BF Summary

8/12/2019 BF Summary

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BF Lecture 1Introduction to Business Finance and Financial Mathematics I

The Market value of the firm

Firm value is the present value of future expected cash flows

BF Lecture 2Introduction to Business Finance and Financial Mathematics II

Valuing Ordinary Annuities

An ordinary annuityis a series of equal, periodic cash flows occurring at the end of each periodandlasting for n periods

Ordinary annuities can be valued as the difference between an ordinary perpetuity and a deferred

perpetuity

The future value of an ordinary annuity can then be obtained by computing the future value of the

above present value at time period n

A deferred ordinary annuityis a series of equal, periodic cash flows occurring at the end of each

periodwhere the first cash flow occurs at a future date

Valuing Annuities Due

An annuity dueis a series of equal, periodic cash flows occurring at the beginning of each period

The beginning of period t is the same as the end of period t-1. So, the overall effect is to move the

annuity back one period on our standard (end of period ) time line


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The present valueof an annuity due at r% p.a. is equivalent to the present value of an ordinary

annuity compounded one additional period

The future valueof an annuity due at r% p.a. is equivalent to compounding by one additional periodthe future value of an ordinary annuity

BF Lecture 3- Valuation of Debt Securities

Short term debt instruments

- Mature within the year- Issuer has contractual obligation to make promised paymennts

Face (or par) value

- It is the dollar amount paid at maturityNo other payments made to debt holders

- Return earned by investors is based on the difference between the price paid and face valueLong term debt instruments

- Typically mature after several years- May or may not promise a regular interest payment- Issuer has contractual obligation to make all promised payments

Face (or par) value

- It is the dollar amount paid at maturityCoupon rate

- The interest rate promised by the issuer, expressed as a percentage of the face valueInterest payment

- It is the periodic payment made to debt holders- Coupon payment = coupon rate x face value

Bank accepted Bills

- Short term debt instruments where the acceptor of the bill is a bank, the bank promises to paythe holder the face value of the bill at maturity

Valuing Discount Securities


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- The price of discount securities is computed as the present value of the face value at a marketdetermined yield to maturity

- The yield to maturity is the rate of return earned by an investor who holds the security until itmatures assuming no default on the security

- Market yields are always quoted on an annual basis.-- When YTM = coupon rate, Price = Face Value- Bond is selling at par- When YTM < Coupon rate; Price > Face Value- Bond is selling at a premium- When YTM >Coupon rate; Price < Face Value- Bond is selling at a discount

BF Lecture 4Valuation of Equity Securities

BF Lecture 5

Risk and Return

BF Lecture 6Modern Portfolio Theory I

BF Lecture 7Modern Portfolio Theory II

BF Lecture 8Modern Portfolio Theory III

BF Lecture 9Asset Pricing Models I

BF Lecture 10Asset Pricing Models II

BF Lecture 11Asset Pricing Models III

Multifactor Asset Pricing Models

What determines the returns on a firm over a given time?

The return can be thought of as consisting of two parts.

1. The expected return component which depends on all the information available on thesecurity

2. The unexpected return component which is due to unexpected news announcements

The unexpected component is the true risk to any investment

Announcements about changes in interest rates, inflation rates, exchange rates, GDP, etc have

implications for nearly all firms and represent systematicrisks

Announcements about the appointment/registration of a new CEO, a new product, etc are firm-

specific and represent unsystematicrisks


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Systematic risks are very likely to be related to each other and influence security returns

The influence of systematic risks can be captured by beta coefficients

If the return of a security increases with increased economic growth then its economic growthbeta will be positive

If the return of a security decreases with increased inflation then its inflation beta will benegative

If the return of a security is unchanged with increased interest rates then its interest rate betawill be zero

The Arbitrage Pricing Theory

Capital markets are competitive Investors prefer more wealth to less wealth The return generating process for security returns is an N-factor model APT uses fewer assumptions and is also more flexible than the CAPM

- Returns depend on several factors, not just one factor- There is no special role for the market portfolio- There is no requirements for security returns to be jointly normally distributed- No restrictions on investor preferences

The APT uses arbitrage arguments to relate the observed return on any asset j to a number offactors


