MOS final exam Flashcards

Question

Financial markets

Answer 1

financial markets: - primary markets + secondary markets - money market + capital market - organized exchanges/ over the counter

Answer 2

- primary markets: involve the issue of new securities by the borrower in return for cash from investors/ lenders (ie: new securities are created) - secondary markets: provide trading/ market environment that permit investors and buy and sell existing securities +) these markets are critical to the functioning of primary markets since it would be difficult to raise financing if investors were unable to sell their investments when necessary (allows for investment liquidity) +) secondary market trading in equity securities is many times the size of the primary market, whereas it is the opposite for debit securities.

Answer 3

- money market securities: short term debit instruments (maturities less than one year ie T bills) - capital market securities: include debt securities with maturities greater than one year (ie: bonds and equity securities) and equity securities

Answer 4

- exchanges or auction markets: secondary markets that involve a bidding process that takes place in a specific location - dealer or over the counter (OTC) markets: secondary markets that do not have a physical location and consist of a network of dealers who trade directly with one another the distinction has become blurred recent years because trading on most of the major exchanges in the world is now fully computerized, making the physical location of the exchanged of little consequence.

Answer 5

- bootstrap financing: entrepreneur supplies funds, prepares business plan, and searches for initial outside funding - seed-stage financing: venture capitalist provide funds to finish development of the concept - early stage financing: venture capitalists provide financing to get the business up and running - latter- stage financing (mezzanine financing): typically includes one to five additional stages. - venture capitalists exist by selling to a strategic buyer, selling to a financial buyer, or selling stock to the public.

Answer 6

- the process by which many entrepreneurs raise "seed" money and obtain other resources necessary to start their businesses. - the initial "seed" money usually comes from the entrepreneur or other founders. - other cash may come from personal savings, the sale of personal assets, loans from family and friends, use of credit cards. - the seed money, in most cases, is spent on developing a prototype of the product or service and a business plan - usually lasts 1 to 2 years.

Answer 7

- venture capitalists are individuals or firms that help new businesses get started and provide much of their early stage financing - individual venture capitalists or angel investors, are typically wealthy individuals who invest their own money in emerging businesses at the very early stage in small deals. - 3 reasons exist as to why traditional sources of funding do not work for new or emerging businesses: +) the high degree of risk +) types of productive assets +) informational asymmetry problems -> when dealing with high specialized tech, or companies emerging in new business areas, most investors do not have the expertise to distinguish between competent and incompetent entrepreneurs and are reluctant to invest. - the venture capitalists' investments give them an equity interest in the company. - often in the form of preferred stock that is convertible into common stock at the discretion of the venture capitalist. - the extent of the venture capitalists' involvement depends on the experience of the management team. - one of their most important roles is to provide advice - because of their industry and general knowledge about what it takes for a business to succeed, they provide counsel for entrepreneurs when a business is being started and during early stages of operation. - venture capitalists know that only a handful of new companies will survive to become successful firms. - tactics to reduce risk: +) funding the ventures in stages +) require entrepreneurs to make personal investment +) syndicating investments -> a common practice to syndicate seed- and early stage venture capital investments. -> occurs when the originating venture capitalist sells a percentage of a deal to other venture capitalist. +) in depth knowledge about the industry - the exist strategy +) venture capitalists are not long term investors in the companies, but usually exist after a period of 3 to 7 years. +) every venture capital agreement includes provisions identifying who has the authority to make critical decisions concerning the exist process. -> timing (when to exist) -> the method of exist -> what price is acceptable - 3 principle ways in which venture capital firms exist venture backed companies: +) sell to a strategic buyer in the private market +) sell to financial buyer in the private market (private equity firm- does not expect to gain from synergies) +) initial public offering: selling common stock in an initial public offering (IPO)

Answer 8

- advantage of going public: +) amount of equity is larger +) additional equity can be raised at a low cost +) can fund growing business without giving up control +) creates secondary market for trading +) easier to attract top management and motivate current managers - disadvantage: +) high cost of the IPO itself +)costs of complying with ongoing SEC disclosure requirements +) transparency that results from this compliance can be costly for some firms - investment banking services: +) to complete an IPO, a firm will need the services of investment bankers, who are experts in bringing new securities to the market. +) investment bankers provide 3 basic services when bringing securities to the market: -> origination -> underwriting -> distribution

Answer 9

- includes giving the firm financial advice and getting the issue ready to sell - the investment banker helps the firm determine whether it is ready for an IPO -> once the decision to sell stock is made, the firm's management must obtain a number of approvals -> file a registration statement with the securities exchange commission (SEC)

Answer 10

- the risk bearing part of investment banking - the securities can be underwritten in 2 ways: +) firm commitment basis -> investment banker guarantees the issuer a fixed amount of money from the stock Sale. The banker actually buys the stock from the firm at a fixed price and then resells it to the public +) best effort basis -> the investment banker makes no guarantee to sell the securities at a particular price. it promises only to make its best effort to sell as much of the issue as possible at a certain price. - underwriting syndicates +) to share the underwriting risk and to sell a new security issue more efficiently, underwriters may combine to form a group called an underwriting syndicate. +) participating in the syndicate entitles each underwriter to receive a portion of the underwriting fee as well as an allocation of the securities to sell to its own customers. - determining the offer price: +) one of the investment banker's most difficult tasks is to determine the highest price at which the bankers will be able to quickly sell all the shares being offered and that will result in a stable secondary market for the shares. - due diligence meeting - before the shares are sold, representatives from the underwriting syndicate hold a due diligence meeting with representatives of the company. - investment bankers hold due diligence meetings to protect their reputations and to reduce the risk of investors 'lawsuit in the event the investment goes sour later on.

Answer 11

- once the due diligence process is complete, the underwritters and the issuer determine the final offer price in a pricing call. -the pricing call typically takes place after the market has closed for the day. - by either accepting or rejecting the investment banker recommendation, management ultimately makes the pricing decision.

Answer 12

3 basic costs are associated with issuing stock in an IPO: - underwriting spread: difference between the proceeds the issuer receives and the total amount raised in the offering. -out of pocket expense: includes other investment banking fees, legal fees, accounting expenses, printing costs, travel expenses, SEC filing fees, consultant fees, and taxes - underpricing: difference between offering price and the closing price at the end of the first day of the IPO.

Answer 13

- define: a sale of debt or equity by a public company that has previously sold stock to the public +) competitive sale: after the origination work, underwriters bid competitively to buy the issue and sell to investors. +) negotiated sale: the issuer selects the underwritter at the beginning of the origination process and works closely with them to design and sell the issue.

Answer 14

- cheapest source of external funding for smaller firms and firms of lower credits standing is often the private market - when market conditions are unstable, some smaller firms that were previously able to sell securities in the public markets no longer can. - bootstrapping and venture capital financing are part of the private market as well.

Answer 15

- occurs when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, wealthy individuals - private lenders are more willing to negotiate changes to a bond contract. - if a firm suffers financial distress, the problems are more likely to be resolved without going to a bankruptcy court. - other advantages include the speed of private placement deals and flexibility issue size. - the biggest drawback of private placement involves restrictions on the resale of the securities.

