BBA Students 2024

WELCOME TO Capital Markets!!!

Session 7 to 20

Professor: Rodrigo Hurtado AKA Professor Rod

Let´s practice with a quick exercise
Let´s practice with a quick exercise
LONG Call and Put
SHORT Call and Put
Derivative Markets
Derivative Markets: Call Option

• Call Options on Apple

• The right to buy 100 shares at a strike price of $135 using the May
contract costs:
!"#$ !"## %C%'(( ! )*+,-C)*,-

• Is this contract “in the money”?

• When should you buy this contract?
• When should you write it?
Derivative Markets: Put Option

• Put Options on Apple

• The right to buy 100 shares at a strike price of $135 using the May
contract costs:
!"#$ !"## %C%'(( ! )*+,-C)*,-

• Is this contract “in the money?”

Derivative Markets: Future Contracts

• Futures Contracts

• Purchaser (long) buys specified quantity at contract expiration for

set price

• Contract seller (short) delivers underlying commodity at contract

expiration for agreed-upon price
Derivative Markets: Future Contracts
Ex 1
Ex 2
Figure 3.4 Limit Order

•You´ve placed an order to BUY 1.000 shares at a price of 149.76. How

many can I buy?
Trading Costs and more terms

• Commission: Fee paid to broker for making transaction

• Spread: Cost of trading with dealer

• Bid: Price at which dealer will buy from you

• Ask: Price at which dealer will sell to you

!"#$%&'(')#*+$ !"# ! )#*+$ AB&

Buying on Margin

• Margin: Describes securities purchased with money

borrowed in part from broker
• Net worth of investor's account

• Initial Margin Requirement (IMR)

• Minimum set by Federal Reserve under Regulation T, currently
50% for stocks
• Minimum % initial investor equity
• 1 − IMR = Maximum % amount investor can borrow
Buying on Margin

• Equity
• Position value – Borrowing + Additional cash

• Maintenance Margin Requirement (MMR)

• Minimum amount equity can be before additional funds must be
put into account
• Exchanges mandate minimum 25%
• Margin Call
• Notification from broker that you must put up additional funds or
have position liquidated
Buying on Margin

• If Equity / Market value £ MMR, then margin call occurs

!"#$B&'(")*B'+',-##-.B/
' ! '!!M
!"#$B&'(")*B

• Solve for market value

• A margin call will occur when:

!"##"$B&
'(#)B*+,(-.B+ ! +
/ " ''M
Let´s review an example!

• Margin Trading: Initial Conditions

• X Corp: Stock price = $70

• 50%: Initial margin

• 40%: Maintenance margin

• 1000 shares purchased

Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000
Let´s review an example!

• Stock price falls to $60 per share

• Position value – Borrowing + Additional cash

• Margin %: $25,000/$60,000 = 41.67%

New Position
Stock $60,000 Borrowed $35,000
Equity $25,000

• How far can price fall before margin call?

• Market value = $35,000/(1 – .40) = $58,333
Let´s review an example!

• With 1,000 shares, stock price for margin

call is $58,333/1,000 = $58.33
• Margin % = $23,333/$58,333 = 40%
• To restore initial margin requirement, equity = ½
x $58,333 = $29,167

New Position
Stock $60,000 Borrowed $35,000
Equity $23,333
Moving into

Macroeconomic and
Industry Analysis
Determination of Equilibrium Real Rate of Interest
Business Cycles
Free Cash Flow Valuation Approaches

• Free Cash Flow for Firm (FCFF)

𝐹𝐶𝐹𝐹= 𝐸𝐵𝐼𝑇(1−𝑡_𝑐 )+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛−𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠−𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑁𝑊𝐶

• EBIT = Earnings before interest and taxes

• 𝑡_𝑐 = Corporate tax rate
• NWC = Net working capital
• 𝑑𝑒𝑏𝑡

• Free Cash Flow to Equity Holders (FCFE)

