A Scholar’s Introduction to Stocks, Bonds and Derivatives

Martin V. Day
June 8, 2004

1 Introduction
This course concerns mathematical models of some basic financial assets: stocks, bonds and derivative
securities. The real world of financial markets is very complicated and diverse. The models we will use are
simplistic in comparison. However they will include enough features of the real world for us to introduce some
of the ideas on which the subject of mathematical finance (particularly the pricing of derivatives) is based.
For those who have little or no knowledge of financial markets this “Scholar’s Introduction” is intended to
describe those aspects of stocks, bonds and derivatives which you will need to appreciate the mathematical
characterizations of them that our study will be based on. The text by Hull [4] provides additional details
of actual market practices. Students who want to pursue the practical side further should consider courses
offered by the Finance Department.

2 Stocks
Companies sell stock to raise money (capital). Initially a company may be privately owned, but at some
point needs to raise money to expand its business operations. Instead of borrowing money that would need
to be paid back later, it can “go public”, that is sell shares of ownership of the company (i.e. stock) to raise
money. The first time a company does this is called an initial public offering. Once shares of a company
have been sold, they can be resold from one party to another. (But these resale transactions do not produce
new funds for the company itself, any more than Ford Motor Co. benefits if you sell me your used Ford
car.) The stock market is the place where these stock transactions take place (both initial offerings and
resale). Actually the stock market consists of many different stock exchanges: NYSE, AMEX, NASDAQ,
London, Tokyo, Paris, Sydney – there are over a hundred such exchanges world-wide. While some are still
the traditional chaotic room full of brokers scrambling over each other and shouting bids like the NYSE,
others like NASDAQ are based on an electronic network rather than a physical exchange floor.
Stockholders (i.e. owners of shares of stock in a corporation) are thus part owners of the corporation.
The corporation’s profits and losses are the profits and losses of the stockholders. Profits may be distributed
to stockholders as dividends, or they may be reinvested in the company in various ways. Being a stockholder
also gives you certain voting rights for major policy decisions. Your vote counts in proportion to the number
of shares that you own. So when you hear of someone who owns a controlling interest in a company that
means they own enough shares so that the influence of their vote is so large as to control these elections. But
the primary reason most people buy stocks is to make money, either through dividend payments or in the
expectation that the value of their share in the company will go up, so that it can be sold at a higher price
later. The value of your share of the corporation is determined by the stock market — how much it can be
sold/purchased for (not simply by some accounting of the company’s assets, although that would certainly
influence the market value). In essence the stock market functions as an auction. Prices are established as
those wishing to buy a particular stock and those wishing to sell negotiate the price through bids and offers.
The market price is simply the price at which the sellers and buyers are currently agreeing to trade. The
market price reflects not only the estimated value of the company’s assets, but also expectations about the
company’s future prospects, political events, general confidence in the economy, and countless other factors.
Its value changes from day to day (even hour to hour) in ways that seem to have a lot of unpredictable
(random) variation.

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 The number and complexity of factors which influence the price of a stock are so large that it is impos-
sible to predict with certainty its future values given all the information available today. Mathematicians,
statisticians, and economists have tried to develop approaches to describe this unpredictable behavior of
stock prices, so that a careful study can be made of strategies for buying and selling. This course will adopt
one of the standard attempts to do this: namely to consider the price St of a stock at time t as a stochastic
process (i.e. a randomly evolving function of time), using geometric Brownian motion as the description of
its stochastic behavior.
There are many complexities to the behavior of stock prices that we won’t try to account for. For
instance when dividends are paid the price of the stock makes an instantaneous jump down. There are stock
splits, when each previously existing share is split into 2 (or more) new shares. Of course the price of a
share after the split ought to be 1/2 (or less) of the price before the split. Then there is common stock as
opposed to preferred stock (which carry different dividend and voting rights). In addition there are typically
fees associated with any transaction. We will not concern ourselves with the additional complexities these
features would involve.
Something that is relevant for us is the practice of short selling. Mathematically this amounts to buying
a negative number of shares of the stock, so that you owe some number of shares rather than own them. In
practice your stock brokerage can agree to let you sell some of its shares, under your promise to return them
(with some fee or interest, but we will neglect that here) at a future date. Say they “loan” you a share worth
$50 which you immediately sell. You now are holding that $50 but you also have an obligation to return
the share you borrowed, as you promised the brokerage. If the price of the share goes down, say to $30, by
the time you need to return it to your brokerage you can use $30 of the $50 to buy a share to return to the
brokerage, keeping the $20 difference. In general, if S0 denotes the stock price when you borrow it and S1
the price when your return it, then the profit (or loss if negative) of this short-selling transaction is

S0 − S1 = (−1)S1 − (−1)S0 .

