Introduction to Corporate Finance

ParT 2: ValuaTION, rISk aNd reTurN

long position in ordinary shares and bonds.^8 A payoff diagram shows the total value of a security (in this

case, one ordinary share or one bond) on a specific future date on the y-axis, and the value of a share on

that same date on the x-axis. In Figure 8.4, the payoff diagram from holding a share is a 45-degree line

emanating from the origin because both axes of the graph are plotting the same thing – the value of the

share on a future date.^9

8 In Figure 8.4, we do not plot the net payoff, meaning that the diagram ignores the initial cost of buying shares or bonds, or the revenue

obtained from shorting them.

9 Figure 8.4 also shows the payoff diagram for a short position in shares, and as always, it is just the opposite of the long payoff diagram.

When investors short sell shares, they borrow shares from other investors, promising to return the shares at a future date. Short selling

therefore creates a liability. The magnitude of that liability is just the price of the shares that the short seller must return on a future date.

0 20 40 60

20

40

60

0

Share price on expiration date ($)

Long share payoff ($)

–60

–40

–20

0 20 40 60

Share price on expiration date ($)

Short share payoff ($)

0

–100

–50

–75

–25

0 20 40 60

Share price on expiration date ($)

Short bond payoff ($)

0

0 20 40 60

25

75

50

100

0

Share price on expiration date ($)

Long bond payoff ($)

FIGure 8.4 PAYOFF DIAGRAMS FOR SHARES AND BONDS

The graphs show the payoff for long (upper-left) and short (upper-right) positions in ordinary shares and in risk-free, zero-coupon bonds (lower-left for long

bond position, lower-right for short bond position). The payoff diagram for shares is a 45-degree line (upward-sloping for the buyer and downward-sloping

for the seller) because the payoff of the shares simply equals the price of the shares. Similarly, the bond payoff lines are horizontal because the bond pays

$75 to the buyer (or requires the seller to pay $75) with certainty. The bond’s payoff is not affected by changes in the share price.