Mathematical Finance

Lecture 1

S
andor Zolt
an Nemeth

University of Birmingham

Autumn

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emeth (University of Birmingham) Mathematical Finance Autumn 1 / 15
Terminology

1 Shares

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends
3 Supply and Demand

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends
3 Supply and Demand
4 Long and short selling

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends
3 Supply and Demand
4 Long and short selling
5 Risk

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends
3 Supply and Demand
4 Long and short selling
5 Risk
6 Hedging

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends
3 Supply and Demand
4 Long and short selling
5 Risk
6 Hedging
7 Interest rate

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends
3 Supply and Demand
4 Long and short selling
5 Risk
6 Hedging
7 Interest rate
8 Arbitrage

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends
3 Supply and Demand
4 Long and short selling
5 Risk
6 Hedging
7 Interest rate
8 Arbitrage
9 European vanilla call option

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends
3 Supply and Demand
4 Long and short selling
5 Risk
6 Hedging
7 Interest rate
8 Arbitrage
9 European vanilla call option
10 European vanilla put option

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends
3 Supply and Demand
4 Long and short selling
5 Risk
6 Hedging
7 Interest rate
8 Arbitrage
9 European vanilla call option
10 European vanilla put option
11 Exercising options

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Terminology

1 Shares
2 Dividends
3 Supply and Demand
4 Long and short selling
5 Risk
6 Hedging
7 Interest rate
8 Arbitrage
9 European vanilla call option
10 European vanilla put option
11 Exercising options
12 Gearing

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 2 / 15
Shares and Dividens
1 To finance a new project a company (CO) sells out shares in itself.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 3 / 15
Shares and Dividens
1 To finance a new project a company (CO) sells out shares in itself.
2 Investors become proportional owners.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 3 / 15
Shares and Dividens
1 To finance a new project a company (CO) sells out shares in itself.
2 Investors become proportional owners.
3 If CO makes profit may pay dividens or invest.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 3 / 15
Shares and Dividens
1 To finance a new project a company (CO) sells out shares in itself.
2 Investors become proportional owners.
3 If CO makes profit may pay dividens or invest.
4 If A = assets (property, inventory etc) and
L = liability (loans and taxes to be payed, pension plans etc.),
n = number of shares in CO, D = dividend per share
The value of a share is
1
V (A L) + D,
n

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 3 / 15
Shares and Dividens
1 To finance a new project a company (CO) sells out shares in itself.
2 Investors become proportional owners.
3 If CO makes profit may pay dividens or invest.
4 If A = assets (property, inventory etc) and
L = liability (loans and taxes to be payed, pension plans etc.),
n = number of shares in CO, D = dividend per share
The value of a share is
1
V (A L) + D,
n
5 Value of share agreed by seller and buyer.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 3 / 15
Shares and Dividens
1 To finance a new project a company (CO) sells out shares in itself.
2 Investors become proportional owners.
3 If CO makes profit may pay dividens or invest.
4 If A = assets (property, inventory etc) and
L = liability (loans and taxes to be payed, pension plans etc.),
n = number of shares in CO, D = dividend per share
The value of a share is
1
V (A L) + D,
n
5 Value of share agreed by seller and buyer.
6 Sold through a stockbroker.

Commission = ask price bid price

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 3 / 15
Supply and demand

1 Value of a share determined by laws of supply and demand

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 4 / 15
Supply and demand

1 Value of a share determined by laws of supply and demand

2 Large supply many sellers price goes down

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 4 / 15
Supply and demand

1 Value of a share determined by laws of supply and demand

2 Large supply many sellers price goes down
3 Large demand many buyers price goes up

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 4 / 15
Supply and demand

1 Value of a share determined by laws of supply and demand

2 Large supply many sellers price goes down
3 Large demand many buyers price goes up
4 Value determined by buy and sell balance between supply
and demand

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 4 / 15
Risk = uncertainty of investment

1 High risk: High potential gain but also high potential loss

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 5 / 15
Risk = uncertainty of investment

