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Lecture Notes 4

# Lecture Notes 4 - Corporate Finance II Lecture 4 Contingent...

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Corporate Finance II Lecture 4: Contingent Claims I: Payoffs

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Part I Review of Previous Lecture
Part I: Review of Previous Lecture Review of Previous Lecture Part I: Review of Previous Lecture Summary of the Previous Lecture Topics Learning Objectives

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Previous Lecture Topics Last lecture’s topics. Forward Contract. Futures Contract. Option Contract. Examples.
Previous Lecture Learning Objectives Last lecture’s learning objectives. Identifying risk sources. Identifying hedge contracts (forwards, options, etc), positions (long vs short). Calculating forward prices and values. Decomposing payoffs. Futures → forwards. Forwards → options.

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Part II Today: Contingent Claims I: Payoffs Semester 2 2006 8 / 65
Lecture Summary: Outline of Today’s Lecture 1 Put-Call Parity 2 Moneyness 3 Payoff vs. Profit Option cash flows vs. value 4 Option Strategies 5 Semester 2 2006 9 / 65

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Put-Call Parity Definition: European Option A European option can only be exercised at the expiry or maturity date of the option contract. Definition: American Option An American option can be exercised at any time up to the expiry or maturity date of the option contract. Let C A and P A indicate American calls and puts respectively. Semester 2 2006 11 / 65
Put-Call Parity We will return to this issue of early exercise when we consider valuation of an option. However the following “observation” will suffice for the moment: NOTE: Early Exercise If there are no dividends it is never optimal to exercise an American call before the maturity date. That is, C = C A . For American put options it can be optimal to exercise early, irrespective of dividends. That is P < P A . Finally, when there could be confusion we use X c , X p to indicate call and put exercise prices respectively. Semester 2 2006 12 / 65

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Put-Call Parity Perhaps the simplest way to show or demonstrate put-call parity is the BM&A approach There are other/equivalent approaches. Choose which suits you. Buy a put with a strike price of \$X . NOTE: The share purchase price defines/sets the option exercise price. Semester 2 2006 13 / 65 (A) Buy a share for \$ X
Put-Call Parity Payoff Long Share/Stock Payoff Long Put Payoff Combined + = X X 0 S T 0 S T 0 S T X X X Figure: The Long Share & Long Put Payoffs Semester 2 2006 14 / 65

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Put-Call Parity Now: Can I create the combined payoff using a call, stock or bond, but NOT a put option? Yes: I only need to use a call and a bond. Semester 2 2006 15 / 65 (A) After some thought, you will probably realise the following transactions offer the same payoff as that obtained in (A).
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