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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
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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.
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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
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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
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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
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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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