FIN 327 Final - Lachance

Covered Call

"profit strategy" -long on the stock, write a call option / essentially pocket the premium and can -Sell a call with exercise price 𝑋 on a security that already own -If stock prices don't move too much: capture time decay -income strategy = if stock falls below a value, you still collect the premium, if the stock goes up, you lose the ability to gain more money

Delta (Hedge Ratio)

"the change in price of an option for a $1 increase in stock price" -call option has a positive delta, put option has a negative delta -call option delta is between 0 and 1 , put option delta is between -1 and 0 -At-the-money call options have deltas around 0.5 and at-the-money put options have deltas around -0.5

Spot Futures Parity Theorem**

"the futures price is simply the spot price accrued with interest" Current level x (1 + risk free - dividend yield) ex: The current level of the S&P 500 index is 2,000. The dividend yield on the S&P 500 is 2%. The risk-free rate is 1%. What should a futures contract with a one-year maturity sell for? Answer: 2,000 x (1+1%-2%) = 1,980

Contract Sizes

*100 shares Ex: For example, if a call option is quoted for $2, you would pay $2 x 100 = $200 for the option. The payoffs are also multiplied by 100. If the exercise price is $80 and the stock price is $85, the payoff of the call option would be 100 x ($85 - $80) = $500. The profit would be $500-$200=$300.

Duration

*Other things being the same, bonds with higher coupons will have a shorter duration because the coupons have more weight. -One of the main strategies for an active bond portfolio manager is to predict how interest rates will move and adjust the duration of the portfolio in consequence: -Choose a longer duration if he thinks interest rates will decrease -Choose a shorter duration if he thinks interest rates will increase -Bond portfolio managers who want to adopt a more passive management approach would pick a duration that it close to the duration of their benchmark.

Spreads

-2 or more call/put options on on the same s tock with differing excercise prices or times -Money spread=purchase of one option and sale of another -Time Spread=sales and purchase of options with differing expiration dates -Reducing the cost of purchasing puts or calls -Sell options with different exercise prices (money spread) or with different maturities (time spread)

PEG Ratio**

-A PEG ratio is the P/E ratio divided by the forecasted growth rate (multiplied by 100). -Some analysts use a rule-of-thumb where fairly priced companies should have a PEG ratio around 1. (Not theoretically motivated.)

Liquidation Value

-A firm's liquidation value is the net amount that can be realized by selling the assets of a firm and paying off the debt. It provides a "floor" for the value of equity: If the market price of equity drops below the liquidation value of the firm, the firm becomes attractive as a takeover target. -This type of value is relevant for a corporate raider that considers taking over the firm and liquidating its assets. It can also be useful to analysts looking for potential takeover targets.

Forward Contract

-A forward contract is an arrangement calling for future delivery of an asset at an agreed-upon price. -Forward contracts have existed for hundreds of years. Think about a farmer who derives most of his income from selling his crop and worries about fluctuations in the price at which he can sell his crop. A forward arrangement allows him to lock in current prices for his crop.

Naked Options

-A strategy of buying or selling options by themselves is called "Naked options". These are basically purely leveraged strategies, a big bet on up or down price movements.

American vs. European

-An American option allows its holder to exercise the right to purchase (if a call) or sell (if a put) the underlying asset on or before the expiration date. -European options allow for exercise of the option **only on the expiration date**

Long Straddle

-Bet that prices are VOLATILE (no view on price direction) -Buy a put option and a call option with the same exercise price -Payoff is guaranteed to be positive. Profit can be negative after subtracting the options premiums

Regulation of Futures

-CFTC regulates the futures market -Sets capital requirements for member firms of the futures exchanges Authorizes trading in new contracts Oversees maintenance of daily trading records

Futures Contract Sizes

-Contract sizes vary ex: 250 for S&p, or 5000 bushels of corn -Very large contracts between 50,000-100,000 **e-mini SP500 comes in contract size of**50** Payoff example: *Price = 2,082.50 for the December 18, 2015 contract. *Multiplied by 50 *Value of the index ends up being $2,100 on December 18, 2015, the profit on the long position would be: 50 x ($2,100-$2,082.50) = $875

