Equities

Companies need cash to operate or finance new projects. They can choose to raise capital by issuing equity. To compensate stockholders for not receiving interest that they might have received with other investments, companies usually pay them dividends. Dividends can vary over time depending on the company’s performance. Dividends can be expressed as discrete dividends or as a continuous equivalent dividend yield q.

 

If an investor believes a stock price is going to decrease over time. He would then be interested in having a short position in this stock. If he doesn’t hold the stock, he can enter into a repurchase agreement or repo.

 

A repo is a transaction in which the investor borrows the stock from a counterparty that holds the stock and agrees to give it back at a specific date in the future. Repos allow the investor to hold the stock and sell it short immediately in the belief that he can buy it back later in the market at a cheaper price and return it to the lending counterparty. Repos play a large role as speculative instruments. It is interesting to note that stock lenders are people who are just not planning to trade in it. They could be investors that own the stock in order to take control of the company, and repos offer them the advantage to earn an added income paid by the borrowers. The rate of interest used is called the repo rate or borrowing cost.

 

When trading stock, an investor should also be cautious with liquidity that can be quantified by looking at the average daily traded volume. For a stock to be considered liquid, one should be able to buy or sell it without moving its price in the market. Take the scenario where an investor wants to sell a large position in stocks. If the stock is not liquid enough, it is possible that the investor wouldn’t find a buyer at the right time and would not be able to make a profit from his investment. Liquidity is correlated to the stock price. If the latter is too high or too low, the liquidity of the stock suffers.

 

Let us now analyse the forward price of a stock, which is defined as the fair value of the stock at a specific point of time in the future. The forward price of a stock can be viewed as equal to the spot price plus the cost of carrying it.

 

Interest rate increases the cost of carry since the interest that might be received by the stockholder if he had immediately sold his shares and invested his money in a risk-free investment.

--> IR increases the forward

 

If a stock provides an additional income to the stockholder, this causes the cost of carry to decrease, since the stock also becomes a source of profit. Dividends and stock loans (repos) constitute a source of income when carrying a stock.

--> Dividend yield and repo decrease the forward

 

F0(T ) = S0 × e(rqb

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