INVESTMENTS – 2nd Part

FIXED INCOME – BONDS

Bonds: The bond is the most common fixed income security. A bond is an asset that promises to pay fixed coupon
payments at pre-specified dates and a fixed principal amount (face value) at the maturity date. At maturity, a bond pays
the coupon and the face value.
• Face Value is typically expressed in $100 or $1000.
• Coupons are a percentage of face value.
• Maturity ranges from overnight to +30 years.

When there are no coupons, the security is called a pure discount bond or a zero-coupon bond. Otherwise, if it pays a
coupon, it is a coupon bond.

Bonds are traded in financial markets, and they can be traded:

• At discount: P < Face Value → typical in zero coupon bonds
• At par value: P = Face Value
• At premium: P > Face Value

We won’t explore bonds with default risk. We will mostly focus on default-free debt, which means that the issuer of the
bond has no risk of missing out on the payments. In practice this reflects into a few issuers in the market:
• We will focus on the US Government, which is one of the few that can be said to be default risk-free.
• US vs Greek Government.
• US government vs US corporations.

US Treasury Bonds: Types of bonds issued by the US Government – T-Bills, T-Notes, and T-Bonds.

Assets issued by the US Treasury:

• T-Bills: Maturities that are smaller than 1 year (4, 13, 26, and 52 weeks) with no coupons.
• T-Notes: Maturities that range from 2 to 10 years (2, 3, 5, 7 and 10 years) with semi-annual coupons.
• T-Bonds: Bonds with maturity greater than 10 years (30 years), with semi-annual coupons.

These instruments are auctioned on a regular basis:

• Weekly for T-Bills of 4, 13, and 26 weeks.
• Monthly for 52-weeks T-Bills and T-Notes of 2, 3, 5 and 7 years.
• Quarterly for 10-year T-Notes and T-Bonds.

Treasuries are defined by three factors (relevant for valuation):

• Face Value (FV)
• Coupon Rate (C)
• Maturity Date (T)
Price of Bonds: Found by discounting the bond’s future cash flows using spot interest rates (𝑟:→! → spot rate from 0 to t),
appropriate for the default risk and maturity of the bond’s cash flows.

_
𝐶 𝐹𝑉
9 +
(1 + 𝑟:→! ) ! (1 + 𝑟:→_ )_
!B$

When 𝑟:→_ = 𝑟 for all t, we can apply the annuity formula and write the coupon bond price as:

𝐶 1 𝐹𝑉
¯1 − °+
𝑟 (1 + 𝑟)_ ( 1 + 𝑟 )_

Spot Rates and Yield Curve:

Spot Rates: To discount a bond’s future cash flows, we need spot interest rates 𝑟:→! that determine the relevant discount
rate from t to 0. We find them from the price of zero-coupon bonds (𝑃v,! ).

1\
The price at t=0 of a zero-coupon bond with T years to maturity is: 𝑃v,: = ($&' 6 . Therefore, the spot rate is:
8→6 )
$
𝐹𝑉 _
𝑟:→_ =f g −1
𝑃v,:
$:: $
• Price of a one-year ZCB = 98 → 𝑟:→_ = ± Rw ² − 1 = 2.04%
$
$:: 0
• Price of a two-year ZCB = 95 → 𝑟:→_ = ± RD ² − 1 = 2.60%

In practice where do we find the prices of ZCB issued by the US Government? This is not simple, because for maturities
greater than 90 days, the US Government does not issue ZCB. Therefore, to find prices of ZCB issued by the US
Government, we use STRIPS (Separate Trading of Registered Interest and Principal of Securities), which started trading in
January 1985.
• Zero-coupon bonds sold/issued by investment banks and backed by the US government (thus risk-free).
• Investment banks provide the ZCB with larger maturities. How? If we think of a US Government Bond with maturity
of 8 years, with semi-annual coupon payments, we will have every half a year a coupon payment until maturity. We
can think about this as a coupon bond or as different ZCB, that is considering one ZCB for each CF payment. Investment
banks buy the government bonds, and they strip the single payments out, creating separate securities equivalent to
ZCB backed by the US Government. This way, it is possible to have a stream of ZCB prices equivalent to Treasury Bonds
at different maturities, allowing to get different spot rates for pricing your bonds.

For example, a Treasury note with 10 years to maturity consists of:

• A single principal payment at maturity.
• 20 coupon payments (semi-annually for 10 years).
• This note is STRIP’d by the banks. The 20 coupons and the principal become separate securities, i.e., zero coupon
bonds.
The Yield Curve: The yield curve is usually upward sloping (risk increases with maturity). Prices and yield are inversely
related.

But there is considerable time-variation, meaning that there is a different yield curve everyday → Interest rates vary over
time and with maturity.

Yield Curve Over Time:

Inversions (downward yield curve) happen before recessions: investors

fear short-term economic turmoil and avoid reinvestment risk from
investing short-term (but: false alarms).

Relationship between Spot Rates and Maturity:

If we think about two different ZCB that pay the same exact Face Value, one having maturity in 2 years and other in 5
years, if the CF at maturity is the same, we would only be interested in getting the 5-year zero coupon bond if the price of
this bond is lower than the 2-year ZCB → we would not be interested in paying the same amount of money for waiting
longer to receive exactly the same amount of CF. This intuition holds through for the relation between sport rates and
maturity: if prices decrease with maturity, meaning that you pay more if you have to wait less, and keeping in mind that
interest rates are inversely related to the price, if maturity is longer, the interest rate used to discount your payments on
the bond will be higher, leading to a lower price. In other words, we need higher compensation for waiting longer.
Yield to Maturity:

The yield to maturity (YTM) of a bond provides a measure for the return of investing in a bond. The YTM corresponds to
the single interest rate at which discounting future cash flows generates the bond’s current price.
• It is like an internal rate of return.

𝐶 𝐶 𝐶
𝑃: = + + ⋯+
(1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)< (1 + 𝑌𝑇𝑀)_

The YTM is the annualized holding period return if you hold the bond until maturity. If we plan to buy a bond today and
sell it before maturity, the YTM is not a precise measure of the return of the bond, because when we sell the bond, its
price will be influenced by future spot rates that the YTM today cannot capture. It can only capture spot rates that we can
observe today.

Therefore, in general YTM will not correspond to the realized return in each future period. The reason is that interest vary
over time and with maturity – Thus, coupons are reinvested at uncertain rates.

When we are dealing with ZCB, the spot rate = YTM.

Example: Suppose that a 5-year zero-coupon bond with a face value of $100 is selling for $95. What is the yield to maturity
on this bond?

100 100 100

95 = = ↔ (1 + 𝑌𝑇𝑀D )D = ↔ 𝑌𝑇𝑀D = 1.031%
(1 + 𝑟:→D ) (1 + 𝑌𝑇𝑀D )
D D 95

$::
If I hold until maturity, my realized return (nominal) will be: 𝑟!→!&D = − 1 = 5.26% or 1.031% per year.
RD

If, instead, I sell in one year, my realized return will depend on what 𝑌𝑇𝑀L will be in one year.

Example: You can purchase a 5-year coupon bond with an annual coupon rate of 7% and a face value of $1000. You know
the following information for zero coupon bonds from the market for Treasury Strips (prices are quoted per $100 of face
value)
• If you know the zero-coupon prices, you can calculate spot rates and vice versa.

$ $
1\ 6 $:: :
• 𝑆𝑝𝑜𝑡 𝑅𝑎𝑡𝑒 = ±N!',U 6',[3² − 1 → 𝑆𝑝𝑜𝑡 𝑅𝑎𝑡𝑒F = ± R< ² −1

What would you pay for the coupon bond? Either use the spot rates to discount the cash flows or:
𝑃𝑟𝑖𝑐𝑒 = 70 ∗ 0.98 + 70 ∗ 0.95 + 70 ∗ 0.92 + 70 ∗ 0.89 + 1070 ∗ 0.85 = 1171 > 1000
We have essentially constructed a replication portfolio of zero-coupon bonds.
• 70$ worth of 1,2,3,4-year zero coupon bonds.
• 1070$ worth of 5-year zero coupon bond.

This is the no-arbitrage price of the coupon bond.

What if the price is quoted as 1,150? → Arbitrage opportunity

• Buy bond, short-sell replicating portfolio of zeros.
• Payoff today = 21 = 1171-1150
• Payoff at all coupon dates 1,...,5 in the future = 0

What is the YTM?

M: M: $:M:
1,171 = ($&T_?) + ($&T_?)0 + ⋯ + ($&T_?); → 𝑌𝑇𝑀 = 3.24% (In Excel use Solver or IRR)

YTM on the coupon bond is 3.24%, which is much lower than the coupon rate.
• YTM and coupon do not need to be related.
• In practice, firms try to issue bonds at (close to) par and offer a coupon rate that is approximately equal to the yield
to maturity of the bonds to be sold.