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Problems with the APT

The APT does not specify

The number of factors Precisely what these factors might be Specify the sign or magnitude of the factor prices in the pricing relation

Using the market data, researchers have identified (at least) four risk factors as being priced by the

market

Unanticipated changes in the inflation rate Unanticipated changes in industrial production Unanticipated changes in default risk premium on securities Unanticipated changes in the term structure of interest rates

Other Asset Pricing Models

The Fama and French (1993) three-factoor model

It is in the vein of the multifactor models but originated from an analysis of empirical data and

not economic theory

- The first term is the CAPM market factor-

The second term is the returns on diversified portfoliosof small market cap stocksminus big market cap stocks (SMB)


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- The third term is the terms on diversified portfolios of high-book-to-market stocksminus low book-to-market stocks (HML)

- High (low) book-to-market stocks tend to be value (growth) stocksThe Carhart (1997) four-factor model adds a momentum factor

- The forth term is the returns on diversified portfolios of high previous 12-monthreturn minuslow previous 12-month return (UMD)

- Stocks with highest return continue to outperform stocks with lowest return in the nextperiod

BF Lecture 12Capital Market Efficiency

Concept of Capital Market Efficiency

A market is informationally efficientif prices instantaneously and unbiasedly reflect all available,

relevant information

An instantaneous price reaction- Any unexpected news is fully reflected in the price by the time of the next trade- Unexpected news arrives randomly and can be good or bad

An unbiased price reaction- An unbiased price reaction occurs when the market price neither overreacts nor

underreacts to new information in a systematic manner

Main Assumptions

A large number of profit-maximising participants who analyse and value securitiesindependently of each other

New information comes to the market in a random manner and the timing of newsannouncements is independent of each other

Market participants adjust their estimates of security prices rapidly to reflect theirinterpretation of the new information received

- Does not mean that market participants correctly adjust prices- Some market participants may over-adjust and others may under-adjust, but overall theprice adjustments will be unbiased

Securities are priced appropriately for their market risk Security prices react virtually instantaneously to any new information and reach a new

equilibrium before investors can exploit that information for abnormal profit or return

Market efficiency implies that abnormal profit or returns cannot be made consistently andafter taking into account all the costs associated with gathering and analysing information

The types of Capital Market Efficiency

Three forms of market-efficiency

1. Weak form


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2. Semi-strong form3. Strong form

For each type of market efficiency we need to

Define the classification

Explain how that type of efficiency may be tested Explain the implications of each type for investment purposes

Weak Form

Information on past prices is fully reflected in current prices Past prices cannot help investors earn returns in excess of what other investors are earning on

similar risk securities

The best predictor of tomorrows price is the price todaySemi-strong Form

All publicly available information is fully and instantaneously reflected in current marketprices

Past and currently available information is fully reflected in current market pricesStrong Form

All information, public and private, is fully reflected in prices The market does not neglect any relevant information Since all information is impounded in prices fully and instantaneously it will be useless in

predicting future prices Implications of strong form inefficiency: company insiders with inside information may

exploit their private information to earn excess or abnormal returns/profits

Market Analysis and Market Efficiency

The three broad categories of market analysts are..

Technical analysts Fundamental analysts Middle of the road analysts

Technical analystsbelieve in weak form inefficiency

It is possible to beat the market by trading on past price movements and trendsFundamental analystsbelieve in weak form efficiency

Earning abnormal returns or profits requires gathering and analysing information Forecasting the fundamentals better than other investors increases the chance of earning

abnormal returns or profits

Most empirical evidence indicates neither type of analysis has been effective in earning abnormal

returns consistently and after transaction costs


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Testing market efficiency typically involves using some model of asset prices

- Such tests are joint tests of market efficiency and the model- One can reject market efficiency if the asset pricing model is misspecified even if the

market is efficient

Weak Form Market Efficiency

- Typical studies analyse the random walk nature of prices- Filter Rules is used to analyse the profits from specific trading strategies of

buying/selling securities depending on how their prices change over time

- Buy a stock if prices rises- Evidence indicates that some small filter may work, but not after transactions costs

Semi-Strong Form Market Efficiency

- Event studiesare used to test semi-strong form efficiency- Studies analyse the markets response to new information- Identify an event which involves release of news- Unexpectedly high/low earnings, dividend announcements or initiations, share buybacks.

