Long Buy; Short Sell

Call Option to buy

Put Option to sell
Option Right t o buy/sell an
asset at a specified price, at a
future date.
European On maturity date
America On or before mat date
OTC Tailored option traded
between 2 private parties (not
listed on the exchange)
Payoff for European call:
Long = max(S-K,0)
Short = -max (S-K,0)
Payoff for European Put:
Long= max(K-S,0)
Short = - max(K-S,0)
Call Option:
In money S > K
At money S = K
Out money S < K
Put Option:
In money S < K
At money S = K
Out money S > K
------------------------------------------
Straddle: Stock is going to make
a big move, but you aren't sure
which way.
How: Buy the same number of
puts and calls at the same strike
price (K) and expiration rate (T).
Risk: If stock price remains the
same or doesn't move much, then
both call and put will be worthless.
Stradle cost=Total premium paid
Breakeven price:
Upside breakeven price =
strike price + straddle cost
Downside breakeven price =
strike price - straddle cost
Profits are earned outside the
lower and upper breakeven stock
prices.
Losses are suffered between the
breakeven prices (Max loss when
stock price = strike price)

Strangle: It is similar to straddle.
Strangle strategy profits from
market movement in either
direction. Less risky than straddle
How: Buy call with Strike price
higher than the trading price and
Buy put with strike price lower
than the trading price.
Butterfly Spread: Used when
you do not expect stock price to be
very different from strike price.
How: Long 2 call options at
different strike prices and Short 2
call options (same price) at a strike
price equ1al to the average of the
first 2 calls.
Profit is maximum at the middle
strike price. Maximum profit =
Middle strike - lowest strike - cost
of butterfly spread.
Loss is maximum when expiration
price is less than lowest strike price
or more than highest strike price.
Max loss = cost of butterfly spread.
Breakeven points:
First breakeven point = lowest
strike + total cost.
Second breakeven point = highest
strike total cost.
Protective Put: To guard your
downside, by buying a put option
on the same stock.
How: Long on the stock and long
on the put on the same stock
Portfolio insurance:
Protective put for a portfolio
instead of a stock.
Formula :
Cost = (Ask price/Stock price)
Put-Call parity:
Stock price(S)+ Put price (P) =
PV(K) + Call price (C), where K is
the strike price of the option
Binomial Options Pricing:
A technique for pricing options
based on the assumption that
each period, the stocks return
can take on only two values

Upstate : 60+1.06B = 10
Downstate: 40+1.06B = 0.
Solving equations, =0.5, B=-18.87
Val. of portfolio = 50*0.5+(-18.87)
= 6.13
Rationale behind the model:
To create a call option using a stock
and bond, the value of the portfolio
consisting of the stock and bond
must match the value of the option
in every possible state
Formula:
where,



Black-Scholes: A technique
for pricing European-style
options when the stock can be
traded continuously.
Formula:
C = S * N(d1) - PV(K) * N(d2),
where,
SCurrent price of the stock
KExercise price



Where is the annual
volatility & T is the number of
years left to expiration.
PV(K) = PV of a risk-free zero-
coupon bond that pays K
----------------------------------------








P0 = (Div1+P1)/(1+re)
Re = [(Div1+P1)/Po] - 1
= Div1/Po + ( P1- Po)/Po
Total Return=dividend yield
+capital gain rate
Dividend discount model:
Po = Div1/(1+ Re)
1
+ Div2/(1+ Re)
2
+Div3/(1+ Re)
3
++Divn/(1+ Re)
n
Perpetuity/Dividend growing
at rate g:
Po = Div1 / (Re-g)
g = Expected dividend growth rate
g = b r where,
b=% earnings retained
r=expected future return on
retained capital
Re using CAPM:
Re= Rf +e(Rm-Rf)
High growth stocks have low
yields.
Yield=(r-g)/(1+g)
g increase => Yield decreases
Dividend per share in year t:
Divt= EPS * div payout rate
Note:
Assuming no of shares outstanding
is constant, firms can do two
things to increase its dividend:
> Increase its earnings (net
income)
> Increase its div payout rate
Total Payout Model:
PV0=PV(Future Total Dividends
and Repurchases)/ Shares
Outstanding in year 0.
The drawback is that firms dont
have predictable repurchase
patterns.
-------------------------------------------
Equity Value = Enterprise Value
+ Non-Operating Assets Net Debt
Enterprise value=PV (Free Cash
Flows)+PV (Terminal Value)
Net Debt = Total debt - Cash
FCF=EBIT (1-TC) + Depreciation -
Cap-ex WC
Discount rate = WACC
WACCL=(D/(D+E))*(1-TC) +
E/(D+E)
L=U*(1+D/E)
Share Price=Equity Value/Number
of Shares
The current P/E ratio is on current
earnings.
The forward P/E ratio is on next
year earnings.
Forward P/E=Po/EPS
=>Po=Div1/(Re-g)
=(Div1/EPS)/(Re-g)
=Div. Payout Rate/(Re-g)
We use enterprise valuation
multiples to compare firms with
different leverage Because
enterprise value represents the
entire value of the firm before
interest payments are made to the
debt holders.
----------------------------------------
IF (a bond trades at price < face
value) AND (bond pays coupons)
THEN - You get coupons (at
coupon rate) AND You get return
from price appreciation
SO ... Yield to Maturity > Coupon
rate ... and We say that bond is
selling at a discount
If a bonds YTM doesnt change,
then (true for zero-coupon and
coupon bonds)
- Discount shrinks as we get close
to the maturity
- Youll earn a return = YTM from
selling the bond early
When the bond is trading at a
discount, the price drop when a
coupon is made is more than the
price increase between coupons.
Effect of interest rate on bond
prices - Interest rate and prices -
There is an inverse relationship
between interest rates and bond
prices.
As interest rates and bond yields
rise, bond prices fall.
As interest rates and bond yields
fall, bond prices rise.

Effect of interest rate on bond
prices - Interest rate sensitivity
Discount is less for -- near future
cash flows.
PV(Cash flows) to be received in
near future are less sensitive to
interest rate changes than the
PV(Cash flows) that are to be
received in distant future.
Thus, shorter maturity zero-
coupon bonds are less sensitive to
changes in interest rates than the
longer-term zero-coupon bonds.
Bonds with higher coupon rates
are less sensitive to interest rate
changes. Why?
Because they pay higher
payment upfront.
Finally, sensitivity of a bonds
price to changes in interest rates is
measured by the bonds duration.
Bonds with high durations
are highly sensitive to
interest rate changes.

and
1
u d d d
u d f
C C C S
B
S S r

C S B
1 2 1
ln[ / ( )]

2
S PV K T
d and d d T
T

Present Value Determines the
Divedend Payments Stock Price
Total Payout
(All div and repurchases) Equity Value
Free Cash Flow
(Cash available to all) Enterprise value
FCF Based
Val uati on
Comparabl e Based
Val uati on
Cri ti cal I nput
Cash Fl ow Forecast
Growth Forecast
Techni cal Forecast
Di scount Forecast
Good Comparabl es
Cl ean Val ue Dri vers
Output
Absol ute $ Val ue
Fundamental Val ue
Val ue Rel ati ve to
comparabl es