The YTM is a weighted-average of the yield of zero-coupon bonds with equal and shorter maturities. Consequently, the
YTM (3.24%) is closest to the 5-year zero-yield (3.30%), because this yield is used to discount the bond’s largest cash flow.
• The coupon rate influences the YTM, as large coupons increase the weight on the earlier yields.

Therefore, keeping everything else constant higher coupons → higher weight on early payments → lower YTM, because
it gets closer to the sport rates of the earlier dates, when the yield curve is increasing.
• The YTM is not a valid measure of the expected return of coupon bonds, as coupons are reinvested at different rates
each year.

Forward Rates:

A forward rate 𝒇𝑻→𝑻&𝑲 is an estimation of what spot rates can be in the future. We can come up with such an estimate
by using the concept of no arbitrage → it is not possible for an investor to make free profits through an investment (no
free lunch).

𝑓_→_&o (forward rate from T to T+K) is an interest rate quoted today (t=0) for a future period T to T+K.

A forward contract is the financial contract underlying the forward rate. The structure of the contract is straightforward:
today, at t=0, we don’t exchange any CF, we just set the terms of the contract. At time T (the beginning of the forward
rate), we will pay 1$ to our counterpart that sold us the forward rate. At T+K we are going to get back the return of our
investment, which is (1 + 𝑓_→_&o )o . Under the assumption of no arbitrage, we can find that the forward rate must be:

$
_&o o
(1 + 𝑟:→_&o )
𝑓_→_&o = ´ _ µ −1
D1 + 𝑟(:→_) E
 $
($&'8→6#< )6#< <
If the equation does not hold, there are arbitrage opportunities. For example, if 𝑓_→_&o < f 6 g − 1, in three
x$&'(8→6) y

steps we can set up an arbitrage strategy that guarantee us a “free profit” in the future:

1. Sell the forward contract → the interest rate quoted in the financial market is lower than it should be, and therefore
the security is overpriced. By selling the forward contract, we are going to pay to your counterparty in the future less
than you should if there was no arbitrage.

𝟏
2. Borrow PV of 1$ ((𝟏&𝒓 𝑻 ) with maturity T → we are borrowing an amount of money from the bank, that will force
𝟎→𝑻 )

us to pay at time T exactly $1.

𝟏
3. Invest the amount you just borrowed ((𝟏&𝒓 𝑻 ) at the current spot rate from 0 to T+K
𝟎→𝑻 )

In this case, we set up an arbitrage strategy that allows us to get in the future a sure profit. To get this sure profit in the
future:
$ $
• At t=0, the CF exchange is + ($&' 6 − ($&' 6 = 0 → At this point, there is no net profit or loss.
8→6 ) 8→6 )

• At t=T, we pay back to the bank the $1 borrowed and we receive from our counterparty the $1 that started the forward
contract set at t=0. Therefore, the net CF = −1 + 1 = 0.
• At t=T+K we need to pay our counterparty (who bought us the forward contract) (1 + 𝑓!→_&o )o , and we receive from
$ ($&'8→6#< )6#<
our investment ($&' )6
∗ (1 + 𝑟:→_&o )_&o . This gives a net profit of ($&'8→6 )6
− (1 + 𝑓!→_&o )o
8→6

In order to have no arbitrage the net CF should be 0:

$
(1 + 𝑟:→_&o )_&o o
(1 + 𝑟:→_&o )_&o o
(1 )
− + 𝑓!→_&o = 0 ↔ 𝑓_→_&o = ´ _ µ −1
(1 + 𝑟:→_ )_ D1 + 𝑟(:→_) E
$
($&'8→6#< )6#< <
• This proves that the only way to allow no arbitrage in financial markets is if 𝑓_→_&o = f 6 g −1
x$&'(8→6)y

• No arbitrage (or law of one price), is key in economics and finance. If there was arbitrage, investors would immediately
take advantage of that, and the mispricing would be corrected.

The information used to compute forward rates is only considering spot rates today → we are not using any future
information, as the forward rate is an estimate fully based in what we can observe today in the market.
Example: Consider a zero-coupon bond with maturity of two years and a YTM of 5% (=𝑟:→< ).
• Suppose the 1-year spot rate (=𝑟:→L ) is 4%.
• If we invest in this ZCB we expect to receive at year 2 (1 + 𝑟:→< )<

The 2-year 5% bond, which have a return of (1 + 𝑟:→< )< , can be decomposed into a 1-year bond at the rate of 4%, followed
by a 1-year forward loan at an unknown rate 𝒇𝟏→𝟐 :

(1 + 𝑟:→< )< = (1 + 𝑟:→$ )(1 + 𝑓$→< )

• First, invest into a ZCB for one year at the spot-rate of 1 year today.
• Second, reinvest the proceedings into another contract at a future spot rate represented by the forward rate from
year 1 to year 2.
• This equation must hold because, economically, we are making the same type of investment. If they are not equal, we
could have an arbitrage opportunity.

$.:D0
If there is no arbitrage, the forward rate simply solves: (1 + 4%)(1 + 𝑓$→< ) = (1 + 5%)< ↔ 𝑓$→< = $.:L
− 1 = 6.01%
• No arbitrage means there cannot be free profits in the market.

Forward Rates – Economic Interpretation:

Forward rates reflect two things:

(1) Expectations about future spot rates.

(2) Risk Premium, since future spot rates are uncertain → By agreeing today on the forward rate, you are taking risk that
interest rates increase unexpectedly, so you have agreed to a rate that turns out to be too low. You want to be
compensated for this risk with a higher forward rate. Investors require a higher rate when they enter a forward contract,
because they are not only incorporating an investment that they have to pay in the future, but they are also taking on the
risk of future changes in interest rates that might be particularly harmful from their perspective.

If yield curve is upward/downward sloping, then forward rates are higher/lower than spot rates.

How can we use forward rates to come up with estimates of future bond prices?

Given that forward rates are estimates of future spot rates, we can think about calculating estimates of future bond prices
by simply applying the standard bond price formula but instead of discounting the future cash flows with spot rates, we
discount them with the relevant forward rates that we can estimate given the spot rates today.

The moment we get expected prices we can also calculate expected returns on the bond, which, unless we hold the bond
until maturity, are a different object than the YTM itself.
Using Forward Rates to calculate Expected Returns – Exercise Class:

Unless we are holding a ZCB until maturity, YTM ≠ Expected Return in each year over the life of the bond. Expected Return
depends on yield of bonds with shorter maturities, which for coupon bonds means the rate at which coupons can be
reinvested.

What is the expected return if I buy the 5-year coupon bond for 1171 and sell it after 1 year just one second after the 1st
coupon has been paid? Assume the “expectations hypothesis of the term structure” is correct.

Forward Rate = expected future spot rate (+ risk premium = 0)

0 0 0 1\
𝑃: = ($&' + ($&' 0 + ⋯ + ($&' ; + ($&' ; = 1171.3
,→$ ) 8→0 ) 8→A ) 8→; )

0 0 0&1\
𝐸(𝑃$ ) = + ($&2 0 + ⋯ + ($&2 A = 1125.2
($&2$→0 ) $→: ) $→; )

(6$ &0)#68 $$<D.<#$$M$.F

𝐸(𝑅):→$ = 68
= 𝑟:→$ = $$M$.F
= 2.04%

0 0 0&1\
𝐸(𝑃< ) = ($&2 + ($&2 0 + ($&2 :
0→: ) 0→A ) 0→; )

0 0&1\
𝐸(𝑃F ) = ($&2 $ + ($&2 0
:→A ) :→; )

W(6: )#W(60 )
𝐸(𝑅)<→F = W(60 )

For example, if we want to calculate returns over multiple years (for example, from 0 to 3), we need to reinvest the
coupons we receive along the way. For example, we need to reinvest:
• Reinvest coupon paid at year 1 with forward rate 𝑓$→F
• Reinvest coupon paid at year 2 with forward rate 𝑓<→F
• Coupon paid at year 3 not reinvested but received as it is

𝑃# + 𝐶# + 𝐶$ (1 + 𝑓$→#)% + 𝐶%(1 + 𝑓%→#)$

𝐸(𝑅)!→# = − 1 = (1 + 𝑟!→# )# − 1 = (1 + 𝑟!→% )%(1 + 𝑓%→$ )%(1 + 𝑓$→# ) − 1 = (1 + 𝑟!→% )(1 + 𝑓%→# )$ − 1 = (1 + 𝑟!→$ )$ (1 + 𝑓$→# ) − 1
𝑃!
INTEREST RATES

Interest Rate Risk – Duration:

Interest Rate Risk: Even if coupon and principal are guaranteed, Bond returns are still risky. Suppose we invest into a
Treasury Bond that we are willing to hold until maturity. In this case, at a certain point in time, we might want to sell this
bond in the financial markets. If we decide to do it, the price at which we will sell the bond will depend on future spot
rates that are unknown today. Given that spot rates change over time, this involves an important risk component as we
are not able to know for sure at what price we are going to sell our bond, and consequently there will be no way of knowing
which will be our return.
• There is an inverse relation between interest rates/yields and prices.
• Level, slope, and curvature of yield curve vary over time.