Etc

- In an efficient market, good news means an instantaneous upward price adjustment - Abnormal returns are estimated as the difference between observed returns at the

announcement of news and returns predicted by a model like the CAPM

-- Take the average of the abnormal returns across a sample of firms experiencing the same

event, and analyse these in event time

- We also examine the cumulated abnormal returns over some period before and after theevent day

- If markets are efficient in the semi-strong form..

-- If markets are efficient in the semi-strong form..- The cumulated abnormal returns will have no discernible trend before the event day and

following the event day

-

At the event day all the market reaction will be reflected in abnormal returns

Strong Form Market Efficiency

Trades by corporate insiders (US Market)- Insiders who are net purchases of their firms shares tend to earn abnormal returns on

their trades

- Others mimicking these trades can also earn abnormal returns- Abnormal returns mainly in the 1970s and 1980s- Some Australian evidence to indicate that directors time the market and earn abnormal

returns

Professional money managers of mutual funds and pension funds are not able to match theperformance of a simple buy and hold strategy after transaction costs


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Legal implications deter insiders from trading on private informationGlobal Financial crisis

Market strategist Jeremy Grantham has called the EMH responsible for the current financial crisis

because of its role in the chronic underestimation of the dangers of assetbubbles by financialexecutives and regulators

Author Justin Fox in The Myth of the Rational Market essentially says that investors and regulators

were swayed by the notion that market prices reflect all available information and felt little need to

look into and verify the true values of publicly traded securities, and so failed to detect an asset price

bubble

Market Efficiency and the GFC

What does the efficient markets hypothesis say?

What does the efficient markets hypothesis not say?

No one should act on information The market should have predicted the crisis The stock market should have known we were in an asset bubble The collapse of large financial institutions indicates the market is inefficient

Can we draw any lessons on market efficiency from the global financial crisis?

The EMH is just a theory There are limitations to the EMH as a theory of financial markets There are limitations to testing the EMH

BF Lecture 13Capital Budget I

Capital Budgeting Process

1. Generation of investment proposals2. Evaluation and selection of investment proposals3. Approval and control of capital expenditures4. Post-completion audit of investment projects

Methods of Project Evaluation

1. Net Present Value2. Internal Rate of Return3. Accounting rate of return4. Payback period

Net Present Value

- Computing the difference between the present value of the net cash flows from aninvestment and the initial investment outlay

-

All cash flows are discounted at the required rate of return which reflects the projectsrisk


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Projects net cash flows

- Identify the size and timing of incremental cash flowsas a result of the project- Net cash flows aftercorporate taxes need to be evaluated- Incremental cash flows are the cash flows earned by the firm if the project isundertaken

minuscash flows earned by the firm if the project is not undertaken

Internal Rate of Return

- The internal rate of return is the rate of return that is earned by the project over itseconomic life

- Set NPV equal to 0 and compute the internal rate of return (r)

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-No Internal Rate of Return

- In rare cases a project may not have an internal rate of return- The NPV of the project remains positive or negative no matter what discount rate is

applied to the cash flows

BF Lecture 14Capital Budget II

Comparing the IRR and NPV Methods

Independent projects are projects that can be evaluated on their own, that is, independently of each

other

- The decision to accept a project does not affect the decision to accept or reject otherprojects

- Assumes that there are enough funds for all potential independent projects beingconsidered

Decision rule for independent projects

- Invest in all positive NPV projectsMutually exclusive projects are projects where the acceptance of one project rules out the acceptance

of other projects

Decision rule for mutually exclusive projects

- Assuming the projects being considered are worth undertaking- Invest in the highest NPV project

Accounting Rate of Return

- A projects accounting rate of return is the average earnings generated by the project,after deducting depreciation and taxes, expressed as a percentage of the investment outlay

- ARR can be based on either the initial investment or the average value of the capitalinvested over the projects life


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Decision rule

- A project is acceptable if its ARR exceeds a pre-specified minimum rate of return- For mutually exclusive projects the project with the highest ARR is preferred