1 High risk: High potential gain but also high potential loss
2 Low risk: Low potential risk but also low potential gain

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 5 / 15
Risk = uncertainty of investment

1 High risk: High potential gain but also high potential loss
2 Low risk: Low potential risk but also low potential gain

1 Specific risk: Investing in a company

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 5 / 15
Risk = uncertainty of investment

1 High risk: High potential gain but also high potential loss
2 Low risk: Low potential risk but also low potential gain

1 Specific risk: Investing in a company

2 Non-specific risk: Investing in a market

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emeth (University of Birmingham) Mathematical Finance Autumn 5 / 15
Hedging

1 Strategy of investment to minimise risk

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 6 / 15
Hedging

1 Strategy of investment to minimise risk

2 For example invest in the aviation sector risky nowdays because
of high fuel costs

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 6 / 15
Hedging

1 Strategy of investment to minimise risk

2 For example invest in the aviation sector risky nowdays because
of high fuel costs
3 Therefore invest in oil industry too (negatively correlated to aviation)

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 6 / 15
Hedging

1 Strategy of investment to minimise risk

2 For example invest in the aviation sector risky nowdays because
of high fuel costs
3 Therefore invest in oil industry too (negatively correlated to aviation)
4 In general, a hedging strategy is to invest in negatively correlated
sectors.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 6 / 15
Long and short selling

1 long = owned

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 7 / 15
Long and short selling

1 long = owned
2 short = NOT owned but willing to trade

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 7 / 15
Long and short selling

1 long = owned
2 short = NOT owned but willing to trade
3 short selling = selling a share which you dont own.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 7 / 15
Long and short selling

1 long = owned
2 short = NOT owned but willing to trade
3 short selling = selling a share which you dont own.
4 Short selling is done through a stockbroker.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 7 / 15
Long and short selling

1 long = owned
2 short = NOT owned but willing to trade
3 short selling = selling a share which you dont own.
4 Short selling is done through a stockbroker.
5 Ex: If A sells 10 shares (through a broker) in CO which he does not
own but B does, then it has to return these to B in the future.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 7 / 15
Long and short selling

1 long = owned
2 short = NOT owned but willing to trade
3 short selling = selling a share which you dont own.
4 Short selling is done through a stockbroker.
5 Ex: If A sells 10 shares (through a broker) in CO which he does not
own but B does, then it has to return these to B in the future.
6 Any dividens must be payed directly by A to B.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 7 / 15
Long and short selling

1 long = owned
2 short = NOT owned but willing to trade
3 short selling = selling a share which you dont own.
4 Short selling is done through a stockbroker.
5 Ex: If A sells 10 shares (through a broker) in CO which he does not
own but B does, then it has to return these to B in the future.
6 Any dividens must be payed directly by A to B.
7 If B decides to sell his shares in CO, A has to return them
immediately to B.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 7 / 15
Long and short selling

1 long = owned
2 short = NOT owned but willing to trade
3 short selling = selling a share which you dont own.
4 Short selling is done through a stockbroker.
5 Ex: If A sells 10 shares (through a broker) in CO which he does not
own but B does, then it has to return these to B in the future.
6 Any dividens must be payed directly by A to B.
7 If B decides to sell his shares in CO, A has to return them
immediately to B.
8 In reality stockbroker has a chain of clients and A can borrow from C
to return to B etc.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 7 / 15
Long and short selling

1 long = owned
2 short = NOT owned but willing to trade
3 short selling = selling a share which you dont own.
4 Short selling is done through a stockbroker.
5 Ex: If A sells 10 shares (through a broker) in CO which he does not
own but B does, then it has to return these to B in the future.
6 Any dividens must be payed directly by A to B.
7 If B decides to sell his shares in CO, A has to return them
immediately to B.
8 In reality stockbroker has a chain of clients and A can borrow from C
to return to B etc.
9 If stockbroker runs out of clients A is short-squeezed and has to buy
shares at market price.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 7 / 15
Interest rate
1 I = money deposited in bank (risk free investment but not
instantaneous)

