khan-academy-finance-and-capital-markets.markdown

Finance and capital markets

https://www.khanacademy.org/economics-finance-domain/core-finance

Interest and debt

Compound interest basics

• The rule of 72 answers how long to double your money if compounding annually.
• For example, if compounding 10% annually, then it will take 72/10 = 7.2 years. If compounding 6% annually, then it will take 72/6 = 12 years.
• For lower interest rates, the rule of 72 slightly overestimates how long it will take to double your money. For higher interest rates, it slightly underestimates.

Interest basics

• Interest is just rent on money.
• The original amount that is borrowed, or on which interest is charged, is simply called the principal.
• Simple interest is the opposite of compound interest. If you think about it, you're paying a smaller and smaller percentage of what you owe going into that year.
• Given a principal P and an interest rate r, simple interest adds Pr every year, while compound interest multiplies the existing amount by 1+r.
• APR is annual percentage rate. Another number to look for is the daily periodic rate. Many APRs are calculated as the daily periodic rate multiplied by 365.
• The effective APR imposes compound interest on the daily periodic rate, and is much higher than the advertised APR.

Credit cards and loans

• Processors are the people that maintain the credit card network, such as Visa, Mastercard, American Express, and Discover.
• Say a bank wants to issue a credit card to extend credit, earn interest, and make fees. They ask to be a member of the processors' network.
• For a merchant to accept a credit card for a given network, it must have a relationship with a bank that is on that network. That is called the merchant bank, or the acquiring bank, or the acquirer.
• This bank is called the acquirer because it goes out and acquires members to be a part of its network.
• Swiping a credit card goes to the merchant's bank, then to the credit card network, then to the cardholder's bank for authorization.
• When you purchase something from a merchant, the money for what you purchase comes from the bank that issued you the credit card.
• The merchant pays a fee to its acquiring bank, most of which goes upstream to the bank that issued you the credit card. This is called the interchange fee. This is set by the individual networks.
• In the past, usury or usurious meant any kind of interest, but now we associate it with an unreasonable level of interest.

Continuous compound interest and e

• If you were to charge 100% interest on a principal of 1 dollar over 1 year, you would calculate that as 1*(1 + 100%/1)^1. Compounding over n intervals, the limit 1*(1 + 100%/n)^n approaches e as n approaches infinity.
• When n approaches infinity, you could view it as continuously compounding every possible fraction of a second.
• When borrowing a principal P over t years, compounding n times per year, at an annual interest rate of r percent, you compound as P*(1 + r/n)^nt. As n approaches infinity, if you substitute x as n/r, then you have P*(1+1/x)^xrt as x approaches infinity, which simplifies as P*e^rt.

Present value

• The amount of money is not all that matters. When you get or when you have to give the money also matters. This is called the time value of money.
• To determine what is the present value of some amount of money at some time in the future, you must determine what principal you must have now, earning interest at some specified interest rate.
• To determine the future value of some principal at some specified time in the future, you must compute its interest over that time and add it to the principal.
• Another way to discuss this is: Given some amount of money in the future, to determine its present value, we discount the value by a discount rate.
• When the government borrows from you some amount of money at some specified interest rate, it will always pay back the promised amount, because it can print the money if needed.
• If given a number of choices, each with payments over multiple years, you can determine which is best by totaling the present values of each choice.
• Compounding going forward in time is the same as discounting going backward in time.
• When you lower the interest rate, the present value of a future payment goes up, because you're discounting by a smaller number. The terms that are using that discount rate the most, benefit the most.
• A discounted cash flow is when you have a stream of cash flows, and you are discounting them back to get today's present value.
• There are a lot of assumptions in finance. You can justify any present value by picking the right discount rate. And that discount rate is dependent on risk. This is the crux of modern finance.

Personal bankruptcy

• The debtor is the person who borrows money, and now owe money. The creditor is who lent the money, and is owed money.
• Bankruptcy laws are to protect the debtor from being perpetually in debt with no hope of coming out.
• Chapter 7 and Chapter 13 actually apply to chapters of the US bankruptcy code.
• Chapter 7 is straight bankruptcy, in which a trustee or bankruptcy court sells all your assets, splits them among all your creditors, and then you are free of all debt.
• Chapter 7 stays on your credit report for 10 years. And some liabilities, such as certain types of student loans, taxes, child support, and so on cannot be forgiven.
• Chapter 13 is reorganization, in which you create a plan with your creditors to pay them back over the next 3 years. It then shows up on your credit report for the next 7 years.
• If a person does not have a job, then filing for Chapter 13 is not a realistic option, and that person must resort to filing a Chapter 7.

