Week 1 Tutorial

Continuous v discrete compounding

Short selling
Definitions of arbitrage

Miscellaneous concepts

Starting in Lecture 3, then throughout this unit, there are a few

important concepts that you need to understand:
– The use of continuously-compounded interest rates,
– Short selling an asset, and
– The notion of arbitrage.

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Discrete v continuous interest rates

In many finance units, we recognise the so-called time value of

money in calculating present values and future values. Most
likely, you have done these calculations using discrete interest
rates.
– For example: if I invest $100 for 3 years and it earns discrete
interest of 10% pa, how much will it grow to?

FV  100 1.10   $133 .10.

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However, the study of derivatives tends to use continuously-

compounded interest rates:

FV  $100 e 0.103  $134 .99 .

Type: 0.1 × 3

Hit “=“ to get 0.30

Hit the red down

arrow then ex, to get
1.349859

Multiple by 100,
then hit “=“ to get
134.98588

It is essential that
students get
comfortable using
the ex button
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 Type: 100

Hit “shift” then ex

Type: 0.1 × 3

Hit “=“ to get

134.98588

Practice!

Do a few quick practice exercises to make sure you have this

under control at the beginning of the semester.

Make sure you can get the correct answers for each of these:
– Q: if you invest $200 for 5 years with continuously-compounded interest of
3% pa, how much does it grow to? A: $232.37
– Q: if you invest $1000 for 1 year with continuously-compounded interest of
8% pa, how much does it grow to? A: $1083.29
– Q: if you invest $600 for 9 months with continuously-compounded interest of
4% pa, how much does it grow to? A: $618.27 (nb: 9 months = 0.75 year)

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Discrete v continuous interest rates

Similarly, if we were discounting future cashflows to present

value:
– You will receive $500 two years from now. What is the present
value of this cashflow if the (discrete) discount rate is 8% pa:

500
PV   428 .67
1.08 2

If we used a continuously-compounded discount rate:

PV  500e 0.082  426 .07

Type: 0.08, hit the

negative button

Multiply by 2

Hit “=“ to get -0.16

Hit the red down

arrow then ex, to get
0.852144

Multiple by 500,
then hit “=“ to get
426.07

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 Type: 500

Hit “shift” then ex

Type: -0.08 × 2

Hit “=“ to get 426.07

Practice!

Make sure you can get the correct answers for each of these:
– Q: if the continuously-compounded interest rate is 5% pa, what is the
present value of $100 to be received in 3 years? A: $86.07
– Q: if the continuously-compounded interest rate is 2% pa, what is the
present value of $200 to be received in 10 years? A: $163.75
– Q: if the continuously-compounded interest rate is 10% pa, what is the
present value of $5000 to be received in 6 months? A: $4756.15

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 Notice the following:

– When we asked questions like “how much will an investment grow

to” (i.e., calculate a future value), the numbers in the exponent e^x
were positive. For example: 0.1 x 3
– However, when we took a future cashflow and discounted it back to
present value, we inserted a –ve symbol in the exponent. For
example: -0.08 x 2

You will make fewer errors this semester if you understand that
discounting calculations require a –ve symbol in the exponent.

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Discrete v continuous interest rates

The answers differ a little depending on whether we use discrete

or continuous compounding.

However, in BFF3751, you must be competent with continuous

compounding.

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Short selling

Short selling is a concept that confuses many students.

Everyone is familiar with taking a long position:
– Let’s say that you buy CBA shares for $82.
– They rise to $90 and you sell them.
– You have made an $8 profit,
– And this was possible by selling at a higher price than that at which you
purchased.

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Short selling

The concept of short selling is similar:

– You make money by selling at a higher price than that at which you
purchased,
– But the weird aspect is that the ordering of the trades is reversed.
That is, you first short sell CBA then you purchase it back.
For example:
– You short sell CBA when the price is $82.
– CBA share price falls to say $77 so you close-out your short by
purchasing CBA shares on the market.
– The $5 profit still comes from selling high and buying low, but the
first trade we made was a short, then we closed out with a long.

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Short selling

Short selling involves selling an asset which you don't actually

own:
– Imagine ‘borrowing’ an asset from someone,
– then straight away selling it at its current market price. This raises
money for you today.
After short selling, you have a obligation to settle this short sale
by ‘returning’ the asset to its original owner at some point in the
future. To effect this settlement:
– you will have to go into the market (at some point in the future) and
buy the asset at whatever its price is at that time.
– You then give the asset back to the original owner.

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Establishing the short position

Someone who owns the stock

and is willing to lend the shares

Short seller borrows the

shares from the original owner
(and pays a fee)

Short Seller

Short seller then sells the

shares in the stock market and
receives their market value $82

Stock market

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Closing-out the short position

Someone who owns the stock

and is willing to lend the shares

Short seller settles the short

sale by returning the shares
to the original owner

Short Seller

Short seller buys the shares in

the stock market for $77

Stock market

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Short selling

Naturally, people short sell when they expect the price to fall.