Problems with Accounting Rate of Return

Earnings are not net cash flows

- Earnings numbers are subject to the vagaries of the accounting choices made by managersTime value of money ignored

- A dollar of earnings tomorrow is regarded as equivalent to a dollar of earnings todayHurdle is arbitrary

- Subject to managerial discretion rather than market pricingARR tends to favour projects with shorter lives

- A small N would increase the numerator and hence the ARRPayback Period

- A projects payback period is the time it takes for the initial cash outlay on a project to berecovered from the net after-tax cash flows

Decision rule

- A project is acceptable if its payback period is less than a pre-specified maximumpayback period

- For mutually exclusive projects, the project with the shortest payback period is preferredBF Lecture 16Capital Budget III

Issues in Cash Flow Estimation

Timing of cash flows

- The exact timing of project cash flows can affect the valuation of a project-

The simplifying assumption used is that the net cash flows are received at the end of aperiod


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Financing charges

- Cash outflows relating to how the project is to be financed are not included in the analysis- The value of a project is independent of how it will be financed- The discount rate used represents the rate of return required by equity holders, debt holder

and other security holders- Financing costs are not used in the cash flows because that results in their being double

counted

Incremental cash flows

- Only cash flows that change if the project is accepted are relevant in evaluating a project- Cannibalization- Need to be careful with sunk costs and allocated costs

Sunk costs

- These costs are not included as they have been incurred in the past and will not beaffected by the projects acceptance or rejection

Allocated costs

- Overhead costs allocated by management to firms divisions- These costs do not vary with the decision and are usually ignored

Taxes and tax effects

- Taxes need to be included where they have an effect on the net cash flows generated by aproject

Taxes have three main effects on net cash flows

- Corporate income taxes- Depreciation tax shield- Taxed on disposal of assets

Corporate income tax

- Corporate taxes should be included as a cash outflow- After tax cash flow = before tax cash flow x (1-tc)

Depreciation tax savings or depreciation tax shield

- Depreciation itself is not an operating expense and is excluded from the net cash flows- It decreases the taxes payable due to the depreciation tax shield- Depreciation tax savings = tcx depreciation expense

Disposal or salvage value of assets

- The disposal or salvage value of assets needs to be taken into account after taxes- Taxes are payable when an asset is sold for more than its book value- There is a tax saving when an asset is sold for less than its book value as the loss can be

offset against taxable income


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- Book value = Acquisition costAccumulated depreciation- Gain (or loss) = Disposal valueBook value- Taxes payable of gain = t x Gain on sale- Tax saving on loss = t x Loss on sale

Inflation and Capital Budgeting

- For nominal cash flows use the nominal discount rate- For real cash flows use the real discount rate

From the Fisher relationship we have

Projects with different lives

- We assume that both projects are replicated with identical projects until they achieve acommon duration

- The constant chain of replacement assumption- Reasonable as long as there is no technological shift making it obsolete

The constant chain of replacement assumption can be applied using two different methods

- The lowest common multiple method- The perpetuity method- Both methods will give the same decision

Constant chain of replacement in perpetuity method

- Assumes that both projects are replicated forever- The chains of cash flows are of equal length because they are both of infinite length- Method is generally easier to use-

BF Lecture 17 - Capital Budget IV

Weighted Average Cost of Capital (WACC)

The weighted average cost of capital is the benchmark required rate of return used by a firm to

evaluate its investment opportunities

- It is the discount rate used to evaluate projects of similar risk to the firm- It takes into account how a firm finances its investments


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Under the classical tax system

- Interest on debt is tax deductible- Dividend have no tax effect for the firm

-The firm should accept all projects with an IRR greater than the cost of capital

The WACC cannot be used in the following situations.