If we bought n shares at price S0 per share and sold them for S1 per share then our profit or loss would be
given by
nS1 − nS0 .
Thus the effect of short-selling one share is the same as using n = −1 in the formula for buying and selling.
Because such transactions are possible, for our mathematical discussion we will simply say that it is possible
to hold a negative number of shares. (In reality there are limits to how much a brokerage would let you do
this, but we will ignore them in our introductory discussion.)
In addition to the prices of individual stocks, the financial industry tracks numerous stock indexes such
as the Dow Jones Industrial Average (DJIA) or the Standard and Poor 500 (S&P 500). These are prices
of hypothetical portfolios of stock for carefully selected groups of companies, designed to measure the value
of the stocks of companies of particular types (e.g. major industrial firms, mining, utilities, . . . ) or of the
market as a whole. Mutual funds are rather different. When you buy shares of a mutual fund you put your
money into a pool that is managed by a firm, according to strategies that vary from fund to fund. The fund
manager makes decisions about which stocks (or bonds or other financial instruments) to buy and sell to
obtain the best performance possible consistent with the fund’s strategy.

3 Bonds
A bond is basically an I.O.U., a promise to pay the holder a prescribed amount of money at some future
date (or dates). For instance if you hold a $100 U.S. savings bond, the U.S. Treasury is obligated to pay you
$100 at a specified time in the future: the date of maturity (which was set when the bond was issued/sold
and is usually marked on the bond certificate). The U.S. Treasury issues many different kinds of bonds with
maturity periods ranging from months (e.g. “T-Bills”) up to 10 years (e.g. “T-Notes”) or longer (e.g.“T-
Bonds”). Many other federal agencies issue bonds, as do governments at all levels down to towns, as well
as private corporations. Cities and Counties often issue municipal bonds to borrow the money needed for
one-time expenses such as building roads or schools. If you buy a certificate of deposit at your bank, the
bank essentially issues you a “bond”, promising to repay your money (plus interest) at a specified future
date. In general, when you own a bond issued by some institution, you are not part owner of that institution

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(as you would be if you owned some of its stock), but you are a creditor of the institution - it owes you
money and will have to pay up in the future. Another significant difference from stocks is that with a bond
you know now exactly how much your future payments will be and when they will be delivered. For longer
term maturities, there is usually a series of scheduled payments (called “interest” or “coupon” payments)
in addition to the final payment when the bond matures. Bonds that make only a single, final payment are
called “zero-coupon” or “discount” bonds.
The reason an agency or corporation issues bonds is to borrow money for current needs that it plans to
pay back later. But from our point of view as (theoretical) investors, we will view bonds as the mechanism
which allows cash held today to be transferred to an amount of cash of “equivalent value” at a future time.
Lets say I am going to buy a bond that will pay $1000 in 10 years. The price I will pay for that bond had
better be less than $1000, otherwise why would I buy it? I might as well just hold on to my cash. For me to
be willing to put my money into this bond purchase, so that it is not available to me until the bond matures
in 10 years, I expect to realize some benefit. This should be reflected in a purchase price for the bond that
is less than its value at maturity. Lets suppose that I am willing to pay $620 for the bond today. In essence
that says that I consider the value of $620 today to be equivalent to the value of $1000 in ten years. We
sometimes refer to this as the “time value of money”.
The usual way to quantify the time value of money is with an interest rate. If Bt dollars today are worth
Bt+1 dollars in one year, then the simple rate of return, or annual interest rate, is rA = (Bt+1 − Bt )/Bt .
Usually expressed as a percentage, rA expresses the change from Bt to Bt+1 as a fraction of Bt . Said
otherwise,
Bt+1 = (1 + rA )Bt .
Over the course of several years this relationship has a compounding effect: if my Bt dollars today are worth
Bt+n dollars in n years (and the interest rate rA does not change), then

Bt+n = (1 + rA )n Bt .

