Economics 434: The Theory of Financial Markets Professor Burton Fall 2016 August 30, 2016

Update on Class Information Office Hours: 11am-12pm Tues/Thurs at 1900 Arlington Blvd; Suite C Monroe Office: Room 262, 434-924-4054 VNB Office: 1900 Arlington Blvd., Suite C, 212-731-2340 Email: etb6d@virginia.edu Student lunches almost every weekday Class Website: https://pages.shanti.virginia.edu/ETB_Website/students-alums/class-pages/econ-4340-fall-2016/ New Readings for This Week: Chapters 1 – 3 in Textbook Section of Resources Tab in Collab August 30, 2016

Prof Burton will be in Nashville, Tennessee No Class on Thursday Prof Burton will be in Nashville, Tennessee August 30, 2016

Additional Readings for This Week Read Chapters Four and Five which are available at Collab under “Resources” tab. The first three chapters were assigned for last week Not required, but worth reading as an educated citizen: Graham and Dodd, “Security Analysis” August 30, 2016

Arbitrage Buying and selling identical things simultaneously at different prices. An arbitrage profit means the selling price is higher than the buying price. If the timing of the buy and sell are not the same, then arbitrage is a return higher than that of the risk free asset, even though the transaction is risk free. August, 25, 2016

Relation Between Arbitrage & The Risk Free Rate Assume that there are no arbitrage possibilities (the most widespread assumption in finance) An investment that is risk free must earn “the” risk free rate August 30, 2016

Buying gold; selling gold future Two Examples Buying gold; selling gold future Buying corporate bond; buy CDS August 30, 2016

Gold Futures Example Suppose the “spot” price of Gold is $ 1,000 per ounce (suppose gold is “durable” and costs nothing to store) Suppose you want to buy gold at the current price and you would like to own it for at least one month Suppose the risk free rate is 1 percent per month August 30, 2016

What is a gold futures contract? Imagine a one month gold futures contract One month from today the owner of a gold futures contract will be delivered one ounce of gold The gold futures contract owner will pay whatever price the owner originally paid for the futures contract Assume that at the time of purchase of the futures contract, no money changes hands August 30, 2016

Time Line If the risk free rate is one percent per month, what will be the price of the gold futures contract on September 1st Gold delivered at price paid for futures contract Price of gold $ 1,000 Sept 1 Sept 30 August 30, 2016

Note: the translation is risk free Suppose You buy one ounce of gold and sell one one month gold future. You pay $ 1,000 for the gold. If the risk free rate is one percent per month what will the futures price be? Note: the translation is risk free Thus, it must earn the risk free rate of 1 % or $ 10 To do that the gold must be sold for $ 1,010 on Sept 30 Thus, the price of the gold future must be 1,010 August 30, 2016

CDS Example Imagine a company issues a bond (a corporate bond). This has risk of default. The company may stop making payments or may fail to pay the principal at maturity Suppose you buy the bond and would like to have an insurance policy that would make you whole if the bond defaults. August 30, 2016

What is a CDS? Credit Default Swap Essentially a CDS is an insurance contract If a default occurs, the “protection seller” (normally the CDS seller) takes the bond from you and gives you the “par” value of the bond (the original offering price of 100) August 30, 2016

You own the corporate bond….and So, if You own the corporate bond….and You also own the CDS on that corporate bond You have a “risk free transaction” It must earn the risk free rate August 30, 2016

This is a “synthetic” corporate bond So, How is the CDS priced Given these facts The CDS seller must have a stream of cash flows that is identical to that of the corporate bond owner This is a “synthetic” corporate bond August 30, 2016

August 30, 2016