Example:

Consider a 15-year bond with annual coupon of 8 and principal of 100. Suppose that the yield curve is flat at 5% → The
bond then sells at 131.14.
• The assumption on the yield curve is not realistic but helps in understanding better the economic forces behind the
risk. Flat Curve means that all spot rates, no matter maturity, are going to be the same (5%).

When interest rates move, bond price changes:

• Suppose that, immediately after you buy the bond, the yield curve falls by 100 basis points to 4%. Consequently, bond
price goes from 131.44 to 144.47, representing a capital gain of 10.2%.
• If instead the yield curve goes up by 100 basis points to 6%, the bond price goes to 119.42, representing a capital loss
of 8.9%.

We can notice that when we increase/decrease the interest rate by the same proportion, the price changes in different
amounts. This implies that the relationship between interest rates and bond prices is non-linear. Specifically, the relation
between bond prices and interest rates is convex.

Convexity → Price decrease for yield increase is smaller than price increase for equal decrease in yield (-8.9% vs 10.2%).

Bond Price Sensitivity to Changes in Interest Rates: For an investor, it is important to estimate the sensitivity of bond
prices to changes in interest rates. The main reason is because sensitivities are good at providing a better economic
intuition about the forces behind the relationship between prices of bonds and interest rates. However, this will come at
a cost → To develop such measures, we need to approximate for such relationships and need to be careful at which type
of interest rate changes we are looking at.

Duration (D) is crucial in this estimation → Amount of time that investors need to wait to get back in CF, at least, the price
they paid for a bond.

1 𝐶𝐹!
𝐷= 9¯ ∗ 𝑡°
𝑃 (1 + 𝑌𝑇𝑀)!
!
Thus, a first-order approximation to the percentage change in the bond price for a percentage change in YTM can be
written as:

Δ𝑃 1
≈ −𝐷 ∗ ∗ Δ𝑌𝑇𝑀
𝑃 1 + 𝑌𝑇𝑀
$
• −𝐷 ∗ $&T_? → Modified Duration
• There is not a 1-1 relationship between bond prices and interest rates.

Price Risk:

High-coupon bonds are less sensitive than low-coupon bonds: Duration increases if maturity is longer. This means that
Bonds with longer maturity, everything else constant, have a higher sensitivity of their prices to changes in interest rates.
Similarly, if coupons are large, earlier payments are going to count more in the weighted average of time represented by
Duration (D). This means that a bond with higher coupons will have a lower price sensitivity to interest rate changes.

• For zero coupon bonds → duration = maturity

• Duration goes down as yield goes up.

Duration – Example:

Approximate the change in price (using the first-order approximation) of the 15-year bond using duration and compare to
the actual change.

Duration = 9.996 years

Approximated % change Approximated new price Actual new price

To 4% 9.996 143.623 144.474
− ∗ (−1%) = 0.095
1 + 5%
To 6% −0.095 118.655 119.424

First-order approximation is symmetric and ignores convexity → It approximates the relationship to a linear relation.
When changes become particularly large, the two lines diverge a lot, leading to significant errors in the approximation.
Interest Rate Risk – Convexity and Immunization:

Convexity:
• Duration-based approximation works for small changes in yields. This approximation was not able to capture the
curvature of the relation between interest rates and bond prices.
• For larger swings in yields, the first-order approximation ignores convexity. Therefore, use a second-order
approximation:

𝜕𝑃 1 𝜕<𝑃 𝐷 1
∆𝑃 ≈ ∗ ∆𝑌𝑇𝑀 + ∗ < (∆𝑌𝑇𝑀)< = 𝑃 ∗ ¸− ∗ ∆𝑌𝑇𝑀 + 𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 ∗ (∆𝑌𝑇𝑀)< ¹
𝛿𝑌𝑇𝑀 2 𝜕 𝑌𝑇𝑀 < (1 + 𝑌𝑇𝑀 ) 2

∆𝑃 1 1
↔ = −𝐷 ∗ ∗ ∆𝑌𝑇𝑀 + 𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 ∗ (∆𝑌𝑇𝑀)<
𝑃 1 + 𝑌𝑇𝑀 2

$ 01∗x! 0 &!y $
• 𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 = [($&T_?)0 ∑! ($&T_?)" ] ∗ → It always have a positive impact in the bond price.
6

Keeping everything else constant, investors like convexity as it creates positive skewness in bond’s returns. Bonds with
high convexity therefore have higher prices, ceteris paribus.

Example: Approximate the change in price of the 15-year bond using duration and convexity:
• Initial Price (r=5%) = 131.14
• Duration = 9.996 years
• Convexity = 123.29

Approximated % change Approximated new price Actual new price Abs. Difference
First-Order
To 4% 9.996 143.623 144.474 0.85
− ∗ (−1%) = 0.095
1 + 5%
To 6% −0.095 118.655 119.424 0.77
Second-Order
To 4% 0.101 144.432 144.474 0.04
To 6% −0.089 119.463 119.424 0.04

Here we are getting closer to the Actual Price, due to non-linearity in the 2nd order approximation. Still, even larger changes
in yields require even higher order approximations (3rd, 4th, etc.).
• Price changes for an 8% Coupon 30-year bond with an initial YTM of 8%
Immunization – How to Manage Interest Rate Risk?

For example, how to insulate a pension funds balance sheet from interest-rates fluctuations?

Institutions that are interested in managing interest rate risk are those who have large bond portfolios, like an insurance
company or a pension fund. Those institutions need to pay often far in the future CF to their customers. Therefore, they
need to make sure that they are able to provide such CF in the future when they are needed. The technique to make sure
that this happens approximately is called Duration Matching – The idea is that the duration of the liabilities’ portfolio
must equal the duration of the assets’ portfolio.

Asset-Liability Management (ALM):

• Liabilities: long-term pension promises with duration ~ 20 years.
• Assets are chosen to match this duration.
• Doesn’t eliminate interest rate risk → we are hedging it.

𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝑚𝑎𝑡𝑐ℎ𝑖𝑛𝑔: 𝐷=QQ3!Q ∗ 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐷.,-^,.,!,3Q ∗ 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Thus, invest a large fraction of portfolio in long-term bonds and long-term assets, such as real estate. However, also invest
in shorter-maturity assets, for liquidity and to capture attractive risk premia and diversify, such as stocks.

If not matched correctly, there is a problem → Pension funds have seen unprecedented increase in liabilities since financial
crisis due to falling yields.

Issues with Duration Matching:

1. Reinvestment risk → If you are investing in your portfolio of assets, for example in coupon bonds, you will receive CF
payments over time and you will need to reinvest your CF at uncertain rates in order to make sure that the duration
matching holds.

2. Accuracy → Approximations are not necessarily precise when interest rates change more than usual, when they face
big shocks. We can improve this problem by also matching the convexity of the liability and the asset portfolios.

3. Active Rebalancing → Matching will constantly require rebalancing, because as interest rates in the market change,
the yields on the bonds can change, which can change duration, and therefore you might need to rebalance the
portfolio frequently.

4. Non-parallel shocks to yield curve → Although we assume a flat yield curve, in reality there are non-patterned shifts
of the yield curve. All our calculations are made using the YTM of bonds, which are a weighted average of yields of
different maturities. However, our calculations are robust to the extent that slope and curvature shocks affect YTM.

5. Use interest-rate derivatives to manage duration → Swaps, interest-rate futures (Later).

Accrued Interest:

Bond Price Conventions: In practice, bond prices are expressed as % of face value (100 basically).
• Number after the hyphen denotes 32nds (also called “ticks”).
• A “+” sign means half a tick.

Example:
• Price of 101-12 means 101.375% of face value.
F$.D
• Price of 108-31+ means (108 + )% of face value.
F<

This is like this because traditionally, trades and quotes were communicated by hand. But does this tick size and reporting
method make sense given today’s technology?

There are more oddities in bond pricing that abstract from what is important.

Accrued Interest: When purchasing a bond between coupon dates, the buyer must pay accrued interest to the seller in
excess of the quoted price. The holder of the bond at coupon payment date receives the full amount of interest, whereas
the seller actually held the bond over part of the current coupon period.

