Corporate Finance (ECON GU4280)

Lecture 4

Tri Vi Dang

Columbia University

Spring 2018

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 1

 I. The theory of corporate finance II. The practice of corporate finance

I.1. Valuation concepts II.1. Internal finance, corporate

control and merger analysis

I.2. Financial structure decisions II.2. Private equity and venture

capital finance

I.3. Taxes and the costs of financial II.3. Business analysis and
distress financial analysis

I.4. Financial decisions and conflict II.4. Enterprise valuation

of interests

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 2

 Lecture 4

I.1. Valuation concepts

F. Interpretation and Applications of NA-pricing

G. Stocks, risks and arbitrage
H. Options
I. Put-Call Parity

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 I.1.F. Interpretation and Applications of NA-Pricing

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 4

The Framework (Bond trading)

There are S dates and N bonds with prices at t=0 of

p=(p1, p2,...., pN)

Let xi be the S-vector of payoffs of bond i at tS

xi=(xi1, xi2,...., xiS)

Let X be the payoff matrix of the N bonds in the S dates:

date
1 S

 x 11  x 1S  Bond 1
X      
x N1  x NS  Bond N

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 5

Remark

This kind of abstraction will be very useful and actually needed if you want to
work at

- structured product groups of investment banks

- proprietary trading desks

- quantitative hedge funds

(AQR, DE Shaw, Renaissance Technologies, Two Sigma)

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Definition

There are N assets. Let  and p be N-vectors, and X a (NS) matrix. An

Arbitrage or arbitrage opportunity is a N-vector , such that

p0 (non-positive cost)

and

X 0 (positive payoff)

where at least one of the two inequality is strict.

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 7

Remark

There are two cases

(1) p0 and   X  0

 x11  x1S 
X  (1 ...... N )        ( y1 ,...., y S )
where
 x N 1  x NS 
with at least one yi>0

(2) p<0 and   X  0

Note, p<0 and   X  0 (special case of (1)) is also an arbitrage or arbitrage

portfolio.

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 8

The No-Arbitrage Theorem

Let q be S-vektor, p the N-vektor of asset prices, and X the (NS)-matrix of the
payoffs of the N assets in the S dates.

NA  {q>>0 : Xq=p}.

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 9

Interpretation

There is NA if the following equation system has a strictly positive solution

(q1,q2,….,qS).

 x 11 .... x 1S   q1   p1 
          
      
x N1  x NS   q S  p 
 N

q1  x 11  q 2  x 12  ....  q S  x 1S  p1
q1  x 21  q 2  x 22  ....  q S  x 2S  p 2

q1  x N1  q 2  x N2  ....  q S  x NS  p N

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 10

Remark

With this theorem at hand, it is easy to check whether there is arbitrage. You
only have to solve the equation system p=Xq.

If all elements of the vector q is strictly positive, then there is no arbitrage.

If one or more elements of the vector q is zero or negative, there is arbitrage.

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 11

Interpretation

The vector q=(q1, q2,...., qS) of the Theorem is the vector of prices of the
following assets.

q1 is the t=0 price of the following asset (1,0,0,…,0)

q2 is the t=0 price of the following asset (0,1,0,…,0)

qS is the t=0 price of the following asset (0,0,0,…,1)

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 12

Remark

So qi=0 (qi<0) means such an asset has a zero (negative) price.

These assets might not be (explicitly) traded but can be created out of the
tradable assets.

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Suppose

1 0 0  p1 
   
X  0 1 0 and  p 2 
0 0 1 p 
 3

where asset (1,0,0) has price p1, etc.

Solving

1 0 0  q1   p1   q1   p1 
0 1 0   q        
   2  p2    q2    p2 
0 0 1  q3  p 
 3
q 
 3
p 
 3

q=(q1, q2,...., qS) will play a central role in option pricing.

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Application 1: Law of one price

NA implies if X  0 then p  0 .

Asset A and B are identical if ( x A1 , x A2 ,....x AS )  ( xB1 , xB 2 ,....xBS ) for all xis

Consider portfolio   (1,1)

This portfolio has payoff x  (0,0,....,0)

NA implies that price of the portfolio: p  0

For p  0 , this implies that p A  p B .