Answer 16

- dividend policy: a firm's overall policy regarding distributions of value to stockholders. - dividend: something of value that tis distributed to a firm's stockholders on a pro-rata basis. - can involve the distribution of cash, assets, or something else, such as discounts on the firm's products that are available only to stockholders. - when a firm distributes value through a dividend, it reduces the value of the stockholders' claims against the firm. - a dividend reduces the stockholders' investment in a firm by returning some of that investment to them - different types: +) regular cash dividend +) extra dividend +) special dividend +) liquidating dividend

Answer 17

- most common form - generally paid on a quarterly basis - common means by which firms return some of their profits to stockholders - set a level that management expects the company to be able to maintain in the long run, barring some major changes in the fortunes of the company

Answer 18

- management can afford to be on the side of setting the regular cash dividend too low because it always has the option of paying an extra dividend if earnings are higher than expected. - often paid at the same time as regular cash dividends

Answer 19

- a one time payment to stockholders - are larger than extra dividends and occur less frequently

Answer 20

paid to stockholder when a firm is liquidated

Answer 21

- begins when the board votes to pay a dividend. shortly afterward, the firm publicly announces its intent to pay a dividend, along with, at a minimum, the amount of the dividend and the record date, the ex- dividend date, which is set by the stock exchange, normally precedes the record date by 2 days. the payable date is the date on which the firm actually pays the dividend. - Diagram: board vote - public announcement (declaration date) - ex dividend date - record date - payable date

Answer 22

- they do not represent a pro- rata distribution of value to the stockholders, because not all stockholders participate. - when a company repurchases its own shares, it removes them from circulation. - stock repurchases are taxed differently than dividends. - how stock is repurchased: 3 ways +) open market repurchase +) tender offer -> fixed price: 1. management announces the price that will be paid for the shares and the max number of shares that will be repurchased. interested stockholders "tender" their shares by responding with how many shares they are willing to sell. 2. shares repurchased up to max, repurchased in proportion to the fraction of the total shares each shareholder tendered (if over max) -> dutch auction 1. management announces the number of shares it would like to repurchase and offers it at a series of prices above the market price, to see which price is best to allow for the required shares to be purchased. +) targeted stock repurchase

Answer 23

- does not involve the distribution of value - when a company pays a stock dividend, it distributes new shares of stock on a pro-rata basis to existing stockholders - value of company does not change - the stockholder is left with exactly the same value as before.

Answer 24

- is quite similar to a stock dividend, but it involves the distribution of a larger multiple of the outstanding shares - we can often think of a stock split as an actual division of each share into more than one share. - can send positive signal to investors about the outlook that management has for the future and this, in turn, can lead to a higher stock price. - management is unlikely to want to split the stock of a company two for one or three for one if it expects the stock price to decline

Answer 25

- a company's dividend policy is about how the excess value in a company is distributed to its stockholders. - it is extremely important that managers choose their firm's dividend policies in a way that enables them to continue to make the investments necessary for the firm to compete in its product markets. - managers should consider several practical questions when selecting a dividend policy: +) over the long term, how much does the company's level of earnings (cash flows from operations) exceed its investment requirements? How certain is this level? +) does the firm have enough financial reserves to maintain the dividend payout in periods when earnings are down or investment requirements are up? +) does the firm have sufficient financial flexibility to maintain dividends if unforeseen circumstances wipe out its financial reserves when earnings are down? +) can the firm quickly raise equity capital if necessary? +) if the company chooses to finance dividends by selling equity, will the increased number of stockholders have implications for the control of the company?

Answer 26

- define: the purchase of one firm by another. An acquisition occurs when one firm (the acquiring firm or bidder) completely absorbs another firm (the target firm)

Answer 27

- define: the combination of 2 or more firms into a new legal entity. both (all) sets of shareholders must approve the transaction

Answer 28

- define: a merger in which 2 firms in the same industry combine +) related businesses (horizontal relationship) +) transferring competitively valuable expertise +) combining the related activities of separate businesses into a single operation to lower costs +) exploiting common use of a well known brand name +) this relates to: -> manufacturing facilities -> production facilities -> specialized skills -> distribution channels -> patents, copy rights, etc -> favorable reputation

Answer 29

- define: a merger in which one firm acquires a supplier or another firm that is closer to its existing customers. +) backward into sources of supply (Walt Disney acquires Pixar in 2006 - supplier of animation for media) +) forward toward the end-users of final product (Bell Globemedia's acquisition of CHUM Ltd. radio)

Answer 30

- define: a merger in which 2 firms in unrelated businesses combined - different businesses face different risks, cancel each other out, lowering the overall risk of the company - diversification

Answer 31

- the primary motive should be the creation of synergy. - synergy value is created from economies of integrating a target and acquiring a company; the amount by which the value of the combined firm exceeds the sum value of the two individual firms

Answer 32

operating synergies: 1. economies of scale: - spreading fixed costs and geographic synergies. - ie: all production can be done in one factory if businesses combine instead of 2, use excess capacity. 2. economies of scope - the combo of 2 activities reduced costs - ie: using a single distribution system to sell 2 lines of product instead of one 3. complementary strengths - one firm is more efficient in certain area(s) of operations than another - ie: marketing oriented firm acquires a production oriented firm efficiency increases - new management team will be more efficient and add more value than what the target now has. - the combined firm can make use of unused production/ sales/ marketing channel capacity Financing synergy - reduced cash flow variability - increase in debt capacity - reduction in average issuing costs tax benefits: - make better use of tax deductions and credits strategic realignment: - permits new strategies that were not feasible prior to the acquisition. the acquisition of new management skills, connections to markets or people, and new products/services

Answer 33

- transparency - information disclosure +) to ensure complete and timely info be available to all parties while at the same time not letting this requirement stall the process unduly - fair treatment +) to avoid oppression or coercion of minority shareholders +) to permit competing bids during the process and not have the first bidder have special rights (in this way, shareholders have the opportunity to get the greatest and fairest price for their shares) +) to limit the ability of a minority to frustrate the will of a majority (minority squeeze out provisions)

Answer 34

critical shareholder percentage: 1. 10%: early warning: - when a shareholder hits this point a report is sent to OSC - this requirement alerts other shareholder that a potential acquisitor is accumulating a position (toehold) in the firm. 2. 20%: take over bid - not allowed further open market purchases but must make a takeover bid. - this allows all shareholders an equal opportunity to tender shares and forces equal treatment of all at the same price. - this requirement also forces the acquisitor into disclosing intentions publicly before moving to full voting control of the firm. 3. 50.1%: control - shareholder controls voting decisions under normal voting (simple majority) - can replace board and control management 4. 66.7%: amalgamation - can approve amalgamation proposals requiring a 2/3s majority vote (supermajority) 5. 90%: minority squeeze out - once the shareholder owns 90% or more of the outstanding stock minority shareholders can be forced to tender their shares. - this provision prevents minority shareholders from frustrating the will of the majority.

Answer 35

moving beyond the 20% threshold 1. takeover circular sent to all shareholders 2. target has 15 days to circulate letter to shareholders with the recommendation of the board of directors to accept/reject 3. bid must be open for 105 days following public announcement, subject to target board's ability to reduce the bid period to at least 35 days. Note: - shareholders tender to the offer by signing authorizations - a competing bid automatically increases the takeover window by 10 days and shareholders during this time can withdraw authorization and accept the competing offer Prorated Settlement and Price - takeover bid does not have to be for 100% of the shares - tender offer price cannot be for less than the average price of share that the acquirer bought shares in the previous 90 days (prohibits coercive bids) - if more shares are tendered than required under the tender, everyone who tendered shares will get a prorated number purchased.

