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Financial Instruments and Contracts

Financial Instruments and Contracts. Hongjun Yan Yale School of Management. Challenge #1. Hongjun Yan Name tag please!. How many of you think Andy Murray will win his first US Open on Sep 9? How many of you would like to bet against me? $100 vs $100 $100 vs $200 $100 vs $300.

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Financial Instruments and Contracts

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  1. Financial Instruments and Contracts

    Hongjun Yan Yale School of Management
  2. Challenge #1 Hongjun Yan Name tag please!
  3. How many of you think Andy Murray will win his first US Open on Sep 9? How many of you would like to bet against me? $100 vs $100 $100 vs $200 $100 vs $300
  4. Another gamble:One of the top three American win US Open ($100, $300) The top three American: Mardy Fish, Andy Roddick, andJohn Isner.
  5. Claim: If you agree to the first gamble, I will make $24.53 for sure! Claim: If you agree to the second gamble, I will make $94.04 for sure.
  6. Lesson Arbitrage by replication: A security is worth what it costs to replicate it. What is needed? A market for the underlying
  7. Betting markets The numbers here are in funny English units. Suppose you “back” Murray at 5.3 and wager $1. You get back $5.3 (net profit is $4.3) if Murray wins and nothing if Murray loses (net loss $1). The quoted numbers are like inverse probabilities. You can trade either side of the market. If you “lay” Murray at 5.4, that means you would like to bet that Murray is not going to win. If you lay $x. Then you win $x if Murray loses, and pay the site $5.4x (your net loss is $4.4x) otherwise.
  8. Arbitrage for the Murray gamble The ‘back’ for Murray is 5.3: If you put $1 in it, you win $5.3 if Murray wins and you get nothing otherwise. My positions: A bet ($100, $300) with you. An online bet of x dollars on Murray winning the title Profit: If Murray wins the title: 5.3x – x – 300 Otherwise: – x + 100 Make the profit riskless 5.3x – x – 300 = -x + 100 => x = 75.47 My net profit: $24.53 for sure
  9. Pricing of derivatives What is the price bound for a security, which pays $100 if one of the three American seeded players wins? Upper bound price This is what it costs to buy this security from betfair.com You have an arbitrage opportunity if you can sell the same security for more to someone else. Lower bound price This is what you can get if you short this security on betfair.com You have an arbitrage opportunity if you can find some way to buy the same security for less.
  10. 100x $1 if one of the top three USA seeds wins $0 otherwise Pricing of derivatives Security A: $100 if one of the top three USA seeds wins $0 otherwise $1 if Fish wins $0 otherwise $1 if Isnerwins $0 otherwise $1 if Roddickwins $0 otherwise
  11. Pricing of derivatives (cont’d) What are the upper and lower bounds? How much do you have to pay to buy it from betfair.com? $1/260=$0.00385 How much can you sell it to betfair? $1/340=$0.00294 $1 if Fish wins $0 otherwise $260 if Fish wins $0 otherwise is worth $1 $1 if Fish wins $0 otherwise is worth $1/260
  12. Pricing derivatives (cont’d) The upper and lower bounds for a security, which pays $1 when Roddick wins, are 0.26 cents and 0.20 cents. Back price is 390: A security which pays $390 if Roddick wins is worth $1 A security which pays $1 if Roddick wins is worth $1/390 Lay price is 490: lower bound is $1/490
  13. Pricing derivatives (con’t) Upper and lower bounds for $1 when Isner wins: 1.05 cents (=1/95), 1.00 cents (=1/100) The upper and lower bounds for the security, which pays $1 when an American seed wins Upper: 1.70 cents (= 0.39+0.26+1.05) Lower: 1.49 cents (= 0.29+ 0.20 + 1.00) The upper and lower bounds for security A are $1.70 and $1.49.
  14. Pricing of exotic derivatives ATP Ranking (as of August 20, 2012) Payoff of security B: if one of these players wins, the security pays $x, where x is the ranking of the winner. Homework
  15. Some questions How would the price we computed change if I told you the true probability of Murray winning was 0.16? What if the true probability of Murray winning were zero? Which derivatives can't we price? What about a bet that pays off 1 if Murray makes it to the final round?
  16. About the course Class website http://faculty.som.yale.edu/hongjunyan/teach/mgt543/ Class format Notes Cases Guest lectures
  17. Guest speaker 1 Valentina Antill Managing Director, Citi (Emerging Markets Derivatives and Structured Products)
  18. Guest speaker 2 James Rothman Managing Director NAB Capital, Ltd.
  19. Guest speaker 3 Ian Lyngen Principal at CRT Capital Group Senior Rates Strategist
  20. Guest speaker 4 (TBC) Marc Mansourian Managing Director CREDIT SUISSE
  21. Teaching Assistants Stephen Karolyi PhD student in Finance stephen.karolyi@yale.edu.
  22. Your commitment 5 hours per week. Read lecture note and the book before coming to the class. Homework No exam Project Grade G=0.5H+0.3P+0.2C
  23. Project Design a security. Open-end question What is the current regulatory environment for derivative markets, and how should they be regulated in the future? How are derivative transactions taxed? Reported? Are there potential problems with them? Goldman vs SEC Greece
  24. Your commitment (cont’d) Externality
  25. Your commitment (cont’d) About Math
  26. Complainers are needed! Homework 1 Next class: August 31, Friday
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