MOS final exam

Question 1

Define finance

Answer 1

the study of how and under what terms savings (money) are allocated between lenders and borrowers

Question 2

Goal of the firm

Answer 2

• create value for the firm’s shareholder by maximizing the price of the existing common stock.
• good financial decisions will help inc stock P
• poor FD will lead to a dec in stock P

Question 3

Role of management

Answer 3

• management serves as an arbitrator and moderator between conflicting interest groups/ stakeholders and objectives
• creditors, managers, employees, and customers hold contractual claims against the company
• shareholders have residual claims against the company

Question 4

Role of finance in business

Answer 4

address 3 issues:
1. what long term investments should the firm undertake? (capital budgeting decision)
2. how should the firm raise money to fund these investments (capital structure decision)
3. how to manage cash flows arising from day to day operations (operating decisions)

Question 5

principle 1 of finance

Answer 5

• define: cash flow is what matters
• accounting profit are not = cash flows
• it’s possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books
• cash flow, and not profits, drive the value of a business
• must determine additional cash flows when making FD

Question 6

principle 2 of finance

Answer 6

• define: money has a time value
• a dollar received today is worth more than a dollar received in the future
• since we can interest on money received today, it is better to receive money sooner rather than later.

Question 7

computation of present value

Answer 7

an investment can be viewed in 2 ways:
- future value
- present value

Question 8

present value formula

Answer 8

P= Fn/ (1+r)^n
Fn= money received after a period of time/ year
r= return rate in decimal/ discount rate
n= time/ year

Question 9

Net present value method

Answer 9

1. calculate the present value of cash inflows
2. calculate the present value of cash outflows
3. subtract the present value of the outflows from the present value of the inflows

Question 10

Evaluate net present value method/ general decision rule

Answer 10

• NPV is positive = the project is acceptable since it promises return greater than the required rate rate of return
• NPV is 0 = acceptable since it promises a return = the required rate of return
• NPV is negative = not acceptable since it promises a return < the required rate of return

Question 11

typical cash outflows and inflows

Answer 11

• outflows:
  +) initial investment (cash need to purchase asset)
  +) incremental operating costs
  +) repairs and maintenance of new equipment
  +) additional investment in inventory
• inflows
  +) incremental revenues
  +) reduction of operating costs
  +) salvage value

Question 12

choosing a discount rate

Answer 12

• the firm’s cost of capital is usually regarded as the min required rate of return
• cost of capital = average rate of return the company must pay to its long term creditors and stockholders for the use of their funds.

Question 13

principle 3 of finance

Answer 13

• define: risk requires a reward
• risk: the uncertainty about the outcome or payoff of an investment in the future
• rational investors would choose a riskier investment only if they feel the expected return is high enough to justify the greater risk

Question 14

diversification of investment

Answer 14

• some risk can be removed or diversified by investing in several different securities
• firm specific risk vs market risk

Question 15

real vs financial assets

Answer 15

• real assets:
  +) define: tangible things owned by persons and businesses
  +) ie:
  1. residential structures and property
  2. major appliances and automobiles
  3. office towers, factories, mines
  4. machinery and equipment
• financial asset:
  +) define: what 1 indi has lent to another
  +) ie:
  1. consumer credit
  2. loans
  3. mortgages

Question 16

function of money

Answer 16

• medium of exchange:
  +) how transactions are conducted: something that is generally acceptable in exchange for goods and services. money removes the need for double coincidence of wants by separating sellers from buyers .
• standard of value:
  +) how the value of goods and services are denominated: something that circulates and provides a standardized means of evaluating the relative P of goods and services
• store of value:
  +) how the value of goods and services are maintained in monetary terms: the ability of money to command purchasing power in the future

Question 17

financial system

Answer 17

• gov/ business<-> financial intermediaries <-> households
• non residents <-> market intermediaries

Question 18

Channels of money transfer

Answer 18

• financial intermediaries: transform the nature of the securities they issue and invest in (bank, insurance company)
• market intermediaries: make the markets work better (ie: real estate broker, stock broker)
• non market transaction: in which the markets are not involved (ie: lending money to your sibling so they can buy a car)

