derivatives

derivatives - FINA0301Derivatives Dr.TaoLin 1...

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1 FINA0301  Derivatives Faculty of Business and Economics  University of Hong Kong Dr. Tao Lin Chapter 5 and 6.1, 6.2 Financial Forwards and Futures
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2 Outline Financial futures and forwards On stocks and indexes On currencies ( Chapter 6, 6.1* ) On interest rates ( Chapter 6, 6.2* ) How are they used? How are they priced? How are they hedged? *:  these two sections in “Fundamentals of Derivatives Markets”  are included in chapter 5 of “Derivatives markets”.
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3 Alternative Ways to Buy a Stock Four different payment and receipt timing  combinations Outright purchase:  ordinary transaction Fully leveraged purchase:  investor borrows the  full amount Prepaid forward contract:  pay today, receive  the share later Forward contract:  agree on price now,  pay/receive later
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4 Alternative Ways to Buy a Stock Payments, receipts, and their timing
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5 Pricing Prepaid Forwards If we can price the  prepaid  forward  ( F P ), then  we can calculate the price for a forward contract F  =  future value  of  F P Three possible methods to price prepaid forwards Pricing by analogy Pricing by discounted present value Pricing by arbitrage For now, assume that there are  no dividends
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6 Pricing Prepaid Forwards (cont’d) Pricing by analogy In the absence of dividends, the  timing  of delivery  is  irrelevant Price of the prepaid forward contract is the  same  as  current stock price Analogy ( replica  of prepaid forwards): the asset is  bought at  = 0, delivered at  t  =  T 0 , 0 S F P T =
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7 Pricing Prepaid Forwards (cont’d) Pricing by discounted preset value  ( α : risk-adjusted discount rate) If expected time  T  stock price is  E 0 ( S T ), then  Since expected value of the stock at time  T  is Combining the two,  F P 0, T = E 0 ( S T ) e T E 0 ( S T ) = S 0 e T 0 0 , 0 S e e S F T T P T = =
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8 Pricing Prepaid Forwards (cont’d) Pricing by arbitrage Arbitrage:  a situation in which one can generate  positive cash flow by simultaneously buying and  selling related assets, with no net investment and  with no risk   free money!!!  If at time t = 0, the prepaid forward price somehow  exceeded the stock price, i.e.,      an arbitrageur could: buy stock and sell  F P 0, T S 0
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9 Pricing Prepaid Forwards (cont’d) Since, this sort of arbitrage profits are traded away  quickly, and cannot persist, in equilibrium we can expect: F P 0, T = S 0
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10 Pricing Prepaid Forwards (cont’d) What if there are dividends?   Is               still  valid? No, because the holder of the forward will not 
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This note was uploaded on 01/26/2010 for the course FINA 2802 taught by Professor Xia during the Fall '09 term at HKU.

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derivatives - FINA0301Derivatives Dr.TaoLin 1...

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