Inflation

Inflation basics

• Measuring inflation is difficult becuase it is based on the cost of a representative "basket of goods and services," but what is in that basket changes over time, e.g. new technology replaces old.
• The basket of goods and services is called a consumer price index, or CPI, and you are measuring its price inflation between two given years. Price inflation is simply referred to as inflation.
• Monetary inflation is inflation purely due to an increase in the money supply. If the increase in the money supply outstrips the productive capacity of a country, it can lead to price inflation.
• With inflation, each dollar is worth less because you can buy less with each dollar. Consequently people have less purchasing power.
• The Bureau of Labor Statistics is responsible for creating the CPI. The Table A is the percent changes in CPI for all urban consumers, or the CPI-U.
• Changes in inflation between months are seasonally adjusted, e.g. it considers if people use a different amount of energy or a different amount of gasoline between one month and the next.
• In addition to a total inflation number, food and energy are typically also subtracted out since they represent a large portion of the basket and are highly volatile.
• The Case-Shiller index is arguably the best index for recording the actual increases or decreases in prices of holmes.

Inflation scenarios

• In a good economy, employment is up, so employees have more negotiating power, and wages go up. So demand goes up, and companies' and services' utilization goes up, and their profit goes up. If they near full utilization, they can invest more, or increase prices.
• More investment and more utilization will increase supply, which can inhibit price. But increased utilization, investment, and profit will lead to more employment, thus completing a loop.
• Stagflation is when you have inflation while you also have stagnation in the economy.
• A supply shock is something like an embargo. Supply decreases, so price increases and thereby causes an inflation, so demand decreases, which in turn decreases utilization and investment and profit, and so employment decreases.
• Hyperinflation is typically when a government prints too much money, leading to prices going up, which requires printing more money to support that.
• When hyperinflation happens, money is less worth every hour, so people instead choose to hoard hard assets. So merchants hold their own supply, which increases prices even more, and so prices increase even more.

Real and nominal return

• The nominal return is the actual return divided by your original principal. The real return is the actual return divided by the principal, adjusted for inflation.
• If N is the percent return, I is in the inflation rate, and R is the real return, then you get 1+N = (1+R)(1+I). So compounding by the nominal interest rate equals compounding the real growth by the rate of inflation.

Capacity utilization and inflation

• COGS is an acronym for cost of goods sold. Gross profit is calculated as COGS subtracted from revenue. Overhead cost subtracted from gross profit yields operating profit.
• Return on asset is operating income divided by your initial investment.
• Huge returns attracts competition, which in turn attracts capacity, which in turn leads the players to lower their prices in order to increase their utilization.
• When you have high utilization of your asset, there is incentive to raise prices. You will in turn get better return on your asset, and can invest more to build more capacity.
• When you are at low utilization of your asset, there is incentive to lower prices and increase utilization.
• Capacity utilization, whether that is of people or of factories, is what drives inflation. And utilization is a function of demand.
• Normally if the money supply goes up, demand increases. But money is just a vechicle for expressing demand. You can have money but lack desire to spend, such as if your confidence in the economy is low.
• Money supply multiplied by the velocity of money equals the average price of goods multiplied by the total quantity of goods and services that we have.
• Our output is broken down into consumption and savings. Savings turn into an investment; they are two sides of the same coin. This investment, in turn, yields a larger output in the future.
• GDP is all of the goods and services, i.e. all of the income, that we produce. Disposable income is the amount that ends up in the hands of people.
• Up until about 1984, people saved about 10% of their disposable income. Now people save close to 0 of their disposable income. This is because we took on credit and started having "perceived savings."
• Every time we went through a recession from the mid-80s onwards, the government solution as to make financing easier, meaning the fed would lower interest rates and increase available credit.
• When people cannot borrow anymore, they are forced to save. Consequently, demand will decrease by the amount saved, which in turn decreases capacity utilization, and consequently prices.
• When World War II ended, factories were no longer utilized for the war. But Germany, Western Europe, and Japan had their factories bombed, and so their demand picked up the slack from US capacity.