• 𝐹𝐶𝐹𝐸=𝐹𝐶𝐹𝐹−𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒×(1−𝑡_𝑐 )+𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑖𝑛 𝑛𝑒𝑡
Free Cash Flow Valuation Approaches

Estimating Terminal Value using Constant Growth Model

$
1 + 𝐹𝐶𝐹𝐹! 𝑃$
𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 = , +
(1 + 𝑊𝐴𝐶𝐶)! (1 + 𝑊𝐴𝐶𝐶)$
!"#

𝐹𝐶𝐹𝐹$%#
𝑃$ =
𝑊𝐴𝐶𝐶 − 𝑔

WACC = Weighted average cost of capital

Free Cash Flow Valuation Approaches EXAMPLE

Suppose FCFF = $1 mil for years 1-4 and then is expected to

grow at a rate of 3%. Assume WACC = 15%

$
1 + 𝐹𝐶𝐹𝐹! 𝑃$
𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 = , ! +
(1 + 𝑊𝐴𝐶𝐶) (1 + 𝑊𝐴𝐶𝐶)$
!"#

𝐹𝐶𝐹𝐹$%#
𝑃$ =
𝑊𝐴𝐶𝐶 − 𝑔

WACC = Weighted average cost of capital

Free Cash Flow Valuation Approaches EXAMPLE

"If 500,000 shares are outstanding, what is the predicted

price of this stock if the firm has $5,000,000 of debt?"
Free Cash Flow Valuation Approaches EXAMPLE
Suppose FCFF = $1 mil for years 1-4 and then is expected to
grow at a rate of 3%. Assume WACC = 15%
!
A%AA #!
AC'(F*+,- = # +
" =! #! + ./%% $ "
#! + ./%% $ !

%!& '''& ''' ! !(')

"
%!& '''& ''' (!* " (')
=# +
" =! #! + (!*$ "
#! + (!*$ "
= +%+,& ,-.& *.,
"If 500,000 shares are outstanding, what is the predicted
price of this stock if the firm has $5,000,000 of debt?"
"#$% $&'% ('$)#(%!!!%!!!
!! = " = #(*(+
(!!% !!!
Intrinsic Value versus Market Price

= expected dividend per share

= current share price
= expected end-of-year price

Example: Suppose you purchased a share of STARK Inc. for $40 in January. You expect to
sell it for $42 in December and expect to receive a dividend of $2.42 during that year.
What is your expected HPR or Holding Period Rate?

! # "! $ + % ! # #! $ ! #" & '()*( + '*( ! *"

$#% = ! #& $ = = = )!!"+ = !!)"+,
#" *"
Intrinsic Value versus Market Price

• Intrinsic Value
• Present value of firm’s expected future net cash flows
discounted by required Rate of Return (RoR)

• Market Capitalization Rate

• Market-consensus estimate of appropriate discount rate for
firm’s cash flows
Intrinsic Value versus Market Price
• Intrinsic Value

𝑬 𝑫𝟏 $𝑬(𝑷𝟏 )
• 𝑽𝟎 =
𝟏$𝒌

• For holding period H

𝑫𝟏 𝑫𝟐 𝑫𝑯 + 𝑷 𝑯
𝑽𝟎 = + 𝟐
+ ⋯+
𝟏 + 𝒌 (𝟏 + 𝒌) (𝟏 + 𝒌)𝑯

• Dividend Discount Model (DDM)

• Formula for intrinsic value of firm equal to present value of all
expected future dividends
Dividend Discount model

For stock with market price = intrinsic value, expected holding

𝐸 𝑟 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑

𝐷7 𝑃7 − 𝑃9 𝐷7
+ = +𝑔
𝑃8 𝑃9 𝑃9
Dividend Discount model

Life Cycles and Multistage Growth Models

Two-stage DDM

DDM in which dividend growth assumed to level off only at

future date

Multistage Growth Models

Allow dividends per share to grow at several different rates as

firm matures
Dividend Discount Models: Two Stage Example

Consider the following information:

• The firm’s dividends are expected to grow at g = 20% until t = 3 yrs.