- If the project alters the operational risk of the firm- If the project alters the financial risk of the firm by dramatically altering its capital

structure

BF Lecture 18Debt, Dividends and Taxes I


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Corporate tax: 30%

Personal tax: progressive, tax rates rise with the taxable income

Taxable income at the personal level is defined as the total assessed income minus allowable tax

deductions

Assessable income includes salary and wages, investment income, realized capital gains, etc Deductions include those related to work, managing investments, etc

For individuals, a capital gains tax (CGT) is the tax that is paid on the net capital gains realized in a

particular tax year

A net capital gain is defined as the total capital gain realized during the tax year minus the total capital

loss realized in that year any unapplied net capital losses from earlier years

Three methods for computing capital gains taxes

The other method The indexation method The discount method

Before 20 Sep 1985, no tax

For CGT events before 21 Sep 1999, use the indexation method

For CGT events on and after 21 Sep 1999, use the indexation factor (123.4)

The other method is used if an asset was purchased and sold within 12 months


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Classical Tax System for dividends

A dollar of corporate profits is taxed at a flat corporate tax rate, tc, leaving (1-tc) to bedistributed as a dividend

Dividends received by shareholders are then taxed at the shareholders personal marginal taxrate, tp

From a dollar of corporate profit, the shareholder ends up with (1-tc) (1-tp) dollars of after-personal-tax dividend

Earnings (profits) paid as a dividend are effectively taxed twice In Australia, a classical tax system operated until 1 July 1987 when it was replaced by an

imputation tax system

Imputation Tax System for Dividends

Under the imputation tax system taxes paid at the firm and individual levels are treated in anintegrated manner

Dividends paid to shareholders from earnings on which taxes have been paid at the corporate

level are taxed using an imputation system

The tax paid by the firm is allocated to shareholders via franking credits attached to the

dividends paid

Franking credits are treated as both (imputed) personal income and (imputed) taxespaid on that income


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Franking credits can be used by shareholders to fully (or partly) offset tax payable onthe dividends

Unfranked dividends are taxed as part of the shareholders ordinary income

Franked dividends are associated with imputation (or franking) credits, which are computedas.

Franking credits can be used to offset tax liabilities associated with any other income

If the shareholders marginal tax rate is equal to thecorporate tax rate (30%), a fully franked

dividend is effectively tax free

If the shareholders marginal tax rate is less than the corporate tax rate, a fully franked

dividend will result in excess tax credits which can be used to reduce the tax payable on other

income, or refunded if it cannot be used

Implications?

The imputation tax system eliminated the double taxation of corporate earnings

Each shareholder is effectively taxed at their marginal personal tax rate


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BF Lecture 19Debt, Dividends and Taxes II

Financial Leverage

Business (or operational) risk

The variability of future net cash flows attributed to the nature of the firms operations

It is the risk faced by shareholders if the firm were financed only by equity

Financial risk

The risk attributed to the use of debt as a source of financing a firms operations

Financial risk exists if the firms operations are financed using debt, that is, when there is financial

leverage

Financial leverage is measured as the debt-to-equity (D/E) or the debt-to-total-assets[D/(D+E)] ratios

Effects of financial leverage?

Expected rate of return on equity increases The variability of returns to shareholders also increases Increasing leverage involves a trade-off between risk and return

Modigliani and Miller (MM) Analysis

It based on the following major assumptions

Capital markets are perfect Firms and individuals can borrow funds at the same interest rate No taxes No costs associated with the liquidation of a firm Firms have a fixed investment policy and investment decisions are not affected by financing

decisions

Assume that all cash flows from operations are perpetual and all earnings are paid out as dividends

The value of the firms is the present value of the future expected cash flows

No debt, no corporate taxes and 100% payout


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EAT = EBI = EBIT

Proposition 1

the market value of a firm is independent of its capital structure

Changing the mix of debt versus equity used to finance a firms operations will change theway in which the net operating income is divided between debt holders and shareholders but

it will not change the value of the firm

If the market values are not the same there are riskfree arbitrage opportunities eg buy low; sellhigh OR sell high, buy back low

Homemade leverage

Borrow on personal account 1% of firm Ls borrowing, that is, 1% of DLand purchase 1% offirm U

The total market value is not altered by the capital structure because the total size of the pies remains

unchanged

MM and Capital Structure Changesslide 27

BF Lecture 20Debt, Dividends and Taxes III

Proposition 2the expected return on equity of a leveraged firm increases in direct proportion

to its debt-to-equity ratio

The overall cost of capital (k0) of the firm remains unchanged Default risk free debt the cost of debt (kd) remains unchanged as well The rate of increase in the return on equity (ke) depends on the spread between the firms

overall cost of capital and its cost of debt (kd)

The firms overall cost of capital (k0) is the rate of return expectedby investors on the firms

assets


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Implication?