We describe this by saying that the interest rate rA is compounded annually. In our example above, B0 = 620
and B10 = 1000 corresponds to an annual interest rate of rA = 4.896%. That would be the designated interest
rate for the particular bond we described.
Annually compounded interest rates are fine if the time variable t is limited to whole numbers of years.
But if we need to work with fractional numbers of years, it is more convenient to work with an equivalent
continuously compounded interest rate rC :

1 + rA = erC , or rC = ln(1 + rA ).

Now the formula connecting equivalent numbers of dollars at two times t < s is

Bs = erC (s−t) Bt .

As we begin our discussion, we will consider only a single bond whose value at time t is given by the
formula
Bt = ert ,
using a fixed continuously compounded interest rate r. This is very simplistic compared to the real world of
bonds. (It is actually closer to the description of an interest-earning bank account, since the formula takes
no account of the term of the bond.) Typically, different interest rates are available for bonds of different
maturities. (The farther away the date of maturity the higher the interest rate is, usually.) And of course
available interest rates fluctuate up and down for all kinds of reasons associated with the state of the economy.
Selling a bond roughly corresponds to borrowing money, and buying a bond is the usual way to hold money
over some period of time. In fact the interest rates that apply to my efforts to borrow are usually different
(higher) than those that apply to my efforts to buy bonds. There is also a resale market for bonds, which
takes place at the New York Stock Exchange and other places. I can sell my bond to someone else, if I want,
prior to its maturity. (U.S. Savings bonds are special in this regard; they cannot be resold.) The price I can
get is determined by the marketplace, and so can fluctuate from day to day. The interest rate for a bond is
fixed when it is issued/sold (unless it is a “floating rate” bond). But as its market (resale) value changes,

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the ratio of its market value to its value at maturity changes, meaning that its original interest rate is not
as meaningful an indicator as it was at the time of original sale. Instead the financial industry calculates
and reports the “yield” of a bond in various ways, which can be interpreted as effective interest rates based
on the market price, the remaining time to maturity, the scheduled interest payments that remain, and the
final value at maturity. To interpret these numbers takes some knowledge of how they are calculated.
Even for newly issued bonds, the way prices are reported can be confusing. For instance T-Bill prices
are reported using what is called the discount rate or banker’s discount yield, rather than the actual price or
interest rate. On top of all this, bond issuers might default, failing to meet their payment obligations. Hence
there are bond ratings to indicate reliability of the issuer: from AAA (most reliable) to C (least reliable;
so-called “junk” bonds).

4 Options and Derivatives

Stocks and bonds are what we will call primary securities. In addition to them we will be particularly
interested in derivative securities. A derivative security is typically a contract which either obligates or
entitles the parties involved to carry out a transaction in the future, under terms specified in the contract
but which may also depend on future events.
A simple example is a forward contract. For instance if I manage a restaurant chain perhaps I sign a
contract with a beef supplier to sell me a specified quantity of beef a year from now at a price we agree on
today. If the market price of beef a year from now turns out to be higher that the price specified in our
contract, then I would be glad I made the contract; it protected me from the rise in prices. However if the
price ends up being lower than what the contract specified, I still have to pay the higher contractual price.
That would please the beef supplier; it would protect him from the decline in prices and guarantee a buyer
that he might otherwise loose. From both points of view (mine and the supplier’s) changes in market prices
for beef will change how valuable that contract is. If it begins to appear that beef prices are going to rise
a lot, my supplier may want to get out of his contract with me. Or maybe another restaurant manager is
desperate to insure a source of beef at a predictable price, so wants to buy my contract with the supplier from
me. For me to release my contract either to the original supplier or to a third party, I would demand some
payment, since giving up the contract will mean I have to pay the market prices for beef that I expect to be
higher in the future. Thus the contract has a price that is determined by the beef market (and expectations
about its future), i.e. its value is derived from the market price of a primary asset, beef in this example. The
contract itself can become a tradable asset1 , but one whose value is derived from other primary assets. That
is why this type of forward contract is called a derivative asset. Derivaties are also called contingent claims
because they represent a claim on assets that is contingent on the future state of the market.
Derivative securities can be based on commodities (beef, crude oil, gold, ...) but also on primary financial
assets such as stocks and bonds (and many other things such as foreign currencies, and various interest rates).
Options are a particular type of derivative security in which the holder has a right but not an obligation to
carry out the terms of the agreement. For instance suppose you buy a (European) call option for the stock of
XYZ Corporation, with a specified exercise price K and date T of expiry. When the specified date T arrives,
you have the right to buy 100 shares of XYZ stock for K/share (from whoever sold you the call option) if
you want. But if you don’t want to you don’t have to exercise your option; you can just let it expire. If the
market price ST of a share of XYZ stock on date T is more than K, then of course you would exercise your
option. (You will pay K per share for something you can turn around and sell for ST per share.) However
if it turns out that ST < K, then the option is of no value to you. (Why would you pay K per share when
you can pay less on the open market?) So the value of your call option at the date of expiry is something
that is determined by the prices of other securities in the market. A call option gives you the right (but
not the obligation) to buy at the price specified in the contract. A put option gives you the right (but not
the obligation) to sell at a price specified in the contract. European options allow you to exercise your right
only on the specified date of expiry. American options allow you to exercise your right at any time up to
the specified date of expiry.
In a sense, an option is very like conventional insurance. You pay a premium up front to enter into
a contract with another party (the insurance company) which obligates them to pay you certain amounts
1 Actually, forward contracts are not usually traded, but many other types of derivates are, such as options.