Credit Risk

-Corporate bonds (and other-than-U.S. Treasury bonds) are subject to credit risk or default risk - this is the risk that the issuer may not be able to make its coupon or principal payments -To compensate investors for default risk, issuers must offer a "spread" in yields over Treasuries. The spread is higher when the economy is worst. *Spreads increase when the economy is deteriorating and decrease when the economy is improving

Credit Default Swap

-Credit Default Swap (CDS) can be purchased to protect a bondholder against the default risk of an issuer. They can be viewed as insurance policies against default risk. -One would buy CDSs when default risk is expected to increase and sell them when default risk is expected to decrease -In 2008, AIG had sold more than $400 billion of CDS contracts, which led to its insolvency. They had to be rescued because of the potential domino effect (if they do not pay firms that count on their payments, then these firms may become insolvent).

Bond Structure

-Face value (or par value): Payment to bondholder at maturity of bond, typically $1,000. -Coupons: Periodic interest payments. The coupon rate is expressed as an annual rate per dollar of par value. Semi-annual coupons are most common. In that case, the semi-annual payments are equal to half of the annual coupon rate, times the par value. -A zero-coupon bond is a special case with no coupon payments, just a par value -Buy and hold strategy = hold until maturity

Free Cash Flow Model (FCF)**

-Free cash flows (which are cash flows available to the firm or the equityholders, net of capital expenditures) rather than dividends. -Start with EBIT less taxes -Undo some of the artificiality caused by accounting practices, e.g. by adding back depreciation -Deduct money that is not available because it is used for capital expenditures or to increase the net working capital (NWC) -Project cash flows for a few years, and then make an assumption for the terminal price of the stock (can be based on DDM or multiples-based)

Hedging

-Hedgers try to insulate themselves against price movements. Usually, hedgers are already exposed to a risk and they use futures to "neutralize" this risk EX: Farmer: Lock in a price for selling its crop. Airline company: Lock in the price of oil for future purchases. Multinational corporations: Eliminate variations in their offshore profits due to exchange rate risk

Index Arbitrage

-If the futures price is too high, you would sell the futures contract and buy the stocks in the index . -If the futures prices is too low, you would buy the futures and sell the stocks in the index.

Horizon Analysis

-If you are trying to predict your realized return by making assumptions about the rate at which coupons will be reinvested, this is called horizon analysis.

Variations of DDM

-Instead of projecting dividends for an infinite number of years, we can assume that the stock will be sold for a price 𝑃_𝐻 in 𝐻 years. -Constant growth model (CGM): Assume that dividends grow at a constant growth rate 𝑔 -Two-stage growth model: Assume that dividends grow at a constant rate 𝑔_1 for a number of years, and then at a rate 𝑔_2 afterwards.

Bond Ratings

-Investment grade bond: Rated BBB and above by S&P or Baa and above by Moody's. -Speculative grade or junk bond (these are called high-yield bonds now): Rated BB or lower by S&P, Ba or lower by Moody's, or unrated.

Clearinghouse

-Once a trade is agreed to, the long and short traders deal with a clearinghouse (instead of each other). -The clearinghouse becomes the seller of the contract for the long position and the buyer of the contract for the short position. -The clearinghouse is responsible for both sides of the transaction, if one party is not able to fulfill its obligations, it has to step in

Options vs Futures

-Options allow for leveraged investments (can be used for speculation, hedging, or synthetic -Differences = Options have asymmetric payoffs Options are more common than futures for individual stocks

PE Ratios & Forward Looking measures

-P/E ratios that are reported in financial media can use historical EPS (trailing 12 months EPS) or forecasted ones (using next year's forecasted EPS). -Forward-looking measures are often more appropriate beacause historical ones have a number of issues: *No P/E ratio when earnings are negative or available for less than a year . *Earnings are based on arbitrary accounting rules. *Firms can use earnings management to manipulate numbers. *Last year's earnings can be affected by one-time events that are unlikely to repeat in the future.