The required return on equity is directly proportional to the firms debt-to-equity ratio The higher the debt-to-equity ratio, the higher the required return on equity

What is the relation between systematic risk and the debt-to-equity ratio?

The firms systematic risk is also directly proportional to the firms debt-to-equity ratio

Implication?

The higher the debt-to-equity ratio, the higher the systematic risk of equity The higher the systematic risk of equity the higher the required rate of return on equity

MM and Market Imperfections

MM ignores capital market imperfections including.

Corporate and personal taxes Transaction costs Costs associated with financial distress Different cost of borrowing for firms and individuals Changing cost of debt due to changing risk Agency costs

Under the classical tax system

As leverage increases, a firms value will increase because the interest on debt is a taxdeductible expense


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The results in an increase in the after-tax net cash flows to the firm and investors

Implication?

With the introduction of corporate taxes in the MM analysis the existence of debt matters The natural conclusion is that firma should maximise the level of debt in their capital

structure as this will maximize the value of the firm

MM with Corporate and Personal Taxes

The existence of personal taxes on interest income can reduce the tax advantage associated with debt

financing

Investors may face higher tax rates on interest income than on income from shares

Income from shares = dividends + capital gains Capital gains are taxed at a lower rate and the effective tax rate on capital gains mat even

approach zero if share sale are postponed well into the future

Under a classical tax system, the tax advantage of debt at the firm level may be reduced or even

eliminated at the shareholder level

MM and the Imputation Tax System

There is tax neutrality between debt and equity

Shareholders whose personal tax rates are higher than the corporate tax rate may face higher tax rates

on interest income than on income from shares

Under the imputation tax system, personal taxes result in neutrality or a bias towards equity,

depending on the investors marginal tax rate

MM and Other Market Imperfections

Non tax factors that can cause a firms value to depend on its capital structure as well:

Financial distress and bankruptcy costs Agency costs

Financial distressis the state where a firm is getting close to breaching its debt obligations, which

may not necessarily result in bankruptcy

Direct costs of financial distress

- Fees associated with advisors, lawyers, accountants, etc


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Indirect costs of financial distressfinancial distress leads a range of stakeholders to behave in ways

that can disrupt a firms operations and reduce its value

- Effects of lost sales- Reduced operating efficiency- Cost of managerial time devoted to averting failure

Indirect costs are typically much higher than the direct costs

Agency costsarise from the potential for conflicts of interest between the parties forming the

contractual relationships of the firm

- Management may make wealth transfers from debtholders to shareholders- New debt holders will require higher interest rates to reflect the likelihood of wealth transfers- Shareholders ultimately lose as higher interest payments reduce earnings for shareholders

The sources of potential conflict are:

- Asset substitution- Underinvestment

Asset substitution

- A firms incentive to undertake risky investments increases with the use of debtbecause thereis limited liability associated with equity

- If risky investments are successful the benefits mainly go to shareholders. If risky investmentsfail most of the costs are borne by debt holders as shareholders have limited liability

- Undertaking risky investments that may fail will result in total firm value falling, but therelative value of equity will rise and the value of the debt will fall

- There is a wealth transfer from debt holders to shareholdersUnderinvestment

- A firm may potentially reject low risk investments even if they are positive NPV investments- With risky debt, it may not be in the interest of shareholders to contribute additional capital to

finance these new investments

- Although the investments are profitable and will increase firm value, shareholders may stilllose because the risk of the debt will fall and the debts value will increase

An optimal Capital Structure

The present value of expected bankruptcy costs depends on the probability of bankruptcy and present

value of costs incurred if bankruptcy occurs

The trade-off theory of capital structure

The possibility of a trade-off between the opposing effects of the benefits of debt finance andthe costs of financial distress may imply that an optimal capital structure exists


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Management should aim to maintain a target debt-equity ratio

BF Lecture 21Debt, Dividends and Taxes IV

Dividend declaration(announcement) date

Ex-dividend date: 4 business days before the record date

Record date: date on which shareholders of record receive the announced dividend

Payment date: date dividend is mailed or paid electronically

Pure residual dividend policy

Pay out any earnings that the firm does not need to reinvest Dividends and dividend payout ratios tend to be unstable

