Mathematics of Finance

Professor Mikhail Smirnov

The Role of Stocks and Bonds in Corporate Capital Formation
• Companies need capital (i.e. money) to purchase inventory,
open new plants, etc.

• Companies w/o an established name usually raise capital by:

– getting a loan from a bank, and/or
– getting money from some private equity source

• Companies w/an established name can raise capital through the

stock and the bond markets at a more attractive level
Stocks and Bonds
A stock is a security representing an ownership interest in a company

A bond is a security whereby the issuer borrows money, called the principal, and
agrees to:

– pay the lender (the bond holder) interest payments based on the outstanding
amount of principal

– return the principal through a “lump sum” payment, periodic payments over
time, or in the case of a “perpetual” bond, not at all

Publicly traded stocks are actively traded at exchanges as well as OTC (Over the
Counter) markets (independent market makers)

Publicly traded bonds are actively traded mainly in the OTC market
(i.e., wall street bond dealers)
Investment Banks’ Role in Corporate Funding

Traditionally, investment banking refers to Corporate Finance,

– which is the process of raising money for corporate clients (or public
institutions) in the form of equity/stocks, debt, or convertible securities.

This process involves two steps:

– determining the most efficient funding for the client

type, amount, and structure
– finding investors to supply those funds
for larger investment banks, this step will involve other areas of the
firm, such as sales, trading, research and a syndicate function
Example:

ABC Co. needs money to build a new plant

ABC Co. decides to employ Investment Bank IBK in this pursuit

Services IBK provides ABC Co.:

(1) Corporate Finance expertise:

+ evaluates funding options (amount, type, and structure); options

considered:
– common equity
– debt (fixed-rate and floating rates with various maturities)
– convertible debt

+ helps decide that a $200MM 7 yr. fixed-rate bond offering is the best
option
Services IBK provides ABC Co. (continued):

(2) Pricing & Underwriting, and Distribution Capability:

+ IBK’s sales/trading expertise in the secondary market helps determine fair

pricing of the bond (new issues are sold in the primary market, issues are
subsequently traded in the secondary market)

+ IBK leads an underwriting group, which purchases the bonds and sells them
to investors (over days and sometimes weeks)

+ IBK (and other dealers) are expected to provide 2-way markets to buy/sell
ABC’s bonds in the secondary market, an important function that would
– keep institutional investors happy which in turn satisfies ABC Co., and
– keep IBK on “top of the market” and remain competitive
Governments’ Need to Borrow Money
The U.S. Government, federal agencies, and state/local governments
(municipalities)
raise money in the capital markets to fund expenditures and other activities, for
example:

the U.S. Government issues Treasury Bills/Notes/Bonds to fund federal

programs

federal agencies such as FNMA issue debt (bearing its name) so as to help
provide funds to home buyers

state and local governments issue municipal bonds to fund building roads,
etc.
Investment Banks’ Role in Government Related Debt
The main roles of investment banks in these debt markets are:

U.S. Treasury Debt Market: bid in U.S. Treasury auctions (if primary
dealers)

Agency and Municipal Debt Market:

– advise on efficient financing: e.g., maturities, call features, the need for
credit enhancement (muni bonds)
– underwrite and distribute debt

Secondary Market for the above: provide 2-way markets for investors to
buy/sell
Who are the Institutional Investors?
Institutional Investors are clients on the sales/trading side, including:

Pension Funds

Money/Asset/Investment Managers (& Hedge Funds)

Insurance companies

Banks

Mutual Funds

Central Banks (in various nations)

Front Office Functions
Sales:
– Talk to institutional investors; facilitate trades between customers and
traders
– Sometimes specialize in a major product (e.g., government, mortgage
sales)

Trading:
– Commit the firm’s capital buying/selling securities
– A “Market Maker” has the obligation and the privilege to trade with
customers
usually trade a specific sector within a product (e.g., 1-5 yr. Treasuries
)
also trades with other dealers via brokers

– A “Proprietary Trader”: has neither the obligation nor privilege to trade

with customers
 1.Basic traded assets.

There are many financial instruments that are traded every day on
exchanges and among dealers around the world. Stocks of
individual companies are probably best known in the general public.

Other actively traded assets are currencies, government and

corporate bonds, physical commodities: crude oil, oil products,
natural gas, electricity, precious metals, base metals, agricultural
commodities, and others.

Many assets are traded on organized exchanges, like New York

Stock Exchange, American
Text Stock Exchange, Chicago Mercantile
Exchange, EUREX etc.
The mechanics of trading can be different on different
exchanges, and exchanges themselves can be fully
electronic or include human brokers in the trading process.
We do not go here in the details of mechanics of trading.

It is important to understand that many assets are traded

not on organized exchanges but “over the counter”. That
is when the trading is done between interested
counterparties, often one of the parties is a dealer having
some inventory of the asset.
 2. Forward Contract.
A forward contract is an agreement made between two
counterparties to buy or sell an asset on a certain future date for
an agreed price, called the delivery price.

The party who agrees to buy the asset is said to hold the long
position, and the party who agrees to sell holds the short
position in the contract.
T=Now

Contract
Forward Forward
Buyer Seller
(Long) (Short)

T=Later Delivery Time

Money
Forward Forward
Buyer Asset Seller
(Long) (Short)
A forward contract is usually transacted not on an organized
exchange but “over the counter” by agreement of two
counterparties. When a forward contract is negotiated, the
delivery price that denoted here by K is usually set in such
way that neither counterparty owes money initially. Such
price K is called forward price of the underlying asset for
delivery time T.

