FM quick/important Flashcards
Kd=
=(i(1-T))/P0
Kp=
D/P0
ie 8% preference would be 8 for D and P0 is ex div price
gordon growth model
g=r*b
r= Earnings/Opening shareholder’s funds
b= Retained profit for the year/Earnings
OTC interest options, forex?
No * by contracts its literally just looking at whether the traded option price is better, and if it is then exercise at the rate you chooose + premium
forex is the same, find best rate go with it and charge premium and make sure you get the right put or call (remmeber denominated in foreign currency so go with what youre doing with this)
Transaction risk
The risk that the exchange rate moves between the transaction date and payment/receipt date (think typical hedging)
Economic risk
The risk that long term changes in the economy can impact a business (positively or negatively) usually concerned with importers and exporters
Eg if you are an importer say of euros, you favour a weaker euro to pound conversion as you can buy goods for cheap compared to the sterling price
However if you’re an exporter you prefer a stronger euro as you will be selling in euro price based on pounds hence if the euro was weaker you would require an even higher price to get the same sterling return
In this way say the economy is such that the euro strengthens, this would therefore benefit the exporter businesses and hinder importers
The way to hedge this is to diversify the conducts of business to help mitigate the risk
Translation risk
The risk that at ye when foreign assets and liabilities are retranslated we will get a forex gain or loss (though this won’t be realised unless you sell the assets or pay the liabilities)
The way to hedge is to fund foreign assets with foreign loans
Interest rate futures how to?
Think pro forma
underlying contract based what the interest rate become
then no of contracts based on standard contract £ and size
sell futures contracts if worried about 100-i decreasing and worried about i increasing (ie if borrowing)
buy futures contracts if worried about i decreasing and 100-i decreasing
then just add the profit/loss on the futures contracts (*by cotnracts etc) to get the final figure
have to exercise regardless !
Approach for hedging discussion. (4)
-Discuss risk appetitie and scenario
-Conclusion
-Discuss calculations
-Discuss scenario eg forwards and discounts , interest rate parity theory and depreciation of currency
DIfferences between OTC and traded options. (4)
Differences between traded currency options and OTC currency options:
-OTCs are, typically, purchased from a bank.
-OTCs are tailor-made and so will lack negotiability
-Traded options are for standardised amounts and can be traded and a profit/loss made.
-Traded options are not available in every currency
Implications of a late payment/receipt on hedge of:
No
Forward
Futures
OTC
If asked in exam talk about each contract in turn to get credit ie each option asked to evalute in the question
if no hedge how this will just be translated at the future rate
forward legal obligation to exchange currency on the date so will potentially need to borrow on a short term basis to fulfill the contract
Futures - separate transaction so wont affect futures contract regardless of when paid
OTC- could let the option lapse and then exchange on the date it is received at that spot rate OR could borrow in the short term to benefit from the option so that the option can be exervcised on the date.
What is the margin system
Have to put an initial margin on futures to ensure you dont run away, essentially money on deposit, a margin call will happen if the acocunt falls below a threshold (typically the inital deposit amount required) and these are done based on the closing out of the futures on a daily basis to work out a profit or a loss
OTC vs traded options
OTCS:
OPTIONS OVER FORWARDS attached to forward contracts. Just like a forward contract there will be a price agreed up front.
They are tailor made to the transaction, to cover the exact amount and dates required.
Traded options:
OPTIONS OVER FUTURES
As futures are traded on an exchange, an option on a futures contract is known as a traded option.
This product is standardised, just like with futures contracts and will be fixed in terms of the contract size and date.
5-8 FRA/ FRAs generally
starts in 5 months time and lasts for 3 months (till the 8th month)
remmeber FRAs are just interest forward agreements so the rate will always be the forward rate agreed, then the difference will be the cash settlement on the FRA (ie if not exactly the rate agreed with the bank you will receive or pay more money to get to the agreed rate)
FRAs qlway pay the effective rate and then the difference is what is paid to you or bank THIS IS ALL YOU WORK OUT ON EXAM FRA RATE IS INTEREST PAID
IRF buy or sell
If you want to deposit money you want to buy futures today think David Beckham (deposit, buy)
This is because if youre deposting money you are worrying about a decrease in the interest rate and therefore an increase in the futures price (100-i), hence to make a product you would buy at todays futures price and sell at the expected increased futures price to get a profit!
If you are lending money you sell futures today (think Britney Spears - borrow sell) as you are worried about the interest rate rising therefore you are going to sell at todays futures price as you expect that interest rates will rise thus the futures price will decrease allowing you to make a profit!
What is basis risk
Futures contracts:
Happens when the future is closed before expiry date, eg mightve agree a future with 5% but close a month ealrier when its 6% and therefore the profit/loss made may not offset as well as the agreement to cover movements in the underlying transaction
Reasons for swaps
Change exposure to risk without changing existing commitments
No arrangement fees or lower
allows you to gain a fixed rate if youre the fixed rate company thus eliminating variable risk/ or variable allows you to take advanatge of negative shifts in exchange rate
-comparative advantage -save money by entering the swap and paying less than market rates through mutual benefit
Easy way to remember buy and sell generally
Think about what you are worried about protecting
eg futures and youre selling your index portfolio in the future youre worried about a fall in index and thus the futures price therefore you are going to want to sell today to get the highest profit
if eg youre a bank with a loan on interest you are going to be worried about an increase in interest rates and therefore the futures price quoted as 100-i decreasing therefore you are going to sell today at the higher futures price to get a profit
Intrinsic value and time value
Instrinsic:
exercise price and market price impact on this and to find you compare Strike price vs current price
in the money or out of depending on whether a buy or a sell position as a seller if higher will want that so will be out of the money here (hence 0 intrinsic value) where as a buyer with a higher price at mv wont want that so is in the money
Time value
Contract length eg longer contracts are more valuable so will be at a higher premium as securing for a longer time period, volatility (more volatile means more volatile as more risk that youre protecting so higher premium eg think car insurance) and interest rates (if they rise call become more attractive and put less attractive) impact this
Premium less intrinsic value calculated
How does purchasing power parity work wb interest rate parity theory
The law of one price, eg the price of a book for £10 in the UK should equal the USD equivalent as per forex
However due to inflation this can lead to increased purchasing power and profit eg if greater inflation was in the US you would make a profit
Therefore used ot predict future spot is spot*1+foreign inflation rate/home inflation rate
This is to counteract the benefits brought about by inflation, so effectively the country with the higher inflation will see its currency weaken in forex to bring back to this one price
Can check if you have the question right if the currency with higher inflation has weakened after the calc
Flaws:
Forecasts not absolute eg unforeseen events, speculators distorting the market, artifical intervention in rates eg gov policy
Solution interest rate partity theory!
Same formula but using interest rates and higher interest rate country sees currency weaken as this combats high inflation, indicative of greater economic issues thus less attractive
Still a forecast! Gov intervention/fiscal policy
IRP superior as governments have a choice but inflation is independently
Explain how shareholder value analysis can be used. (7)
SVA is useful to highlight the key drivers of value, namely:
Cost of capital;
Life of projected cash flows;
Sales growth rate; Investment in working capital;
Investment in non-current assets;
Corporation tax rate;
Operating profit margin.
This enables managers to set targets for achieving value-enhancing strategies in each area. By examining each area for the project managers can ensure that shareholder’s wealth is
increased.