Question 19

Intermediation

Answer 19

• intermediation: the transfer of funds from lenders to borrowers
• 1st channel: direct intermediation- the lender provides money directly to the borrower (non market transaction)
• 2nd channel: direct intermediation through a market intermediary - the borrower uses a market intermediary to help find suitable lenders
  +) market intermediary- an entity that facilitates the working of markets (mortgage brokers, insurance brokers, stockbrokers)
• 3rd channel: indirect intermediation - the financial intermediary lends the money to the ultimate borrowers but raises the money itself by borrowing directly from other indi

Question 20

channels of intermediation

Answer 20

lenders
non market transaction <-> direct claims <-> market intermediaries
financial intermediaries <-> indirect claims
borrowers

Question 21

Financial intermediaries

Answer 21

• banks and other deposit taking institutions
• insurance companies
• pension funds
• mutual funds: a passing through for indi, providing them with a convenient way to invest in the equity and debt market
  +) do not change the nature of the underlying financial security

Question 22

financial instruments

Answer 22

• debt instruments: legal obligations to repay borrowed funds at a specified maturity date and to provide interim interest payment.
  +) bank loans, commercial paper, treasury bills (T bills), etc
• equity instruments: ownership stakes in a company
  +) common shares: part ownership in a company, usually gives voting rights on major decisions affecting the company
  +) preferred shares: equity instruments that usually entitle the owner to fixed dividend payments that must be made before dividends are paid to common shareholders.

Question 23

equity instruments issued by corporations: common stocks

Answer 23

• the common stockholders are the owners of the corporation’s equity
• voting rights
• no specified maturity date and the firm is not obliged to pay dividends to shareholders
• returns come from dividends and capital gains
• on liquidation of company, common stockholders are last in list for company assets, only after creditors, bondholders, and preferred shareholders are paid out.

Question 24

preferred stock

Answer 24

• equity instruments
• usually entitle the owner to fixed dividend payments that must be made before any dividends are paid to common shareholders
• generally do not have voting rights in the company
• have characteristics of both bonds and stocks
• on liquidation of the company, preferred stockholders will be paid out before common stockholders (but after creditors/bondholders)

Question 25

Financial markets

Answer 25

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

Question 26

Financial market (primary and secondary markets

Answer 26

• 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.

Question 27

Financial market (money and capital markets)

Answer 27

• 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

Question 28

Financial markets (exchange or auction / dealer or over the counter

Answer 28

• 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.

Question 29

Financing sources

Answer 29

• 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.

Question 30

bootstrapping (initial funding of the firm)

Answer 30

• 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.

Question 31

venture capital

Answer 31

• 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)

Question 32

initial public offering

Answer 32

• 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

Question 33

1. origination (IPO)

Answer 33

• 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)

Question 34

2. Underwriting (IPO)

Answer 34

• 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.

Question 35

3. Distribution (IPO)

Answer 35

• 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.

Question 36

IPO pricing and cost

Answer 36

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.

Question 37

general cash offer by a public company

Answer 37

• 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.

Question 38

private markets (private vs public market)

Answer 38

• 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.

Question 39

private placements

Answer 39

• 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.

Question 40

Dividends

Answer 40

• 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

Question 41

regular cash dividend

Answer 41

• 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

Question 42

extra dividend

Answer 42

• 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

Question 43

special dividend

Answer 43

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

Question 44

liquidating dividend

Answer 44

paid to stockholder when a firm is liquidated

Question 45

the dividend payment process (timeline for a public company)

Answer 45

• 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

Question 46

stock repurchases

Answer 46

• 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

Question 47

stock dividends

Answer 47

• 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.

Question 48

stock split

Answer 48

• 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

Question 49

practical considerations in setting a dividend

Answer 49

• 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?

Question 50

acquisition

Answer 50

• 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)

Question 51

merger (amalgamation= Cdn term)

Answer 51

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

Question 52

horizontal merger

Answer 52

• 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

Question 53

vertical merger

Answer 53

• 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)

Question 54

conglomerate merger

Answer 54

• 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

Question 55

motivations for mergers and acquisition (creation of synergy motive for M&As)

Answer 55

• 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

Question 56

value creation motivations for M&As

Answer 56

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

Question 57

general intent of the legislation

Answer 57

• 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)

Question 58

securities legislation

Answer 58

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.

Question 59

takeover bid process

Answer 59

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.

