CHAPTER 1

Basic Financial Concepts

1. Denitions
This is a mathematics course, in the sense that nance is used to learn
new mathematical concepts and methods. Before we start, we need to have
an appropriate vocabulary of nancial terms. Each term has two aspects:
what it means in the real world and what it means mathematically.
Lets start with some important terms commonly used in nance. Since
not all nancial terms are formally dened in this book. It will be helpful to
have a dictionary of nance handy. Dictionary of Finance and Investment
Terms, by John Downes and Jordan Elliot Goodman, published by Barrons,
2nd edition.
Stock. Ownership of a corporation represented by shares.
Option. A contract that gives the owner the right to buy or sell an
underlying asset at a xed price K (strike price) before or at a xed time T
(expiration). A put (option) is a right to sell, and a call is a right to buy.
American option. An option that can be exercised at any time prior to
expiration.
European option An option that can be exericised only at expiration.
Note that a holder of an option never loses money and has the potential
to make money. Therefore it is worth something, i.e., it has a price, which
is called the premium. If you purchase an option (instead of being given
one), the maximum loss you can have is the amount of the premium. The
premium is the value of an option (or of any nancial instrument). It should
not be confused with commission , which is the fee you pay to a broker for
the service provided. When purchasing an option from a broker, you need
to pay both premium and commission.
To simplify the exposition, unless otherwise stated, we assume that the
market is frictionless, i.e., we ignore commissions in all our computations.
Another assumption we often use is that the market has innite capacity,
i.e., you are able buy from the market or sell to the market any number of
shares of an underlying asset at the market price.
We will use the following notations for option prices:
European call option: c(t, T, K; S);
European put option: p(t, T, K; S);
American call option: C(t, T, K; S);
American put option: P(t, T, K; S);
1
2 1. BASIC FINANCIAL CONCEPTS
where the parameters are
t = current time,
T = expiration time,
K = strike price,
S = current asset price (spot price).
A parameter can be omitted if its value is understood. We will explain these
parameters in the next section.
Interest. The cost of using money or an asset, expressed as a rate per
period of time (usually a year). The nominal rate is the rate without com-
pounding, and the eective rate is the rate after compounding.
Arbitrage. Proting from dierences in price of the same currency or
commodity traded on dierent markets. For example, if the price of gold is
higher in London than in New York one can buy in New York and sell in
London for a risk-free prot. That would be an arbitrage opportunity. While
these opportunities night exist, it would necessarily be of short duration.
Market observers attempting this strategy would drive up the price of gold
in New York with increased demand and lower the price of gold in London
with increased supply. This would end the arbitrage opportunity.
An arbitrage argument is an argument based on the principle that there
are no arbitrage opportunities without risk. Prices of many nancial instru-
ments are determined by an arbitrage argument. We will discuss this topic
later in great detail.
Bond. An interest-bearing corporate or government security with the in-
terest and principal payable at a xed time. It may also pay a cash dividend
(coupon) at regular time intervals during the life of the contract.
A bond has a face value (or par value), a maturity date, and a coupon
rate. For example, a bond with face value $5,000, maturity date August 1,
2021 and coupon rate 8% will allow the bearer to collect $200 (4%) every
6 months for the next 20 years and a maturity payment of $5,000 on the
maturity date. The current price of the bond may be $2,050. A zero-coupon
bound A bond that pays no coupons (cash dividend). Most of education
bonds are of this type.
Short sale. Sale of a security not owned by the seller in hopes of taking
advantage of an anticipated price decline. For the short seller, it is basically
a promise to deliver the security at a xed price on a future date. If the
seller actually owns the security, his short position is said to be covered.
The concept of short sales is the stock equivalent of borrowing money from
a bank. Just as you can you borrow cash from a bank, we also assume that
you can borrow stocks from a stocker broker. But there is an important
dierence. When you return a cash loan, you pay back the borrowed amount
(principal) and the interest for the loan period, whereas for a loan on a
stock, you return in kind, namely, you return the same number of shares
2. OPTION CONTRACTS 3
of the same stock to the lender. Of course, in practice you need to pay a
commissionfor theloan, but under our assumptionof thefrictionlessmarket,
thecommission is ignored.
Forward contract. An agreement to buy or sell a speci c amount of a
commodity or nancial instrument at the current price with delivery and
settlement at a futuredate.
Note that a forward contract is not an option, i.e., the transaction has
to takeplaceat thespeci ed time.
A largepart of this courseis devoted tooption pricingtheory developed
by Black, Scholes and Merton. The subject was born in 1973 with the pa-
pers\ Thepricingof optionsand corporateliabilities" in Journal of Political
Economics by Black and Scholes and \ The theory of rational option pric-
ing," in Bell J. Econ. Management Sci. by Merton. In these papers, the
famous Black-Scholes formula for pricing options was derived. In thesame
year, the Chicago Board Options Exchange (CBOE) opened. In the inter-
veningyearstheBlack-Scholesformulahasbecometheacceptedwaytoprice
stock and other options. Therearetrillionsof dollarsinvolved in optionsex-
changes yearly. Moreover, option pricing and risk management has become
a major area of applied mathematics. Research activity in Mathematical
Finance requires highly sophisticated tools frommathematics (mainly sto-
chastic analysis) and is carried on in academia as well as in the nancial
industry.
2. Option contracts
Here is a list of essential terms related to options, some of which you
arealready familiar with fromthelast section. Consult a nancedictionary
and try to memorize their meanings. If you cannot nd a term in your
dictionary, try to guess what it means. Dual terms aregrouped together.
{ Call option, put option
{ StrikePrice
{ Expiration date(expiry)
{ Exercise
{ American option
{ European option
{ Option buyer, option writer
{ In themoney, at themoney, out of themoney
{ Intrinsic value
{ Premium
Intrinsic value is the pro t to be made on an option at the time of
exercise. If thestrikepriceof a call option is $50 and current market price
is $55, theintrinsic valueis $5. If thereis pro t tobemade, theoption is in
the money; if exercisingtheoption will incur a loss, theoption is said to be
out of the money; if the strike price is equal to the market price, it is said
to beat the money .
3. EXAMPLES OF OPTIONS 5
(a speculator) has to be willing to accept risk. A hedger in eect transfers
(or sells) his risk to a speculator. Hedging by purchase of an options contract
is tantamount to buying insurance, which is not free. The advantage of a
call option over outright purchase of the stock is that with a call option the
loss is capped at the premium of the option (which would be the loss in the
long position of an unexercised option), whereas with the stock the loss can
be the whole purchase price of the stock.
Lets assume that we have purchased a European call option at time
t = 0. We denote its value at time t by c(t, T, K, S
t
). Thus c(0, T, K, S
0
)
is the premium paid at t = 0 for the option. The prot from this option
at the expiration is easy to write down. First we introduce two functions.
We use x
+
to denote 0 if x < 0 and x otherwise. This function is called the
positive part of x. The negative part of x is the function x

