the foreign currency, which compensates for the lower foreign
interest rate. If the domestic interest rate is lower than the foreign interest rate,
there is an expected depreciation of the foreign currency, which compensates for
the higher foreign interest rate. This expected depreciation or appreciation is
reflected in the forward exchange rate of the currency pair.
 Page 51

Interest Rate Parity (Part 2)

The foreign exchange market involves trading currencies. Transactions in the

foreign exchange market determine the rate at which currencies are exchanged.
There are two kinds of exchange rates:

The spot exchange rate pertains to spot transactions and immediate (two-
day) exchanges of bank deposits denominated in two given currencies.

The forward exchange rate pertains to forward transactions, where the

exchange of bank deposits takes place at a future date.

Interest rate parity simply implies that the expected returns are the same on both
domestic and foreign assets. It describes an equilibrium condition for the foreign
exchange market.

If we ignore compounding, the interest parity equation simply states:

Where:

iD is the domestic interest rate

iF is the foreign interest rate

 Page 52

S is the spot exchange rate

F is the forward rate

t is the time period

For example, suppose banks in the USA offer 1% annual interest per dollar
deposits, while banks in Britain offer 5% per pound sterling deposits. The GBP-
USD spot exchange rate is 1.7, meaning one can buy 1 GBP for 1.7 USD right now.
According to interest rate parity, the forward exchange rate of GBP-USD would be
less than 1.7, meaning it would be less expensive to buy pounds in a one-year
forward contract than it is right now.
 Page 53

Covered Interest Arbitrage

If, due to imperfections in the market, rates vary from the interest rate parity
condition, arbitrage opportunities arise. As arbitrageurs exploit the arbitrage
opportunity, the spot and forward exchange rates readjust to a level such that
interest rate parity is restored. One of these arbitrage strategies is called covered
interest arbitrage. Covered interest arbitrage exploits variation from interest rate
parity by exchanging domestic currency for foreign currency at the current spot
exchange rate before investing the foreign currency at the foreign interest rate.
Simultaneously, a forward contract to sell the future value of the foreign currency
amount is entered into, with a maturity date of the investment in the foreign
currency.

Covered interest arbitrage is a tactic through which an investor uses a forward

contract to hedge against the rate risk of exchange. This is the practice of using
favorable interest rate differentials to invest in a currency that is currently
yielding a higher rate, and hedging the exchange risk with a forward currency
contract. There is always the risk that the foreign bank interest will fall, and the
hedging covers the investor on all sides, both now and in the future.

Consider an example in which the interest rate parity of British and US currency is
disturbed. Let’s say that the USD interest rate is 1%, the GBP interest rate is 5%,
and both the spot and one-year forward rate for GBP-USD are 2. This deviation
would give an opportunity for covered interest arbitrage. An American bank can
borrow $1,000,000 at 1% for one year. It will then owe $1,010,000 (principal +
 Page 54

interest) after that year. It can subsequently sell the $1,000,000 to buy £500,000.
It can then lend the pounds for one year at a rate of 5%, a transaction that would
yield a £525,000 return after one year. Simultaneously, it can enter into a one-
year forward contract to sell £525,000 after one year at the forward GBP-USD
exchange rate of 2. One year later, it receives $1,050,000. It pays back $1,010,000
to its obligors, thus netting a profit of $40,000.
 Page 55

Triangular Arbitrage
Triangular arbitrage is a foreign exchange arbitrage strategy that takes advantage
of the price discrepancy between three currency pairs. The opportunity for
triangular arbitrage emerges when market imperfections cause a mispricing
between the currency pairs. Traders can then exploit this price discrepancy by
executing a cyclic trade in the three currency pairs.

In triangular arbitrage, an investor converts one currency into another, converts it

again to a third currency, and finally converts it back again to the starting
currency. The investor does all of this in a very short time frame to take
advantage of the opportunity to access riskless profit when the currency’s
exchange rates are not exactly matching up.

Consider three currencies A, B, and C.

Let the market quoted exchange rates for A-B, B-C, and A-C be denoted by
(A/B)m,(B/C)m, and (A/C)m respectively.

Let (A/C)I be the implicit cross rate of A and C determined from (A/B) m and (B/C)m,
such that (A/B)m x (B/C)m = (A/C)I.