• At the start of year four, growth slows to gs= 5%.
• The stock just paid a dividend Div0 = $1.00
• Assume a market capitalization rate of k = 12%
• What is the price, P0, of this stock?
Dividend Discount Models: Two Stage Example

Consider the following information:

• The firm’s dividends are expected to grow at g = 20% until t = 3 yrs.

• At the start of year four, growth slows to gs= 5%.
• The stock just paid a dividend Div0 = $1.00
• Assume a market capitalization rate of k = 12%
• What is the price, P0, of this stock?
#! ! $% + $ & #! ! $% + $ &! #! ! $% + $ &! ! $% + $ " &
%! = + ''' + +
$% + & & $% + & & !
$% + & &! ! $ & " $ " &
)%! $% + '#& )%! $% + '#& # )%! $% + '#&" #! ! $% + '#&" ! $% + '!(&
= + + +
$% + '%#& $% + '%#& #
$% + '%#& "
$% + '%#&" ! $'%# " '!(&
= )%'!* + )%'%( + )%'#" + )%+',( = )#%'-!
Dividend Discount Models: Stock Value

The Constant Growth Model states that a stocks

value will be greater

• The larger its expected dividend per share.

• The lower the market capitalization rate, k.
• The higher the expected growth rate of dividends.
Dividend Discount Models: Stock Value
Price-Earnings Ratios

Price Earnings Ratio and Growth Opportunities

• Price-earnings multiple

• Ratio of stock’s price to earnings per share

• Determinant of P/E ratio

:! 7 :=>?
• = #"
;" <
$
*PVGO= Present Value of Growth Opportunities
Price-Earnings Ratios

P/E Ratio for Firm Growing at Long-Run

Sustainable Pace
+* -./
• =
,+ 0.(12,×/)

PEG Ratio (Price to Earnings Growth)

• Ratio of P/E multiple to earnings growth rate

Price-Earnings Ratios

P/E Ratios and Stock

+ -./
• =
, 0.4

• All else equal, riskier stocks have lower P/E multiples,

higher required RoR, k
Price-Earnings Ratios

Pitfalls in P/E Analysis

• Earnings Management

• Practice of using flexibility in accounting rules to improve

apparent profitability of firm

• Large amount of discretion in managing earnings

From Chapter 3
From Chapter 3
From Chapter 3
From Chapter 3
From Chapter 3
From Chapter 12
From Chapter 12
From Chapter 12
From Chapter 12
From Chapter 12
From Chapter 12
Values of Options at Expiration

• Call Options

• Payoff to call holder at expiration

• 𝑆! − 𝑋 if 𝑆! > 𝑋; 0 if 𝑆! ≤ 𝑋
• Payoff to call writer
• − 𝑆! − 𝑋 if 𝑆! > 𝑋; 0 if 𝑆! ≤ 𝑋

• Put Options
• Payoff to put holder
• 0 if 𝑆! ≥ 𝑋; 𝑋 − 𝑆! if 𝑆! < 𝑋

• ST= Stock/Asset price at expiration date

• X = Exercise price
Payoff, Profit to Call Option at Expiration
Payoff, Profit to Call Writers at Expiration
Payoff, Profit to Put Option at Expiration
Values of Options at Expiration
• Options versus Stock Investment
• Strategies:
1) Invest entirely in stock, 100 shares for $90 each
2) Invest entirely in at-the-money options; buy 900 calls,
each selling at $10
3) Buy 100 call options for $1,000; invest remaining $8,000
in 6-month T-bills at 2% interest
Values of Options at Expiration
• Stock price

• RoR
RoR to Three Strategies
 Option
Strategies
Option Strategies
• Protective put
• Asset combined with put option that guarantees
minimum proceeds equal to put’s exercise price