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 8 / 15
Interest rate
1 I = money deposited in bank (risk free investment but not
instantaneous)
2 I (t0 ) = I0

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 8 / 15
Interest rate
1 I = money deposited in bank (risk free investment but not
instantaneous)
2 I (t0 ) = I0
3 t = time

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 8 / 15
Interest rate
1 I = money deposited in bank (risk free investment but not
instantaneous)
2 I (t0 ) = I0
3 t = time
4 r = r (t ) = interest rate

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 8 / 15
Interest rate
1 I = money deposited in bank (risk free investment but not
instantaneous)
2 I (t0 ) = I0
3 t = time
4 r = r (t ) = interest rate
dI dI
dt = r (t )I or I = r (t )dt
5

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 8 / 15
Interest rate
1 I = money deposited in bank (risk free investment but not
instantaneous)
2 I (t0 ) = I0
3 t = time
4 r = r (t ) = interest rate
dI dI
dt = r (t )I or I = r (t )dtR
5
t
6 log(I (t )) log(I (t0 )) = t0 r (t )dt

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 8 / 15
Interest rate
1 I = money deposited in bank (risk free investment but not
instantaneous)
2 I (t0 ) = I0
3 t = time
4 r = r (t ) = interest rate
dI dI
dt = r (t )I or I = r (t )dtR
5
t
6 log(I (t )) log(I (t0 )) = t0 r (t )dt
Rt
r (t )dt
7 I (t ) = I0 e t0

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 8 / 15
Interest rate
1 I = money deposited in bank (risk free investment but not
instantaneous)
2 I (t0 ) = I0
3 t = time
4 r = r (t ) = interest rate
dI dI
dt = r (t )I or I = r (t )dtR
5
t
6 log(I (t )) log(I (t0 )) = t0 r (t )dt
Rt
r (t )dt
7 I (t ) = I0 e t0
8 Risk free profit at t = T
 Rt 
r (t )dt
Prf = I (T ) I (t0 ) = I0 e t0
1

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 8 / 15
Interest rate
1 I = money deposited in bank (risk free investment but not
instantaneous)
2 I (t0 ) = I0
3 t = time
4 r = r (t ) = interest rate
dI dI
dt = r (t )I or I = r (t )dtR
5
t
6 log(I (t )) log(I (t0 )) = t0 r (t )dt
Rt
r (t )dt
7 I (t ) = I0 e t0
8 Risk free profit at t = T
 Rt 
r (t )dt
Prf = I (T ) I (t0 ) = I0 e t0
1

9 If r = constant, then I (t ) = I0 e r (t t0 ) and

 
Prf = I0 e r (t t0 ) 1 .

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 8 / 15
Arbitrage: Example

1 Arbitrage means there is no instantaneous risk free profit.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 9 / 15
Arbitrage: Example

1 Arbitrage means there is no instantaneous risk free profit.

2 Suppose 1 = $2.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 9 / 15
Arbitrage: Example

1 Arbitrage means there is no instantaneous risk free profit.

2 Suppose 1 = $2.
3 Suppose share in CO $2.00 in New York and 1.10 in London.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 9 / 15
Arbitrage: Example

1 Arbitrage means there is no instantaneous risk free profit.

2 Suppose 1 = $2.
3 Suppose share in CO $2.00 in New York and 1.10 in London.
4 What happens?

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 9 / 15
Arbitrage: Example

1 Arbitrage means there is no instantaneous risk free profit.

2 Suppose 1 = $2.
3 Suppose share in CO $2.00 in New York and 1.10 in London.
4 What happens?
5 Many buy in New York large demand price goes up

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 9 / 15
Arbitrage: Example

1 Arbitrage means there is no instantaneous risk free profit.

2 Suppose 1 = $2.
3 Suppose share in CO $2.00 in New York and 1.10 in London.
4 What happens?
5 Many buy in New York large demand price goes up
and
sell in London large supply price goes down

