FinancialPrimerapril3汇.pptVIP

IS-1 Financial PrimerStochastic Modeling Symposium By Thomas S.Y. Ho PhD Thomas Ho Company, Ltd Tom.ho@ April 3, 2006 Purpose Overview of the basic principles in the relative valuation models Overview of the basic terminologies Equity derivatives Fixed income securities Practical implementation of the models Examples of applications “Traditional Valuation” Net present value Expected cashflows Cost of capital as opposed to cost of funding Capital asset pricing model Cost of capital of a firm as opposed to cost of capital of a project (or security) Relative Valuation Law of one price: extending to non-tradable financial instruments Applicability to insurance products and annuities (loans and GICs) Arbitrage process and relative pricing Stock Option Model Modeling approach: specifying the assumptions, types of assumptions Description of an option Economic assumptions: Constant risk free rate Constant volatility Stock return distribution Efficient capital markets Binomial Lattice Model Generality of the model in describing the equity return distribution Market lattice and risk neutral lattice Dynamic hedging and valuation Intuitive explanation of the model results Comparing the relative valuation approach and the traditional approach – the case of a long dated equity put option One-Period Binomial Model Su/S exp(rT) Sd/S In the absence of arbitrage opportunities, there exist positive state prices such that the price of any security is the sum across the states of the world of its payoff multiplied by the state price. ?=(Cu – Cd)/(Su -Sd ) Πu =(S- exp(-rT) Sd )/(Su - Sd ) C = πuCu + πdCd S= πuSu + πdSd 1 = πuexp(rT)+ πdexp(rT) Numerical Example: Call Option Pricing Stock lattice Call Option Lattice Martingale Processes, p and q measures C/R = puCu/Ru + pdCd/Rd S/R = puSu/Ru + pdSd/Rd 1 = pu + pd C/S = quCu/Su + qdCd/Sd R/S = quRu/Su + qdRd/Sd 1 = qu + qd Probability measure: assigning prob Denominator: numeraire Martingale: “expected” value= current value Con