Answer 36

- private companies are generally exempt from provincial securities legislation. - public companies that have few shareholders in one province may be subject to takeover laws of another province where the majority of shareholders reside. - purchase of shares from fewer than 5 shareholders

Answer 37

- the acquisition of a target company that is willing to be taken over - usually, the target will accommodate overtures and provide access to confidential info to facilitate the scoping and due diligence process

Answer 38

1. normally starts when the target voluntarily puts itself into play. - target uses an investment bank to prepare an offering memorandum - may set up a data room and use confidentiality agreements. - a signed letter of intent (usually includes a no-shop clause and a termination or break fee) - legal team checks documents 2. can be initiated by a friendly overture by an acquisitor seeking info that will assist in the valuation process

Answer 39

info memorandum/ approach target - confidentiality agreement = sign letter of intent - main due diligence - final sale agreement - ratified

Answer 40

- define: a takeover in which the target has no desire to be acquired and actively rebuffs the acquirer and refuses to provide any confidential info. - the acquirer usually has already accumulated an interest in the target (20% of the outstanding shares) and this preemptive investment indicates the strength of resolve of the acquirer

Answer 41

1. slowly acquire a toehold by open market purchase of shares at market prices without attracting attention. 2. file statement with OSC at the 10% early warning stage while not trying to attract too much attention. 3. accumulate 20% of the outstanding shares through open market purchase over a long period of time. 4. make a tender offer to bring ownership percentage to the desired level (either the control (50.1%) or amalgamation level (67%) - this offer contains a provision that it will be made only if a certain minimum percentage is obtained During this process the acquirer will try to monitor management/ board reaction and fight attempts by them to put into effect shareholder rights plans or to launch other defensive tactics.

Answer 42

market clues to the potential outcome of a hostile takeover attempt: 1. market price jumps above the offer price - a competing offer is likely, or - the bid price is too low 2. market price stays close to the offer price - the offer price is fair and the deal will likely go through 3. little trading in the shares - a bad sign for the acquirer because shareholders are reluctant to sell. 4. great deal of trading in the shares - large numbers of shares being sold from normal investors to arbitrageurs (arbs) who are, themselves building a position to negotiate an even bigger premium for themselves by coordinating a response to the tender offer.

Answer 43

- shareholders rights plan +) known as a poison pill or deal killer +) can take different forms but often: -> gives non acquiring shareholders the right to buy 50% more shares at a discount price in the event of a takeover. makes acquisition more expensive. +) target board under the new regime would have enough time to respond to hostile takeover -> poison pill no longer necessary - selling the crown jewels +) the selling of a target company's key assets that the acquiring company is most interested in to make it less attractive for takeover. +) can involve a large dividend to remove excess cash from the target's balance sheet - white knight +) the target seeks out another acquirer considered friendly to make a counter offer and thereby rescue the target from a hostile takeover

Answer 44

- define: the removal of barriers to free trade and the closer integration of national economies. - consumers in many countries buy goods that are purchased from a number of countries other than just their own. - the production of goods and services has also become highly globalized. - the financial system has also become highly integrated

Answer 45

- define a multinational corporation: a business firm that operates in more than one country but is headquartered or based in its home country - multinationals are owned by a mixture of domestic and foreign stockholders - transnational corporations, regardless of the location of their headquarters, are managed from a global perspective rather than the perspective of a firm residing in particular country

Answer 46

6 factors can cause international business transactions to differ from domestic deals 1. the uncertainty of future exchange rate of movements 2. differences in legal systems and tax codes 3. while english is the official business language, it is not the world social language 4. cultural views also shape business practices and people's attitude toward business 5. an economic system determines how a country mobilizes its resources to produce goods and services needed by society, as well as how the production is distributed 6. country risk refers to political uncertainty associated with a particular country - at the extreme, a country's gov may even expropriate business's asset within the country. - other actions include: change in tax laws, restrictive labour laws, local ownership, tariffs and quotas, disallow any cash from subsidiary to parent - these types of actions clearly can affect a firm's cash flows

Answer 47

- stockholder value maximization is the accepted goal for firms in Canada, the UK, and the US - in continental europe, countries such as france and germany focus on maximizing corporate wealth - the european manager's goal is to earn as much wealth as possible for the firm while considering the overall welfare of all stakeholders

Answer 48

- remain the same whether a transaction is domestic or international - the limit value of money is not affected by whether a business transaction is domestic or international - the same models are used for valuing capital assets, bonds, stocks, and entire firms

Answer 49

- define: a group of international markets connected electronically where currencies are bought and sold in wholesale amounts

Answer 50

- spot rate: the rate at which one agrees to buy or to sell a currency today - forward rate: +) is established at the date on which the agreement is made and defines the exchange rate to be used when the transaction is completed in the future. +) agree to pay for money in the future at a certain rate +) ie: 1. sign a contract today to buy the money on a date in the future 2. used to manage risks/ eliminate uncertainty-by contracting now to buy or sell foreign currencies at some future date, managers can lock in the cost of foreign exchange at the beginning of a transaction, and do not have tp worry about the possibility of an unfavorable movement in the exchange rate before the transaction is completed. - by contracting now to buy or sell foreign currencies at some future date, can lock in the cost of foreign exchange and do not have to worry about the risk of an unfavorable movement in the exchange rate in the future. - companies can use forward transactions to lock in (hedge) the cost of foreign exchange - currency exchange rate: value of one currency relative to another currency - direct quotation method: indicates the amount of a home country's currency needed to purchase one unit of a foreign currency - indirect quotation method: indicates the amount of a foreign currency needed to purchase one unit of the home country's currency

Answer 51

- bid rate: the rate at which the dealer will buy foreign currency - ask rate: the rate at which the dealer will sell foreign currency - dealer's spread: the difference between the bid and ask price, often expressed in % form: bid-ask spread = (ask rate - bid rate)/ ask rate

Answer 52

- define: exchange rates between 2 different currencies - calculation

Answer 53

- to hedge means to engage in a financial transaction to reduce risk - can use forward rates to do this

Answer 54

- when a multinational firm wants to consider overseas capital projects, the financial manager faces the decision of which capital projects should be accepted on a company- wide basis - the decision to accept projects with a positive net present value increases the value of the firm and is consistent with the fundamental goal of financial management, which is to maximize stockholder wealth - determining the cash flows +) a number of issues complicate the determination of cash flows from overseas capital projects +) companies find it more difficult to estimate the incremental cash flows for foreign projects +) problems with cash flows can arise when foreign government restrict the amount of cash that can be repatriated, or returned, to the parent company

Answer 55

- financial managers have to deal with foreign exchange rate risk on international capital investment - to convert the project's future cash flows into another currency, we need to come up with projected or forecast exchange rates. - one of the problems with obtaining currency rate forecasts for use in analysis of capital projects is that many projects have lives of 20 years or more.