Stocks and bonds

Introduction to stocks

What it means to buy a company's stock

• When you buy stock, you become part owner of a company. When you buy a bond, you become part lender to a company.
• An asset is something that has value or has future benefit. A loan to someone else is an asset, because they will pay you back. (Whereas a loan to you is a liability.)
• Assets minus debt or liability leaves owners equity. When you a part owner of a company, you own a piece of that equity.
• If the share price of a company is less than the owners equity divided by the number of outstanding shares, then it means that the market doesn't believe the company is worth that price.
• Average volume is the number of shares sold per day. Market cap is the publicly traded price multiplied by the number of outstanding shares.
• The market cap reflects the market's view of the company's assets, and again, it may differe from the assets reflected by the books.

Bonds vs. stocks

• A company can raise money by borrowing money, which is debt, or selling shares of itself, which is equity.
• A security is something that can be bought or sold and that has some sort of claim on something, or some economic value.
• A security in the equity world is a stock, and a security in the debt world is a bond.
• Debt could be a bank loan, or typically a bond, which is borrowing from the public market.
• The face value, or par value of a bond, is an I.O.U. from a company for payback at some future date called maturity.
• A zero coupon bond is where the company does not pay interest until they pay off the entire loan. The interest is implicit in the value delivered.
• A coupon is a regular payment on the bond that the company makes.
• Bonds are traded just like stocks, but their price is somewhat difficult to find.
• When you hold a bond, you have lent some money to the company, and as long as the company doesn't go bankrupt then it will pay you interest and your money back.

Shorting stock

Basic shorting

• A short on a stock is a bet that the stock is going to go down.
• To short, you borrow the stock and then immediately sell it its current price. Then later, you can buy the stock at its lower price, and return it to the owner.
• Obviously, if the stock appreciates in value, then you lose money instead of make money. Shorting is the riskiest thing you can do, as a stock price can go unbelievably high.

Shorting stock

• When you short a stock, you borrow the share from a broker or brokerage. These shares typically belong to other clients of the broker.
• When you long on a security, you're buying the security. When you go short, you're borrowing the security and then selling it.
• When you borrow a share, you have to pay interest on it.
• If you borrow a share from the broker, and the owner of that share then immediately sells it, the broker really just shuffles around the ownership of shares. This is because stocks are fungible.
• The stockholders give the brokerage permission to do this becuase they get a percentage of the interest that you are paying. It is beneficial to them.
• If the company then issues a dividend on the stock, then as a borrower you forfeit that dividend. The broker makes it appear like the real stockholder still owns the stock and receives it.
• If the stock depreciates in value, then you can unwind your trade or cover your short by purchasing a share at the lower price and returning that to the broker.

Shorting stock 2

• When you buy a stock, your potential loss is at most the stock price. When you short a stock, your potential loss is unbounded.

Is short selling bad?

• People who short create extra supply for the stock, which lowers the price at which the stock is borrowed, because you have more aggregate sellers.
• When the short is covered, you have more aggregate buyers at the point where it is covered, which raises the price at which it is covered.
• A short seller therefore reduces the volatility of the stock by reducing peaks and raising the trophs of a curve with no short sellers present, which is good for everybody.
• Management has the best incentive to be positive of a stock. They are shareholders and have the best transparency and are compensated based on how the stock does.
• Sell-side analysts work for brokerages and investment banks who publish reports with buy ratings. They work for the people who offer securities or financial services.
• Bankers, government, and rating agencies are all in the positive camp and benefit when stocks continue to go up beyond where they should go up.
• Only the short sellers have the sophistication, the time, and the monetary incentive to scrutinize what management is doing. They are on society's side in keeping management in check.

Understanding company statements and capital structure

Gross and operating profit

• Revenue minus the cost of goods sold equals gross profit. It's called gross profit because it's the profit that we think of from selling an incremental unit.
• The gross profit minus expenses like rent, salaries, debt and amortization, and so on leaves you with the operating profit. It tells how much profit is coming from the business. You subtract items relating to business operations.
• Subtracting interest expense from operating profit leaves you pre-tax income. Subtracting taxes from that leaves you net income.

Basic capital structure differences

• The capital sturcture of your business affects everything after your operating profit. It answers how the company is funding its assets.

Market capitalization

• A publicly traded company simply means that its shares are traded on some exchange, such as the NYSE or NASDAQ.
• The market capitalization specifies what the market thinks the owner equity of a company is worth. It's different from the number on the books.

Market value of assets

• When the market values a company more than its books, then the intangibles represent the difference, such as management expertise, location, and so on.