Other ratios analysts use

-Price-to-book -Price-to-cash-flow (can address concerns that earnings are manipulated by accounting practices) -Price-to-sales (useful for start-up firms with no earnings - can be affected by margins)

Ratios and time to get money back

-Ratios are a basis for rules-of-thumb, e.g. a P/E ratio of 15 can be interpreted as: "it takes 15 years to get back your investment if earnings don't change".

Options Clearinghouse

-Similarly to what we had with futures, there is a clearinghouse (the Options Clearing Corporation) that becomes the effective buyer of the option from the writer and the effective writer of the option to the buyer. "mediator"

Callable Bonds

-Some corporate bonds are callable. They may be repurchased by the issuer at: *a specified call price *during a call period.

Swaps

-Swaps are similar to futures, except that they involve a series of payments rather than a single payment. -For example, a swap arrangement could call for the exchange of a fixed interest rate of 6% for a variable interest rate (e.g. tied to LIBOR) for each of the next 7 years. The difference between the two interest rates would then be multiplied by the contract's notional principal, e.g. $1 million. *For example, if LIBOR turn out to be 8%, the company that pays the fixed rate would get $1,000,000 x (8%-6%) = $20,000.

Swap Dealers

-Swaps transactions are entered with a swap dealer, which is typically a bank. The dealer charges a spread for his services (see example on next slide), but must bear the risk that one of the counterparties defaults on its obligations.

Moneyness**

-The "moneyness" of an option describes whether immediate exercise of the option would be profitable at the money** = if the strike price is the same as the current spot price of the underlying security in the money** = in the money when the strike price is below the spot price. A put option is in the money when the strike price is above the spot price out of the money** = out of the money when the strike price is above the spot price of the underlying security. A put option is out of the money when the strike price is below the spot price The more an option is in-the-money, the more expensive it is. The more an option is out-of-the-money, the least expensive it is. Deep-out-of-the-money options are similar to lottery tickers.

Book Value

-The book value is the net worth of common equity according to a firm's balance sheet. This is obtained by subtracting a firm's liabilities from its assets. -Book values represent an accountant's view of the original cost of acquiring assets, with an adjustment for depreciation. -While financial analysts use information from financial statements, they are more interested in forward-looking measures of the firm's value.

Volatility

-The implied volatility of a stock is computed by asking which standard deviation (𝜎) would make the Black-Scholes equation price equal to market prices. -Example: Tesla (current price $218) vs. SPY (current price $188). The at-the-money call option for May 2014 is 15.5 vs 2.57 for SPY. The implied volatility is 69.4% for TSLA and 11.5% for SPY.

Market Value

-The prices per share that you see on stock exchanges do not reflect book values, they reflect *the market value of the shareholder's equity investment*, which is the difference between the current market value of assets and liabilities. -Market capitalization = price per share X the number of shares outstanding.

No arbitrage Argument

-This is a common approach in finance to determine the price of a derivatives contract. We ask: **Is there another combination of securities that gives us the same payoff 𝑆_𝑇−𝐹_0 at maturity?** If so, then both strategies must have the same price today. Otherwise, we could earn risk-free profits by buying the cheaper strategy and selling the more expensive one.

Discounted Cash Flow Valuation**

-With a discounted cash flow (DCF) approach, the analyst projects the cash flows of the firm and discounts them with a risk-adjusted discount rate 𝑘. -The book covers two types of DCF approaches: dividend discount models (DDM) and free cash flows (FCF) models.

Leverage Example

-With an initial margin of $4,758 on the e-mini S&P 500 contract, you can afford to enter 20 futures contracts by paying the margin of 20 x $4,758 = $95,160. -If you are correct and the index goes up by 1%, your payoff will be 20 x 50 x (2,080x(1.01)-2,080)=$20,800 -If you consider that your investment was the initial margin of $95,160, this is a return of $20,800/$95,160=21.9%

Dividend Discount Model** (DDM)

-With the Dividend Discount Model (DDM), the value of the stock is equal to the present value of the stock's future dividends, discounted at the market capitalization rate 𝑘. -For MATURE companies Dividend / (1+ market cap rate)

Zero Coupon Bond

-You have a zero-coupon bond with a par value of $1,000 that will mature in 5.5 years. If the appropriate annual discount rate is 6%, what should be the price of the bond today? = 1,000/(1.06)^5.5 = 725.80

Relative Valuation (valuation by comparables)

-analyst identifies companies similar to the one they are trying to value. They judge whether the stock is underpriced or overpriced by comparing standardized measures (e.g. P/E ratio) across companies.