Then, ideally, (A/C)m = (A/C)I

Occasionally, however, the quoted rate may differ from the implicit rate. This
mispricing can be exploited by quickly converting the first currency to the second,
converting the second to the third, and finally converting the third back to the
 Page 56

first. The opportunities for triangular arbitrage are rare. When they do emerge,
they quickly disappear as arbitrageurs seek to exploit the mispricing.
 Page 57

Triangular Arbitrage (Part 2)

As an example, suppose the market quotes are as follows:

EUR-USD is 1.3399

EUR-GBP is 0.802

GBP-USD is 1.6833

The implicit cross rate of EUR-GBP is 0.796, which differs from the market quote
of 0.802.

An American bank can use $1,00,000 to buy €746,324 at 1.3399.

It can then sell the Euros to buy £598,552.

Finally, it can sell the GBP to buy $1,007,543, netting a profit of $7,543.
 Page 58

Carry Trade

Currency carry trade, also called open interest arbitrage, is another arbitrage
strategy that takes advantage of the difference between the interest rates of two
different currencies. In a currency carry trade, investors borrow in the low-
interest currency and convert it into the high-interest currency. They then lend in
the high-interest currency. On maturity, they buy back the low-interest currency.
The profit is the difference between the interest rates of the two currencies.

The biggest risk in a currency carry trade is exchange rate risk. Fluctuations in the
exchange rate can cause losses if the low-interest currency becomes more
expensive when buying back.

The carry trade is not an arbitrage, but a strategy used by currency traders. They
borrow in one currency with a low interest rate and then use the funds to buy a
different currency that is paying a higher interest rate. In addition to earning an
interest rate differential due to the difference between the two currencies, there
is also a chance that the currency they purchased will appreciate. However, this
strategy can be risky because the trader’s profit depends on the exchange rate
remaining the same until the transactions are completed.
 Page 59

For example, suppose the annual interest rate on US dollars is 1%, the interest
rate on British pounds is 5%, and the exchange rate of GBP-USD is 1.6833. An
arbitrageur can borrow $1,000,000 at 1%, convert it to £594,071, and then buy a
one-year GBP bond that yields 5%. On maturity, the bond will return 623,775
GBP. Assuming the exchange rate is constant, he can then sell the pounds to buy
$1,050,000. After paying back the $1,000,000 million with 1% interest, he would
have a $40,000 profit.

For a carry trade to be profitable, the exchange rate must not move adversely
against the currency with the higher interest rate. In the above example, if the
GBP-USD exchange rate decreases, (i.e., the USD becomes more expensive) the
carry trade will be less profitable.
 Page 60

Options Overview
An option is a financial derivative representing a contact that is sold by one party
to another. The contact gives the party the right to buy or sell a security, but they
are not obligated to buy or sell it. The contract outlines an agreed price and time
or end date.

A call option is a contract for the right to buy a bond, stock, commodity or any
other security at a given price, on or before a given date.

A put option is a contract for the right to sell a bond, stock, commodity or any
other security at a given price, on or before a given date.

The long put option, or taking a long position, involves buying a security with the
expectation the security will rise in value.

Option Styles

The option style depends upon the dates on which the option can be exercised.
Options that can be exercised on any day before the expiration date are known as
American style. Options that can be exercised only on the expiration date are
known as European style. American and European style options, known as vanilla
options, are the most common. The payoff of other, “exotic options,” is calculated
differently.
 Page 61

Option Payoffs Equation

The options payoff equations for call and put options are as follows:

C = max(0,S – K)

P = max(0,K – S)

Let's look at some examples:

Long Call

A trader buys a call option on stock ABC with a strike price of $60 and one month
to expiry. The buyer pays the seller an upfront premium of $5. The stock is
currently trading at $60; as such, upon expiry, the buyer will yield a positive
payoff if the stock price exceeds $65. If the stock price does not go above $60, the
buyer may choose not to exercise the option and will lose the $5 paid as a
premium to the option seller.
 Page 62

Short Call

The payoff for the option writer is exactly opposite to the payoff of the option
buyer.
 Page 63

Options Payoffs—Put Options

Put Options: Long Put

A trader buys a put option on stock ABC with a strike price of $90 and one month
to expiry. The buyer pays the seller an upfront premium of $8. The stock is
currently trading at $90. Upon expiry, the buyer will have positive payoff if the
stock price falls below $82. If the stock price does not fall below $90, the buyer
may choose not to exercise the option and will lose the $8 paid as a premium to
the option seller.
 Page 64

Put Options: Short Put

The payoff for the option writer is exactly opposite to the payoff of the
option buyer.
 Page 65

Option Strategies
There are various option strategies through which an investor can take a bullish or
bearish view on the underlying security. To maximize the payoff, these strategies
require simultaneous buying and selling of various options of the same
underlying.