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 9 / 15
Arbitrage: Example

1 Arbitrage means there is no instantaneous risk free profit.

2 Suppose 1 = $2.
3 Suppose share in CO $2.00 in New York and 1.10 in London.
4 What happens?
5 Many buy in New York large demand price goes up
and
sell in London large supply price goes down
6 Prices will meet and gap of opportunity closes

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 9 / 15
Arbitrage: Example

1 Arbitrage means there is no instantaneous risk free profit.

2 Suppose 1 = $2.
3 Suppose share in CO $2.00 in New York and 1.10 in London.
4 What happens?
5 Many buy in New York large demand price goes up
and
sell in London large supply price goes down
6 Prices will meet and gap of opportunity closes
7 Balance of supply and demand any opportunities of
instantaneous risk free profits vanish quickly.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 9 / 15
Arbitrage: risk free investment

1 Suppose investment costs C = I0 at t = t0 and has a return IT at

t = T . Then, Phypothetical = IT I0 .

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 10 / 15
Arbitrage: risk free investment

1 Suppose investment costs C = I0 at t = t0 and has a return IT at

t = T . Then, Phypothetical = IT I0 .
2 If Phypothetical < Prf invest in bank

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 10 / 15
Arbitrage: risk free investment

1 Suppose investment costs C = I0 at t = t0 and has a return IT at

t = T . Then, Phypothetical = IT I0 .
2 If Phypothetical < Prf invest in bank
3 Suppose Phypothetical > Prf , then instantaneously borrow I0 from a
bank and purchase the hypothetical investment.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 10 / 15
Arbitrage: risk free investment

1 Suppose investment costs C = I0 at t = t0 and has a return IT at

t = T . Then, Phypothetical = IT I0 .
2 If Phypothetical < Prf invest in bank
3 Suppose Phypothetical > Prf , then instantaneously borrow I0 from a
bank and purchase the hypothetical investment.
4 Profit only at t = T , but you know instantaneously this
information at t = t0 . What happens?

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 10 / 15
Arbitrage: risk free investment

1 Suppose investment costs C = I0 at t = t0 and has a return IT at

t = T . Then, Phypothetical = IT I0 .
2 If Phypothetical < Prf invest in bank
3 Suppose Phypothetical > Prf , then instantaneously borrow I0 from a
bank and purchase the hypothetical investment.
4 Profit only at t = T , but you know instantaneously this
information at t = t0 . What happens?
5 Investors borrow lot of money and immediately invest in the
hypothetical investment

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 10 / 15
Arbitrage: risk free investment

1 Suppose investment costs C = I0 at t = t0 and has a return IT at

t = T . Then, Phypothetical = IT I0 .
2 If Phypothetical < Prf invest in bank
3 Suppose Phypothetical > Prf , then instantaneously borrow I0 from a
bank and purchase the hypothetical investment.
4 Profit only at t = T , but you know instantaneously this
information at t = t0 . What happens?
5 Investors borrow lot of money and immediately invest in the
hypothetical investment
6 Interest rate will increase and the opportunity vanishes quicly

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 10 / 15
Arbitrage: risk free investment

1 Suppose investment costs C = I0 at t = t0 and has a return IT at

t = T . Then, Phypothetical = IT I0 .
2 If Phypothetical < Prf invest in bank
3 Suppose Phypothetical > Prf , then instantaneously borrow I0 from a
bank and purchase the hypothetical investment.
4 Profit only at t = T , but you know instantaneously this
information at t = t0 . What happens?
5 Investors borrow lot of money and immediately invest in the
hypothetical investment
6 Interest rate will increase and the opportunity vanishes quicly
7 Again laws of supply and demand made the arbitrage oportunity
disappear.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 10 / 15
Options

1 Options: contracts between two parties with options and obligation

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 11 / 15
Options

1 Options: contracts between two parties with options and obligation

2 Traded on stockmarket, negotiated through intermediary

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 11 / 15
Options

1 Options: contracts between two parties with options and obligation

2 Traded on stockmarket, negotiated through intermediary
3 Goal:

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 11 / 15
Options

1 Options: contracts between two parties with options and obligation

2 Traded on stockmarket, negotiated through intermediary
3 Goal:
1 To speculate, bet on future performance of a share

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 11 / 15
Options

1 Options: contracts between two parties with options and obligation

2 Traded on stockmarket, negotiated through intermediary
3 Goal:
1 To speculate, bet on future performance of a share
2 To reduce risk (hedging)

