Weakest areas Flashcards
(22 cards)
Difference between debt vs equity?
Ownership: Equity represents ownership stake in the company, with shareholders being partial owners.
Debt is a loan agreement between the firm and creditors. No ownership or voting rights.
Obligation to pay: Debt creates a legal obligation to pay interest and repay the principal. Failure to do so can lead to bankruptcy. e.g. Lehman Brothers.
Equity involves no guaranteed payments. Dividends are discretionary and not legally binding. Firms with irregular cash flow may prefer equity.
Tax treatment: Interest on debt is tax deductible reducing firms taxable income (tax shield).
Equity - dividends are not tax deductible, equity more expensive from a tax perspective. Incentive to use debt rather than equity, increasing financial risk e.g. due to higher risk of too much debt, lead to bankruptcy.
Give me three examples of cost of carry and two benefits?
Cost of carry is all benefits and costs associated holding an asset until a future date T. Influences forwards/futures pricing, key to determining arbitrage opportunities.
Example 1: Storage costs (u). e.g. warehouse costs on holding physical commodities such as wheat, oil etc. Investor expects price to rise above storage costs. Can compare buying now vs future. storage costs are predictable and observable.
Example 2: Financing costs- when an investor borrows money to invest in an asset, interest they pay is a financing cost. E.g investor puts money into FTSE100, with interesr rate at 5%, expects gains to be larger than interest, but reduces returns. In low interest rate environments returns rise and vice versa.
Example 3: Admin costs- can incur custody or holding fees for safekeeping when trading OTC investments. Costs can accumulate over large holdings, impacting arbitrage opportunities.
Benefits: Dividend yield (q) - Holding FTSE100 yields 3% annually in dividends, reducing cost of carry. Encourages holding asset.
Convenience yield (y) - Non-monetary benefit of physically holding a commodity. e.g. manufacturer holding copper avoids production delay during supply shocks. Ensures production continuity.
What is delta and gamma?
Delta: Δ= ∂S/∂C. Rate of change of option price with respect to underlying stock price. Between 0 and 1, a cumulative probability. Delta is the slope. Delta changes as stock price changes. First derivative of the option premium.
Gamma: Γ= ∂S^2 / ∂^2C Γ=
Gamma is the change in delta as the stock price changes. The rate of change of delta. Gamma distributed fairly symmetrical around exercise price. Gamma is the first derivative of delta. When gamma is large important to rebalance portfolio to remain delta neutral. Gamma is the change in the slope of the option premium graph. Gamma corrects for the error that can occur if just relying on delta for readjustment.
What is delta and gamma neutral?
Delta neutral- a small movement in the stock price is unaffected as it hedges against small movements. Is not reliable for large moves in price, must be constantly rebalanced leading to error. Effective for small local changes.
Gamma neutral- Helps reducing hedging error over time, meaning delta wont change much when stock prices change. If gamma is high, delta neutral hedges break down faster. It stabilises over time, harder to maintain. Reduces need for constant rebalancing.
What is WACC and assumptions?
It is the weighted average cost of debt and equity. Determines if a projects return is higher than WACC, so like a benchmark, as a minimum to satisfy shareholders and debt holders.
Assumptions:
-capital structure remains constant, D/E ratio doesnt change.
-Risk free rate and market premium are constant.
-No transaction costs, perfect capital markets.
What is the Beta of a firm?
The beta of a firm reflects the firms price sensitivity compared to the market. It is used in the CAPM which measures return required by investors given systematic risk.
What is the CAPM and its components?
Expected return on an investment, based on its risk relative to the market.
Rf- the risk free rate, the return on a riskless investment.
Beta- Measures how much the asset moves with the market. Indicates systematic risk.
Rm- Expected return of the market. Average return of the market portfolio.
Rm-Rf- Extra return expected from investing in the market over the risk-free rate.
What is the binomial pricing model?
Prices an option, typically call options. If its European we cant exercise early.
Options typically fall in value when there is a dividend. Dividends typically reduce the stock price, upside potential is lower with. Lowers probability stock ends up in the money. Can be seen as undervalued.
For Americans typically higher than Europeans, as they can exercise option early. Optimal for in the money calls.
Simple and intuitive model to estimate price options, but has limitations. Can introduce approximation errors, compared to continuous models like BSM.
What is a Long Forward?
Agrees to buy underlying asset for a certain price at a certain time in the future. Draw graph. Explain why investor would invest, example, critical analysis.
When is an option ITM, ATM and OTM for long calls?
S>X ITM
S<X OTM
S=X ATM
What is MM 1 and 2 for no taxes?
P1- capital structure is irrelevant if there are no taxes, as no tax benefits.
P2- WACC stays constant regardless of D/E ratio. Cost of equity increases with leverage, debt to equity ratio.
What is MM with taxes P1 and P2?
P1: Having more debt is better because of the tax shield which suggests levered firms are better than unlevered firms, where debt is tax deductible.
P2: the more debt in the ratio, the lower the WACC, making it better for funding projects.
Disadvantages of MM with taxes?
Bankruptcy if a firm cannot pay off its debt as they may have too much, can also offset tax benefits. Additional debt is only good up until a certain point.
Legal and administrative costs of bankruptcy e.g. Lehman brothers total fees were $1.05 billion.
Other costs such as lost sales, suppliers and customers lose trust. Increases cost of doing business.
What is the trade off theory?
Too much debt increases probability of bankruptcy. Trade off between tax benefits of debt and bankruptcy costs. Optimal capital structure does exist.
Market value of a firm initially increases up until a certain point , eventually where tax benefits are offset by rising distress costs due to additional borrowing.
What is pecking order theory?
Focuses on using internal financing first, then issuing debt, then using equity as a last resort. Profitable firms borrow less. Optimal capital structure does not exist.
What is the difference between forwards and options?
Forward: Obligated to complete transaction, binding agreement, no upfront cost, unlimited potential gain/loss.
Option: Right but not obligation to execute contract. Premium to seller for right to exercise option. Limited risk as max loss = premium paid. Can be left to expire.
What is the intrinsic value?
The minimum value of a call. A positive value when being exercised, and 0 when out the money. Can only apply the rules to an american call. S-X. At expiration a call option is worth intrinsic value. Call value = max [0, S - X].
S - X increases 1-for-1 with the asset price implying 45º line.
What is the time value?
The difference between price and intrinsic value.
Forward vs future?
Forward: private agreement between two parties. OTC. Customisable. High risk of default. Settled at expiry. Less regulated, no margin requirements. No money traded before expiry.
Futures: Standardised contract such as time, size on an exchange e.g. CME. Low risk, guaranteed by an exchange. Daily P/L. Highly regulated.
What 3 important questions are there for corporate finance?
- In which assets should you invest?
- Which financing source should be used for capital
expenditures? (Capital structure) - How to manage short-term operating cash flows?
What is theta?
Θ = -∂C/∂T or ∂C/∂t. and Θ = -S₀N’(d₁)σ/2√T - rXe⁻ʳᵀN(d₂) < 0 This gives the time decay of the option
* Ceteris paribus the option loses value as time passes
What is vega?