, which has the

value 0 if x > 0 and x otherwise. Note that these two functions satisfy the
relations.
x = x
+
x

, |x| = x
+
+x

.
At time T, if the option is in the money, meaning S
T
K, we exercise the
option and have the prot S
T
K; otherwise we let the option expire and
the prot in this case is 0. It follows that the value of the option at time T
is just (S
T
K)
+
. This can be written as
c(T, T, K, S
T
) = (S
T
K)
+
.
A similar argument can be applied to a put option:
p(T, T, K, S
T
) = (K S
T
)
+
.
Of course, the cost of purchasing the contract (premium plus commission)
must be subtracted to obtain the net prot.
We have seen that the function c(t, T, K, S) has a terminal value
c(T, T, K, S) = (S K)
+
.
What we are interested in is its initial value c(0, T, K, S). After all we need to
determine the fair price for these instruments. One of our goals in this course
is to develop a theory which enable us to determine this function completely.
But even without knowing this function explicitly, we can use some common
sense (and some not so common sense) to derive several important properties
this function must satisfy. This will be done in the next few sections.
3. Examples of options
The value of a call option c(t, T, K, S) is a decreasing function of K,
because the option is less valuable if you have to pay a higher price when
you exercise it. Symbolically,
c(t, T, K
1
, S) c(t, T, K
2
, S) if K
1
K
2
.
6 1. BASIC FINANCIAL CONCEPTS
Example 3.1. (Bull spread) Suppose you are bullish on a given stock,
that is, you expect that its value will rise. Can you use options to prot
from a rise in the stocks price? Heres what you might try:
(a) Buy a call with strike price K
1
.
(b) Sell a call with strike price K
2
> K
1
.
Suppose that the value of the call options are c(K
i
) = c(t, T, K
i
), i = 1, 2.
We have just seen that
c(K
2
) c(K
1
).
Let P(t) denotes the value of this portfolio at time t. Then
P(t) = c(t, T, K
1
, S
t
) c(t, T, K
2
, S
t
).
At t = 0,
P(0) = c(K
1
) c(K
2
) 0,
which is the cost to establish the portfolio. At expiration
P(T) = (S
T
K
1
)
+
(S
T
K
2
)
+
.
This function is nonnegative function of the stock price S
T
(see the diagram).
[Diagram of f(s) = (s K
1
)
+
(s K
2
)
+
.]
The maximum loss of the bull spread is limited to c(K
1
) c(K
2
) if the stock
price decreases below K
1
, and the maximum prot is limited to K
2
K
1