Outlook Strategy Payoff Positions Taken

Unlimited profit,
Long call Buy call option
limited loss

Limited profit,
Short put Sell put option
unlimited loss

Limited profit,
Covered call Buy stock and sell call option
Bullish unlimited loss

Protective Unlimited profit,

Buy stock and buy put option
put limited loss

Buy call option; sell another call

Limited profit, option at a higher strike price
Bull spread
limited loss
(or)
 Page 66

Sell put option; buy another put

option at a lower strike price

Limited profit,
Short call Sell call option
unlimited loss

Unlimited profit,
Long put Buy put option
limited loss

Bearish
Sell put option; buy another put
option at a higher strike price
Limited profit,
Bear spread (or)
limited loss
Sell call option; buy another call
option at a higher strike price

Long Unlimited profit, Buy call and put option at the same
straddle limited loss strike price

Highly Buy call option with higher strike

Unlimited profit,
Volatile Long strangle price; buy put option with lower
limited loss
strike price

Long condor Limited profit, Sell put and buy put at higher
 Page 67

limited loss strike price;

Buy call and sell call at higher strike

price

Buy two calls, sell one call at lower

Short Limited profit,
strike price and sell one at higher
butterfly limited loss
strike price

Short Limited profit, Sell call and put option at the same
straddle unlimited loss strike price

Sell call option at higher strike

Short Limited profit,
price and sell put option at lower
strangle unlimited loss
strike price

Range
Buy put and sell put at higher strike
Bound price;
Limited profit,
Short condor
limited loss Sell call and buy call at higher strike
price

Sell two calls, buy one call at lower

Long Limited profit,
strike price and buy one at higher
butterfly limited loss
strike price
 Page 68

Greek Letters
“Greeks” are a measure of the risks involved with taking a position in an option.
The risk variable is the results of a relationship or the assumption of the option
with another underlying variable.

There are five Greeks: delta, gamma, theta, vega, and rho.

Delta is the amount an option price is expected to move based on a $1 increase in

the underlying stock. In other words, price sensitivity. Stocks always have a delta
of either -1 (short) or 1 (long). There is no delta in between. On the other hand,
options have a delta anywhere between -1 and 1 (depending on whether you are
long or short and using puts or calls).

Gamma is a derivative of the rate an option’s delta changes, or second-order time

price sensitivity. Gamma is the rate of change of delta with respect to the change
 Page 69

in the price of the underlying asset. Delta and Gamma are used by people who are
trying to hedge positions in options.

Theta options have a limited time frame and, because of this, the time value
portions of their prices decay as the expiration date moves closer. Time sensitivity
itself changes the value of the option.

Vega is not an actual Greek letter. It is used to measure the sensitivity of an

options price with an implied volatility of a 1% point change. In other words, the
sensitivity of volatility.

RHO is the rate of change between an options values and the interest rate. In
other words, sensitivity to the interest rate.
 Page 70

Theta, Vega, and Rho

Theta is the rate of change of the value of the option with respect to the passage
of time, all else remaining constant.

Vega is the rate of change of the value of the option with respect to the
volatility of the underlying asset.
 Page 71

Rho is the rate of change of the value of the option with respect to the
change in the interest rate.
 Page 72

Black-Scholes Model

The Black-Scholes Model is a mathematical model that is used to estimate the

price of European-style options (call and put). It is regarded as one of the best
methods to determine fair options prices. The model requires the following inputs
to estimate the price of an option:

S = sport price

K = strike price or exercise price

r = risk-free rate of interest

o = implied volatility

t = time to maturity (in years)

The value of delta for any non-exotic option lies between -1 and +1.

Implied volatility, strike price, interest rate, and time to maturity are known
variables of the model and are assumed to be constant. As the spot price is the
only stochastic variable taken into consideration in the Black-Scholes model, it is
known as a “single factor” model. It calculates European-style call or put options
prices based on the assumption that the stock does not pay dividends.
 Page 73

The pricing model is:

The function N(x) is the cumulative probability distribution function for the
standardized normal distribution (mean = 0 and standard deviation = 1). In other
words, it is the probability that a variable with standard normal distribution N(0,
1) will be less than x.
 Page 74

Black-Scholes Model (Part 2)

Example

Consider an example through which we compute the price of a European-style

call and put for a stock.

