Ifm Formula Sheet A
Ifm Formula Sheet A
Ifm Formula Sheet A
Forward
price underlying
Guarantee/lock in
Short Obligation to sell at
Short F%," − S" F%," − S" ∞ F%," sale price of
Forward the forward price
underlying
Right (but not Insurance against
max [0, S" − K]
Long Call obligation) to buy Long max [0, S" − K] AV(Prem. ) ∞ high underlying
− AV(Prem. )
at the strike price price
Call
Naked Writing vs. Covered Writing Graphing Payoffs from First Principles
• If an option writer does not have an offsetting position in the underlying Create a payoff table separated by the strike regions, and then graph the total
asset, then the option position is said to be naked. payoff in each region accordingly.
• If an option writer has an offsetting position in the underlying asset, then
the option position is said to be covered. Shortcut Method for Graphing the Payoff of All Calls or All Puts
• For calls, go left-to-right on the payoff diagram, and evaluate the slope of
Floor, Cap, Covered Call, Covered Put the payoff diagram at each strike price.
Key Relationship: Call – Put = Stock – Bond Going left-to-right means that a positive slope is one that increases left-
Rearranging, we have: to-right, and a negative slope is one that decreases left-to-right.
• Floor = + Stock + Put (guarantee a minimum selling price for stock) • For puts, go right-to-left on the payoff diagram, and evaluate the slope of
• Write a covered put = – Floor = – Stock – Put the payoff diagram at each strike price.
• Cap = – Stock + Call (guarantee a maximum purchase price for stock) Going right-to-left means that a positive slope is one that increases right-
• Write a covered call = – Cap = + Stock – Call to-left, and a negative slope is one that decreases right-to-left.
Ratio Spread Collar Collared Stock
Long and short an unequal number of calls/puts Long put (K1) + Short call (K2), K1 < K2 Long collar + Long stock
with different strike prices
Straddle Strangle Butterfly Spread (Symmetric/Asymmetric)
Long put (K) + Long call (K) Long put (K1) + Long call (K2), K1 < K2 Buy high- and low-strike options. Sell middle-
strike option. Quantity sold = Quantity bought.
Example - For 3 strike prices 30, 43, 46:
• Buy 46 − 43 = 3 options with strike 30
• Buy 43 − 30 = 13 options with strike 46
• Sell 46 − 30 = 16 options with strike 43
Any multiple of (buy 3, sell 16, buy 13) would
work.
Dividend Structure 𝐏𝐏
𝐅𝐅𝐭𝐭,𝐓𝐓 (𝐒𝐒) The investor has to add more funds to bring the Call
margin balance back to the initial margin. C(K_ ) ≥ C(K Ü ) ≥ C(K á)
No Divs SE
C(K_ ) − C(K Ü ) ≤ K Ü − K_
Discrete Divs SE − PVE," (Divs) European: C(K_) − C(K Ü) ≤ PV(K Ü − K_ )
PUT-CALL PARITY (PCP)
PUT-CALL PARITY (PCP) C(K_ ) − C(K Ü ) C(K Ü ) − C(K á )
Continuous Divs SE eNS("NE) ≥
PCP for Stocks K Ü − K_ Ká − KÜ
Dividend Structure 𝐅𝐅𝐭𝐭,𝐓𝐓(𝐒𝐒) ? (S)
C(S, K) − P(S, K) = FE," − KeN>("NE) Put
No Divs SE e>("NE) P(K_ ) ≤ P(K Ü ) ≤ P(K á )
PCP for Futures P(K Ü ) − P(K_ ) ≤ K Ü − K_
Discrete Divs SE e>("NE) − AVE," (Divs) C(F, K) − P(F, K) = FeN>("NE) − KeN>("NE)
European: P(K Ü) − P(K_ ) ≤ PV(K Ü − K_ )
Continuous Divs SE e(>NS)("NE) P(K Ü ) − P(K_ ) P(K á) − P(K Ü)
PCP for Bonds ≤
? (B)
C(B, K) − P(B, K) = FE," − KeN>("NE) K Ü − K_ Ká − KÜ
F%,"
Arbitrage strategy: “Buy Low, Sell High.” where x % is in d/f Call Put
Δ + −
Cash-and-Carry
B − +
The actual forward is overpriced.
COMPARING OPTIONS
COMPARING OPTIONS
Short actual forward + Long synthetic forward To replicate a call, buy shares and borrow money.
Reverse Cash-and-Carry Bounds of Option Prices To replicate a put, sell shares and lend money.
