StaticArbitragePart1.pdfVIP

Imperial College London Business School One-Period Model of Financial Markets 1 / 42 Imperial College London Business School Outline Present simple framework to study fundamental problems in Finance: The model: One period, finite number of states The problems: Risk Hedging Introduce concept of Payoff Replication. Asset Pricing Introduce concepts of Arbitrage, State Prices, Risk-neutral probabilities. Portfolio Optimization Need to introduce concept of Utility and Lagrangian Optimization. ? We skip due to time constraint. 2 / 42 Imperial College London Business School Asset-pricing Terminology Asset: Represents possible future economic benefit. Security: An investment instrument issued by an organization. Broadly categorized into debt and equity. Debt: Entitles holder to payment of principal and interest. May be protected by collateral (secured) or not (unsecured). If unsecured, may be “senior” (have higher repayment priority) to “junior” (or “subordinated”) debt. Equity: Entitles holder to a share (fraction) of the company’s capital stock, profits, and control of a company. Note: In bankruptcy, debt-holders take control. Equity-holders receive residual value after all obligations are paid. 3 / 42 Imperial College London Business School Asset-pricing Terminology (continued) Price (value) = amount for which an asset can be exchanged Payoff = amount of money one receives by owning the security = Price sold (+ dividends, etc.) Return = Payoff / Price paid Risk-free asset: Whose future payoff is known with certainty Usually government bond with short maturity Risk-free interest rate: Return of risk-free asset Risky asset: Whose future payoff is not known with certainty, random Portfolio: Collection of investments held by institution or individual 4 / 42 Imperial College London Business School Asset-pricing Terminology (continued) Derivative: Security whose value depends on “underlying” security Option: Derivative that entitles holder to the right to buy (“call”) or sell