Law of one price: Two identical assets have the same price.

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Application 2: Investment Advice and Cash Management

Suppose you want to obtain the payoff vector y=(y1,….,yS) .

What portfolio generates y? Or what does your financial advisor recommend you
to buy?

Solve the following equation system:

X=y

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  x11  x1S 
(1 ...... N )      
 = (y1,…,yS).
 x N 1  x NS 

 1 x 11   2 x 21  ..   N x N1   y1


 1 x 1N   2 x 2N  ..   N x NS   y S

The solution ( 1 ...... N ) of the above equation system is a portfolio that delivers
(y1,…,yS).

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Example

Asset 1: (1,2)
Asset 2: (3,4)

You want y=(1,1)

1 2
1, 2    (1,1)
3 4

1  3 2  1
 21  4 2  1

 (1 , 2 )  (0.5,0.5)

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 18

Remark

This highlights the key principle of how firms are doing cash management.

In general firms save their cash by investing in a portfolio of bonds such that it
pays off the desired amount at desired dates.

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Question

Apple has more than $250bn cash.

Instead of putting its cash in a checking account it has a cash management team
to manage its cash by investing in bonds.

Why not just putting money in checking or saving account?

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 20

Apple Buys More Company Debt Than World's Biggest Bond Funds
Bloomberg, 05/04/2017

The iPhone-maker has $148 billion of its record $257 billion cash pile invested in
corporate debt alone, according to a company filing from Wednesday. That’s enough to
buy all the assets in the world’s largest fixed-income mutual fund, the Vanguard Total
Bond Market Index Fund, which has about $145 billion of assets including company,
government and mortgage bonds.

https://www.bloomberg.com/news/articles/2017-05-04/apple-buys-more-company-debt-than-the-world-s-biggest-bond-funds

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Apple's Rain of Cash Washes Away Debt Doubts
Bloomberg, 09/05/2017
Its current plan makes sense, but investors ought to question the prudence of packing
debt onto a company that operates in a highly competitive and mercurial industry that
hasn't been tested over a far-reaching horizon.

https://www.bloomberg.com/gadfly/articles/2017-09-05/apple-s-rain-of-cash-washes-away-doubts-about-its-debt

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Apple’s cash pile is as big as the GDP of Finland and Jamaica, combined
Washington Post, 05/01/2017
https://www.washingtonpost.com/business/economy/apples-cash-pile-is-as-big-as-the-gdp-of-finland-and-jamaica-combined/2017/05/01/192d082c-2e7d-11e7-9dec-764dc781686f_story.html?utm_term=.039c75c0d805

Apple's Bonds Are Acting More and More Like Government Debt
Bloomberg, 09/06/2017
https://www.bloomberg.com/news/articles/2017-09-06/apple-gets-favored-nation-status-in-bond-market-short-on-safety

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 23

Application 3: Exploiting Arbitrage

Suppose you find an arbitrage (i.e. qi=0 or qi<0). How can you exploit it?

The simplest strategy is to generate a bond with (0,0,..,1,,..,0,0) that has a price
qi=0 or qi<0.

I.e.
 x11  x1S 
(1 ...... N )      
= (0,0,..,1,..,0,0)
 x N 1  x NS 

By doing this, you obtain qi at t=0, and has no negative payoff and one positive
payoff at t=i.

Remark
See Problem Set 2 for examples.

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 I.1.G. Stocks, Risks and Arbitrage

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Remark

This section applies the NA-Theorem in the context of stock trading.

Then we will use it to price options in I.1.H.

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Using DCF-Model to price stocks

The “income” of stockholders consists of dividends and resale price.

The stock price (present value) at t=0

DIV1  P1
P0 
1 r

Stock price at t=1

DIV2  P2
P1 
1 r

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 27

 DIV1 P1
P  
Substitution of P1 into 0 1  r 1  r yields

DIV2  P2
 1 r
DIV1
P0 
1 r 1 r

DIV1 DIV2  P2
 0 1  r  (1  r ) 2
P 

T
DIVt PT
Further Substitution yields: P0   
t 1 (1  r ) t
(1  r )T

For T infinite

DIVt
P0  
t 1 (1  r ) t

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Terminology

Dividend yield

DIV1
DIV ( yield ) 
P0

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Remark

The problem with the above approach is the following.