The actual forward is underpriced. Call and Put
1. Calculate the continuously compounded The prepaid forward price for a futures contract is
Lognormal Model for Stock Prices returns: just the present value of the futures price:
S" Sæ
? (F)
For T > t, ln ® © ~N[m, v Ü] ræ = ln i = 1,2, … , n F%," = FeN>"
SE SæN_
• m = (α − δ − 0.5σÜ )(T − t) 2. Calculate the sample mean of the returns: Options on Currencies
• v Ü = σÜ(T − t) ∑ñæ¡_ ræ Use the generalized BS formula in conjunction
≠ r̅ = with the appropriate prepaid forward prices.
• Æ ~LogN(m, v Ü ) n
≠Ø
3. Estimate the standard deviation of returns by For example, the prepaid forward price for 1 yen
Ü ]
For T > t, ln[S" ] ~N[m, v taking the square root of the sample variance of denominated in dollars is:
• m = ln SE + (α − δ − 0.5σÜ )(T − t) the returns:
• v Ü = σÜ(T − t) $
∑ñæ¡_(ræ
− r̅)Ü ? (¥1)
$F%," = qx % r (¥1eN>¥ " ) = $x %eN>¥ "
• S" ~LogN(m, v Ü) ¬` = √
σ ¥
n−1
E[S" ] = E[S" |SE ] = SE e(±NS)("NE) 4. Annualize the estimate of the standard
§
Var[S" ] = Var[S" |SE ] = (E[S" ])Ü Äe£ − 1Å deviation:
§
S" = SE eıNSN%.¢ë Å("NE)êë√"NE⋅≤ , Z~N(0,1) SEê`
S" Var ®ln ©=σ¬Ü h = σ
¬`
SE
Cov(SE , S" ) = E ® © ⋅ Var[SE |S% ]
SE ¬`
σ
⇒σ ¬=
√h
Δ? = −eNS("NE)N(−d_ ), −1 ≤ Δ? ≤ 0 Alternatively, overnight profit is the sum of: Earnings-Enhanced Death Benefit
ΔŒ − Δ? = eNS("NE) • Gain on options, ignoring interest • Pays the beneficiary an amount based on the
expÄ−δ(T − t)ÅNÕ (d_ ) • Gain on stocks, ignoring interest increase in the account value over the original
ΓŒ = Γ? = amount invested, e.g., 40% ⋅ max( S" − K, 0).
Sσ√T − t • Interest on borrowed/lent money
• The embedded option is a call option. Its value
θŒ = δSeNS("NE) N(d_ ) − rKeN>("NE)N(dÜ)
VegaŒ = Vega? = SeNS("NE) NÕ(d_ )√T − t = ΔE (SEê` − SE ) − (VEê` − VE ) GMAB with a Return of Premium Guarantee
ρŒ = (T − t)KeN>("NE) N(dÜ ) • Similar to GMDB with ROP guarantee, but the
− Äe>` − 1Å(ΔE SE − VE )
ρ? = −(T − t)KeN>("NE) N(−dÜ ) benefit is contingent on the policyholder
1 surviving to the end of the guarantee period.
ψŒ = −(T − t)SeNS("NE)N(d_ ) ≈ − ϵÜ ΓE − hθE − Äe>` − 1Å(ΔE SE − VE )
2 • The embedded option is a put option. Its value
ψ? = (T − t)SeNS("NE)N(−d_ ) where ϵ = SEê` − SE
§ is:
eNœ /Ü
NÕ (x) = P(m) ⋅ Pr[T†∗ ≥ m]
√2π If h is small, then e>` − 1 ≈ rh.
Mortgage Loan as Put
Risk Premium For an uninsured position, the loss to the mortgage
Breakeven
The risk premium of an asset is defined as the lender is max(B + C ∗ − R, 0), where:
If the price of the underlying stock changes by one
excess of the expected return of the asset over the • B is the outstanding loan balance at default
standard deviation over a short period of time,
risk-free return: • C ∗is the lender’s total settlement cost
then a delta-hedged portfolio does not produce
• Risk Premium“”Eæ‘ñ = γ − r • R is the amount recovered on the sale of
profits or losses.
• Risk Premium≠E‘’ï = α − r
property
Assuming the BS framework, given the current This is a put payoff with K = B + C ∗ and S = R.
