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Pricing Techniquese 2.72

short selling-Gain or loss with dividend payouts

An investor with a short position must pay to the broker any income,sucthat have been shorted.The broker will transfer this income to the accou

investor shorts position

Name shares RateSale DLF 500 120 April 500*120

Dividend 1 May 500*1

Buy 500 100 June 500*100

Net Gain

60000-500-50000 9500

Cash Flows bearish phase

for PurchaserApril Purchase 500 shares of DLF for Rs 120

May Received Dividend June sell 500 shares for 100 per shares

Net Profit

for seller April Borrow 500 shares and sell them for 12May Pay Dividend

June Buy 500 shares for 100Replace borrowed shares to close short

Net Profit

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as dividends or interest,that normally be received on the securitiesnt of the client from whom the securities have been borrowed.

60000

500

50000

-60000

50050000

-9500

Rs 60000-500

-50000position

9500

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Forward Price for an Investment Asset

Risk Free Interest r is the rate at which money is borrowed or lent whso that the money is certain to be repaid

Arbitrage Arbitrageur Trader

One who profits from the differences in price when the same, or extremely similar, security, currency The arbitrageur profits by simultaneously purchasing and selling these securitie

Arbitrageurs also play an important role in the operation of capital markets, as t

what is zero coupon Bond

If you bought the zero-coupon bond for $952.38, you would receive $1,000 at mIf you bought the coupon bond, you would have received two coupon payments

ExampleLong forward contract for 3 months

if forward rate is high43 and current rate is 40

Rate Forward -3 Month Risk free rate40 43 5%

Now Buy at 40 sell at 43 To buy 40 with rate 5 % for 3 months40e^0.05*3/12 40 2.718281282^(0.05*3/12)

after 3 month

sell 43

Arbitrageurs are typically very experienced investors since arbitrage opportunities are difficult to find

The difference between a zero-coupon bond and a regular bond is that a zero-coupon bond does no

The holder of a zero-coupon bond only receives the face value of the bond at m The holder of a coupon paying bond receives the face value of the bond at matuZero-coupon bondholders gain on the difference between what they pay for the bond and the amouZero-coupon bonds are purchased at a large discount, known as deep discount, to the face value of A coupon-paying bond will initially trade near the price of its face value. In other words, a zero-coupon bond gains from the difference between the purchase price and the faFor example, imagine that you have the choices between a one-year zero-coupon bond with a face

So in this case, no matter which bond you buy, you will get the same return, eve

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An arbitrageur can borrow 40 at the risk free inerest rate of 5% per anAt the end of the 3 months,the arbitrageur delivers the shares and rec

By above strategy ,the arbitrageur locks in a profit of 43-40.50=2.50 r

now forward rate is low39 and current is 40

Rate now forward 3 month40 39

sell 40 long

invest at 5 % for 3 months

40e^0.05*3/12

40.5 Buy at 39 Profit 40.50-39 1.50 Rs p

In Both situations..

Forward price 43

Action nowBorrow 40 at 5% for 3 monthsBuy one shareEnter into forward contract to sell share in 3 month for 43

Action in 3 monthsell share for 43use 40.5 to repay loan with interest

Profit realized 2.50

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n there is no credit risk,GOI Bond 10 Year Bond rate always used

, or commodity is traded on two or more markets.to take advantage of pricing differentials (spreads) created by market conditions

eir efforts in exploiting price inefficiencies keep prices more accurate than they otherwise

aturity, which is a gain of 5% ($47.62/$952.38).of $25 each during the year for a total of $50, which also represents a 5% gain ($50/$1,00

1.01 40.5 Cost The sum of money to pay off loan

43

profit 43-40.50 2.5 Rs per shares

and require relatively fast trading.

t pay coupons, or interest payments, to the bondholder while a typical bond does make these interest payments.

turity.rity but is also paid coupons over the life of the bond.t they will receive at maturity.the bond.

e value, while the coupon bond gains from the regular distribution of interest.alue of $1,000, which can be purchased for $952.38 or a one-year 5% semi-annual coupon bond trading at its fa

n though the source of the return is different. This is not always true, as each case is diffe

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nume,buy one share and short a forward contract to sell one share in 3 months.eives 43.

s per share at the end of 3 months.

r shares

forward price 39

Action nowshort 1 share to realize 40Invest 40 at 5% for 3 monthsEnter into forward contract to buy share in 3 months for 39

Action in 3 monthBuy share for 39close short positionReceive 40.50 from investment

profit realized 1.50

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would be

0).

ce value of $1,000.

ent.

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Lot CMP Bro. STT/other ser.Tax1-Nov Ril.Fut-DEC,10 100 2000 0.05 0 12.5

100 4 12.5

Total cost

20-Nov 100 2025 0.05 0 12.5

101.25 4.05 12.66

Profit

Actual charges. in %security transaction Tax STT On Turnover 0

Transaction charges 0

stamp duty 0.01

Brokerage-Trading 0.05

delivery 0.5

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200000

116.5

200116.5

202500

117.96

###

2265.54