DATE1 DATE2 DATE3

C1 C2
Part of Coupon2 belonging to Part of Coupon2 belonging to
Seller = Accrued Interest Buyer

The price that is paid including accrued interest is called dirty price or full price. The quoted price before accrued interest
is called instead clean price or flat price.

𝐶𝑙𝑒𝑎𝑛 𝑝𝑟𝑖𝑐𝑒 = 𝐷𝑖𝑟𝑡𝑦 𝑝𝑟𝑖𝑐𝑒 – 𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 ∗ 𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒 ∗ 𝐷𝑎𝑦 𝐶𝑜𝑢𝑛𝑡 𝐹𝑎𝑐𝑡𝑜𝑟

• Define Date1 (Y1.M1.D1) as the last coupon payment date.

• Define Date2 (Y2.M2.D2) as the day the bond transaction is settled.
• Define Date3 (Y3.M3.D3) as the next coupon payment date.

The Day Count Factor (DCF) can be calculated differently. The most popular conventions are:

FG:∗(T<#T$)&F:(?<#?$)&(7<#7$) 7-!3<#7-!3$
30/360: 𝐷𝐶𝐹 = 𝐴𝐶𝑇/360: 𝐷𝐶𝐹 = FG:
FG:

7-!3<#7-!3$ 7-!3<#7-!3$
𝐴𝐶𝑇/𝐴𝐶𝑇: 𝐷𝐶𝐹 = (7-!3F#7-!3$)∗0*>U*" 1'3`>3"[A 𝐴𝐶𝑇/365: 𝐷𝐶𝐹 =
FGD
Summary:

Exact calculation of bond transaction price depends on market conventions and fine print:
• In US, yields are quoted as APRs with semi-annual compounding, whereas in Europe yields are quoted as EARs.
• Day count convention: Actual/360, Actual/Actual, …?
• Accrued Interest ignores the effect of discounting.
• As long as everyone agrees on the exact formula with which the price (or payoff) is calculated
OTHER FIXED INCOME MARKETS AND DEFAULT RISK

Overview of fixed-income markets in the US:

The total size of fixed income markets in the US is around 41 trillion $.

The US stock market is currently 34 trillion $.

The majority of these securities incorporate a component that was missing in Treasury-Bonds → Default-Risk

Default Risk: Risk that the issuer of a fixed income security will not be able to pay all the promised cashflows in the future.
This happens, for example, when a company goes bankrupt.

When the issuer is not the Treasury, there is default risk. Under default, lender does not receive the bond’s promised
payments, but might be able to receive some recovery value which depends on:
• The bond’s provisions such as seniority and collateral.
• The result of a complex bargaining process in the bankruptcy courts.
• The liquidation value of the firm’s assets.

𝑌7 is the rate used to discount a bond with Default Risk:

𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑌𝑖𝑒𝑙𝑑 = 𝑌7 = 𝑆𝑝𝑜𝑡 𝑅𝑎𝑡𝑒 + 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚

Rating agencies evaluate the risk of default. Rating defines the credit spread.

𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑝𝑟𝑒𝑎𝑑 = 𝑌7 − 𝑇𝑟𝑒𝑎𝑠𝑢𝑟𝑦 𝑌𝑖𝑒𝑙𝑑

Credit Default Swaps can be used to manage default risk.

Really risky bonds, that are close to default, might have large variations with respect to the Treasury Yield: You can think
about paying/receiving an interest rate that is 5 to 6% higher than the Treasury Yield.
Ratings:

Transition Matrix (Moody’s):

Yield Spread:
OPTIONS

What are Options? Put and Call Options:

An option is a financial contract that gives you the right to trade the underlying asset of this contract at a pre-determined
price. We focus on put and call options where the underlying asset is a stock which pays or does not pay dividends, during
the life of the option.

A call option with strike price k and maturity T gives the holder (long position) the right (not the obligation) to buy the
underlying asset at price k.
• By date T → If the call is American.
• At date T → If the call is European.

The seller (short position) of the call has the obligation to sell the underlying asset at price k when holder exercises his
right.

A put option with strike k and maturity T gives the holder (long position) the right (not the obligation) to sell the underlying
asset at price k.
• By date T → If the put is American.
• At date T → If the put is European.

The seller (short position) of the put has the obligation to buy the underlying asset at price k when holder exercises his
right.

Price of any option > 0 before maturity.

• Option holder’s payoff at maturity cannot be negative because he will only exercise when it is attractive for him.
• Exercise when payoff > 0; otherwise, don't exercise and payoff = 0.
• Profit = payoff - price (the profit can be negative!).

Option Payoffs:

• K = Strike Price
• 𝑆_ = Price of asset at maturity

In the Call Option the payoff is given by the difference

between the Stock Price at maturity and the Strike Price. If
this difference is negative, we don’t exercise the option.

In the Put Option, the payoff is given by the difference

between the Strike Price and the Stock Price at maturity. If
negative, we don’t exercise the option, receiving a 0 payoff.
Analytical Expressions for Option Payoffs at Maturity:

LONG SHORT
CALL 𝑀𝐴𝑋(0, 𝑆_ − 𝐾) −𝑀𝐴𝑋(0, 𝑆_ − 𝐾) = 𝑀𝐼𝑁(𝐾 − 𝑆_ , 0)
PUT 𝑀𝐴𝑋(𝐾 − 𝑆_ , 0) −𝑀𝐴𝑋(𝐾 − 𝑆_ , 0) = 𝑀𝐼𝑁(𝑆_ − 𝐾, 0)

• Payoff to the long position at T cannot be negative.

• The inexistence of arbitrage opportunities thus implies that the option has a positive price on any date t before
maturity T (t<T).
• Options are bought/traded at this price: “the option premium”.
o 𝑐! is the premium of a call option.
o 𝑝! is the premium of a put option.

One will buy a Call option if the stock price at maturity is expected to increase in relation to K, and the other way around
for the Put option.

The payoff of the call and put option look very similar, but they are not exactly the same. The call option is riskier because
the stock price can go up potentially to really high values, to infinity, and therefore the potential upside for the buyer of
the call option is much higher than for the buyer of the put option because the stock price, in the case of the put option,
can never fall below zero. The same applies for the seller of the put and call option: If one sells a call option, he might get
a really large loss in case the price goes up by a lot, while if one sells a put option this does not happen because the stock
price can’t go below than zero.

Important Concepts:

Intrinsic Value: Payoff that you would get if you could exercise the option in this second. (Theoretical for European options
as you can only exercise options at maturity. In case of the American options, it can turn into a real Cash Flow if you indeed
decide to exercise the option at this second).
• Call: max (𝑆! − 𝐾, 0)
• Put: max (𝐾 − 𝑆! , 0)

Time Value: Difference between the price of the option in the market at this second and the intrinsic value of the option.
This intuitively tells us how valuable the benefit of waiting is, before exercising the option. In some cases this can turn out
to be negative, meaning that it is not beneficial to wait before exercising the option. This is not relevant for the European
case, but for the American case it provides an insightful information.
• Call: 𝑐! − max (𝑆! − 𝐾, 0)
• Put: 𝑝! − max (𝐾 − 𝑆! , 0)

Moneyness: Tells us if we are going to get a positive, a negative or a zero payoff, if we exercise the option at this second.
• In-the-money (ITM): 𝑆! > 𝐾 for calls; 𝑆! < 𝐾 for puts → Here it makes sense to exercise the option, as you get a
positive payoff.
• At-the-money (ATM): 𝑆! = 𝐾 → Zero payoff.
• Out-of-the-money (OTM): 𝑆! < 𝐾 for calls; 𝑆! > 𝐾 for puts → You would get a negative payoff and if you had an
American option you would choose to not exercise.
Option Payoffs Example: You buy two call options on the firm with different strike prices: 45 (=𝐾.*j ) and 55 (=𝐾@,5@ ).
What is your payoff if the stock price at expiration is 40? 50? 60?

Payoff: 𝑀𝑎𝑥(0, 𝑆_ − 45) + 𝑀𝑎𝑥(0, 𝑆_ − 55):

• If 𝑆_ = 40 → Payoff = 0 + 0 = 0
• If 𝑆_ = 50 → Payoff = 5 + 0 = 5
• If 𝑆_ = 60 → Payoff = 15 + 5 = 20 (both in the money, i.e. both payoffs > 0).

What is your payoff if you bought put options with these strike prices instead?