γ − r = Ω(α − r) stock price, S, the two stock prices after a period of
σ“”Eæ‘ñ = |Ω|σ≠E‘’ï h for which the market-maker would break even Static vs. Dynamic Hedging
Elasticity
% change in option price Δ ⋅ S
Ω= =
% change in stock price V
ΩŒ ≥ 1; Ω? ≤ 0
than or equal to the value of an otherwise GapCall − GapPut = S% eNS" − K_ eN>" Extrema lookback options are known as lookback
equivalent ordinary option. options with a fixed strike price.
Exchange Option
As N increases:
C(A, B) = F ? (A) ⋅ N(d_ ) − F ? (B) ⋅ N(dÜ ) Shout Option
• Value of average price option decreases
P(A, B) = F ? (B) ⋅ N(−dÜ ) − F ? (A) ⋅ N(−d_ ) An option that gives the owner the right to lock in
• Value of average strike option increases
F ? (A) 1 a minimum payoff exactly once during the life of
ln ã ? (B) å + σÜ (T − t)
Barrier Option F 2
d_ = the option, at a time that the owner chooses. When
Three types: σ√T − t
the owner exercises the right to lock in a minimum
• Knock-in dÜ = d_ − σ√T − t
Goes into existence if barrier is reached. payoff, the owner is said to shout to the writer.
A
• Knock-out
√Var Ïln BÌ S ∗ is the value of the stock at the time when the
Goes out of existence if barrier is reached. σ=
t option owner shouts to the option writer.
• Rebate
Pays fixed amount if barrier is reached. = ÓσÜ{ + σÜÔ − 2Cov{,Ô
Payoff for a shout call
Down vs. Up: max[S" − K, S∗ − K, 0] if shout is exercised
• If S% < barrier: = ÓσÜ{ + σÜÔ − 2ρσ{σÔ =„
max[S" − K, 0] if shout is not exercised
Up-and-in, up-and-out, up rebate
Barrier option ≤ Ordinary Option • max(cA, cB) = c ⋅ max(A, B) c > 0 Rainbow Option
max(cA, cB) = c ⋅ min(A, B) c < 0 An option whose payoff depends on two or more
Special relationships: • max(A, B) + min(A, B) = A + B
• If S% ≤ barrier ≤ strike: risky assets.
⇒ min(A, B) = − max(A, B) + A + B
Up-and-in Call = Ordinary Call
Up-and-out Call = 0 Forward Start Option
• If S% ≥ barrier ≥ strike: For a call option expiring at time T whose strike is MEAN-VARIANCE PORTFOLIO THEORY
MEAN-VARIANCE PORTFOLIO THEORY
Down-and-in Put = Ordinary Put set on future date t to be XSE :
Risk and Return of a Single Asset
Down-and-out Put = 0 C(SE , XSE , T − t) ñ
Expected Return
σÜ? = x_Ü σ_Ü + x ÜÜ σÜÜ + x Üá σÜá + 2x_x Ü Cov[R_ , RÜ ] initially. 20%
Corr. = -1
+ 2x_x á Cov[R_ , Rá ] • Even with a very large portfolio, we cannot
No Risk
+ 2x Üx á Cov[RÜ , Rá ] eliminate all risk. The remaining risk is 15%
For an n-stock portfolio: systematic risk that cannot be avoided through Corr. = +1
ñ ñ ñ
diversification. 10%
σÜ? = ⁄ x æ Cov[Ræ, R? ] = ⁄ ⁄ x æ x ¯Cov•Ræ , R¯ ¶
Total risk = Systematic risk + Unsystematic risk • To determine optimal portfolios, investors only Risky
need to know the expected returns, variances, Portfolio
Diversification reduces a portfolio's total risk by and covariances of returns. Portfolio with x
averaging out nonsystematic fluctuations: • There are no transactions costs or taxes. invested in the
• Investors can eliminate nonsystematic risk for risky portfolio
free by diversifying their portfolios. Thus, the Efficient Frontier
risk premium for nonsystematic risk is zero. • A portfolio is efficient if the portfolio offers the
highest level of expected return for a given level
• The risk premium of a security is determined by
its systematic risk and does not depend on its of volatility (or the lowest level of volatility for a • At the intercept, the portfolio only consists of
nonsystematic risk. given level of return). the risk-free asset.
• The portfolios that have the greatest expected • At point P, the portfolio only consists of risky
For an equally-weighted n-stock portfolio: return for each level of volatility (or the lowest assets.