Both dividends payments and price movements of stocks are uncertain.

The question is how to price risky assets, such as stocks and options.

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Reinterpretation of the Framework in I.1.E

Two dates (t=0, and t=1)

From the perspective of the investors at date t=0, outcomes (or payoffs of assets)
at t=1 are uncertain.

At t=1, there is a set of potential states of the world that can be realized.

There are S states of the world at t=1

S={s1, s2,...., sS},

There are N assets

At t=0 the price of asset i is pi.

Asset i generates in state s at date t=1 a payoff of xis.

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Notation

Let p be the N-vector of the N-asset prices at t=0 :

p=(p1, p2,...., pN)

Let xi be the S-vector of payoffs of asset i in different states at t=1

xi=(xi1, xi2,...., xiS)

Let X be the payoff matrix of the N assets in the S states :

States
1 S
 x 11  x 1S  Asset1
X      
x N1  x NS  Asset N

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 32

Interpretation

S={Dow Jones Index}

={…., 20,000; 20,100; 20,200;….}

How does the payoff (share price) of Apple at t=1 vary with the Dow?

S={Inflation rate}

S={…., 2.0%, 2.1%, 2.2%, ….}

How does the payoff (share price) of Apple at t=1 vary with the inflation rate?

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Example

S=3, N=2

t=1

Dow s: 20,000 20,100 20,200

Apple : xA=( 140 146 148 )

Google : xG=( 1130 1140 1120)

Price of Apple stocks at t=0 : pA=130

Price of Google stocks at t=0 : pG=1100

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Remark

Is there an arbitrage opportunity by trading Apple and Google?

Solution:

 q1 
140 146 148   130 
1130 1140 1120   q 2    
  q  1100 
 3

If (q1, q2, q3) are strictly positive there is no arbitrage.

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 35

The Framework (Stock trading)

Two dates (t=0, und t=1) and there are N stocks with prices at t=0 of

p=(p1, p2,...., pN)

Let xi be the S-vector of payoffs of stock i in state s at date 1

xi=(xi1, xi2,...., xiS)

Let X be the payoff matrix of the N stocks in the S states at date 1:

States at t=1
1 S

 x 11  x 1S  Stock 1
X      
x N1  x NS  Stock N

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 36

The Framework (Bond trading)

There are S dates (and no uncertainty) and N bonds with prices at t=0 of

p=(p1, p2,...., pN)

Let xi be the S-vector of payoffs of bond i at date s

xi=(xi1, xi2,...., xiS)

Let X be the payoff matrix of the N bonds in the S dates:

date
1 S

 x 11  x 1S  Bond 1
X      
x N1  x NS  Bond N

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 37

Remark

- In contrast to bond trading,

 x 11  x 1S 
X      
x N1  x NS 

is not observable for stocks.

- Traders need to come up with expectations about possible future payoffs.

- After forming expectations, a trader can try to find arbitrage given his
expectations.

- In Section I.1.M we introduce another formulation of X.

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 38

Interpretation

The vector q=(q1, q2,...., qS) of the Theorem is called the vector of

state prices or Arrow-Debreu prices in a general equilibrium context of stock

trading

q1 is the t=0 price of the following asset (1,0,0,…,0)

q2 is the t=0 price of the following asset (0,1,0,…,0)

qS is the t=0 price of the following asset (0,0,0,…,1)

These assets are called state contingent claims since they only have a positive
payoff in one state and zero payoff in all other states.

 Building block for option pricing

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Question

Is no arbitrage a “reasonable” assumption in financial markets?

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Different views

One View (efficient market):

Rational traders will compete away any arbitrage profits until prices are
arbitrage free.

Other view (behavioral finance)

If it takes time to realize arbitrage profit and funds manager faces short term
compensation schemes, then they are reluctant to do so.

Herding of traders may move prices even further away from fundamental value.

Some markets (e.g. investment grade bonds) are more efficient than other market
(e.g. stock markets).

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Remark

We will come back to this discussion again and again in subsequent sections.