Payoff: 𝑀𝑎𝑥(45 − 𝑆_ , 0) + 𝑀𝑎𝑥(55 − 𝑆_ , 0):

• If 𝑆_ = 40 → Payoff = 5 + 15 = 20 (both in the money)
• If 𝑆_ = 50 → Payoff = 0 + 5 = 5
• If 𝑆_ = 60 → Payoff = 0 + 0 = 0

Option Profit Example:

Option Profit refers to the gains of an option strategy, i.e., the payoff at T minus the price (called also premium).

Suppose you bought a call on MSFT with strike K = $30 for a

premium of $1 (per share), for which stock price do you break-even
(profit = 0)?

Notation:

• c → European call option price. • K → Strike Price.

• C → American call option price. • T → Life of option.
• p → European put option price. • 𝜎 → Volatility of stock price.
• P → American put option price. • r → (Continuously Compounded) Risk-free rate for
• 𝑆: → Stock Price today. maturity T.
• 𝑆_ → Stock Price at option maturity. • PV(D) → Present Value of Dividends

Assumptions:
1. There are no transaction costs.
2. All trading profits (net of trading losses) subject to the same tax rate.
3. Borrowing and lending are possible at the risk-free interest rate.
4. There are no arbitrage opportunities.
Factors Impacting Option Prices:

c p C P
Current Stock Price 𝑆_ + - + -
Strike Price K - + - +
Maturity T + +’ + +´
Volatility 𝜎 + + + +
Risk-free Rate r + - + -
Dividend D - + - +

Longer time-to-maturity is typically good for the option holder as payoffs are asymmetric, therefore waiting can only
increase the possibility for having favorable price movements in the underlying stock.
• + → Option prices increase with Time to Maturity:
o Having a long time to wait before the exercise of the option, is beneficial and therefore it costs more to the option
holder.
o More time for possibly large up (down) move is beneficial for call (put) option holder, whereas downside is limited
through no exercise.
• +’ → Special Case: In the case of a put option, if the stock price is close to 0, it might be that waiting longer is not
beneficial and therefore the option price does not increase with Maturity. In other words, the positive effect might be
outweighed by the benefit of receiving the strike price sooner (i.e. when 𝑆! close to 0).

Higher volatility is always beneficial for the option holder as payoffs are asymmetric: Higher volatility, means higher option
price. The intuition is that when the stock is more volatile, there are higher chances that the stock price will go up a lot, or
down a lot. Considering that we only exercise the option when it is beneficial for us, this is a valuable opportunity for the
option holder because it has higher chances of ending up in higher payoff scenarios.

Higher risk-free rate is good (bad) for call (put) option holder as it reduces present value of strike price to be paid
(received).
• Higher RF Rate increases the price of the call option, being beneficial for the option holder: When you have a higher
RF rate, we are reducing the value ok k, which is what the option holder has to pay to buy the underlying stock.
• Instead, the higher RF Rate, decreases the price and the value of the put option because it decreases the present value
of k, which is what the put option holder has to receive by selling the stock.

Higher dividend during life of option lowers stock price ex-dividend, which is good (bad) for put (call).
• This is only relevant when we have an underlying stock that is paying dividends from the moment you buy the option
until maturity.
• A higher dividend is beneficial for the put option holder, it increases the put option price, because once a dividend is
paid, the stock price decreases automatically. Moreover, a decrease in the stock price is always beneficial to the put
option holder since it increases the payoff.
• The opposite is true for the case of the Call Option: A higher dividend payment will also mean a higher decrease in the
stock price which harms the call option holder, since he is going further away from higher payoffs.
Comparing American and European Options:

The American options give more flexibility to the option holder because it allows the option holder to decide to exercise
the option anytime between the moment he buys the option until maturity. It is therefore intuitive that the price of an
American option must be higher than the price of a European Option because you need to pay for the added flexibility
that adds value to the option. Therefore, an American option is worth at least as much as an otherwise identical European
option.
American Options = European Options + Premium

This premium can be > 0 or = 0, depending on whether we have:

• Call option vs Put option.
• Stock with dividends vs Stock without dividends.
• It is only equal to zero in a special case.

American Options – Optimal Exercise:

When is it optimal to exercise earlier than maturity the American Option? Whenever the benefit of waiting is not there,
that is when the time value of the option is negative, which depends on whether we are looking at a call vs put option, or
if the stock is paying or not dividends, during the life of the option.

Call: 𝑐! ≥ 𝑆! − 𝑃𝑉(𝐾) > 𝑆! − 𝐾

• Intuition: holding on to the call allows you to pay K later and gives downside protection like a put, because when 𝑆!
falls below K you won't exercise, and the minimum payoff is zero.
• If the stock is not paying any dividend, it is never optimal to exercise early an American call option. Here, the price of
the American option and the price of the European option are the same → C = c. The intuition is that, without dividends
in between, the stock price can always go up to an undetermined amount and, therefore, the benefit of waiting is
always there.
• If the stock pays a dividend, we may want to exercise the American call option early, before the stock price decreases
due to the dividend payment (before ex-dividend drop in stock price) → C > c

Put: 𝑝! > 𝐾 − 𝑆!
• There are cases in which, despite having dividends or not, it is always optimal to exercise earlier. This is often the case
when K and/or r are particularly large. In this case, the Time Value of the put option can be negative, and it is optimal
to exercise earlier.
• Intuition: the benefit from receiving K sooner is larger than the benefit from the stock possibly moving further down
(as it may also go up!).
• American put P > European put p (with and without dividends).
Bonds on Option Prices:

Relative Pricing: Put-call Parity:

No arbitrage: If we have an asset or a portfolio of assets that give a certain payoff in the future, and we have another
asset or portfolio of assets that give exactly the same payoff in the future, the price of the two assets or the two portfolios
of assets must be the same. Otherwise, there is an arbitrage opportunity.

Consider two portfolios:

• A: One European call option plus a ZCB with FV = K (ZCB that will pay at maturity as much as the strike price K).
• B: One European put option plus a stock (the stock is the one underlying both the options).

Those portfolios can be written this way:

• A: One European call option plus deposit cash equal to 𝐾𝑒 #'_ .
• B: One European call option plus one share.

At maturity the payoffs are:

𝑆_ ≤ 𝐾 𝑆_ > 𝐾
Portfolio A 0+𝐾 =𝐾 𝑆_ − 𝐾 + 𝐾 = 𝑆_
Portfolio B 𝐾 − 𝑆_ + 𝑆_ = 𝐾 0 + 𝑆_ = 𝑆_

Portfolio A and B have the same payoff at maturity, so they need to have the same price; this yields the put-call parity
relation:
𝒄 + 𝑲𝒆#𝒓𝒕 = 𝒑 + 𝑺𝟎

• 𝐾𝑒 #'! is the price today of the ZCB → K discounted with the stock rate r.

Intuition: Owning the stock and the right to sell at price K is equivalent to having the cash to pay K and the right to buy the
stock at that price.

• Payoffs of put + stock equal the payoffs of call + bond.

By no arbitrage, the price of the strategies must be the same: 𝑝: + 𝑆: = 𝑐: + 𝑃𝑉(𝐾)

After having derived the central relationship between the put and call price, we can use the put-call-parity to derive the
limits, the bounds on option prices, that is, the maximum and minimum prices that both call and put option can have.

Upper Bounds with No Dividends:

Upper Bound Call: 𝑐: = 𝑝: + 𝑆: − 𝐾𝑒 #'! → 𝑐: ≤ 𝑆: and 𝐶 ≤ 𝑆: , otherwise arbitrage.

• The only way to have 𝑐 > 𝑆: , knowing the equation holds, is if 𝐾𝑒 #'! < 0. Since 𝐾𝑒 #'! can never be negative because
a price cannot be negative, the upper limit on the call price is the stock price today, and 𝑐: ≤ 𝑆: and 𝐶 ≤ 𝑆: .

Arbitrage Opportunity if 𝑐: > 𝑆: :

Today T, if 𝑆L ≤ 𝐾 T, if 𝑆L > 𝐾
Sell c 0 −(𝑆L − 𝐾)
Buy 𝑆M 𝑆L 𝑆L
= 𝑐 − 𝑆M > 0 = 𝑆L =𝐾

Upper Bound Put: 𝑝: = 𝑐: + 𝐾𝑒 #'! − 𝑆: → 𝑝 ≤ 𝐾𝑒 #'! and 𝑃 ≤ 𝐾, otherwise arbitrage.

• The only way to have 𝑝 > 𝐾𝑒 #'! , in order for the equation to hold, is to have 𝑆: < 0. However, as the stock price
cannot be negative, the upper limit on the put option price is the price of the bond today: 𝑝 ≤ 𝐾𝑒 #'! .