1 1 volatility for a given level of return) make up • The line extending to the right of σ? represents
σÜ? = ⋅ ‚‚‚‚‚
Var + ã1 − å ⋅ Cov‚‚‚‚‚ the efficient frontier.
n n portfolios that invest more than 100% in the
• In a very large portfolio (n → ∞), the covariance risky portfolio P. This is done by using leverage
among the stocks accounts for the bulk of (borrow money to invest).
portfolio risk:
and down the same percentage as the market. αæ = E[Ræ ] − ræ Multi-factor Model
• If β > 1, then the asset has more systematic risk = E[Ræ ] − (rv + βæ [E[R˘ïE ] − rv]) • Considers more than one factor when
than the market. The asset will tend to go up If the market portfolio is efficient, then all estimating the expected return.
and down more than the market, on a securities are on the SML, and: • Also known as the Arbitrage Pricing Theory
percentage basis. E[Ræ ] = ræ and αæ = 0 (APT).
• If β < 1, then the asset has less systematic risk If the market portfolio is not efficient, then the • Similar to CAPM, but assumptions are not as
than the market. The asset will tend to go up securities will not all lie on the SML, and: restrictive.
and down less than the market, on a percentage E[Ræ ] ≠ ræ and αæ ≠ 0
Key Equations
basis. Investors can improve the market portfolio by:
Using a collection of N well-diversified portfolios:
• If β = 0, then the asset’s return is uncorrelated • buying stocks whose E[Ræ ] > ræ (i.e., αæ > 0) ‰
with the market return. • selling stocks whose E[Ræ ] < ræ (i.e., αæ < 0) E[Ræ ] = rv + ⁄ βúñ
æ (E[ Rúñ ] − rv )
ñ¡_
Calculating Beta
Required Return on New Investment where βú_ úñ
æ , … , βæ are the factor betas of asset i
Cov[Ræ, R˘ïE ] σæ
βæ = = ρæ,˘ïE ⋅ Adding the new investment will increase the that measure the sensitivity of the asset to a
σܢïE σ˘ïE
ñ
Sharpe ratio of portfolio P if its expected return particular factor, holding other factors constant.
β? = ⁄ x æβæ exceeds its required return, defined as:
If all factor portfolios are self-financing, then we
r‰}˙ = rv + β‰}˙,? [E[R? ] − rv ]
æ¡_ can rewrite the equation as:
In general, the beta of an asset i with respect to a ‰
Beta can be estimated using linear regression:
portfolio P is: E[Ræ ] = rv + ⁄ βúñ
Ræ − rv = αæ + βæ (R˘ïE − rv) + ϵæ æ (E[ Rúñ ])
Cov[Ræ, R? ] σæ ñ¡_
βæ = = ρæ,? ⋅
σÜ? σ?
Value of real option Percentage ownership
Breakeven Analysis Amount invested
= NPV(with option) – NPV(without option) =
Calculate the value of each parameter so that the Post-money valuation
project has an NPV of zero. # shares owned × Pre-money price per share
Timing Option (Call Option) =
Sensitivity Analysis Gives a company the option to delay making an Post-money valuation
investment with the hope of having better # shares owned
Change the input variables one at a time to see =
information in the future. Total # shares
how sensitive NPV is to each variable. Using this
analysis, we can identify the most significant Venture Capital Financing Terms
Factors affecting the timing of investment:
variables by their effect on the NPV. Venture capitalists typically hold convertible
• NPV of the investment
preferred stock, which differs from common stock
Scenario Analysis o Without the timing option, invest today if
due to:
Change several input variables at a time, then NPV of investing today is positive.
• Liquidity preference
calculate the NPV for each scenario. The greater o With the timing option, invest today only if
Liquidity preference = Multiplier × Initial inv
the dispersion in NPV across the given scenarios, NPV of investing today exceeds the value of
the option of waiting, assuming the NPV is • Participation rights
the higher the risk of the project.
positive. • Seniority
• Anti-dilution protection
• Board membership
new capital.
Homemade leverage: Investors can borrow or lend
Corporate Debt: Private Debt
• Secondary offerings: Existing shares sold by at no cost on their own to achieve a capital
Private debt is negotiated directly with a bank or a
current shareholders. structure different from what the firm has chosen.
small group of investors. It is cheaper to issue due
When issuing an IPO, the company and to the absence of the cost of registration. MM Proposition II (Without Taxes)
underwriter must decide on the best mechanism
• The cost of capital of levered equity increases
2 main types of private debt:
to sell shares: with the firm's debt-to-equity ratio.