Futures Contracts

-basically forward arrangements that: 1. Have been standardized (for size, quality, maturity) 2. Can be traded on exchanges 3. Standardization makes futures contracts highly liquid; transaction costs can be cheaper than for trading the underlying commodities directly.

Holding Period Return**

-compute the bond's total return =(Change in price + coupon payment) / Initial Price

Protected Put

-long stock, purchase a put (pay premium initially) -Protect your investment against downside risk -Combination of the underlying security and a put with exercise price 𝑋 -Similar to purchasing an insurance premium -Disadvantage: We are giving up the premium 𝑃 when the stock price does not drop below 𝑋 -Advantage: The protected put will not drop below a floor 𝑋−𝑃 when the stock underperforms If stock goes down, payoff of put option overcomes the premium

Treasury Inflation Protected Securities

-make payments that are tied to the Consumer Price Index -The par value increases by the rate of increase in the CPI -Since the coupon rate is multiplied by the par value, the coupons also increase with inflation -TIPS offer a fixed rate of return in real terms. They offer investors a true hedge against inflation: the more inflation increases, the more you receive in payments from the TIPS. For example, a TIPS has initially a par value of $1,000 and a coupon rate of 4%. If, after the first year, inflation is 2%, the par value increases to $1,000 x (1+2%) = $1,020 and the coupon payment (assuming annual coupons) is 4% x $1,020 = $40.80.

Fundamental Analysts & Intrinsic value (and time value)

-payoff that can be obtained from immediate exercise -Time value= call price - intrinsic value if intrinsic value > market price = BUY if intrinsic value < market price = SELL

Option Pricing

-proportional to current stock prices -For example, GOOGL is a relatively expensive stock at $546 vs. Citigroup at $48. The at-the-money call option for GOOGL for May 2014 is $13.25 vs. $1.14 for Citigroup. When buying options, there is usually a contract fee of $0.75 per contract in addition to the commission. For example, if you buy 10 contracts, that represents an additional $7.50 transaction cost on top of the commission

Margins

-requires option writers to post margin to guarantee that they can fulfill their contract obligation (unless they own the security). Margin calls are possible if the required margin exceeds the posted margin. -The option buyer does not need to post margin because after purchasing the option, no further money is at risk.

Bond Indenture

-the contract between the issuer and the bondholder. It specifies a set of restrictions (covenants) that protect the rights of the bondholders, e.g.: Sinking fund Subordination of further debt Dividend restrictions Collateral

Option Writer

-the party that sells the contract (takes the short position) is called the option writer

Yield to Maturity

-yield curve shows the YTM -Yield curves are generally upward sloping: The liquidity preference theory explains this by saying that investors want to be compensated for the greater risk and illiquidity of long-term bonds -inverse curve may be a sign of coming recession**

Margin Account

1. Initial margin: Buyer and seller must set cash aside (the initial margin) in a margin account. 2. Marking-to-market: The margin account is adjusted daily to reflect gains and losses. 3. Maintenance margin: If the balance of the margin account drops below the maintenance margin, a margin call will be issued and funds must be added. **typically around 5-15% of contract value

Bearish with Options (3 ways)

1. Short position on securities 2. Long position in puts 3. Short position in calls

Uses of Futures (3)

1. Speculation - bet on price direction 2. Synthetic - A combination of cash and futures can replicate the payoffs of an index 3. Hedging - Insure existing exposures against prices going up (for buyer) or down (for seller)

Notional Value

=current futures price times the contract size ex:if the e-mini S&P 500 index futures trades at 2,000 and has a contract size of 50, its notional value is 50 x $2,000 = $100,000

Bond Pricing**

BOND PRICES ARE INVERSELY RELATED TO INTEREST RATES *Interest rates decrease: Good for bond prices *Interest rates increase: Bad for bond prices

What are the 4 types of value?