Arbitrage Opportunity if 𝑝 > 𝐾𝑒 #'! :

Today T, if 𝑆L ≤ 𝐾 T, if 𝑆L > 𝐾
Sell p −(𝐾 − 𝑆L ) 0
Buy 𝐾𝑒 NOP 𝐾 𝐾
= 𝑝 − 𝐾𝑒 NOP > 0 = 𝑆L =𝐾

Lower Bounds with No Dividends:

Lower Bound Call for European call: 𝑐: = 𝑝: + 𝑆: − 𝐾𝑒 #'! → 𝑐 ≥ 𝑆: − 𝐾𝑒 #'! otherwise arbitrage.
• The only way to have 𝑐 < 𝑆: − 𝐾𝑒 #'! , knowing that by no arbitrage the equation holds, is if 𝑝: < 0. This is not
possible, and therefore the lower limit on the call price is 𝑐 ≥ 𝑆: − 𝐾𝑒 #'!

Arbitrage Opportunity if 𝑐 < 𝑆: − 𝐾𝑒 #'! :

Today T, if 𝑆L ≤ 𝐾 T, if 𝑆L > 𝐾
Buy c 0 (𝑆L − 𝐾)
Borrow 𝑆M , Buy 𝐾𝑒 NOP 𝐾 − 𝑆L 𝐾 − 𝑆L
NOP
= 𝑆M − 𝐾𝑒 −𝑐>0 = 𝐾 − 𝑆L =0

Lower Bound for European put: 𝑝: = 𝑐: + 𝐾𝑒 #'! − 𝑆: → 𝑝 ≥ 𝐾𝑒 #'! − 𝑆: otherwise arbitrage.

• The only way to have 𝑝 < 𝐾𝑒 #'! − 𝑆: is to have 𝑐: < 0. As prices cannot be negative, the lower limit on the put option
price is the difference between the ZCB price today and the stock price: 𝑝 ≥ 𝐾𝑒 #'! − 𝑆: .

Arbitrage Opportunity if 𝑝 < 𝐾𝑒 #'! − 𝑆: :

Today At T, if 𝑆L ≤ 𝐾 At T, if 𝑆L > 𝐾
Buy p (price is lower than it should be) 𝐾 − 𝑆L 0
Borrow 𝐾𝑒 NOP , buy 𝑆M 𝑆L − 𝐾 𝑆L − 𝐾
= 𝐾𝑒 NOP − 𝑆M − 𝑝 > 0 =0 = 𝑆L − 𝐾
Dividends and option prices: The case in which the stock pays a dividend in between the moment you buy the option and
the option’s maturity.

If you long a stock: 𝑓𝑖𝑛𝑎𝑙 𝑝𝑎𝑦𝑜𝑓𝑓 = 𝑆_ + 𝐹𝑉(𝐷)

If you short a stock: 𝑓𝑖𝑛𝑎𝑙 𝑝𝑎𝑦𝑜𝑓𝑓 = −(𝑆_ + 𝐹𝑉(𝐷)), as you need to reimburse the dividend to the party you borrowed
the stock from.

Changes in put-call parity relation (European Options):

𝑐 + 𝐾𝑒 #'! = 𝑝 + 𝑆: − 𝑃𝑉(𝐷)

We deduct the present value of the dividend on the right-hand side. The intuition is that we are not receiving the dividend
through any positions that we have on the left-hand size: we are not receiving through the call option neither through the
ZCB. Therefore, we need to deduct it to make the two portfolios comparable and the relationship equal.

Lower bound for dividend-paying stocks:

Call-option: 𝑐! = 𝑝! + 𝑆: − 𝑃𝑉(𝐷) − 𝐾𝑒 #'! → 𝑐 ≥ 𝑆: − 𝑃𝑉(𝐷) − 𝐾𝑒 #'! otherwise arbitrage.

Arbitrage Opportunity if 𝑐! < 𝑆: − 𝑃𝑉(𝐷) − 𝐾𝑒 #'! : Buy call option and ZCB with FV = K + FV (D) (both undervalued)
Today, assuming D is paid just before T T, if 𝑆L ≤ 𝐾 T, if 𝑆L > 𝐾

Buy c (undervalued) 0 𝑆L − 𝐾

Borrow 𝑆M , buy (𝐾 + 𝐷)𝑒 NOP −𝑆L − 𝐷 + 𝐾 + 𝐷 −𝑆L − 𝐷 + 𝐾 + 𝐷

−𝑐P + 𝑆M − =𝐾 + 𝐹𝑉(𝐷)@𝑒 NOP > 0 >0 =0

Put-option: 𝑝! = 𝑐! + 𝐾𝑒 #'! − 𝑆: + 𝑃𝑉(𝐷) → 𝑝 ≥ 𝑃𝑉(𝐷) + 𝐾𝑒 #'! − 𝑆: otherwise arbitrage

Arbitrage Opportunity if 𝑝 < 𝑃𝑉(𝐷) + 𝐾𝑒 #'! − 𝑆: :

Today, assuming D is paid just before T T, if 𝑆L ≤ 𝐾 T, if 𝑆L > 𝐾

Buy p 𝐾 − 𝑆L 0

Borrow (𝐾 + 𝐷)𝑒 NOP , buy 𝑆M −𝐾 − 𝐷 + 𝑆L + 𝐷 −𝐾 − 𝐷 + 𝑆L + 𝐷 (>0)

Investment Strategies with Options: How options can significantly expand the investment universe for any type of
investors.

Trading Strategies with Options:

1. Strategies involving one option (call or put) and a stock.
2. Spreads: Strategies with multiple positions in two or more options of the same type (call vs puts) on the same
underlying asset.
3. Combinations: Strategies with both puts and calls. Here you are effectively taking positions on different option types
at the same time.
 Figures with payoffs and profits of options often ignore the time-value of money. In theory, compare payoff with future
value of option price.

Strategy 1 – Protective Put: Strategies involving one option and a stock.

Risk management: (i) buy a stock and (ii) a put option to effectively fix a minimum price at which you can sell the stock.

This strategy guarantees you that you can sell the

stock at least at a price = k, not lower. Your payoff
will never be lower than k.

This strategy is not done to make extra returns, but

as an insurance to avoid negative price movements
of a stock, that might push the stock’s price behind
k.

Strategy 2 – Spreads: Betting on bad news: Bear Spread:

Bear Spread (constructed with puts) consists of (i) selling a put with strike 𝐾$ and (ii) buying a put with strike 𝐾< , where
𝐾< > 𝐾$ .

Is the initial cash flow of this strategy positive or negative? It is negative, as

higher strike put is more expensive.

In this case the profit function gives positive profits when the stock price
falls into the lower-hand of the graph.

This is a strategy that you enter into when you expect the stock price to
decrease in the future. Investing into puts allow you to minimize your loss on the right-hand side. This strategy only make
sense if you have a strong prior that stock prices will fall in the near future, within the maturity of the option → You are
betting on bad news for the company that issued the stock underlying the options.

Strategy 3 – Straddle: Betting on turmoil: Consists of buying a call and a put with the same strike on the same stock.

This strategy delivers positive profits, either if the stock price falls a lot below k,
or increases a lot above k. Therefore, an investor enters into such a strategy if he
believes the stock price will have higher volatility in the future, up to the maturity
of the option. Investors are gaining if the stock price moves a lot, far away from
K.
Option vs Stock Investment:

Could a call option strategy be preferable to a direct stock purchase? If an investor wants to get exposure to a stock, is it
better to invest everything into the stock directly or to get exposure by investing everything into options? There is not a
perfect strategy, this depends on the risk preferences of each investor. There might be an investor who is willing to make
an investment just to maximize as much as possible potential gains in the future and does not care much about losing the
amount invested in the beginning. On the other hand, there might be investors who are willing to minimize as much as
possible the losses on a strategy and don’t care as much about the upward potential because they want to have
guaranteed cash flows in the future.

Suppose you have a stock, currently selling for $100 (𝑆: = 100), that you think will appreciate. A 6-month call costs $10
(𝑐: = 10$), where the contract size is 100 shares. You have $10000 to invest. Investing for 6 months in the risk-free
Treasury Bond would give a return of: (1 + 𝑟:→G ):.D − 1 = 3%

Three Alternatives:
1. Strategy A – Equity: Invest entirely in stock. Buy 100 shares, each selling for $100.
2. Strategy B – Options: Invest entirely in at-the-money call options. Buy 1000 calls, each selling for $10. This would
require 10 contracts, each for 100 shares.
3. Strategy C – Levered Equity (Combination between buying options and gaining some exposure to the bond): Purchase
100 call options for $1000. Invest your remaining $9000 in 6-month T-Bills, to earn 3% interest. The bills will be worth
$9270 at expiration.