Answer 56

- financial derivative securities: derive all or part of their value from another (underlying) security - why trade these indirect claims? +) expand investment opportunities +) lower cost +) increase leverage

Answer 57

- options are created by investors, sold to other investors (corporation of the underlying stock has no direct interest in the transaction) - call: buyer has the right but not the obligation to purchase a fixed quantity from the seller (writer) at a fixed price up to a certain date - put: buyer has the right but not the obligation to sell a fixed quantity to the seller (writer) at a fixed price up to a certain date

Answer 58

- exercise (strike) price: the per share price at which the common stock may be purchased or sold - expiration date: last date at which an option can be exercised +) American - can exercise anytime up until the expiration date +) European - can exercise only on the expiration date - option premium: the price paid by the option buyer to the writer of the option in order to purchase the option (applies for both put or call option)

Answer 59

- call buyer expects the price of the underlying security to increase - call seller (writer) expects the price of the underlying security to decrease or stay the same - put buyer expects the price of the underlying security to decrease - put seller (writer) expects the price of the underlying security to increase or stay the same - possible courses of action: option may expire worthless, be exercised, or be sold prior to expiry

Answer 60

- options exchanges +) Montreal exchange (ME) +) Chicago Board Options Exchange (CBOE) - standardized exercise dates, exercise prices, and quantities +) facilitate offsetting positions through a clearing corporation +) clearing corporation is guarantor, handles deliveries

Answer 61

- in the money options have a positive cash flow if exercised immediately +) call options: stock price (S) > exercise price (E) +) put options: S < E - out of the money options should not be exercised immediately +) call options: S < E +) put options: S> E - if S=E, an option is at the money

Answer 62

- in canada, all equity, bond, and stock index position are issued and guaranteed by a single clearing corporation, the canadian derivatives clearing corporation (CDCC) +) owned by the montreal exchange (ME) - CDCC functions as an intermediary between the brokers representing the buyers and writers - once the brokers representing the buyer and seller negotiate the price on the exchange, they no longer deal with each other but with the CDCC. - CDCC guarantees that all contract obligations will be met .

Answer 63

- define: the value of an option if today was the expiration date - for a call, if the call option is at or out of the money (exercise price is more than market price), the intrinsic value is 0 and the price of the option is based entirely on its speculative appeal - if the call option is in the money (exercise price is less than the market price), the intrinsic value is the difference between the stock price and the exercise price

Answer 64

- for a put, if the put option is at or out of the money (exercise price is less than market price), the intrinsic value is 0 and the price of the option is based entirely on its speculative appeal - if the put option is in the money (exercise price is more than the market price), the intrinsic value is the difference between the exercise price and the stock price

Answer 65

- uncovered option writer (naked option writer): one who does not have their position covered in the underlying stock - ie: the writer does not own shares in the underlying stock to make available if the call option is exercised by the buyer - faces unlimited potential loss (no cap on share price increase) - if the option expires out of the money, their profit is the option premium that the buyer paid them for the option - covered calls: when you write/sell a call option while owning the underlying stock - the position is covered because the writer owns the stock and could deliver it if called to do so as a result of the exercise of the call option by the holder - in effect, the investor is willing to sell the stock at a fixed price (the exercise price), limiting the gains if the stock price rises, in exchange for cushioning the loss by the amount of the call premium, if the stock price declines

Answer 66

- a strategy involving the purchase of a put option as a supplement to a long position in an underlying asset - owning a stock and buying a put for the same stock - the put acts as insurance against a decline in the underlying stock price, guaranteeing an investor a minimum price at which the stock can be sold. - in effect, the insurance acts to limit losses or unfavorable outcomes

Answer 67

- option prices almost always exceed intrinsic values. with the difference reflecting the option's potential appreciation, referred to as the time value +) the actual source of value is volatility in price +) price volatility decreases with a shortening of the time to expiration, hence the term time value +) because buyers are willing to pay a price for potential future stock price movements, time has a positive value +) the longer the time to expiration for the option, the more chance it has to appreciate +) as expiration approaches, the time value of the option declines to 0 - define: time value - the difference between the intrinsic value of an option and its market price - time value= option price - intrinsic value

Answer 68

- spot market: price refers to item available for immediate delivery - forward market: price refers to item available for delayed delivery - future market +) set features (contract size, delivery date, conditions) for delivery +) an obligation to buy or sell a fixed amount of an asset on a specified future date at a price set today +) future market are, in effect, organized and standardized forward market +) characteristics: -> centralized marketplace allows investors to trade with each other -> performance is guaranteed by a clearing house +) commodities: agricultural, metals, energy related +) financials: foreign currencies, debt and equity instruments

Answer 69

- a corporation separate from, but associated with, each exchange - exchange members must be members or pay a member for these services +) buyers and sellers settle with clearing corporation, not with each other +) helps facilitate an orderly market and ensures fulfillment of each contract +) keep track of obligations +) on the other side of all transactions

Answer 70

- seller and buyer agree to take or make delivery on a future date at a price agreed on today. +) short position (seller) commits a trader to deliver an item at contract maturity +) long position (buyer) commits a trade to purchase an item at contract maturity

Answer 71

- hedgers +) at risk with a spot market asset and exposed to unexpected price changes +) buy or sell futures to offset the risk +) used as a form of insurance +) willing to forgo some profit in order to reduce risk -> hedged return has smaller chance of low return but also smaller chance of high return

Answer 72

speculators - buy or sell future contracts in an attempt to earn a return - absorb excess demand or supply generated by hedgers. - assuming the risk of price fluctuations that hedgers wish to avoid - speculation encouraged by leverage, ease of transacting, low costs

Answer 73

market intermediary

Answer 74

stockbroker

Answer 75

market intermediaries provide for direct borrowing and lending through financial instruments, while financial intermediaries provide for indirect borrowing and lending

Answer 76

household and gov

Answer 77

mutual funds

Answer 78

money market securities

Answer 79

a secondary market transaction because the investor has bought the stock from other investors

Answer 80

the globalization of the equity markets means the linkages between the global markets are getting tighter

Answer 81

because canada is a small, open economy, interest rates prevailing in the canadian econ will, at least roughly, mirror prevailing interest rates in the world as a whole. global financial markets are also important to canadians because foreign issues of financial assets provide foreign investment and borrowing opportunities for canadian individuals and firms

Answer 82

adopt syndications

Answer 83

wealthy individuals who invest their own money in new ventures

Answer 84

- by finding a strategic buyer - by finding a financial buyer - through an IPO

Answer 85

with firm commitment underwriting, the risk that proceeds of a stock issue will be less than expected as assumed by the investment banker.

Answer 86

going public mandates compliance with on going SEC disclosure requirements

Answer 87

most corporations issuing stock prefer firm commitment arrangements to best effort contracts. in fact, more than 95% of all underwritten offerings involve firm commitment contracts

Answer 88

underwriter's spread = 5% proceeds per share to the firm= [20 dollar x (1-0.05)] = 19 dollar to raise 11 million, the company will issue 579,947 new shares (11 million/ 19 dollar per share = 578,947)

Answer 89

- number of shares sold = 150 million/ 30 dollar = 5 million shares - underwriting spread= (30 dollar - 27 dollar) x 5 million shares = 15 million dollar - out of pocket expenses = 410,000 dollar - the dollar amount of underpricing = [(30 dollar x 1.135) - 30 dollar]= 4.05 dollar x 5 million shares = 20,250,000 dollar - the firm's total cost of issuing the securities = 15 million dollar + 410,000 dollar + 20,250,000 dollar = 35,660,000 dollar

Answer 90

out of pocket expenses

Answer 91

underwriter's spread: 70 cad - 64.05 = 5.95 net profit per share: 5.95- 1 = 4.95

Answer 92

200 million dollar/ 780 million shares x 1000 shares = 256 dollar

Answer 93

2 business days

Answer 94

an indication that the firms have run out of positive NPV projects in which to invest

Answer 95

reduces the stockholder's investment in a firm

Answer 96

the ex dividend date is the 1st day that the stock will be trading without the rights to the dividend, and that occurs 2 days before the record date, or on wed sep 6, 2017. therefore the last date that you can purchase the stock and still receive the dividend will be the day before the ex dividend date or tuesday, sep 5, 2017

Answer 97

0.48 (0.6 x (1-0.2))

Answer 98

in the case of a stock repurchase, the distribution of value is not proportionally done across all shareholders