• Risk management
• Strategies to limit risk of portfolio

• Covered call
• Writing call on asset together with buying asset
Option Strategies
• Straddle
• Combination of call and put, each with same exercise
price and expiration date
• Spread
• Combination of two or more call options/put options
on same asset with differing exercise prices/times to
expiration
• Collar
• Options strategy that brackets value of portfolio between
two bonds
Payoff to Protective Put Strategy
Value of Protective Put Position at
Expiration
Protective
Put versus
Stock
Investment
Payoff to Covered Call
Value of Covered Call Position at Expiration
Payoff to Straddle
Payoff and Profit on Straddle at Expiration
Payoff to Bullish Spread
Value of Bullish Spread Position at
Expiration
Optionlike Securities
• Callable Bonds

* Issued with coupon rate higher than on straight debt

Investor’s compensation for call option retained by

issuer

*Usually includes call protection period

Optionlike Securities
• Callable Bonds

• Issued with coupon rate higher than on straight debt

Investor’s compensation for call option retained by

issuer

• Usually includes call protection period

Values of Callable Bond Compared with Straight Bond
Optionlike Securities
• Convertible Securities

• Convey options to holder rather than issuer

• Typically give holder right to exchange for common

stock, regardless of market price
Value of Convertible Bond as Function of Stock Price
Optionlike Securities
• Warrants

• Option issued by firm to purchase shares of firm’s

stock

• Collateralized Loans

• Nonrecourse loan
• No recourse beyond right to collateral
Optionlike Securities
• Collateralized Loans

• Three views
• Gives implicit call option to borrower

• Borrower turns collateral over and retains right to

reclaim it by paying off loan

• Borrower will repay L dollars and can sell collateral

to leaders for L dollars, even if 𝑆_𝑇 is less than L
Collateralized Loan
Optionlike Securities
• Leveraged Equity and Risky Debt

• Any time corporation borrows money, maximum

possible collateral for loan is total of firm’s assets
Exotic Options
• Asian Options
• Options with payoffs that depend on average price of
underlying asset during portion of option life

• Currency-Translated Options
• Have either asset or exercise price denominated in foreign
currency

• Digital Options
• Have fixed payoffs that depend on price of underlying asset
From chapter 15
From chapter 15

• A) 7.25
• B) 725
• C) 55
From chapter 15
From chapter 15

• A) $140
• B) $135
• C) $134.70
From chapter 15

• A) $46
• B) $40
• C) $45.5
From chapter 15

• A) -$16
• B) -$16.5
• C) -$15.5
From chapter 15

• A) -$7.5
• B) -$8
• C) -$8.5
From chapter 15
From chapter 15
From chapter 15
From chapter 15
Option Valuation
Introduction
• Intrinsic Value of a Call option
• Stock price minus exercise price, or profit that could be
attained by immediate exercise of in-the-money call option

• Time Value
• Difference between option’s price and intrinsic value
Introduction
• Determinants of Option Value
• Stock price
• Exercise price
• Volatility of price
• Time to expiration
• Interest rate
• Dividend rate

• (later to be covered as “the greeks”)

 Call Option Value before Expiration

• As time passes, blue curve morphs into grey line due to time decay.
Determinants of Call Option Values
Binomial Option Pricing
• Two-State Option Pricing
• Assume stock price can take one of two values
• Increase by u = 1.2, or fall by d = .9
Binomial Option Pricing
• Two-State Option Pricing
• Compare payoff to one share of stock, borrowing of $81.82 10%
interest.

• Outlay is $18.18 ($100 for the stock less the $81.82 proceeds from
borrowing); payoff is three times call option.
Binomial Option Pricing
• Two-State Option Pricing
• Portfolio of one share and three call options is perfectly hedged.