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 11 / 15
European vanilla call option

1 Principal elements: cost, starting date, expiry date, exercise price

(strike price)

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 12 / 15
European vanilla call option

1 Principal elements: cost, starting date, expiry date, exercise price

(strike price)
2 Contract: between two parties the holder and the writer

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 12 / 15
European vanilla call option

1 Principal elements: cost, starting date, expiry date, exercise price

(strike price)
2 Contract: between two parties the holder and the writer
3 Holder may buy share in CO on the expiry date at the exercise price

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 12 / 15
European vanilla call option

1 Principal elements: cost, starting date, expiry date, exercise price

(strike price)
2 Contract: between two parties the holder and the writer
3 Holder may buy share in CO on the expiry date at the exercise price
4 Writer must sell on the expiry date at the exercise price if holder
decides to buy.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 12 / 15
European vanilla call option

1 Principal elements: cost, starting date, expiry date, exercise price

(strike price)
2 Contract: between two parties the holder and the writer
3 Holder may buy share in CO on the expiry date at the exercise price
4 Writer must sell on the expiry date at the exercise price if holder
decides to buy.
5 The contract has a cost which has to be payed at the starting date

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 12 / 15
European vanilla call option

1 Principal elements: cost, starting date, expiry date, exercise price

(strike price)
2 Contract: between two parties the holder and the writer
3 Holder may buy share in CO on the expiry date at the exercise price
4 Writer must sell on the expiry date at the exercise price if holder
decides to buy.
5 The contract has a cost which has to be payed at the starting date
6 When you invest in this option you are betting that the share price
will increase in the future.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 12 / 15
European vanilla put option

1 Principal elements: cost, starting date, expiry date, exercise price

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 13 / 15
European vanilla put option

1 Principal elements: cost, starting date, expiry date, exercise price

2 Contract: between two parties the holder and the writer

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 13 / 15
European vanilla put option

1 Principal elements: cost, starting date, expiry date, exercise price

2 Contract: between two parties the holder and the writer
3 Holder may sell share in CO on the expiry date at the exercise price

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 13 / 15
European vanilla put option

1 Principal elements: cost, starting date, expiry date, exercise price

2 Contract: between two parties the holder and the writer
3 Holder may sell share in CO on the expiry date at the exercise price
4 Writer must buy on the expiry date at the exercise price if holder
decides to sell

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 13 / 15
European vanilla put option

1 Principal elements: cost, starting date, expiry date, exercise price

2 Contract: between two parties the holder and the writer
3 Holder may sell share in CO on the expiry date at the exercise price
4 Writer must buy on the expiry date at the exercise price if holder
decides to sell
5 The contract has a cost which has to be payed at the starting date

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 13 / 15
European vanilla put option

1 Principal elements: cost, starting date, expiry date, exercise price

2 Contract: between two parties the holder and the writer
3 Holder may sell share in CO on the expiry date at the exercise price
4 Writer must buy on the expiry date at the exercise price if holder
decides to sell
5 The contract has a cost which has to be payed at the starting date
6 When you invest in this option you are betting that the share price
will decrease in the future.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 13 / 15
Exercising Options

1 European vanilla call: Holder in the money at the expiry if

share price at expiry > exercise price . Then, holder can make
profit by buying shares from the writer and selling them on the
market or retain them as part of an investment portfolio.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 14 / 15
Exercising Options

1 European vanilla call: Holder in the money at the expiry if

share price at expiry > exercise price . Then, holder can make
profit by buying shares from the writer and selling them on the
market or retain them as part of an investment portfolio.
2 European vanilla put: Holder in the money at the expiry if
share price at expiry < exercise price . Then, holder can make
profit by buying shares from the market and selling them to the writer.