Constant payout dividend policy

Pay a constant proportion of earnings as dividends Stable dividend payout ratio but unstable dividends


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- The party that agrees to buy the underlying asset on a certain prespecified future date for theprespecified price is long a forward contract or has bought the forward contract

- The party who agrees to sell the underlying asset on a certain prespecified future date for theprespecified price is short a forward contract or has sold the forward contract

Spot price

- This is the price at which the underlying asset can be bought and sold in the spot market nowDelivery price

- This is the prespecified delivery price on the forward contractForward price

- The forward price and the delivery price are equal at the time the forward contract is enteredin to

- With the passage of time, the forward price will change as market conditions change whilethe delivery price remains fixed

Maturity or delivery date

- The prespecified date on which the contract is settled- The holder of the short position delivers the underlying asset to the holder of the long position

in return for the delivery price

- Some contracts are settled in cash since it is either impossible or impractical to deliver theunderlying asset

Settlement

- Physical deliverywhere the underlying security is exchanged for cash- Cash settlementwhere payment is made by the buyer to the seller of an amount equal to the

delivery price minus the market price at settlement multiplied by the number of units in the

contract

Forwards Versus Futures Contracts

Future contracts are essentially standardized forward contracts

- Contract is for the exchange of the underlying commodity or security at a prespecified futuredate, at a prespecified price

- Contract is standardized in terms of size, maturity, quotations, settlement, delivery, etc


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Transportation costs Financing costs

Overview of Options Markets

Option contracts are instruments that give the holder of the contract the right, but not the obligation, to

buy or sell the underlying instrument at a prespecified price

Equity option contracts usually represent 1000 shares of the underlying shares in Australia The exercise price is the prespecified price for which the underlying security may be

purchased or sold by the option buyer/holder if the option is exercised

Equity option holders do not enjoy the right due shareholders

In an exchange market, option prices are set in a competitive auction market among various buyers

and sellers

Over-the-counter instruments

Contracts are privately negotiated and tailored to meet customer needs Transactions occur off-market or outside registered exchanges Counterparty risk is a major consideration

Products typically traded through commercial banks, investments, banks and brokers

Exchange traded instruments


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Contracts are standardized Clearinghouse acts as a middleman between the buyer and seller Counterparty risk or the risk of default is quite low Products are liquid and can be easily traded

American versus European options

An American option can be exercised at any time up to and including the expiration date A European option can be exercised only at expiration

Call and Put Options

An optiongives the holder the right to buy or sell the underlying security at, or before, a specified

expiration date, at a pre-specified exercise price

To the buyer/holder the contract is an option and not an obligation A call option gives the right to purchase the underlying security A put option gives the right to sell the underlying security

To the option writer (or seller) the contract is an obligation

The writer of a call option has the obligation to sell the underlying security The writer of a put option has the obligation to purchase the underlying security

Contract Type Buyer or Holder Seller or Writer

Call Option Right, but no obligation, to buythe underlying security

Obligation, and not a right, tosell the underlying security ofoption exercised

Put Option Right, but no obligation, to sellunderlying security

Obligation, and not a right, tobuy the underlying security if

option exercised

Moneyness of Call Options


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At-the-money option: Current spot price

In-the-money option: If profitable to exercise at the spot price

For a call option this when

Current spot price > Exercise priceOut-of-the-money option: if unprofitable to exercise at the spot price

For a call option this is when

Current spot price < Exercise priceThe breakeven price is where the profit to the buyer is zero. Or a call option this is

Exercise price + option premium

BF Lecture 24Introduction to Derivative Securities II


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Option value (or price) = Intrinsic value + Time Value


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Factors Affecting Option Prices

Price of the underlying security Exercise or strike price Time to maturity Volatility of underlying security Riskfree interest rate Expected dividend


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Benefits of synthetic positions

Replicating a short position without having to borrow the underlying security Replicating a long position with lower capital requirements No price impact on the underlying security Replicating an index

The put-Call parity defines a relationship between the price of a call and the price of a put that must

hold in a perfect capital market

BF Summary

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