Book Liquidation Intrinsic Market

Major futures exchange is the:

CME Group (electronic trading is on GLOBEX) -most trading today is on GLOBEX -can trade almost 24 hours a day

Call and Put Options

Call = gives its holder the right to PURCHASE an asset for a specified price, called the exercise or strike price, on or before some expiration date. *make money when prices go up* Put = gives its holder the right to sell an asset for a specified exercise price or strike price. *make money when prices go down* **Purchase price of an option is called a PREMIUM**

Current Yield**

Current yield = coupon payment / initial price

Constant Growth Model**

Dividend / (market cap rate - growth rate) Ex: You project a dividend of $4 next year for XYZ company. The risk-free rate is currently 1% and the expected market return 12%. Consulting Yahoo! Finance, you find that the beta of XYZ is 1.0. If you project a growth rate of 5% for XYZ, what is the value of the stock according to the CGM? 𝑘=1%+1.0×(12%−1%)=12.0% 𝑉_0=$4/(12%−5%)=$57.14

FCFF vs. FCFE

FCFF = Use all FCFs, Deduct the value of debt from the value of the FCFCs, Use WACC as a discount rate. FCFE = Deduct interest payments and add increase in net debt from the FCFFs. Use cost of equity as a discount rate.

Higher dividends, higher growth, higher risk

Higher dividends = higher value Higher growth = higher value Higher risk = lower value

Bond Quotes

Invoice Price = Flat price + Accrued Interest 𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡=(𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡)/2 ×(𝐷𝑎𝑦𝑠 𝑠𝑖𝑛𝑐𝑒 𝑙𝑎𝑠𝑡 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡)/(𝐷𝑎𝑦𝑠 𝑠𝑒𝑝𝑎𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠)

Payoffs (Long vs. Short)

LONG = Commits to purchasing the commodity on the delivery date (or maturity) for the futures price 𝐹_0. **We say that someone who takes the long position is BUYING the futures. SHORT = Commits to delivering the commodity on the delivery date ( or maturity) for the futures price 𝐹_0. **We say that someone who takes the short position is SELLING the futures.

Make Money (Long vs. Short)

LONG = make money when prices go up SHORT = make money when prices go down

Maximum losses with Puts & Calls

Maximum loss with a put = the premium Maximum loss with a call = UNLIMITED

High P/E Ratios Problems

PRO - Can reflect higher growth prospects for the firm CON - Can be a warning sign of overpricing (too much hype

Payoff before maturity: Reversing Trade

Payoff = Price when exited - price when entered Payoffs are multiplied by a contract size

Payoffs & Profits

Payoffs = always positive Profits = can be negative

Premium vs. Discount Bonds

Premium bonds: Bonds selling above par value Discount bonds: Bonds selling below par value

Interest Rate Risk

Short term bonds = least sensitive *If interest rates go down, they gain the least. If interest rates go up, they lose the least. Long term bonds = most sensitive *If interest rates go down, they gain the most. If interest rates go up, they lose the most.

Spot Price & Futures Price

Spot Price = Current price for immediate delivery Futures Price = Price for future delivery Convergence property = At maturity, the futures price and the spot price must converge

Price Earnings Multiple Valuation**

Stock value = Forecasted P/E Ratio X Forecasted earnings ex: forecast earnings per share (EPS) of $2.00 , P/E ratio of 15 , By how much does the price increases if he revises his EPS forecast to $2.50? > 15x2 = 30 / 15x2.50 = 37.50 > 7.50 increase

Bullish with Options (3 ways)

Take : 1. Long position in securities 2. Long position in calls 3. short position in puts

Volume vs. Open Interest

Volume = total number of contracts that have changed hands in a day open interest = Number of contracts outstanding. When contracts begin trading, open interest is zero. As time passes, open interest increases as more contracts are entered.

Program Trading

coordinated purchases or sales of entire portfolios of stocks.

DDM Continued

k = risk free + beta(expected return - risk free)