Underlying Stock - Citigroup

Stock price: $47

Strike price: $48

Time to maturity: 1 month

Implied volatility: 25%

Interest rate: 0.5%

The prices of European-style call and put options are calculated as:
 Page 75

Solving the above equations, we calculate the value of options as:

Call option = $0.932

Put option = $1.912

 Page 76

Dynamic Delta Hedging

The delta (Δ) of an option is defined as the rate of change of the premium (option
price) with respect to the underlying asset price.

C = Option premium

S = Underlying asset price

The value of delta for any non-exotic option lies between -1 and +1.

Let’s explore delta in more depth by looking at an example:

If a call option has a delta of 0.6, this means that when the price of the underlying
asset changes by a small amount, the option price changes by 60% of that
amount.
 Page 77

In the above diagram, the stock price corresponds to point A, and the option price
corresponds to point B. Thus, the delta will be the slope of the line indicated in
the diagram.

Delta Hedging

Delta hedging is a mechanism to hedge an option position using the underlying

stock.

For example, suppose the price of a stock is $100, and the price of a call option of
the same stock is $10, with a delta 0.6. An investor has sold 20 call options,
assuming each contract represents 100 shares of the underlying stock. The
investor’s options position can be hedged by buying 0.6*100*20=1200 shares.
The gain (loss) on the options position would then tend to be offset by loss (gain)
on the stock position.

If the stock price goes up…

If the stock price goes up by $1, the result is a gain of $1,200 on the stock
purchases. The price of the sold call option goes up by 0.6*$1=$0.6, producing a
loss of $1,200 on the written options position.
 Page 78

If the stock price goes down…

If the stock price goes down by $1, the result is a loss of $1,200 on the stock
purchases. The price of the sold call option goes down by 0.6*$1=$0.6, resulting
in a gain of $1,200 on the written options position.

For the example above, the delta of the option position is 0.6*20*100=1200. In
other words, the investor loses 1200*ΔS on the short option position when the
stock price increases by ΔS.

The delta of the stock is 1.0. So, for a long position of 1200 shares in the stock, the
delta will be 1200.

In this case, the delta of the investor’s overall position is zero. The delta of the
stock position offsets the delta of the options position. A position with a delta of
zero is known as “delta neutral.”

Continuous changes in the option's delta value mean that the investor’s position
remains delta-hedged for only a short period of time, and the hedge needs to be
adjusted periodically. This is known as position rebalancing.
 Page 79

Dynamic Delta Hedging

Dynamic delta hedging is the process by which the delta is periodically adjusted in
response to movement in the underlying asset prices.

Continuing from the above example, let’s say that, at the end of two days, the
stock price increases to $110. An increase in the stock price leads to an increase in
the delta. The delta increases from 0.6 to 0.65, and an extra 0.05 delta would
require an extra 0.05*2000=100 shares to be purchased for the delta to be
hedged.
 Page 80

Binomial Option Pricing Model

The binomial option pricing model (BOPM) is extensively used for option pricing
because it can value options over time. This makes BOPM a very useful tool for
valuing American-style and exotic options that can be exercised before the expiry
date.

The BOPM starts with the current stock price as the initial node and generates a
price tree based on the expected up move (u) and down move (d) at various time
intervals. The subsequent prices of the underlying assets are calculated using the
up move and down move factor, the volatility of the underlying asset, and
passage of time between two steps. The up move and down move factors are
calculated as:

The binomial value is calculated at each node for a risk-neutral portfolio. The
portfolio value from the up move of the underlying must be equal to the value
from the down move of the underlying under a no-arbitrage condition. Solving
the equation and discounting it to the present value provides the current value of
the riskless portfolio. The present value of the portfolio is equal to the delta unit
of the stock minus the value of the call option.
 Page 81

Binomial Option Pricing

Example

Consider the following parameters for a stock option:

The value of the portfolio at up move is $110 Δ - 5, and the value of the portfolio
at down move is $90 Δ. The value at both the nodes of the binomial tree must be
equal. Hence Δ = 0.25. The future value of the riskless portfolio is $22.5. The
present value of the portfolio is $22.2205, calculated by discounting the future
value of the portfolio using the risk-free rate. The present riskless portfolio is $100
Δ - call option = $ 22.2205. The value of the call option calculated using BOPM,
with three months to expiry, is $2.7795.