The concept of short selling is used in Lecture 3 (and

elsewhere) when we consider pricing derivative securities.

nb: don’t confuse short selling with things like:

– Short forward contract
– Short futures contract
– Short option contract

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Short selling

Moodle site has a handful of newspaper clippings relating to

huge short selling of banking stocks ahead of the recent royal
commission into Australian banks:
– The feeling was that the royal commission would make strong
recommendations that would hurt the banks (and their profitability).
– Many investors (especially hedge funds) entered short positions on the Big
four banks over the days prior to the report release (approx. $5bn).
– These ‘bets’ would have made a lot of money if the banking stocks fell.
– However, the report’s recommendations (released 4 Feb-2019) were
nowhere near as painful for banks as was expected.
– On Tuesday 5 Feb-2019, banking stocks soared (Westpac 7.4%,
Commonwealth 4.9%, ANZ 6.1%, NAB 5.2%).
– Those with short positions in the banks got ‘squeezed’. As bank prices rose,
these short positions started making big losses. The short sellers scrambled
to buy bank shares (to cover their short positions) before losses got too
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high.

Informative newspaper clippings

“Short sellers target banks as royal commission looms”, Sydney

Morning Herald, 1 Feb-2019.
“Bank short sellers feeling $5bn worth of Hayne pain”, Sydney
Morning Herald, 5 Feb-2019.
“Hedge funds sell and short banks ahead of banking royal
commission final report”, Sydney Morning Herald, 6 Feb-2019.
“Short selling is harder than you think”, Hugh Dive, 18 Apr-2018.
“Why the market needs short sellers and how investors can
profit from them”, Michael McCarthy, 11 Sep-2018.
“Short seller reveals secrets of a reliable bet”, Sydney Morning
Herald, 28 Oct-2019.

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 21

Short selling: GameStop

GameStop (GME) operates many physical stores located in

shopping malls, selling video games.
Their fundamentals were poor and they had not made a profit for
years.
Many investors believed GME would go the way of Blockbuster
videos.
But, curiously, GME had risen from around $4 in Jul-2020 to $18
in Dec-2020.
Nevertheless, there was a lot of negative sentiment about GME.
Short sellers believed GME would go down and had taken huge
bets on this happening.

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Short selling: GameStop

In early 2021, it became known that short sellers had taken

huge short positions in GME.
Via the WallStreetBets forum on Reddit, small-time investors
conspired to purchase (i.e., go long) on GME and importantly
agreed to not sell their stock.
This resulted in a “short squeeze”:
– The short sellers, who had been waiting/hoping for GME to fall, were now
under big pressure to buy GME stock to settle/close their obligations.
– And if the people with long GME positions are not willing to sell their stock,
the short sellers are in trouble!
– Short sellers would have to bid higher and higher prices to try to tempt
someone to sell.

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Short selling: GameStop

As a result of the short squeeze, GME went from around $18 on

4 Jan-2021 to $350 on 27 Jan-2021.
Short sellers had little option but to pay whatever price was
necessary to settle their short positions.
This meant they ended up paying (i.e., going long) at much
higher prices than they initially shorted at. Rather than “buy low
sell high” they “sold low and bought high”.
In particular, Melvin Capital had huge short positions on GME
and lost billions of dollars when they closed out.
Conversely, some of the investors involved in WallStreetBets
made hugh amounts of money.

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Short selling: GameStop

However, a situation like this cannot last:

– Sooner or later, those who had bought GME (i.e., held long positions) would
have to sell their stock in order to capitalise their profits.
– Once they started selling, GME price started falling.
– This prompted more and more long positions to start liquidating, therefore
accelerating the price drop. It was like a dam wall bursting.

By 18 Feb-2021, GME had gone right back down to $40.

There would have been lots of WallStreetBets investors who
bought (i.e., went long) at maybe $100 or $200 or $300, who
suddenly found themselves with GME stock worth only $40.

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Informative newspaper clippings

“What happened with GameStop, explained” by Hunter Morrison

(www.uwfvoyager.com)
“GameStop has surged thanks to enthusiastic WallStreetBets Reddit
user”, Paul Donoughue and David Chau (www.abc.net.news.au), 28
Jan-2021.
“6 lessons from the Gamestop saga” by Damien Klassen
(www.australianfintech.com.au) 9 Feb-2021.
“The GameStop stock situation isn’t about populism, it’s about whether
the market is real”, The Washington Post , 2 Feb-2021.
“Here’s the GameStop stock situation explaine din the most simple way
possible” by Shannon Grixti (www.press-start.com.au), 29 Jan-2021.
“Painful lessons: The GameStop revolt by the masses will be short
lived”, Sydney Morning Herald, 4 Feb-2021.

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“GameStop explained”, The Weekly (ch10)

This 3-minute explanation of GameStop and short selling is

hilarious. Although I am not sure her example of “short selling”
Clive is strictly correct 
https://www.youtube.com/watch?v=p3xj0EJ8fxk

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Definitions of arbitrage

There are different ways to think about what constitutes

arbitrage, but they are essentially the same idea.

– If two trading strategies always result in identical payoffs in the

future, then they must have the same cost today. Else arbitrage
opportunity.
– A trading strategy that produces a fixed/certain/known outcome is
essentially riskless and therefore must earn the riskless rate of
interest. Else arbitrage opportunity.
– If a trading strategy costs nothing to establish, its payoff in the
future must also be nothing. Else arbitrage opportunity.

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