Example (Cont)
For a put buyer with an exercise price = Rs.70.
If current share price < exercise price (Rs.60); put option is in the
money.
If current share price = exercise price (Rs.70); put option is at the money
If current share price > exercise p
Risk-Minimization Hedging
Soybeans Case
Step 2: run a regression analysis in Excel (recall that to do this in
Excel you need to go to Tools, Data Analysis, Regression. The
Y variable will be the change in the commodity price. The X variable
will be the c
Arbitrageurs
Arbitrageurs attempt to profit from pricing inefficiencies in the
market by making simultaneous trades that offset each other and
capture a risk-free profit. An arbitrageur may also seek to make
profit in case there is price discrepancy betwe
Forward Contract
Definition: A forward contract is a commitment to purchase at a future date a given amount of a
commodity or an asset at a price agreed on today.
The price fixed now for future exchange is the forward price.
The party with a long position
Futures Terminology
Spot price: The price at which an asset trades in the spot market.
Futures price: The price at which the futures contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures contract
Speculators
A Speculator is one who bets on the derivatives market based on his views on the potential
movement of the underlying stock price. Speculators take large, calculated risks as they trade
based on anticipated future price movements. They hope to
Risk-Minimization Hedging
Soybeans Case
Step 1: estimate the price change and percentage price changes for the
soybean using the previous 60 days daily data of soybean prices.
Day
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Cash (S)
890327
890328
Impact of Futures
Generally, a dollar-for-dollar relationship exists between the
changes in the price of the underlying security and the price of the
corresponding futures contract.
In effect, being long (short) in futures is identical to subtracting
(a
P1-30
a).
2013 ROE
2012 ROE
b).
2013 ROA
2012 ROA
P1-31
a.
General Mills, Inc.
Income Statement ($ millions)
For Year Ended May 26, 2013
General Mills, Inc.
Balance Sheet ($ millions)
May 26, 2013
General Mills, Inc.
Statement of Cash Flows ($ millions)
F
M2-21.
a.Net income computation
Service revenue
Wages expense
Net income
b.Net cash flow computation
Cash inflow from services rendered
Cash outflow for wages paid
Net cash inflow
E2-27
Barth Company
Income Statement
For Year Ended December 31, 2013
Barth
M3-21
($ millions)
a.
b.
ANF RNOA
=
TJX RNOA
=
ANF NOPM
=
TJX NOPM
=
ANF NOAT
=
TJX NOAT
=
ANF RNOA
=
TJX RNOA
=
M3-23
a.
Home Depot
2013 NOPAT =
Lowes
2013 NOPAT =
b.
Home Depot
NOPAT as a percentage of sales =
Lowes
NOPAT as a percentage of sales =
E3-2
M5-11
Year
2013
2014
2015
Total
Costs incurred
Revenue
recogniz
ed
Percentage-of-Completion
Completed Contract
(percent
Method
age of
costs
Income
Percent incurred (Revenu
of total
total e Costs
expected contract incurred
Revenue
costs
amount)
)
Recogniz
Spot future parity
The future value discounted is equal to present value
F0T = S0(1 + cost of carry)T
Works fine in case there is no dividend, or cost of
storage. Else need to adjust for these.
Cost of carry = storage cost + foregone interest income
fr
Option contracts
Options
Instruments that grant their owners (holders) the right, but not
the obligation, to buy or sell an underlying asset at a specific
price (or exercise or strike price), either on a specific date or any
time up to a specific date (
Real World Fair Value Calculation
Cost of carry model where futures fair value FVt
should be FVt = St(1+i)T . where St is the spot price
for the same time stamp and i is the cost of carry
and T is the time period. For estimate i and T we
use the normal ov
Risk-Minimization Hedging
Soybeans Case
Suppose that you are a soybean meal processor. You hold soybeans
for regular use in your business. From this inventory, you purchase
soybeans and sell soybeans to your customers.
You have an ongoing inventory of 1
Covered Calls
Purchase of a stock and simultaneous sale of a call on the stock (the sales
is covered as you own the stock). Writing without owning stock is
naked position.
Fund Manager has a target sell price (for an owned stock) say: Rs. 110.
And the fun
Example (Cont)
For a call buyer with an exercise price = Rs.70.
If current share price > exercise price (Rs.80); call option is in the
money.
If current share price = exercise price (Rs.70); call option is at the money
If current share price < exercis
Other key definitions used in option trading
Exercise (strike) price: Pre-determined price at which the
underlying asset may be purchased (in the case of a call) or sold to
a seller or writer (in the case of a put).
Expiration date: Last date at which
Risk Less Arbitrage Strategy: Spot
futures Parity relationship
Arbitrage Strategy
Cost of Carry Relationship
Action
Initial Cash
Flow
Cash flow in 1
year
Borrow So
funds
So
-So (1+rf)
Buy Stock for So -So
St+D
Enter short
0
Futures position
Fo-St
With Div
Technical Trading using options
Contrary-opinion technicians use put options, which give
the holder the right to sell stock at a specified price for a
given time period, as signals of a bearish attitude.
A higher put/call ratio indicates a pervasive bea
Short put position (selling a put option)
The put writer bets that the price will not decline greatly
collects premium income with no payoff
The payoff for the buyer is the amount owed by the writer
(payoff loss limited to the strike price since the st
Example: Call options
Suppose you own a call option (long call position) with an
exercise (strike) price of Rs.30.
If the current stock price is Rs.40 (in-the-money):
Your option has an intrinsic value of Rs.10.
You have the right to buy at Rs.30, and
Using Index futures for Hedging
Let us consider an example. Suppose you own a portfolio of Rs 3 million which has
a beta of 0.9. How would I hedge this portfolio? By selling Rs 2.7 million of index
futures.
The portfolio beta is computed as the weighted a
Hedgers
These investors have a position (i.e., have bought
stocks) in the underlying market but are worried about
a potential loss arising out of a change in the asset
price in the future. Hedgers try to avoid price risk
through holding a position in the
Example: Put options
Suppose you own a put option (long put position) with an
exercise (strike) price of Rs.30.
If the current stock price is Rs.20 (in-the-money):
Your option has an intrinsic value of Rs.10.
You have the right to sell at Rs.30, so you