Stock Price
Portfolio $95 $100 $105 $110 $115 $120
A: All stock $9500 $10000 $10500 $11000 $11500 $12000
B: All options 0 0 5000 10000 15000 20000
C: Call plus Bills 9270 9270 9770 10270 10770 11270

For strategy A the rate of return is a linear function of the price of the stock,
it is going to be directly proportional to the price that the stock will have at
maturity. If the stock falls below the price that you paid for it, you are going
to have a negative return and vice-versa.

Option B is very risky → You are leveraging the payoffs of the stock. It will
pay a positive payoff only if the stock price is above the Strike Price (100).
Nevertheless, you will also need to compensate for the amount that you
have paid for this strategy, so this strategy will only deliver positive returns
when the stock price increases far away from 110.

Calls + T-Bill Strategy (C) shows the insurance value of the options, therefore is more appropriate for an investor who
wants to minimize losses.
• C’s T-Bill position cannot be worth less than $9270.
• Some return potential is sacrificed to limit downside.
Applications:

Consider the following data on SPY option prices:

• In reality we pay transaction costs.

• The stock price must go up by 70$ to be In-the-Money, until maturity.
• The price of a put is much higher because given the stock price today, the put is much closer to be in-the-money than
the call, which is deep out-of-the-money.

Q1: Discuss the patterns of open interest for call and put options on the SPY ETF:
• Little liquidity far out of the Money (really low open interest, i.e. number of contracts open)

Q2: Do option prices verify no-arbitrage lower and upper bounds? What about put-call parity?
• Assume no dividends and short-term rate r=0 in April 2014.
• Prices (average of bid and ask) satisfy these bounds tightly.
• Lower bound 180 call=188.71-180 = 8.71< (8.97+9.08)/2 =9.025
• Difference between 𝑐 + 𝐾𝑒 #'! and 𝑝 + 𝑆: is well-within bounds defined by bid vs ask prices!
• For 180 call and put: [(8.97+9.08)/2+180] – [(0.31+0.34)/2+188.71]=0.01 < bid-ask spread of both put and call.

One Period Binomial Model:

Option Pricing in a binomial model:

What should the price of a European call, put, or any other derivative be at any date before T?
• We used put-call parity to price the call relative to the put, or vice versa.
• What about the absolute pricing of the call or put? This is what we will see now.

Here we are focusing on European options, when we have a fixed point in time where the option realizes, which is at
maturity (K), and we will see how this formula can gives us an idea of how option pricing can be extend to more
complicated setups.
Main Idea: If an asset has a certain CF in the future, and another asset has the exactly the same CF in the future, the prices
of the two assets have to be the same, today.

Main Simplifying Assumptions:

• The binomial option pricing model assumes underlying stocks can move up or down each period.
• The stock price of the option at maturity, can only have a limited amount of values → only two: either the stock price
is higher than the stock price today, or it is lower.
o In reality, this does not work like that as, at maturity, the stock price can potentially reach an infinite amount of
values.

If we can replicate option’s payoff using a stock and risk-free bond, then we can price it by no arbitrage. The technique is
general, and real-world option pricing models extend the intuition of the binomial model.

Example: Let us price a European call option on a non-dividend paying stock with exercise price of $50. The stock price
today is equal to $50 (Note, 𝑆: does not always equal K, but K’s close to S0 are most actively traded). In one period, the
stock price will either rise by $10 or fall by $10. The one-period (simple) risk-free rate is 6%.

Payoffs:

Replicating Portfolio:

Find ∆ (position in stock) and B (position in bond) such that call’s payoffs are matched in both states:

• 𝑈 = ∆ ∗ 𝑆> + 𝐵 ∗ 𝑒 '! = 𝑐> ↔ ∆ ∗ 60 + 𝐵 ∗ 1.06 = 10

• 𝐷 = ∆ ∗ 𝑆a + 𝐵 ∗ 𝑒 '! = 𝑐a ↔ ∆ ∗ 40 + 𝐵 ∗ 1.06 = 0
• By solving the two above equations: ∆= 0.5 ; 𝐵 = 18.9

Thus, to prevent an arbitrage opportunity, we must have: 𝑐: = 0.5 ∗ 50 − 18.89 = 6.1

Conveniently and critically important: we don’t even know the probability of the states.

The general solutions uses the additional notation: 𝑆: , 𝑆> , 𝑆a , 𝑟2 , 𝐶> , 𝐶a :

• 𝑆: → Price of the Stock today • 𝑟2 → Risk free interest rate until maturity
• 𝑆> → Price of the Stock at maturity if it goes up • 𝐶> → Payoff of the option if the stock price went up
• 𝑆a → Price of the Stock at maturity if it goes down • 𝐶a → Payoff if the stock price went down
General Solution:
[ #[ [4 #N4 ∆
∆= NQ#N4 and 𝐵 = $&'%
, such that 𝑐: = ∆𝑆: + 𝐵
Q 4

• ∆ is the sensitivity of the option’s value to changes in the stock price.

• For call options: 0 ≤ ∆ ≤ 1 and 𝐵 ≤ 0 (borrow/short risk-free bonds). The practice of constructing this riskless
portfolio at each point in time is called “delta hedging”.
• This solution holds for any security that depends on the stock price.

Thus, for a European Put:

UQ #U4
• −1 ≤ ∆= ≤ 0 → Short
QQ #Q4
U4 #Q4 ∆
• 𝐵= ≥ 0, (invest/lend) → Long
$&'%

Example 2: Recall 𝑆: = 50, 𝐾 = 50, 𝑇 = 1, 𝑅𝐹 = 6%, and the stock can move up to 60 or down to 40.

What is the value of a put?

UQ #U4 ~•€(:,D:#G:)#~•€ (:,D:#L:)
• ∆= QQ #Q4
= G:#L:
= −0,5
U4 #N4 ∆ ~•€(:,D:#L:)#L:∗(#:.D)
• 𝐵= $&'%
= $.:G
= 28.3

• Check −0.5 ∗ 60 + 28.3 ∗ 1.06 = 10

• 𝑝: = −0.5 ∗ 50 + 28.3 = 3.3

Again, we find the price of the derivative, a put in this case, by replicating its payoffs using the underlying stock and a risk-
free bond.

o D:
Does call-put parity hold? [𝑝: + 𝑆: = 3.3 + 50] = [$&' + 𝑐: = $.:G + 6.1] → Yes, it holds.

To make all this more realistic, that is by allowing the stock price at maturity to have more than two values, we will study
the Multi Period Binomial Model.

Multi Period Binomial Model and Black Scholes:

To make the one-period binomial model more realistic, one can divide the same time until expiration into smaller and
smaller periods. This allows for a wider range of possible stock prices, potentially infinite, at expiration of the option.

1. Binomial setting with two periods:

• Flexible: extends to 3,4,5 periods, and so on.
• However it is computationally challenging.

2. Replication in continuous line:

• Infinite number of infinitely small periods.
• Gives us a solution in closed form when interest rate and volatility are constant up to expiration.
Multi-period Binomial Model:

Here we extend the binomial tree for more than one period. Here, we apply the same trick of the one-period, working
backwards.

First Step: Given the Stock Prices on the tree, we start from the left calculating the payoffs at maturity, given the stock
price in each point of the tree. In the middle, we can see that the payoff of the option is the same as the price of the
option.

Second Step: In the second branch, we must think about the 2nd + 3rd branch as a one period binomial model on its own,
and solve it for the price of the option at time = 1. The same applies for both the up and down part of the tree.

Third Step: The last step is to find the prices at time = 0. Here we are left by only one binomial tree (stock price at 0, stock
price going up, and stock price going down). Here we are not looking at payoffs, as these only occur at maturity. In the
end, after finding delta and B we are able to define the call/put option price at time 0.

• Already calculated 𝑐$,> = 6.1 𝑎𝑛𝑑 𝑐$,a = 0.

• Left with a similar problem as before, which we solve to find 𝑐: = 3.6
• The replicating strategy is dynamic, as ∆ and B vary over the states.
Black-Scholes Option Pricing Technique:

This is the most realistic technique for pricing European options that incorporates that the stock is traded continuously. It
can be derived from the Binomial Option Pricing Model by allowing the length of each period to become very small and
letting the number of moves in the stock price very large, potentially infinite (holding time until expiration fixed).

Building Blocks:
• Main Idea: Replication with stock and risk-less bond and no arbitrage. This is similar to what we seen before: the only
difference is that we assume that investors can trade the stock at any second, which will lead to potentially an infinite
number of stock prices in the future.
• Continuously compounded stock returns, and normally distributed (independent and with constant variance).
• No dividend payments during the life of the option.
• No transaction costs.
• The risk-free rate (r) is continuously compounded and constant until expiration.