c(K
1
) c(K
2
) if the stock rises above K
2
.
Compare the bull spread with a straightforward call option, which can
also be used to prot from a rise in the stocks price.
Example 3.2. (Bear spread) On the other hand if youre pessimistic
about the outlook for a stock, you can construct a portfolio of options to
prot in case you turn out to be correct. Try reversing the procedure with
the bull spread. That is
(a) Buy a put with strike price K
2
.
(b) Sell a put with strike price K
1
< K
2
.
The payo of the option is
P(T) = (K
2
S
T
)
+
(K
1
S
T
)
+
.
[Diagram of f(s) = (K
2
s)
+
(K
1
s)
+
.]
The cost of establishing this portofolio is
P(0) = p(0, T, K
2
, S
0
) p(0, T, K
1
, S
0
).
Since the payo is nonnegative we have
p(0, T, K
2
, S
0
) p(0, T, K
1
, S
0
),
Namely, the value of a put option is an increasing function of the strike
price.
3. EXAMPLES OF OPTIONS 7
Example 3.3. (Buttery spread) Lets now discuss the so-called but-
tery spread . This time the agent expects the underlying asset price will
not move very much between the times 0 and T. He does the following:
a. Buy a call with strike K
1
.
b. Buy a call with strike K
2
> K
1
.
c. sell two calls with strike K
3
= (K
1
+ K
2
)/2.
In this case, the payo at expiration is
P(T) = (S
T
K
2
)
+
+ (S
T
K
1
)
+
2

S
T

K
1
+ K
2
2

+
.
The cost of establishing this portfolio is
C = c(K
1
) + c(K
2
) 2c(K
3
).
The diagram of the payo as a function of the stock price S
T
is
[Diagram of f(s) = (s K
2
)
+
+ (s K
1
)
+
2

s
K
1
+K
2
2

+
.]
Note that the payo function is nonnegative, i.e., this portfolio can never lose
money. It follows that the cost of establishing this portfolio is nonnegative,
namely, C 0 in this case, or
c

K
1
+ K
2
2

c(K
1
) + c(K
2
)
2
.
A function with this property is called a convex function.
A function f(x) on an interval [a, b] is called convex if for any a < x, y <
b, the graph of the function on the interval [c, d] lies below the straight line
joining the two points (x, f(x)) and (y, f(y)) on the curve. This condition
can be written as follows: for any x, y [a, b] and any 0 1,
f(x + (1 )y) f(x) + (1 )f(y).
When = 1/2, we have
f

x + y
2

f(x) + f(y)
2
.
In fact, it can be shown that this special case implies that the above in-
equality holds for all 0 1. Hence we have the following conclusion.
Theorem 3.4. The price of a call option c(K) = c(0, T, K, S) is a de-
creasing, convex function of the strike price K.
For a smooth function (with continuous second derivative), there is a
simple condition for convexity.
Theorem 3.5. If the second derivative f

is nonnegative, then f is
convex.
If f is a convex function, then f is called a concave function.
8 1. BASIC FINANCIAL CONCEPTS
Example 3.6. (Straddle) Now the agent expects a big change in the
stock price, though he is uncertain in which direction. This time the agent
establishes the following portfolio:
(a) Buy a call with strike K.
(b) Buy a put with strike K.
Then his payo at expiration is
P(T) = (S
T
K)
+
+ (K S
T
)