Answer 99

individual stockholders can decided whether they want to participate in stock repurchases

Answer 100

fixed P tender offer

Answer 101

from management's perspective, a stock repurchase provides greater flexibility than dividends in distributing value to shareholders

Answer 102

in a real world, the P of a company's stock remains the same when a dividend is announced

Answer 103

Veiled acts has replaced a commitment to distribute cash that does not have to be acted on. This should be a negative signal from the firm if the announcement was interpreted to suggest that management is concerned about the level of cash flows from operations this quarter

Answer 104

a stock split, by itself, could have an impact on control of a firm explanation: stock splits refer to a pro rata distribution of new shares to existing stockholders that is not associated with any change in the assets held by the firm; stock splits involve larger inc in the number of shares and do not impact the total value or the per share value of the firm

Answer 105

stock dividend

Answer 106

companies split their stock so as to bring its P down to an appropriate trading range

Answer 107

- number of shares owned after the stock split: 21,600 x 2 = 43,200 - reverse split: 1/2 x 21,600 = 10,800

Answer 108

- firms tend to have long term target payout ratios - dividend changes follow shifts in long term sustainable earnings - managers are reluctant to make dividend changes that might have to be reversed.

Answer 109

If all other characteristics of the two companies are the same, then Publicks could be expected to have a more aggressive dividend payout. Since Publicks has issued debt in the past, while Privicks has not, Publicks is likely to have greater access to the capital markets than Privicks. Firms with greater access to capital markets can be more aggressive in their dividend payouts to the extent that they can raise capital more easily (cheaply) if necessary.

Answer 110

both mergers and acquisition require 2/3 votes from both firms. in mergers, the approval of the target company's shareholders is required, but the shareholders of the acquiring company do not normally have to give their approval

Answer 111

there are many legal problems

Answer 112

an acquisition involves one legal entity absorbing another, whereas a merger involves the creation of a new legal entity

Answer 113

- 10%: early warning - 20%: takeover bid - 50.1%: control - 90%: minority squeeze out

Answer 114

a formal vote by the target shareholders is required

Answer 115

cooperating with the acquirer

Answer 116

confidentiality agreement

Answer 117

a friendly acquisition requires a willing management, whereas a hostile acquisition involves a combative management of the firm to be acquired

Answer 118

acquirers often justify paying a premium for a target firm by suggesting the transaction, through the elimination of redundancies, will result in significant efficiency gains

Answer 119

diversification in general is a poor motive for a merger

Answer 120

- move closer to its customers - move closer to its source or raw resources - take control of an inconsistent supplier

Answer 121

increased need of external financing

Answer 122

a firm that has widely dispersed ownership and that is managed from a global perspective is known as a transnational corporation

Answer 123

transnational corporation are viewed as stateless corporations with no allegiance or social responsibility to any nation or region of the world

Answer 124

- a mechanism to transfer purchasing power via exports and imports - a mechanism for hedging the risk associated with currency fluctuations - a channel for businesses to acquire credit for international transactions

Answer 125

$1.75/ pound divided by rupee 94.53/ pound = $0.0185/Rs

Answer 126

the spot rate is the cost of buying a foreign currency today

Answer 127

if the foreign exchange rate is the P in dollars for a foreign currency, then the exchange rate quote is known as an American or direct quote

Answer 128

- value of receivables: 138,500 pound x $1.2225/pound = $169,316.25 - loss incured by not hedging $169, 316.25 - 138,500 pound x $1.1950/ pound = $3,808.75

Answer 129

when converting a project's future cash flows into another currency, we need to forecast and use projected exchange rates

Answer 130

repatriation of earnings restrictions usually take the form of a ceiling on the amount of cash dividends that a foreign subsidiary can pay to its parent

Answer 131

some of the crimes typically associated with organized crime include money laundering, mail and wire fraud, conspiracy, and racketeering.

Answer 132

opportunity includes both opportunity to complete the fraud and conceal it without getting caught

Answer 133

business reversal such as bankruptcy

Answer 134

the fraud scale adds the characteristic of integrity to the fraud triangle

Answer 135

failing to retain adequate financial records

Answer 136

the more expensive thefts are observed in jobs with greater access to the assets of value in the organization

Answer 137

any person who receives regular and periodic compensation from an organization for his or her labor

Answer 138

intent of those involved

Answer 139

the fraud triangle

Answer 140

investment losses by managers

Answer 141

A marketable asset is one that can be traded between or among investors after issuance, but before expiry. The asset’s market value will also change over time while the asset is outstanding. In contrast, non-marketable assets cannot be traded between or among investors.

Answer 142

Providers of Financing: Financial Sector: This includes banks, credit unions, and financial institutions that lend money to individuals, businesses, and other entities. Savings/Investors: Individuals or entities that save money and invest in various financial instruments, such as stocks, bonds, mutual funds, etc. Government: Through the issuance of bonds and securities, governments can raise funds from investors. Net Users of Financing: Corporate Sector: Companies often require financing for various purposes, such as expansion, operations, research, and development. They seek funds from banks, investors, or by issuing stocks/bonds. Households: Individuals and families may borrow money for various reasons, including buying homes, cars, education, or covering day-to-day expenses through credit cards or loans. Government (in certain situations): Governments can be both providers and users of financing. While they issue bonds to raise funds (being providers), they also spend money on various programs, infrastructure, defense, etc., often requiring financing through borrowing.

Answer 143

Bank Accounts: Savings accounts offered by banks are one of the most common channels for individuals to save money. These accounts often provide a safe place to deposit money while offering some interest on the savings. They are easily accessible, and many people use them for short-to-medium-term savings goals. Investment Accounts: Investment accounts, such as brokerage accounts or retirement accounts like IRAs (Individual Retirement Accounts) or 401(k)s, allow individuals to save money with the goal of generating higher returns over the long term. These accounts may involve investing in stocks, bonds, mutual funds, ETFs (Exchange-Traded Funds), or other financial instruments. Fixed Deposits or Certificates of Deposit (CDs): These are time-bound savings instruments offered by banks where individuals deposit a certain amount of money for a specific period, usually with higher interest rates compared to regular savings accounts. They often have penalties for early withdrawal but provide a secure way to save money for a fixed duration.

Answer 144

Market and financial intermediaries both play crucial roles in the economy, but they function differently in facilitating the flow of funds and financial transactions. Market Intermediaries: Stock Markets: These are platforms where stocks, bonds, and other securities are bought and sold. Examples include stock exchanges like the New York Stock Exchange (NYSE) and NASDAQ. Bond Markets: These markets deal with buying and selling debt securities. Governments, municipalities, and corporations issue bonds to raise capital. Commodity Markets: Here, commodities like gold, oil, agricultural products, etc., are traded. Foreign Exchange Markets (Forex): These markets deal with trading different currencies. Participants include banks, corporations, governments, and investors. Market intermediaries primarily provide a platform for buyers and sellers to interact directly. They facilitate transactions, provide liquidity, and establish transparent pricing mechanisms. They do not hold or own the assets being traded but enable their exchange. Financial Intermediaries: Banks: They accept deposits from customers and provide loans and other financial services. They act as intermediaries between depositors and borrowers. Insurance Companies: These entities provide risk management through various insurance products, collecting premiums and compensating policyholders for covered losses. Mutual Funds: These pools of investors' money are managed by professionals who invest in diversified portfolios of stocks, bonds, or other securities. Pension Funds: These funds manage and invest money to provide retirement benefits to employees. Financial intermediaries act as middlemen between borrowers and lenders or between individuals and the financial markets. They accept funds from savers or investors and allocate these funds to borrowers or invest in various financial instruments. They also provide services like risk management, financial advice, and wealth management. In essence, market intermediaries facilitate direct transactions in financial markets, while financial intermediaries channel funds between savers and borrowers, providing various financial services in the process. Both are integral to the efficient functioning of the financial system.