Bonds

Corporate debt versus traditional mortgages

• With a mortgage, the bank determines a fixed payment that you pay every month. It won't change over the course of the mortgage. Some part is interest, and some is principal, or paying down the debt on the mortgage.
• With each new fixed payment, you're paying less interest because you've paid off more of the principal. And consequently you're paying off more of the principal.
• Corporate debt is usually interest only debt. The company pays interest on every payment, and on the last payment they also repay the full amount of the principal.
• If the company cannot pay back the principal at this time, it can take out a new loan for the same amount and use that to pay the principal of the previous loan.

Introduction to bonds

• A bond is a way to parcipate in lending to a company.
• For a company to raise money, they can either issue new shares and collect the price per share on each share to raise money. This is financing via equity.
• If a company instead borrows money, it does not get a cut of the profits. Instead they are paid interest on the money that was lended, before shareholders get any profits at all.
• If the company does well, then shareholders benefit but not bond holders. But if the company does poorly, then shareholders suffer while bond holders remain secure.
• The interest on a bond is called the annual coupon because the first bonds that were issued had coupons that could be redeemed for interest.
• Coupons are generally paid semi-annually, or every six months.

Introduction to the yield curve

• When most people talk about the yield curve, they are talking about the risk free yield curve, or the yield curve for treasuries.
• Treasury bills, notes, and bonds are simply loans to the federal government. They are considered risk free, because if the government is low on cash they it raise taxes to pay you back.
• T-bills, T-notes, and T-bonds are all loans to the government, but for different amounts of time.
• Lending money for shorter amounts of time has less risk, because only so much can happen in a short amount of time.
• The interest rate is an annualized interest rate. On a 1-month T-bill, it is the interest aggregate interest accrued if you made the loan over 12 consecutive months.
• The yield curve simply plots the annualized interest rate over different amounts of time.
• When the government needs to borrow money, it declares how much it needs to borrow over what amount of time, and they have an auction where investors from the world participate. The demand at the auction determines the rate.
• If a lot of people want to buy the treasury, then there is a lot of demand relative to the supply, and so the government has to pay a lower interest rate.

Relationship between bond prices and interest rates

• If interest rates go up, then the price of bonds goes down, which is also known as trading at a discount to the par.
• This is because if the bond were reissued, then someone would expect a higher coupon value, commensurate with what you could get on the open market.
• Similarly, if interest rates go down, then the coupon value of the bond is therefore exceptional, and the bond is worth more. We also say that it trades at a premium to par.

Treasury bond prices and yields

• When the price of a treasury security goes up, the yield or interest that you get on your loan goes down. You receive the same amount back, but lend more money.
• The price of a treasury goes up when there is more demand to buy them.

Annual interest varying with debt maturity

• In a short amount of time, there is less of a chance of something catastrophic happening, and more predictability of the world. Therefore money lent for shorter times have lower interest rates.

The yield curve

• When people talk about the yield curve, they are talking about the plot for the United States Treasury bills and bonds in dollars.

Investment vehicles, insurance, and retirement

Mutual funds and ETFs

Open-ended mutual fund (part 1)

• With a mutual fund, there is a corporation and its management company, both registered with the SEC.
• The corporation can issue more shares and grow its assets under management, or AUM; the management company takes a percentage on the order of 1%.
• The management company is a mutual fund, and so it can both market itself and solicit funds from the public.
• With open-ended mutual funds, the public can buy shares to grow the AUM.
• If the management grows the company valuation, then that added wealth is distributed among all the shares, minus the management fee.

Open-end mutual fund redemptions (part 2)

• The valuation of the corporation is called its net asset value, or NAV. The share price is the NAV per share.
• At the end of the day shares can be added or removed from the fund; this is done at the NAV per share.
• When a client redeems a share from the company, the management company buys back the share and therefore cancels the share.
• An open-ended fund means at the end of the day it can add or remove investors, and the fund can keep growing and shrinking.
• Because of this constant buying and selling with the public, management cannot have their money invested in relatively illiquid assets.
• Therefore investors must keep 3-5% of the AUM in cash for buying back shares, but they are not getting return on cash.

Closed-end mutual funds

• With a closed-end mutual fund, initial investors are found, and then the share structure is locked and the fund is closed.
• After the fund is closed, shares cannot be created or canceled.
• There is no need to market the fund after the fund is closed, since it cannot take on new investors.
• If you are an investor and need your money back, then you cannot redeem your share; you must instead sell it to someone else.
• This is what happens with any company. When you buy or sell a stock of IBM, you do not transact with IBM, but from someone else in the secondary market.
• The disadvantage to the fund manager is that it's much less flexible in terms of growing and shrinking the fund.
• The advantage is that he doesn't need to keep cash around in case the shareholders want to redeem their shares.