• Hedge ratio for two-state option

• Where Cu or Cd stand for option’s value when stock goes up or

down and uS0 or dS0 are the stock prices of the two states.
Binomial Option Pricing
• Two-State Option Pricing

• Binomial option pricing may seem overly simplistic so we can

generalize to include more realistic assumptions.

• Suppose we can break up the year into two six month segments
and assign two possible values over each half year.
Binomial Option Pricing
• Two-State Option Pricing

• Ex: we can say it can increase 10% (i.e., u=1,1) or decrease 5%

(i.e., d=0.95)

• A stock initially selling at $100 could follow the following paths over
the course of the year:
Binomial Option Pricing
$121
$110
$100 $104.50
$95
$90.25

• Subdivide further using the same pattern

Different subintervals (3, 6 and 20)

• Next three slides show probability distributions for final stock

price:

• In each slide, the stock’s expected annualized, continuously

compounded rate of return is 10% and the standard deviation
is 30%
Three subintervals
Six subintervals
Twenty subintervals
Black-Scholes Option Valuation

• Black-Scholes Pricing Formula

Trading Mechanics
•Clearinghouse and Open Interest
• Clearinghouse
• Facilitates trading; may be intermediary between two traders

• Closing out positions

• Reversing trade
• Take or make delivery
• Most trades reversed and do not involve actual delivery

• Open interest
• Opened contracts not offset with reversing trade
Trading with and without Clearinghouse
Trading Mechanics
•Marking to Market and Margin Account
• Marking to Market
• Daily settlement of obligations on futures positions

• Maintenance Origin
• Value below which trader’s margin may not fall; triggers margin call

• Convergence Property
• Convergence of futures prices/spot prices at maturity of futures contract
Trading Mechanics
•Cash versus Actual Delivery
• Cash settlement
• Cash value of underlying asset delivered to satisfy contract
Trading Mechanics
•Cash versus Actual Delivery
• Regulations
• Regulated by Commodity Futures Trading Committee (CFTC)

• Exchange can set limits on one-day price changes

• Taxation

• Paid at year-end on cumulative profits/losses regardless of whether

position is closed
Futures Market Strategies
•Trading Strategies
• Speculation
• Short if you believe price will fall
• Long if you believe price will rise

• Hedging
• Long: Endowment fund will purchase stock in 3 months; manager
buys futures now to protect against rise in price
• Short: Hedge fund invests in long-term bonds; manager worries
interest rates may increase and sells futures
Futures Market Strategies
•Basis and Hedging
• Basis
• Difference between futures price and spot price

• Basis risk
• Risk attributable to uncertain movements in spread between
futures price and spot price

• Spread (futures)
• Taking long position in futures contract of one maturity and short
position in another, in same commodity
Futures Prices
•Spot-Futures Parity Theorem
• Purchase commodity now, store to T

• Simultaneously take short position in futures

• “All-in cost” of purchasing commodity and storing it (including

cost of funds) must equal futures price to prevent arbitrage
Futures Prices
•No-Arbitrage Condition
Action Initial Cash Flow Cash Flow at T
1. Borrow S0 S0 -S0(1+rf)T
2. Buy spot for S0 -S0 ST
3. Sell futures short 0 F0 - ST
Total 0 F0 - S0(1 + rf)T

• Strategy: Cost 0 initially, cash flow at T must = 0, therefore:

• F0 – S0(1 + rf)T = 0
• F0 = S0 (1 + rf)T
• Futures price = Spot price – Cost of carry
Futures Prices
•No-Arbitrage Condition
Action Initial Flows Flows at T
Strategy A: Buy gold −S0 ST
Strategy B: Long Futures 0 ST − F0
Invest in bills: F0/(1 + rf)T −F0/(1 + rf)T F0
Total for B −F0/(1 + rf)T ST

• Strategies have same cash flows at same time, T

• F0/(1 + rf)T = S0
• F0 = S0(1 + rf)T
• Futures price = Spot price - Cost of carry
Financial Futures
•Stock-Index Futures
• Available on domestic and international stocks