Answer 145

Certainly! The four most important types of financial intermediaries—banks, insurance companies, mutual funds, and pension funds—play critical roles in the economy by facilitating the flow of funds and managing risks. Here's an overview of how each operates: 1. Banks: Deposits and Loans: Banks accept deposits from individuals and businesses, paying interest on these deposits. They use these funds to provide loans to borrowers, including mortgages, personal loans, and business loans. Financial Services: Banks offer various financial services such as checking and savings accounts, credit cards, wealth management, and investment advisory services. Risk Management: They manage risks through diversification, lending practices, and various financial instruments. 2. Insurance Companies: Risk Transfer: Insurance companies provide policies to individuals or businesses, offering protection against specific risks (e.g., life insurance, health insurance, property insurance). Premium Collection and Payout: They collect premiums from policyholders and use these funds to cover losses or payouts to policyholders when claims are made. Investment Management: Insurance companies invest premiums in various assets like stocks, bonds, and real estate to generate returns and cover future obligations. 3. Mutual Funds: Pooling Investor Funds: Mutual funds gather money from multiple investors and pool these funds to invest in diversified portfolios of stocks, bonds, or other securities. Professional Management: They are managed by professionals who make investment decisions based on fund objectives, aiming to maximize returns for investors. Liquidity and Diversification: Mutual funds offer investors diversification and liquidity since they can easily buy or sell shares in the fund. 4. Pension Funds: Retirement Savings Management: Pension funds manage funds contributed by employers and employees for future retirement benefits. Investment Strategies: They invest these funds in various financial instruments such as stocks, bonds, and real estate to generate returns over the long term. Risk Mitigation: Pension funds diversify their investments to reduce risk and ensure a steady income for retirees.

Answer 146

Government: 1. Tax Revenue: Governments collect taxes from individuals, corporations, and other entities to finance public services, infrastructure development, defense, healthcare, education, etc. 2. Debt Instruments: Government Bonds: Issuing bonds allows governments to borrow money from investors, promising to repay the principal amount with interest at a specified future date. Treasury Bills (T-bills) and Notes: Short- to medium-term debt securities issued by governments to raise funds. They are sold at a discount to face value and redeemed at face value upon maturity. Government Loans: Governments might borrow from international organizations or other countries to finance specific projects or cover budget deficits. 3. Grants and Aid: International aid and grants received from other countries or international organizations for development projects, humanitarian assistance, or budget support. Businesses: 1. Equity Financing: Stock Issuance: Businesses can raise capital by issuing stocks, allowing investors to become partial owners and share in profits. Venture Capital: Startups and growing companies secure funds from venture capitalists in exchange for an ownership stake. 2. Debt Financing: Bank Loans: Businesses secure loans from banks for various purposes, like expansion, inventory, or working capital. Corporate Bonds: Issuing bonds allows companies to borrow from investors, promising periodic interest payments and repayment of principal at maturity. 3. Retained Earnings: Businesses can reinvest profits back into the company for expansion, research and development, acquisitions, or debt reduction. 4. Alternative Financing: Crowdfunding: Companies raise funds from a large number of people, typically via online platforms, by soliciting small contributions. Angel Investors: Individuals invest their own money into startups or early-stage companies in exchange for equity. 5. Trade Credit and Supplier Financing: Businesses may negotiate extended payment terms with suppliers or use trade credit to finance their operations.

Answer 147

Primary Market: Issuance of New Securities: The primary market is where newly issued financial securities are bought and sold for the first time. Role in Capital Formation: Companies and governments use the primary market to raise capital by issuing stocks, bonds, or other securities directly to investors. Direct Transactions: Transactions in the primary market involve direct interaction between issuers and investors. Price Determination: Prices in the primary market are often determined through mechanisms such as auctions or fixed-price offerings set by the issuer. In summary, the primary market is where securities are initially created and offered to the public for the first time. Secondary Market: Trading of Existing Securities: The secondary market is where existing securities are bought and sold among investors after their initial issuance in the primary market. Liquidity and Price Discovery: It provides liquidity by allowing investors to buy and sell previously issued securities, contributing to price discovery based on market demand and supply. No Involvement of Issuers: Transactions in the secondary market involve investors trading with each other; the issuing company or entity doesn't directly participate in these transactions. Facilitated by Exchanges and Over-the-Counter (OTC) Markets: Securities exchanges (like NYSE, NASDAQ) and OTC markets facilitate trading in the secondary market.

Answer 148

NYSE, NASDAQ

Answer 149

1. Financial Institutions: Banks: Accept deposits, offer loans, and provide various financial services. Insurance Companies: Offer risk management through insurance policies. Investment Firms: Including brokerage firms, asset management companies, and investment banks that facilitate investments and manage assets. Pension Funds and Mutual Funds: Entities that manage funds for retirement or investment purposes. 2. Financial Markets: Stock Markets: Platforms where shares of companies are bought and sold. Bond Markets: Dealing with the issuance and trading of debt securities. Money Markets: For short-term borrowing and lending, dealing with low-risk, highly liquid instruments. Derivatives Markets: Trading financial contracts derived from underlying assets. 3. Central Banks and Regulatory Authorities: Central Banks: Responsible for monetary policy, issuing currency, and regulating commercial banks. Regulatory Authorities: Oversight and regulation of financial institutions and markets to ensure stability, fairness, and investor protection. 4. Financial Services Providers and Support Infrastructure: Payment Systems: Facilitate the transfer of funds between individuals and businesses. Credit Rating Agencies: Assess the creditworthiness of entities and securities. Financial Technology (Fintech) Companies: Innovators providing digital financial services, payment solutions, and other technological advancements.

Answer 150

1. Exchange-Traded Secondary Markets: Stock Exchanges: Platforms where securities such as stocks, bonds, and other financial instruments are traded. Examples include the New York Stock Exchange (NYSE), NASDAQ, London Stock Exchange (LSE), etc. Regulated Environment: Trading occurs in a regulated and centralized environment, ensuring transparency, fairness, and liquidity. Standardized Transactions: Transactions are standardized and executed through specific rules and procedures set by the exchange. Immediate Execution: Orders are matched electronically, allowing for immediate execution of trades at prevailing market prices. 2. Over-the-Counter (OTC) Markets: Decentralized Markets: Trading occurs directly between parties without a centralized exchange. Dealers or market makers facilitate these transactions. Customized Transactions: OTC markets offer flexibility for customized transactions in securities that may not meet the requirements for listing on exchanges. Less Regulation: While subject to regulatory oversight, OTC markets generally have less stringent requirements compared to exchanges. Diverse Securities: A wide range of financial instruments, including stocks, bonds, derivatives, and unlisted securities, can be traded in OTC markets.

Answer 151

Decision Given the available information, you should be cautious about accepting the proposed offer price of $15 per share. The investment bank's IPO pricing model estimates that your stock's current market value is $20 per share. This estimate is validated by the fact that it is very close to the price of the similar firm's stock. If you sold the stock for $15 and the closing price at the end of the first day was $20, the first-day return would be 33.3 percent [($20 − $15)/$15 = 0.333, or 33.3 percent], which is on the upper end of the first-day returns in Exhibit 10.4. Unless your IPO is unusual in some way—for example, you are issuing a large number of shares or the stock price is highly uncertain—a more reasonable price might be $18 per share. With a price of $18 you would expect a first-day return of 11.1 percent [($20 − $18)/$18 = 0.111, or 11.1 percent].