Exchange traded funds (ETFs)

• An ETF combines both the dynamic growth of open-ended mutual funds and the trade on an open market of closed-ended mutual funds.
• In an ETF, only approved, large institutions can go to the fund and buy or redeem a large block of shares.
• This is good for the fund because the lack of small transaction saves them cost on overhead.
• These large institutions then go and trade the shares on the open market.
• ETFs have lower fees because they don't have to do back-and-forth with each individual investor.
• Moreover they are not actively managed; instead they simply buy some market or some asset class or commodity, such as the S&P 500 or gold.

Ponzi scheme

• In a Ponzi scheme, investors are not having their money invested.
• Whoever is running the scheme sends statements to investors showing that their investment is actually growing.
• Because of this perceived success, new investors will join.
• When the first investor leaves and withdraws his perceived value, the positive difference is covered by the investments from the other investors. Such a withdrawl only legitimizes the scheme.
• A ponzi scheme collapses if all the investors get scared and there are mass withdrawls.

Retirement accounts: IRAs and 401ks

Traditional IRAs

• In a traditional IRA, income that you contribute is not taxed. If you did not have an IRA, what you could have contributed would be taxed.
• You pay a penalty and taxes if you withdraw from your IRA before age 59.5. Otherwise you can buy and sell securities within the IRA without being penalized.
• Capital gains are gains made from capital investments. Profit from an investment within an IRA are not subject to capital gains.
• When you are 60 or over, you can withdraw without paying a penalty, but you must pay taxes. But you're likely earning less money, and so the tax bracket you're in will be lower.

Roth IRAs

• A Roth IRA will tax you on contributions, but will not tax you on withdrawl. Like a traditional IRA, earnings are not taxed in the account.
• Early withdrawl from a traditional IRA incurs a 10% penalty and taxes, whereas there is no taxes or penalty if you withdrawl the principal amount from a Roth IRA. You only pay 10% penalty and taxes on earnings.
• With a Roth IRA, when you withdraw over 59.5, you get your money regardless of your tax bracket.
• With a traditional IRA, you pay taxes at the end not only on what you put in, but on all of your earnings. With a Roth IRA, you pay taxes only on what you put in.
• At age 70.5, you are forced to withdraw from a traditional IRA, whereas there is no age limit on a Roth IRA.

401(k)s

• A 401k is very similar to a traditional IRA in that you put pre-tax money in, and you can withdraw after age 59.5, whereupon you will pay income tax.
• Again, this is advantageous if you are in a high tax bracket when making money, and in a low tax bracket when withdrawing money after age 59.5.
• 401k accounts have a higher limit for contributing annually.
• 401k accounts are also organized by your current employer, who may specify potential investments and run the fund, and also match your contributions.
• You can also borrow from the 401k without penalty, although you must pay interest to the 401k.
• A traditional IRA gives you much more flexibility on where you want to invest; a company may structure a 401k so that you can only invest in that company's stock.

Hedge funds

Hedge funds intro

• Hedge funds are not regulated by the SEC, and so they cannot market themselves, and they cannot take money from the public.
• To invest in one, you must be an accredited investor, which means you must have a certain net worth, a certain income, or a certain level of sophistication by virtue of your education.
• In a mutual fund, managers get a percentage of assets. Therefore they market it so that it is large. They do not get a cut of the profits.
• A hedge fund is more actively managed, and so fees are 1 to 2%, and management gets a cut of the profits, on the order of 20%.

Hedge fund structure and fees

• The hedge fund takes a traditional management fee, as well as a percentage of the profits.
• Hedge funds tend to be open-end funds, where at certain points investors can either add more funds or redeem their funds.

Are hedge funds bad?

• Because managers take a cut of the profits but aren't on the line for a percentage of the losses, they may take disproportionate levels of risk.
• To mitigate this, it is expected that the manager has some of their own money invested in the fund, or skin in the game.
• It is in the best interest of the limited partners, who are assumed to be sophisticated investors, to ensure this.
• Note that getting a percentage of the upside but having limited downside is not unique to hedge fund managers.
• Hedge funds are also secretive with their investments. They must reveal something, however, so that they attract investors.
• Secrecy stops others from trading against the fund, making the same investments, or go ahead of the fund and try to buy the same assets.
• Hedge funds become dangerous when they control so much in notional funds that they become too big to fail, or failure hurts not just investors but all of society.
• When something is too big to fail, then people don't let it fail, which goes against everything that we know about capitalism.