• Term loan ˝
• Best-efforts: Shares will be sold at the best • r~ = rµ + (rµ − r˝ )
• Private placement ~
possible price. Usually used in smaller IPOs. ~ ˝
• rµ = rˇ{ŒŒ = r + r
• Firm commitment: All shares are guaranteed Other Types of Debt ~ê˝ ~ ~ê˝ ˝
to be sold at the offer price. Most common. Government entities issue sovereign debt and Assuming the cost of debt is constant:
• Auction IPOs: Shares sold through an auction municipal bonds to finance their activities.
system and directly to the public.
Sovereign debt is issued by the national
Standard steps to launching a typical IPO: government. In the US, sovereign debt is issued as
1. Underwriters typically manage an IPO and they bonds called "Treasury securities."
are important because they:
There are four types of Treasury securities:
o Market the IPO.
• Treasury bills
o Assist in required filings.
• Treasury notes
o Ensure the stocks liquidity after the IPO.
• Treasury bonds
2. Companies must file a registration statement,
• Treasury inflation-protected securities (TIPS)
which contains two main parts:
o Preliminary prospectus/red herring. Municipal bond is issued by the state and local
o Final prospectus. governments.
3. A fair valuation of the company is performed by
There are also several types of municipal bonds Note:
the underwriter through road show and book
based on the source of funds that back them: • Since debt holders have a priority claim on
building.
4. The company will pay the IPO underwriters an • Revenue bonds assets and income above equity holders, debt is
underwriting spread. After the IPO, • General obligation bonds less risky than equity, and thus the cost of debt
underwriters can protect themselves more Asset-Backed Securities is lower than the cost of equity.
against losses by using the over-allotment An asset-backed security (ABS) is a security whose • As companies take on more debt, the risk to
allocation or greenshoe provision. cash flows are backed by the cash flows of its equity holders increases, and subsequently the
4 IPO Puzzles: underlying securities. cost of equity increases.
• The average IPO seems to be priced too low. The biggest sector of the ABS market is the • The rising cost of equity exactly offsets the
• New issues appear cyclical. mortgage-backed security (MBS) sector. An MBS benefits of using a larger proportion of debt as a
• The transaction costs of an IPO are high. has its cash flows backed by home mortgages. cheaper source of financing, resulting in a
• Long-run performance after an IPO is poor on Because mortgages can be repaid early, the constant WACC.
average. holders of an MBS face prepayment risk.
Debt Financing Banks also issue ABS using consumer loans, such
Corporate Debt: Public Debt as credit card receivables and automobile loans.
Public debt trades on public exchanges. The bond
• V¥ = Vµ + PV(Interest tax shield) Shareholders may be unwilling to finance new, Trade-Off Theory
Interest tax shield = Corp. Tax Rate × Int Pmt positive-NPV projects. Balance the value-enhancing effects of debt on a
• The value of a firm is maximized if its capital • Cashing out. When a firm faces financial firm's capital structure with the value-reducing
structure is 100% debt. distress, shareholders have an incentive to effects.
For a firm that borrows debt D and keeps the debt liquidate assets at prices below their market V¥
permanently, if the firm's marginal tax rate is τŒ , values and distribute the proceeds as dividends. = Vµ + PV(Interest tax shield)
and the debt is riskless with a risk-free interest The Agency Benefits of Leverage − PV(Financial distress costs)
rate rv, then the present value of the interest tax Managers have interests that may differ from − PV(Agency costs of debt)
shield is: shareholders' and debt holders' interests: + PV(Agency benefits of debt)
PV(Interest tax shield) = τŒ ⋅ D • Empire building. Managers tend to take on
MM Proposition II (With Taxes) investments that increase the size, rather than
• With taxes, when more debt is incorporated into the profitability, of the firm
the capital structure, the cost of equity will still • Managerial entrenchment. Because managers
rise, but it does not rise as rapidly as it would if face little threat of being replaced, managers can
there were no taxes. run the firm to suit their interests.
˝
• r~ = rµ + (rµ − r˝ )(1 − τŒ ) Leverage can provide incentives for managers to
~
• rˇ{ŒŒ =
~
r~ +
˝
r˝ (1 − τŒ ) run a firm more efficiently and effectively due to:
~ê˝ ~ê˝
• Increased ownership concentration.
Assuming the cost of debt is constant: • Reduced wasteful investment.
• Reduced managerial entrenchment and
increased commitment.
Costs of Asymmetric Information
Lemons principle: When managers have private The optimal level of debt, D∗ , occurs at the point
information about the value of a firm, investors where the firm's value is maximized. It balances
will discount the price they are willing to pay for the benefits and costs of leverage.
new equity issue due to adverse selection.