• Several advantages over direct stock purchase

• Lower transaction costs

• Easier to implement timing/allocation strategies
Financial Futures
•Creating Synthetic Stock Positions
• Synthetic stock purchase
• Purchase of stock-index futures instead of actual shares
• Allows frequent trading at low cost
• Useful for foreign investments

• Classic market-timing strategy

• Switch between Treasury bills and stocks based on market
conditions
• Cheaper to buy Treasury bills then shift stock market exposure by
buying and selling stock-index futures
Financial Futures
•Index Arbitrage

• Exploiting mispricing between underlying stocks and futures

index contract

• Futures price too high

• Short futures; buy underlying stocks

• Futures price too low

• Long futures; sell underlying stocks
Financial Futures
•Index Arbitrage

• Difficult to do in practice
• Transaction costs often too large
• Trades must be done simultaneously
• Program Trading
Financial Futures
•Foreign Currency

• Forward contracts
• Currency markets largest in world
• Available from large banks
• Used extensively to hedge foreign currency transactions

• Futures contracts available for major currencies at CME, the

LIFFE, etc.
• March, June, September, December delivery contracts available
Financial Futures
•Interest Rate Futures

• Major contracts include: Eurodollars, Treasury bills, Treasury

notes, and Treasury bonds
• Some foreign interest rate contracts are also available
• Short position in contracts will benefit if interest rates
increase
• Long position benefits if interest rates fall
Financial Futures
•Interest Rate Futures

• Hedging with futures often requires cross-hedge

• Hedging spot position with a futures contract that has
different underlying asset
• Example: Hedge corporate bond by selling Treasury-bond
futures
Swaps
•Interest rate swaps

• One pays the other a fixed rate of interest in exchange for a

variable rate of interest
• No principal exchanged
Swaps
•Currency Swaps

• Two parties agree to swap principal and interest payments at

a fixed exchange rate

• Firm may borrow money in whatever currency has lowest

interest rate and then swap payments into currency preferred
From chapter 17
From chapter 17
From chapter 17
Option Valuation
Black-Scholes Option Valuation

• What´s the formula of Black-Scholes Pricing Formula

Black-Scholes Option Valuation

• Black-Scholes Pricing Formula

• And where
Black-Scholes Option Valuation

• Black-Scholes Pricing Formula

• And where
Standard Normal Probability Function

• N(d)=The probability that a random draw from a standard normal distribution will be less than d.
This equals the area under the normal curve up to d, as in the above shaded area. In Excel, this
function is called NORMDIST(d) or NORM.S.DIST(d)
EXAMPLE
Black-Scholes Call Option Values - Excel
EXAMPLE
Finding Implied Volatility – How to use goal Seek

• On the Data tab, in the Data Tools group, click What-If

Analysis, and then click Goal Seek.

• In the Set cell box, enter the reference for the cell that
contains the formula that you want to resolve.

• In the example, this reference is cell B4. In the To value box,

type the formula result that you want.
EXAMPLE
Finding Implied Volatility

• Assume a call option is trading for $7. Use Goal-Seek to

calculate implied vol.
Implied Volatility of S&P 500

• The option portfolio has a payoff identical to that of the

levered equity position.

• Therefore the costs of establishing them must be equal.

Payoff-Pattern of Long Call-Short Put Position
Arbitrage Strategy
Using the Black-Scholes Formula

• Hedge ratio or delta (first derivative)

• Number of shares required to hedge price risk of holding an option.

• Option elasticity

• Percentage increase in option’s value given 1% increase in value of

underlying security.
Call Option Value and Hedge Ratio
Using the Black-Scholes Formula

• Portfolio Insurance (investment funds, etc)

• Portfolio strategies that limit investment losses while maintaining

upside potential.

• Dynamic Hedging (propietary trading at banks mostly)

• Constant updating of hedge positions as market conditions change.