Hedge funds, venture capital, and private equity

• A hedge fund can put the invested money to work immediately because it invests in fairly liquid assets.
• A venture capital firm will have to look at business plans and entrepreneurs.
• Similarly, a private equity firm will have to look for companies in which they might want to buy private equity.
• Venture capital and private equity will base their management fee on what was committed.
• But unlike a hedge fund, they invest slowly, making a capital call to collect the committed money for their investments as needed.

Hedge fund strategies: Long short 1

• You may be confident in picking companies that outperform or under-perform the market, but have no confidence in your ability to predict the market.
• In this case, a risk is that you want to buy a company but the market goes down, or that you want to short a company but the market goes up.

Hedge fund strategies: Long short 2

• A long short hedge is when, in equal amounts, you buy shares of companies that you think will do well, and short shares of companies that you think will do poorly.
• If the market goes up, both share prices go up, but the company you thought would do well goes up more.
• Your profit from buying the company that you thought would do well covers the loss from the company that you thought would do poorly.
• If the market goes down, both share prices go down, but the company you thought would do poorly goes down more.
• Your profit from shorting the company that you thought would do poorly covers the loss from the company that you thought would do well.

Hedge fund strategies: Merger arbitrage

• When a company announces that it wants to acquire another company at a higher share price, that other company's stock price usually jumps up.
• Typically it jumps to somewhere between the current price and the higher share price.
• If the acquisition happens, the share price should ascend to the higher share price.
• If the acquisition falls through, the share price should descend to the original share price.
• Merger arbitrage is when you buy if you expect the merger to happen, or short if you expect the merger to fall through.

Options, swaps, futures, MBSs, CDOs, and other derivatives

Put and call options

American call options

• An call option allows you to buy a stock at a certain price; these are sold by options exchanges.
• An American option can be exercised between now and some expiration date; a European option can be exercised only on that date.
• Buying an option allows you to put less capital at risk, in return for less upside.
• If the stock price drops below the option price, the option is "out of the money," and you just won't exercise the option.

American put options

• A put option allows you to sell a stock at a certain price; these are sold by options exchanges.
• Unlike traditional shorting of stock, if the stock goes up you are not required to buy it back; you simply let the option expire.

Call option as leverage

• After buying a stock, the potential upside you can gain is unlimited, while the most you can lose is 100%.
• When you buy an option, the potential gain or potential loss is measured against the cost of the option itself.
• Your potential gain is higher because the option price is smaller than the stock price, but your potential loss is 100% if you don't exercise the option.
• This is financial leverage, where leverage is using a tool to exert more force than you otherwise could.

Put vs. short and leverage

• Typically when you borrow a share for shorting, you have to put at least 50% of the value of the short as capital up front.
• After you short a stock, your gain is measured against the capital that you had up front.

Call payoff diagram

• You can either graph the value at expiration versus the underlying stock price, or your profit/loss versus the underlying stock price.
• The former simply shows the value of the option; the latter incorporates the actual cost of it.

Put as insurance

• If you buy a share of stock and a put option at the same price, then any loss on the stock will be covered by the gain on the put option.
• When people talk about buying insurance on a position, they typically talk about buying such a put option.

Put-call parity

• The value of a bond is constant at the date of expiration; its value can cover any loss on a call option with the same price.
• The value of the call option plus the bond equals the value of the stock plus the put option. This is called put-call parity.

Arbitrage basics

• Arbitrage just means taking advantage of difference in price on essentially the same thing to make a risk-free profit.
• This requires buying from a cheaper source and selling at a more expensive source.
• This increases demand at the cheaper source and supply at the more expensive source, and therefore the prices will approach one another.

Put-call parity arbitrage I

• In the put-call parity scenario, you buy the cheaper side and sell the more expensive side. The difference is your risk-free profit.

Option expiration and price

• Options that expire farther in the future cost more, because you get to retain the option for longer.
• If the stock does well, then you capture more of the upside with a further expiration date.
• If the stock does poorly, then you increase your chances of the stock once again become in the money with a further expiration date.
• If the stock is doing well, do not exercise your option, but instead sell it to capture whatever value the buyer sees in the future optionality.