The normal distribution implies that we must be familiar with 𝑁(𝑑), which is the cumulative probability of the Normal
Distribution up to a certain point defined by d.

For a European call option on a non-dividend paying stock:

R8
•‚ƒ „ J√_
<*7("
• 𝑑$ = + and 𝑑< = 𝑑$ − 𝜎√𝑇 → Here we can see that the volatility of the stock plays an important role in
J√_ <
defining call/put option prices.
• 𝑆: → Current Stock Price
• 𝐾 → Strike Price
• 𝜎 → Annual Volatility
• 𝑇 → # years to expiration
• 𝑟 → Risk-free rate.

N(d) is the cumulative probability of the Standard Normal Distribution. Specifically, it gives the probability that a random
draw from a standard normal distribution (mean=0, variance=1) is lower than or equal to d.
• 0 ≤ 𝑁(𝑑$ ) & 𝑁(𝑑< ) ≤ 1
Black-Scholes model: Replicating portfolio

For a call option on a non-dividend paying stock:

𝑐: = 𝑆: 𝑁(𝑑1) − 𝐾𝑒 (#'!) 𝑁(𝑑< )

Similar replicating portfolio as before: Long the stock ∆= 𝑁(𝑑$ ), and short the riskless bond.

∆→ The change in call option’s price for a $1 change in the stock price.
• Equivalently: The number of shares in the replicating portfolio for the option.
• Always 0 ≤ ∆ ≤ 1, so that change in call price always ≤ change in the stock price.

The replicating portfolio is a leveraged position in the stock.

𝑁(𝑑< ) is similar to the probability that the option will end up in the money (though not exactly).

Black-Scholes Formula: Applications

Formula is derived for European calls:

• Price of American call on a non-dividend paying stock is the same because we already know it will never be exercised
early.

Price of European Put found using put-call-parity:

𝑝: = 𝑐: + 𝐾𝑒 #'! − 𝑆: = 𝑆: 𝑁(𝑑$ ) − 𝐾𝑒 #'! 𝑁(𝑑< ) + 𝐾𝑒 #'! − 𝑆:

𝑝: = 𝑆: (𝑁(𝑑$ ) − 1) + 𝐾𝑒 #'_ (1 − 𝑁(𝑑< ))

• Delta (𝑁(𝑑$ ) − 1) → −1 ≤ ∆≤ 0
• B (𝐾𝑒 #'_ (1 − 𝑁(𝑑< )))→ Borrow 𝐵 ≥ 0
• Put delta = 𝑁(𝑑$ ) − 1 = Call delta minus 1 → Negative as put options become less worth as stock price increases.

Extensions and Volatility:

This chapter have 3 goals: (1) Understand how to deal with American options, both with and without dividends; (2) How
the Black-Scholes Formula changes when we have a stock that pays a dividend; (3) How can we incorporate the volatility
parameter within the binomial model.

American Options: How can we deal with American options in a binomial setting?

1. Without dividends:
• In each node of the tree (including t=0), check how the value of exercising the option compares to the value of not
exercising it.
• If the former is larger: exercise and replace European option value calculated from future payoffs with intrinsic value
that American option holder gets when exercising → This is represented in the first line of the middle branch.
• If it is larger we must consider the price of the American option that we have if we exercise early also in the periods
before.

2. With Dividends → Two important changes to approach:

• Assuming two periods, if we have a dividend paid at time 1, the stock price path from time 1 to time 2 needs to be
adjusted for dividend.
• If the dividend is paid at time 1, the prices at time 2 need to be calculated from the prices of time 1 after the dividend
is paid.
• American option holder could exercise before dividend.
• When we calculate the delta and the B for period 0, we need to use prices at period 1 before the dividend is paid.
• To summarize, in period 2 we have to use prices after the dividend is paid, and in period 0 we have to use prices before
the dividend is paid.

Calls and Dividends:

Supposing the underlying stock pays a dividend:

1. Discrete → E.g.: D$ in 2 months.
2. Continuous dividend yield q up to expiration → E.g.: q% (annualized).

In both cases, we substitute 𝑺𝟎 in the Black-Scholes formula, for 𝑺𝟎 𝒆#𝒒𝒕 :

𝐶: = 𝑆: 𝑒 #`! 𝑁(𝑑$ ) − 𝐾𝑒 #'! 𝑁(𝑑< )

R *7S6
•‚† 8 7(" ‡ J√_
<*
• 𝑑$ = J√_
+ <
and 𝑑< = 𝑑$ − 𝜎√𝑇
• If the dividend is discrete 𝑺𝟎 𝒆#𝒒𝒕 = 𝑺𝟎 − 𝑷𝑽(𝑫)
Puts and Dividends: Similar to the European call, we adjust the Black-Scholes formula for the European Put:

𝑝: = 𝑆: 𝑒 #`_ (𝑁(𝑑$ ) − 1) + 𝐾𝑒 #'_ (1 − 𝑁(𝑑< ))

Since, puts aren’t exercised early because of dividends (the lower the stock price after dividend, the better), the European
put option formula provides a lower bound for American put and this bound is tight practically (except when 𝑆: 𝑒 #`_ is
close to 0).

Confirm put-call parity with dividends holds for the two European options:

𝑐: + 𝐾𝑒 #'! = 𝑝: + 𝑆: − 𝑃𝑉(𝐷) ↔ 0.94 + 25𝑒 #:.:D∗< = 3.32 + 25 − 5𝑒 #:.:D∗$

Volatility Calibration: Volatility is a fundamental parameter to calibrate any option model. For stocks, one can use recent
(high-frequency) return data to estimate volatility.

Instead of using pre-defined volatility (saying that the stock price will go up to x in the upstate and vice versa), we can take
in account real volatility to make our option model more realistic.

Denoting by σ the annualized volatility of the stock’s log returns, this can be computed as

𝜎 = Ä𝑇𝑟𝑎𝑑𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 ∗ 𝐷𝑎𝑖𝑙𝑦 𝑉𝑜𝑙.

Having an estimate for annualized volatility, we can use it in Black-Scholes:

• Also, to calibrate a binomial model: up and down moves are a function of volatility.
• With continuously compounded returns, calibrations use: 𝑺𝒖 = 𝑺𝟎 𝒆𝝈√∆𝒕 , 𝑺𝒅 = 𝑺𝟎 𝒆#𝝈√∆𝒕
• ∆t is the time length of the binomial step → how long there is between each step of the tree.

The biggest problem in Black-Scholes model, and option pricing in general, is that volatility is not constant. There are
some option pricing models that incorporate time-series volatility, such as the GARCH model.

Implied Volatility:
• Option prices are a function of E(volatility) over
the life of the option.
• Thus, inverting the Black-Scholes formula, we can
write market expectation of future volatility as a
function of the option price.
• Suppose the value of the Microsoft call increases
suddenly from 20.92 to 30. What does this say about
expected volatility over the next 6 months? That it
increased from 30% to 52%.
EFTs – How they work and what risks they pose

EFTs Origins: Closed and Open-End Funds

Mutual funds: instrument in which investors put funds together.

Open end funds: companies can offers funds that invest in stocks or indexes…
When you want out: you get the € in the fund
A way to invest by using the expertise of people who have the knowledge required.

Closed end funds: just issue shares, you buy shares of the fund in the 2nd market. You can trade whenever you want.

ETFs try to get the best of both

A Potential Solution: ETF

Advantages of EFTs

Authorized participants will intervene every time the value of the ETF deviates from underlying index → because there
are arbitrage opportunities. If ETF Price > index (overvalued), the AP will sell ETF shares in the market, being able to enjoy
a profit (they get more than what they should). They buy the underlying securities using the proceeds of that sale (which
are underpriced). Then, they go to ETF sponsor, and they give him securities, for him to create additional shares to
accommodate increased demand which put prices overvalued in the first place.

IF ETF price > than it should: ETF is undervalued → AP will buy ETF shares in the secondary market (so they get more than
they should). Then, go to sponsor, and then they redeem those shares to shrink supply so that price goes up again (there
is insufficient demand).

ETFs with complex:

Also called Synthetic ETFs: access strategies that are hard to implement directly but are attractive to get exposure to (for
example good to get exposure to the Argentinian market)
• There are not a lot of synthetic ETFs

ETF Risks: Impact on market pricing during stress

In periods of market stress, Aps might stop engaging into ETF because they become problematic leading to misprices not
being adjusted

ETF risks: counterparty and collateral risks:

Risks typical of synthetic ETFS

Do ETFs increase or reduce the probability of a crisis?

Can etfs contribute to systematic risk?

If Ap stop correcting profits they might create problems for themselves as well, as they own ETFs, creating a vicious circle
as the ones who should be correcting are being prejudiced.