= |S
T
K|.
[Diagram of f(s) = |s K|.]
In this case the holder of the above portfolio stands to gain when the stock
price makes either an up or down movement.
Example 3.7. (Strangle) The agent has the feeling that the asset price
will move well out of its present range. Accordingly he creates a portfolio
composed of
(a) A long position in a call with strike K
2
.
(b) A long position in a put with strike K
1
< K
2
.
Here K
1
< S
0
< K
2
, where S
0
is the stock price at time t = 0. This
combination resembles a straddle, but the diagram between K
1
and K
2
is
at. The time T payo is
P(T) = (S
T
K
2
)
+
+ (K
1
S
T
)
+
[Diagram of f(s) = (s K
2
)
+
+ (K
1
s)
+
.]
The payo for a straddle with K = (K
1
+ K
2
)/2 always exceeds the payo
for a strangle with strikes K
1
and K
2
. The price of a straddle must therefore
be greater than the price of a strangle.
Spreads are strategies of buying and selling the same options at dier-
ent strike prices and/or with dierent expiration times. They are further
classied as follows:
vertical spread: dierent strike prices and same expiration time;
horizontal spread: same strike price and dierent expiration times;
diagonal spread: dierent strike prices and dierent expiration times.
Horizontal and diagonal spreads are collectively referred to as calendar
spreads. Here is an example of calendar spreads.
Example 3.8. (Calendar spread) Our agent now wants to prot in case
the asset price is low at T
1
and rises at a later time T
2
. This calls for the
following portfolio:
(a) Sell a call with strike K and expiration T
1
.
(b) Buy a call with strike K and expiration T
2
.
The resulting payo is (S
T
2
K)
+
(S
T
1
K)
+
. It depends on the asset
prices at both time T
1
and T
2
. If the graph of S
t
is below K at T
1
and above
K at T
2
, the agent will receive S
T
2
K.
4. EXERCISES 9
4. Exercises
Exercise 4.1. John Doe sold short 3,000 shares of XYZ stock short at
$72 per share. A month later, a false alarm caused the stock price to plunge
to $45 per share, at which John Doe bought 3,000 shares to cover his short
position. He then bought 3,500 shares of the same stock at $52, and later
sold these shares at $113 when the price quickly rebounded. How much
prot did John Doe make on XYZ?
Exercise 4.2. Follow the proof for the European call option price func-
tion to show that the European put option price p(K) = p(t, T, K, S) is an
increasing, convex function of K.
Exercise 4.3. (Strap) An agent is fairly condent that a stock price
will move, but wishes to prot more from an upturn, which he feels is more
likely than a downturn. He acquires the following portfolio:
(a) Buy two calls with strike K and maturity T.
(b) Buy one put with maturity K and maturity T
[Graph of the function f(s) = 2(s K)
+
+ (K s)
+
.]
This gives a gave similar to that for the straddle, but the slope of the graph
to the right of K for the strip is twice as large as for the straddle. If the
strike price at expiration is $120, what is the payo of a strap with strike
price $130?
Exercise 4.4. (Strip) An agent has similar expectations as for the strip
except he is more condent that a downturn will occur than an upturn. This
agent acquires the portfolio
(a) Buy a call with strike K and expiration T.
(b) Buy two puts with strike K and expiration T.
The graph of the payo for this combination is obtained from the graph
of the strip by reecting in the vertical line s = K. If the stock price at
expiration is $50, what is the payo with a strike price $35?
Exercise 4.5. Let K
1
< K
2
< K
3
. Show that the three call option
prices c(K
i
) = c(0, T, K, S) satises
c(K
2
)
K
3
K
2
K
3
K
1
c(K
1
) +
K
2
K
1
K
3
K
1
c(K
3
).
If we let = (K
3
K
2
)/(K
3
K
1
), then 0 1 and
c(K
1
+ (1 )K
3
) c(K
1
) + (1 )c(K
3
),
which shows directly that c(K) is a convex function of K.