In the simplest case, the forward price is the current price of

the asset plus an additional amount that reflects interest
earned on the asset's value. We assume first for simplicity
that holding of the asset provides no income or other
benefits from holding. If that is not true, i.e. when the asset
provides income or convenience benefits from holding, we
would need to reflect it in calculating forward price. But for
now we would stick to assets providing no income and
convenience yields.
 Suppose X is the current asset price, r is the continuously
compounded risk-free interest rate, T is delivery time and t is
current time so that T-t is the time length to delivery. Then the
forward price F of the asset at time t is

F=X exp(r(T-t))

If we have to finance holding of asset by borrowing X

dollars at time t,

F is exactly equal to X + Accrued interest from t to T.

As we shall see later there is a deep economic reason for

the last identity.
So when the forward contract is entered, the value of the forward
contract is zero and the forward price is equal to the delivery
price F=K. The delivery price K will remain constant over the life
of the forward contract, while the forward price F may change as
spot price and remaining time to delivery change.

EXAMPLE
Suppose that the current price of a stock is 100. Stock is paying
no dividends. The risk-free interest rate is 5% per year. The
forward price of the stock for 1 year is
F=100 exp(0.05*1)=105.13.

There is a reason why the delivery price K for a forward contract

should be F=X exp(r(T-t)).
We can show that if K is less than or greater than F, then an
investor can easily make an arbitrage, i.e. risk-free, profit.
 3.Arbitrage.

DEFINITION
Arbitrage is exploiting of discrepancies between prices of
the same or related securities in different markets. By
trading securities in these markets, a profit is realized
without taking a risk.

EXAMPLE
Buying XYZ stock in London for 100 British Pounds and
simultaneous selling it in New York for
151 Dollars when 1 Pound=1.50 Dollars will yield a riskless
profit of 1 Dollar. That would be an arbitrage.
EXAMPLE
When the stock price is 100, stock is paying no dividends, and
interest rate is 5% per year with continuous compounding the
theoretical forward price of the stock for 1 year is F=100
exp(0.05*1)=105.13.
Let us show how to make an arbitrage in 2 cases

•There is a buyer of a stock 1 year forward at 107 (above

theoretical forward price).
•There is a seller of a stock 1 year forward at 104 (below
theoretical forward price).

Here we assume that stock is available for borrowing, and can be

sold short.
(Short sale is the sale of shares borrowed from the broker. Short
seller borrows shares from the broker, sells them in the market
and receives cash proceeds. Short seller would eventually buy
shares back and would benefit from share price going down.)
 Take Short Position in Take Long Position in
Forward Contract Forward Contract
(Sell Forward at 107) (Buy Forward at 104)

Borrow Borrow Stock and

100$ At 5% Sell Stock Short at 100$

Invest 100$ from

Buy Stock at 100$
Short Sale at 5%
Wait Wait
1 Year 1 Year

Deliver Stock Receive 105.13$

Receive 107$ From Investment
Repay 100$+Interest 5.13$

Profit Fulfill Forward

1.87 $ Deliver 104$ Receive Stock
Return Stock to Lender

Profit
1.13 $
 Forward Price of Stock Paying no dividends

100 $ = 1 Share Spot price

Continuous Continuous
rusd=5% Compounding rstock=0% Compounding
(Dividends=0%)

100*e0.05*1 =105.13$ = 1Share Forward Price in 1 year

 Forward Price of Stock Paying continuous
dividends at rate d%
100 $ = 1 Share Spot price

Continuous Continuous
rusd=5% Compounding rstock=d=2% Compounding
(Dividends reinvested in stock)

0.05*1 0.02*1
100*e =105.13$ = 1*e =1.0202 Share

(0.05-0.02)*1
100*e =103.05$ = 1Share Forward Price in 1 year
 FX Forward rate

1.30 USD = 1 EUR Spot rate

Annual Annual
rusd=1% Compounding reur=2% Compounding

1.30*(1+0.01) USD = 1*(1+0.02) EUR

In 1 year
1.30*(1+0.01)
1*(1+0.02) USD = 1 EUR

1.2873 USD = 1 EUR 1 year Forward rate

 If 1 year forward is 1.31 USD=1Eur
(more than theoretical forward 1.2873)

Arbitrage:
1. Sell 1 year forward 1 Euro at 1.31$ per Euro

2. Borrow 1.2745$=1.30$/(1+2%) at 1%.

Have to repay 1.30$*(1+1%)/(1+2%)=1.2873$ in 1 year

3. Exchange 1.2745$ at a spot rate 1.30$=1 Euro. Get 1/(1+2%)=

0.9804 Euro now.

4. Deposit 0.9804 Euro now at 2% for 1 year. Get 1 Euro in 1 year.

5. In 1 year using forward that we entered exchange

1 Euro into 1.31 $
Repay 1.2873 $ that you have to repay

6. Profit in 1 year 1.31-1.2873=0.0227$

 If 1 year forward is 1.28 USD=1Eur
(less than theoretical forward 1.2873)

Arbitrage:
1. Buy 1 year forward 1 Euro at 1.28$ per Euro

2. Borrow 1/(1+2%)= 0.9804 Euro now at 2%.

Have to repay 1Euro in 1 year

3. Exchange 1/(1+2%)= 0.9804 Euro at a spot rate 1.30$=1 Euro.

Get 1.30$/(1+2%)=1.2745$ now.

4. Deposit 1.30$/(1+2%)=1.2745$ at 1%.

Receive 1.30$*(1+1%)/(1+2%)=1.2873$ in 1 year

5. In 1 year using forward that we entered exchange

1.28 $ into 1 Euro. Repay 1 Euro that you have to repay

6. Profit in 1 year 1.2873-1.28=0.0073$