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depending on future events which cannot be predicted now. That is one use of options in finance - to insure
against certain events that would be very damaging to your financial holdings. Suppose I buy stock in a
promising but risky new company, but can’t afford to loose all my investment if its stock price drops too
low. To insure against that I might purchase put options for that stock. That would guarantee that I could
sell my stock in this company at (or by) a certain date at a prescribed minimum price. The price of buying
those put options will be determined by the market, and I would have to decide if the cost of the insurance
that the put options would provide is worth it to me. Whoever “writes” or sells those put options to me
is accepting my money to take a certain risk for me. They must be careful to “hedge” the obligation that
their position entails. That means they must manage their own resources so that they are in a position to
fulfill their obligation to buy the stock from me at above market prices if I choose to exercise my option.
Their ability to do this will largely determine the price they would demand to issue the option contract, and
thereby the market price for the put options in question. We will discuss the idea of replicating portfolios,
which essentially describe the seller’s hedging strategy, i.e. how they would take the sale price of the option
and use it to create and manage a portfolio of investments so that they are always prepared to meet their
contractual obligation, whatever happens in the market.
In addition to puts and calls on the stock of specific companies there are many types of options and
derivative contracts that are actively traded, all differing in the terms of contract. There are puts and calls
on the major stock indexes (e.g. the Dow Jones Industrial Average, the S&P 500, and others) rather than
on individual stocks. There are swaps, which are agreements to exchange the streams of income produced
by two investments held by the contracting parties. There are swaptions, which give one party the right but
not the obligation to carry out a swap of income streams. There are interest rate caps, which entitle the
holder to a prescribed cash payment if a certain interest rate rises above a level specified in the contract.
Then there are lookback and Asian options whose values at the time T of expiry depend not simply on the
market price ST of the primary asset they are associated with, but also on the history of that price (e.g.
its maximum, minimum, or average values): St , 0 < t < T . In principle there is no limit on the design of
derivative securities; whatever set of circumstances and possible transactions a “financial engineer” might
formulate could be written as a legal contract and sold/bought for a price. The options that are traded on
exchanges must conform to standard criteria (maturing on fixed days of the month, priced in multiples of
$2.5 or $5, and so forth) in order for prices to be listed in a concise form. The firms that write and sell such
contracts, i.e. derivative securities, of course have a very strong need to know how to hedge their contracts,
i.e. manage their assets so that they are always able to meet their obligations, as well as to know how much
to sell the contract for in the first place. This creates the need for people with the sophisticated mathematical
skills necessary to analyze hedging strategies and prices, and explains the hiring of many mathematicians
and technically trained scientists by large financial firms.

References
[1] D. M. Chance, An Introduction to Derivatives (4th edition), Dryden Press, Ft. Worth, TX, 1998.
[2] M. Musiela and M. Rutkowski, Martingale Methods in Financial Modeling, Springer, Berlin, 1998.

[3] http://www.cboe.com/education/
[4] J. C. Hull, Options, Futures, and Other Derivative Securities (third edition), Prentice Hall,
Englewood Cliffs, NJ, 1997.