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 I.1.H. Options

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 43

Remark

Options are very useful and flexible financial instruments

E.g. you can use options to generate synthetic short bonds

Option theoretic view on capital structure (debt and equity) of a firm

You can generate basically all desired future payoffs with options.

 Financial Engineering

 Product innovation of financial services firms (e.g. Index-saving accounts)

 Hedging of risks

Option pricing is No-arbitrage pricing

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Definition

A Call-Option (or Call) is an asset, that gives the holder the right but no
obligation to buy an object (the underlying) at a pre-specified date T (exercise
date) for a pre-specified price E (exercise price, strike price).

A Put-Option (Put) is an asset, that gives the holder the right but no obligation
to sell an object (the underlying) at a pre-specified date T (exercise date) for a
pre-specified price E (exercise price, strike price).

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Payoff of a call option at date T

Let St be the market price of the underlying object at date T:

The payoff at T:

Call: XC=max[StE, 0]

If EST, exercise the call. Your payoff is StE.

If E>ST, don’t exercise.

It is cheaper to buy the object on the market,

i.e. call is worthless.

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Figure 1
Payoff of Call at T

E ST

Remark
This picture captures the key incentive issues underlying the debate about the
compensation of bankers (see Section I.3).

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 47

Payoff of a put option at date T

Put:XP=max[EtS, 0]

If EST, exercise the put. Your payoff is EtS

If E<ST, don’t exercise the put.

The holder can sell the object for a higher price to the market,

i.e. put is worthless.

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Figure 2

Payoff of Put at T

E ST

Remark
The state space is the stock price at date T.

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 49

Example

Apple: S0=$100

S1=($98, $102, $103)

E=$100 (Exercise price)

Payoff of Call at t=1: xC=(0, 2, 3)

Payoff of Put at t=1: xP=(2, 0, 0)

Remark

Section I.1.J discusses the t=0 prices (premium) of these options.

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 I.1.I. Put-Call Parity

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Remark

The Put-Call parity says something about the relationship between option prices.

In particular, if you know the price of a call, you can price puts, or vice versa.

Option pricing is no arbitrage pricing.

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 52

The Put-Call Parity

No arbitrage implies

E
 C(S 0 , E)  S 0  P(S 0 , E)
1 r
where E denotes the face value of a riskless bond at t=1, S0 denotes the price of
the stock at t=0, r is the riskless rate, C() denotes the price of a call with
exercise price E and P() the price of a put with exercise price E on that stock.

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 53

Remark

It says that the price of a call and the price of a put with the same exercise price
have to obey a specific relationship. Otherwise there is arbitrage.

In other words,

A riskless bond with payoff of E at t=1 and a call with exercise price E on a
stock

is equivalent to

a put with exercise price E on the stock and the holding of that stock.

Equivalent means that both portfolios have the same price at t=0.

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 54

Remark

NA also implies that two identical assets must have the same price.

Two assets are identical if they have identical payoff in all states.

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Proof

According to NA, one just has to show that both sides of the equations yield the
same payoff in all states.

E
 C(S 0 , E)  S 0  P(S 0 , E)
1 r

t=0: price of bond price of call price of stock price of put

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 56

LHS (payoff of portfolio of call and bond at T)

If S1 < E, Call is out of money  0

E
Payoff of bond  E

If S1  E, Call is (at) in the money  S1E

 S1
Payoff of bond  E

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 57

RHS (payoff of portfolio of put and stock at T)

If S1 < E, Put is (at) in the money  ES1

 E
Payoff of Stock  S1

If S1  E, Put is out of the money  0

 S1
Payoff of Stock  S1

Corporate Finance, Tri Vi Dang, Columbia University, Spring 2018 58

Comparison

LHS: If S1 < E,  E

If S1  E,  S1

RHS: If S1 < E,  E

If S1  E,  S1

In all states (for any stock price at T), the two portfolios have the same payoffs.

No-arbitrage implies they must have the same price.

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Remark

A synthetic (safe) bond with final payoff E

 S 0  P( S 0 , E )  C ( S 0 , E )

A synthetic stock

 C (S 0 , E )  P( S 0 , E )  Bond

Remark

ETF provider uses synthetic strategies to replicate indices (e.g. S&P500).

Financial engineering is about the design of new securities (section I.1.K).

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