Answer 152

Decision The method of sale that would more likely achieve the lower funding cost for each of the proposed security issues is as follows: a. Negotiated sale, because negotiated sales are generally better for equity issues. b. Competitive sale, because this is a vanilla bond, and competitive sales are more cost-effective for these standardized bond issues. c. Negotiated sale, because this bond issue involves several complexities. d. Competitive sale, because this is another vanilla bond.

Answer 153

Approach Because the underwriting is a firm-commitment offering, the underwriter guarantees that the issuer will receive the full expected amount, as calculated in the text. The underwriter will have to absorb the entire loss. Solution The total proceeds from the sale are $19 per share. Since the issuer still receives $18.60 per share because of the firm-commitment offering, the issuer receives total proceeds of $18.60 per share × 2 million shares = $37.2 million. By comparison, underwriter receives $0.40 per share. Its total proceeds from the sale are $0.8 million ($0.40 per share × 2 million shares = $0.8 million) rather than the expected $2.8 million. The total proceeds for the IPO sale are $38 million ($37.2 million + $0.8 million = $38.0 million).

Answer 154

Approach The key to working this problem is recognizing that in a best-effort IPO, the underwriter bears no risk. The risk of an unsuccessful sale is borne entirely by the issuing firm. Thus, the underwriter is paid first, and the residual goes to the issuer. Solution Since the underwriter agreed to a spread of 7 percent of the price at which each share of stock is sold, the distribution of the proceeds can be calculated as follows: The underwriter's spread for each share sold is $1.33 per share ($19.00 per share × 0.07 = $1.33 per share). The firm's total net proceeds are $35.34 million [($19.00 per share × 0.93) × 2 million shares = $35.34 million], and the underwriter's total proceeds are $2.66 million ($1.33 per share × 2 million shares = $2.66 million). The total proceeds from the IPO sale are still $38 million, but are distributed differently.

Answer 155

Approach To calculate the total cost to the firm of issuing the stock, we must consider all three major costs associated with bringing it to market: underwriting spread, out-of-pocket expenses, and underpricing. Solution 1. Underwriting spread: The underwriter's spread is $3.50 per share ($50.00 per share × 0.07 = $3.50 per share). The number of shares sold is 1.4 million ($70 million/$50.00 per share = 1.4 million shares). Thus, the underwriting cost is $4.9 million ($3.50 per share × 1.4 million shares = $4.9 million). 2. Out-of-pocket expenses: The out-of-pocket expenses are $200,000. 3. Underpricing: The dollar amount of underpricing is computed as follows. The firm's stock was offered at $50.00 and increased to $57.50 per share ($50.00 per share × 1.15 = $57.50 per share) during the first day of trading; thus, the first-day underpricing is $7.50 per share ($57.50 per share − $50.00 per share = $7.50 per share). The total underpricing is $10.5 million ($7.50 per share × 1.4 million shares = $10.5 million). The total cost to the firm of the IPO is $15.6 million, which consists of the following: (1) $4.9 million in underwriting fees, (2) $0.2 million out-of-pocket expenses, and (3) $10.5 million in underpricing.

Answer 156

Underwriter’s Spread=Offer Price to Public−Price Paid to Issuer Net profit per share = (net income - preferred dividends)/weighted average number of shares outstanding

Answer 157

As long as the ownership structure of the company or the liquidity of its shares is not severely altered or impaired, the open-market repurchase alternative is the better choice. Open-market repurchases can easily be adjusted to accommodate changes in the amount of free cash flow that San Marcos generates without adding to stock price volatility. In contrast, increasing and decreasing a regular cash dividend as free cash flows rise and fall would most likely add to the volatility of the company's stock price. Since an open-market repurchase program is more tax efficient than a regular cash dividend, it will also enable stockholders to keep more of the money that is distributed to them. Finally, it will let individual stockholders choose whether they want to participate in the program in the first place.

Answer 158

Hedgers are parties at risk with a commodity or an asset, which means they are exposed to price changes. They buy or sell futures contracts in order to offset their risk. In other words, hedgers actually deal in the commodity or financial instrument specified in the futures contract. By taking a position opposite to that of one already held, at a price set today, hedgers plan to reduce the risk of adverse price fluctuations—that is, to hedge the risk of unexpected price changes. In effect, this is a form of insurance. In a sense, the real motivation for all futures trading is to reduce price risk. With futures, risk is reduced by having the gain in the futures position offset the loss on the cash position and vice versa. A hedger is willing to forego some profit potential in exchange for having someone else assume part of the risk

Answer 159

The hedged position has a smaller chance of a low return, but also a smaller chance of a high return. The use of hedging techniques illustrates the trade-off that underlies all investing decisions: Hedging reduces the risk of loss, but it also reduces the return possibilities relative to the unhedged position. Thus, hedging is used by investors who are uncertain of future price movements and who are willing to protect themselves against adverse price movements at the expense of possible gains. There is no free lunch! How to Hedge with Futures The key to any hedge is that a futures position is taken opposite to the position in the cash market. That is, the nature of the cash market position determines the hedge in the futures market.8 A commodity or financial instrument held (in effect, in inventory) represents a long position because these items could be sold in the cash market. On the other hand, an investor who sells a futures contract has created a short position. Since investors can assume two basic positions with futures contracts, long and short, there are two basic hedge positions. The short (sell) hedge. A cash market inventory holder must sell (short) the futures. Investors should think of short hedges as a means of protecting the value of their portfolios. Since they are holding securities, they are long in the cash position and need to protect themselves against a decline in prices. A short hedge reduces, or possibly eliminates, the risk taken in a long position. The long (buy) hedge. An investor who currently holds no cash inventory (holds no commodities or financial instruments) is, in effect, short in the cash market; therefore, to hedge with futures requires a long position. Someone who is not currently in the cash market but who plans to be in the future and wants to lock in current prices and yields until cash is available to make the investment can use a long hedge, which reduces the risk of a short position. Short Hedge A transaction involving the sale of futures (a short position) while holding the asset (a long position). Long Hedge A transaction where the asset is currently not held but futures are purchased to lock in current prices. Hedging is not an automatic process. It requires more than simply taking a position. Hedgers must make timing decisions as to when to initiate and end the process. As conditions change, hedgers must adjust their hedge strategy. One aspect of hedging that must be considered is “basis” risk. The basis for financial futures often is defined as the difference between the cash price and the futures price of the item being hedged:9 Basis = Cash price – Futures price The basis must be zero on the maturity date of the contract. In the interim, the basis fluctuates in an unpredictable manner and is not constant during a hedge period. Basis risk, therefore, is the risk that hedgers face as a result of unexpected changes in basis. Although changes in the basis will affect the hedge position during its life, a hedge will reduce risk as long as the variability in the basis is less than the variability in the price of the asset being hedged. At maturity, the futures price and the cash price must be equal, resulting in a zero basis. (Transaction costs can cause discrepancies.) The significance of basis risk to investors is that risk cannot be entirely eliminated. Hedging a cash position will involve basis risk.