Question 60

exempt takeovers

Answer 60

• 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

Question 61

friendly acquisition

Answer 61

• 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

Question 62

the friendly takeover process (friendly acquisitions)

Answer 62

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

Question 63

friendly acquisition diagram

Answer 63

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

Question 64

hostile takeovers

Answer 64

• 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

Question 65

the typical hostile takeover process

Answer 65

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.

Question 66

capital market reactions and other dynamics (hostile takeovers)

Answer 66

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.

Question 67

defensive tactics (hostile takeovers)

Answer 67

• 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

Question 68

globalization

Answer 68

• 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

Question 69

the rise of multinational corporations (international finance management)

Answer 69

• 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

Question 70

factors affecting international financial management

Answer 70

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

Question 71

goals of international finance management

Answer 71

• 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

Question 72

basic principles of managerial finance

Answer 72

• 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

Question 73

foreign exchange market

Answer 73

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

Question 74

foreign currency quotations

Answer 74

• 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

Question 75

bid-ask rate

Answer 75

• 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

Question 76

cross rates

Answer 76

• define: exchange rates between 2 different currencies
• calculation

Question 76

hedging a currency transaction

Answer 76

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

Question 77

international capital budgeting

Answer 77

• 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

Question 78

exchange rate risk

Answer 78

• 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.

Question 79

derivatives

Answer 79

• 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

Question 80

options

Answer 80

• 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

Question 81

option terminology

Answer 81

• 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)

Question 82

how options work

Answer 82

• 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

Question 83

options trading

Answer 83

• 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

Question 84

options characteristics

Answer 84

• 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

Question 85

the clearing corporation

Answer 85

• 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 .

Question 86

intrinsic value of a call option

Answer 86

• 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

Question 87

intrinsic value of a put option

Answer 87

• 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

Question 88

option writers (sellers)

Answer 88

• 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

Question 89

protective puts

Answer 89

• 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

Question 90

option valuation- time value

Answer 90

• 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

Question 91

Future markets

Answer 91

• 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

Question 92

the clearing corporation

Answer 92

• 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

Question 93

the mechanics of trading

Answer 93

• 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

Question 94

using future contracts

Answer 94

• 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

Question 95

speculating

Answer 95

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

Question 96

you have hired someone to purchase 100 shares of a tech firm for your portfolio. the person you have hired is acting as a

Answer 96

market intermediary

Question 97

which of the following is not an example of a financial intermediary?
- stockbrokers
- manulife financial
- ontario teachers’ pension plan
- bank of montreal

Answer 97

stockbroker

Question 98

what is the main difference between market intermediaries and financial intermediaries?

Answer 98

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

Question 99

which of the following is a correct combination of primary fund lenders and fund borrowers in the financial system?
- household and gov
- household and non residents
- businesses and households
- gov and non residents

Answer 99

household and gov

Question 100

which of the following financial intermediaries does not transform the nature of the underlying financial securities?
- banks
- insurance firms
- mutual funds
- pension funds

Answer 100

mutual funds

Question 101

which securities include short term debt instruments, such as T bills, commercial papers and banker’s acceptance?
- money market securities
- capital market securities
- equity
- non marketable assets

Answer 101

money market securities

Question 102

a small investor from new brunswick has just purchased 100 common shares of a telecommunication firm on the toronto stock exchange. this is the first time the investor has purchased this stock. this transaction is an example of

Answer 102

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

Question 103

what is a true statement about the global financial system?

Answer 103

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

Question 104

why are global financial markets important to canadians?

Answer 104

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

Question 105

to reduce risk in any particular investment, venture capitalists

Answer 105

adopt syndications

Question 106

who are angel investors

Answer 106

wealthy individuals who invest their own money in new ventures

Question 107

venture capital firm exit venture backed companies

Answer 107

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

Question 108

true statement

Answer 108

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

Question 109

disadvantage of a company going public

Answer 109

going public mandates compliance with on going SEC disclosure requirements

Question 110

true statement 2

Answer 110

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

Question 111

management of wildhorse corporation, designer and marketer of athletic apparel, is planning an expansion into foreign markets and needs to raise 11 million dollars to finance this move. management anticipates raising the money through a general cash offering for 20 dollar a share. if the underwriters charge a 5% spread, how many shares will the company have to sell to achieve its goal?