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 14 / 15
Exercising Options

1 European vanilla call: Holder in the money at the expiry if

share price at expiry > exercise price . Then, holder can make
profit by buying shares from the writer and selling them on the
market or retain them as part of an investment portfolio.
2 European vanilla put: Holder in the money at the expiry if
share price at expiry < exercise price . Then, holder can make
profit by buying shares from the market and selling them to the writer.
3 In the above cases we say that holder exercises the option. In fact
holder should exercise the option. Why?

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 14 / 15
Exercising Options

1 European vanilla call: Holder in the money at the expiry if

share price at expiry > exercise price . Then, holder can make
profit by buying shares from the writer and selling them on the
market or retain them as part of an investment portfolio.
2 European vanilla put: Holder in the money at the expiry if
share price at expiry < exercise price . Then, holder can make
profit by buying shares from the market and selling them to the writer.
3 In the above cases we say that holder exercises the option. In fact
holder should exercise the option. Why?
4 Otherwise the holder is out of money and should not exercise the
option. Why?

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 14 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence
2 I buy one European vanilla call today with the underlying one share in
CO

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence
2 I buy one European vanilla call today with the underlying one share in
CO
3 Cost of contract 20 pence

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence
2 I buy one European vanilla call today with the underlying one share in
CO
3 Cost of contract 20 pence
4 At expiry share price is 1742 pence

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence
2 I buy one European vanilla call today with the underlying one share in
CO
3 Cost of contract 20 pence
4 At expiry share price is 1742 pence
5 I decide to buy the share

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence
2 I buy one European vanilla call today with the underlying one share in
CO
3 Cost of contract 20 pence
4 At expiry share price is 1742 pence
5 I decide to buy the share
6 Overall profit 1742-1700-20=22 pence

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence
2 I buy one European vanilla call today with the underlying one share in
CO
3 Cost of contract 20 pence
4 At expiry share price is 1742 pence
5 I decide to buy the share
6 Overall profit 1742-1700-20=22 pence
7 Overall profit on my original investment in percentage is
22/20 100 = 110%

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence
2 I buy one European vanilla call today with the underlying one share in
CO
3 Cost of contract 20 pence
4 At expiry share price is 1742 pence
5 I decide to buy the share
6 Overall profit 1742-1700-20=22 pence
7 Overall profit on my original investment in percentage is
22/20 100 = 110%
1 In contrast I decide not to exercise the option and buy a share

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence
2 I buy one European vanilla call today with the underlying one share in
CO
3 Cost of contract 20 pence
4 At expiry share price is 1742 pence
5 I decide to buy the share
6 Overall profit 1742-1700-20=22 pence
7 Overall profit on my original investment in percentage is
22/20 100 = 110%
1 In contrast I decide not to exercise the option and buy a share
2 Overall profit is 1742-1677=65

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence
2 I buy one European vanilla call today with the underlying one share in
CO
3 Cost of contract 20 pence
4 At expiry share price is 1742 pence
5 I decide to buy the share
6 Overall profit 1742-1700-20=22 pence
7 Overall profit on my original investment in percentage is
22/20 100 = 110%
1 In contrast I decide not to exercise the option and buy a share
2 Overall profit is 1742-1677=65
3 Overall profit on my original investment in percentage is
65/1677 100 = 0.72%

S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15
Gearing
1 Today the share price of CO is 1677 pence. Exercise price is 1700
pence
2 I buy one European vanilla call today with the underlying one share in
CO
3 Cost of contract 20 pence
4 At expiry share price is 1742 pence
5 I decide to buy the share
6 Overall profit 1742-1700-20=22 pence
7 Overall profit on my original investment in percentage is
22/20 100 = 110%
1 In contrast I decide not to exercise the option and buy a share
2 Overall profit is 1742-1677=65
3 Overall profit on my original investment in percentage is
65/1677 100 = 0.72%
4 What can you observe? So, what is gearing?
S Z N
emeth (University of Birmingham) Mathematical Finance Autumn 15 / 15