Answer 160

Speculators In contrast to hedgers, speculators buy or sell futures contracts in an attempt to earn a return. They are willing to assume the risk of price fluctuations, hoping to profit from them. Unlike hedgers, speculators typically do not transact in the physical commodity or financial instrument underlying the futures contract. In other words, they have no prior market position. Some speculators are professionals who do this for a living; others are amateurs, ranging from the very sophisticated to the novice. Although most speculators are not actually present at the futures markets, floor traders (or locals) trade for their own accounts as well as others and often take very short-term (minutes or hours) positions in an attempt to exploit any short-lived market anomalies. Speculators are essential to the proper functioning of the futures market, absorbing the excess demand or supply generated by hedgers and assuming the risk of price fluctuations that hedgers wish to avoid. Speculators contribute to the liquidity of the market and reduce the variability in prices over time. Why speculate in futures markets? After all, one could speculate in the underlying instruments. For example, an investor who believed interest rates were going to decline could buy Government of Canada bonds directly and avoid the bond futures market. The potential advantages of speculating in futures markets include Leverage. The magnification of gains (and losses) can easily be 10 to 1. Ease of transacting. An investor who thinks interest rates will rise will have difficulty selling bonds short, but it is very easy to take a short position in a bond futures contract. Transaction costs. These are often significantly smaller in futures markets. By all accounts, an investor’s likelihood of success when speculating in futures is not very good and the small investor is up against stiff odds.

Answer 161

Similar to options markets, futures markets use a clearing corporation to reduce default risk and to arrange deliveries as required. The clearing corporations also ensure that participants maintain margin deposits or earnest money, to ensure fulfillment of the contract. The Canadian Derivatives Clearing Corporation (CDCC) currently issues and clears futures and futures options contracts traded on the ME, in addition to options contracts (discussed in Chapter 19), while ICE Clear Canada is the designated clearing house for ICE Futures Canada. Futures contracts presently include those on 30- day overnight Repo Rates, the US dollar, two-year and 10-year Government of Canada bonds, 3- month bankers’ acceptances, the S&P/TSX 60 Index, the S&P/TSX Sectoral Indexes, and single stock prices. Futures options contracts include options on the 3-month bankers’ acceptance futures. Essentially, the clearing house for futures markets operates in the same way as the one for options, which was discussed in some detail in Chapter 19. Buyers and sellers settle with the clearing house, not each other, and it is actually on the other side of every transaction and ensures that all payments are made as specified. It stands ready to fulfill a contract if either buyer or seller defaults, thereby helping to facilitate an orderly market in futures. The clearing house makes the futures market impersonal, which is the key to its success because any buyer or seller can always close out a position and be assured of payment. The first failure of a clearing member in modern times occurred in the 1980s, and the system worked perfectly in preventing any customer from losing money. Finally, as explained below, the clearing house allows participants to easily reverse a position before maturity because it keeps track of each participant’s obligations.

Answer 162

15-1. Futures Contract: A futures contract is an agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. These contracts are standardized and traded on an exchange. They can involve commodities (like oil, gold, or agricultural products), financial instruments (such as stock indices or currencies), or even interest rates. Futures contracts are used for hedging against price fluctuations or for speculative purposes. 15-2. Forward Contracts vs. Futures Contracts: Forward contracts and futures contracts are similar in that they both involve agreements to buy or sell assets at a predetermined price in the future. However, forward contracts are typically customized between two parties and traded over-the-counter (OTC), which means they are not standardized and are more flexible in terms of terms and conditions. Futures contracts, on the other hand, are standardized and traded on exchanges, making them more liquid and easily accessible. 15-3. Valuation and Settlement of Futures Contracts: Futures contracts are marked to market daily, meaning the value of the contract is adjusted daily based on the current market price of the underlying asset. If the contract moves against the holder, they may have to add more funds (margin) to cover potential losses (variation margin). Most contracts are settled before the expiration date through an offsetting trade where the buyer and seller agree to close the position, resulting in a profit or loss. 15-4. Role of Clearing House in Futures Trading: The clearinghouse acts as an intermediary in futures trading. It ensures the fulfillment of contracts by guaranteeing the performance of both parties involved. It acts as a buyer to every seller and a seller to every buyer, reducing the risk of default. It also handles the process of daily marking to market and manages the margin requirements. 15-5. Margin Call for Investors: An investor receives a margin call when the value of their futures contract decreases enough that it no longer meets the required margin amount set by the exchange. This prompts the investor to deposit more funds into their margin account to bring it back up to the required level. Failure to do so may lead to liquidation of the position by the broker. 15-6. Hedger vs. Speculator: Hedger: A hedger is someone who enters into a futures contract to offset the risk of price fluctuations in the underlying asset. For example, a farmer might hedge against the risk of falling crop prices by selling futures contracts. Speculator: A speculator, on the other hand, enters into futures contracts with the primary goal of profiting from price movements. They take on risk without having a direct interest in the underlying asset, aiming to capitalize on market fluctuations.

Answer 163

14-1. Justifications for the Existence of Options: Risk Management: Options provide a way to hedge against price fluctuations in the underlying asset, reducing risk for investors. Speculation: Options allow investors to speculate on the direction of price movements without owning the underlying asset. Enhanced Portfolio Performance: They offer opportunities to enhance portfolio performance by leveraging market movements through strategic options positions. 14-2. Option Buyer's Right vs. Obligation: An option buyer has the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) the underlying asset at the specified price (strike price) within a specified period. The buyer can choose not to exercise this right if it's not profitable or beneficial. 14-4. Difference between Call/Put Writer's and Buyer's Positions: Writer's Position: The writer (seller) of an option has the obligation to fulfill the contract if the buyer decides to exercise the option. They receive the premium upfront but face potentially unlimited risk. Buyer's Position: The buyer pays the premium and has the right to exercise the option but is not obligated to do so. Their maximum loss is limited to the premium paid. 14-6. Explanation of Terms: Strike Price: The price at which the underlying asset can be bought or sold if the option is exercised. Naked Option: An option position taken without owning the underlying asset. It involves higher risk as there's no protection against adverse price movements. Premium: The price paid by the option buyer to the seller (writer) for the rights conveyed by the option contract. Out-of-the-Money Option: An option that would not result in a profit if exercised immediately. For a call option, the stock price is below the strike price; for a put option, the stock price is above the strike price. 14-7. Who Writes Puts and Calls? Why? Sellers or writers of options are often institutions or individuals looking to collect premiums. They may do so to generate income or hedge their own positions in the market. 14-9. Relationship between Option Prices and Intrinsic Values: The intrinsic value of an option is the difference between the current price of the underlying asset and the strike price. Option prices will reflect both intrinsic value and time value. In-the-money options have intrinsic value, while out-of-the-money options only have time value. 14-10. Time Value of an Option: The time value of an option is the premium amount in excess of its intrinsic value. It represents the potential for the option to gain additional value before expiration due to time remaining for potential price movements. 14-14. Difference between Writing Covered Call and Naked Call: Writing a covered call involves selling a call option on a security that is already owned by the seller (writer). The risk is limited because the seller owns the underlying asset. Writing a naked call involves selling a call option without owning the underlying asset. It exposes the seller to potentially unlimited risk if the stock price rises significantly. 14-16. Advantages of Puts and Calls: Leverage: They allow investors to control a larger position with a smaller amount of capital. Risk Management: Options can be used to hedge against potential losses. Speculation: Options offer opportunities for profit in volatile markets. 14-18. Reasons an Investor Might Purchase a Call: Speculation: To profit from anticipated price increases without owning the underlying asset. Hedging: To hedge against potential losses in a stock position. Leverage: To control a larger position with a smaller upfront investment.

MOS final exam Flashcards

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