Answer 111

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)

Question 112

suppose that a high tech firm raises 150 million an IPO. the firm receives 27 dollar per share, and the stock sold to the public at 30 dollar per share. the firm’s legal fees, SEC registration fees, and other admin costs are 410,000. the firm’s stock P inc 13.5% on the first day. what is the firm’s total cost of issuing the securities?

Answer 112

• 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

Question 113

which of the following is a cost associated with an IPO?
- dividend payments
- interest expenses
- out of pocket expenses
- cost of debt

Answer 113

out of pocket expenses

Question 114

suppose a firm is doing an IPO and the investment bank offers to buy the securities for 64.05 dollar per share with an offering P of 70 dollar. what is the underwriter’s spread? assume that the underwriter’s cost of bringing the security to the market is 1 dollar per share. what is its net profit per share

Answer 114

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

Question 115

a shelf registration allows a firm to register and sell securities over a ____year period without having to make a new, separate registration

Answer 115

2 years

Question 116

linear co will be distributing 200 million to shareholders through a special dividend. the company has 780 million shares outstanding. Ignore taxes, if you own 1000 shares of linear co,, how much will you receive?

Answer 116

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

Question 117

the record date typically follows the ex dividend date by

Answer 117

2 business days

Question 118

dividends represent

Answer 118

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

Question 119

a dividend distribution

Answer 119

reduces the stockholder’s investment in a firm

Question 120

you would like to own a common stock that has a record date of friday, sep 8, 2017. what is the last date that you can purchase the stock and still receive the dividend?

Answer 120

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

Question 121

you believe that the average is subject to a 20% tax rate on dividend payments. if a firm is going to pay a 0.60 dollar dividend, by what amount would you expect the stock P to drop on the ex dividend date?

Answer 121

0.48 (0.6 x (1-0.2))

Question 122

true statement 3

Answer 122

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

Question 123

true statement 4

Answer 123

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

Question 124

with a(n) ____management announces the P that will be paid for the shares and the max number of shares that will be repurchased

Answer 124

fixed P tender offer

Question 125

true statement 5

Answer 125

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

Question 126

false statement

Answer 126

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

Question 127

management of the veil acts company just announced that instead of a regular dividend this quarter, the company will repurchase shares using the same amount of cash that would have been paid in the suspended dividend. should this be a positive or negative signal from the firm?

Answer 127

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

Question 128

false statement 2

Answer 128

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

Question 129

one type of dividend that does not involve the distribution of value is known as a(n)
- regular cash dividend
- special dividend
- extra dividend
- stock dividend

Answer 129

stock dividend

Question 130

what is true statement regarding stock splits is true?

Answer 130

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

Question 131

management of the wildhorse company has just declared a 2 for 1 stock split. if you own 21, 600 shares before the split, how many shares will you own after the split? what if it were a 1 or 2 reverse stock split

Answer 131

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

Question 132

key conclusions from the Lintner study (1956)

Answer 132

• 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.

Question 133

Two publicly traded companies in the same industry are similar in all respects except one. Whereas Publicks has issued debt in the public markets, Privicks has never borrowed from any public source. In fact, Privicks always uses private bank debt for its borrowing.

Which firm is likely to have a more aggressive regular dividend payout?

Answer 133

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.

Question 134

which of the following statement about takeovers is false?
- mergers create a new firm, while acquisition do not
- both mergers and acquisition require 2/3 votes from both firms
- in the tender offer, the acquiring firm makes a public offer to purchase shares of the target firm.
- acquisition of assets is one of the types of takeover

Answer 134

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

Question 135

which of the following firm structures is least likely to be the target for a bidder?
- common shares are widely held
- the stock is undervalued
- it has a simple corporate structure
- there are many legal problems

Answer 135

there are many legal problems

Question 136

true statement 6

Answer 136

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

Question 137

critical shareholder %

Answer 137

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

Question 138

which of the following statements about hostile takeovers is false?
- in hostile takeover bids, there is usually a tender offer
- a formal vote by the target shareholders is required
- the target has no desire to be acquired
- the target actively rebuffs the acquiring firm and refuses to provide any confidential info

Answer 138

a formal vote by the target shareholders is required

Question 139

which of the following is not a defensive tactic in a hostile takeover?
- a shareholder rights plan (a poison pill)
- selling the crown jewels
- finding a white knight
- cooperating with the acquirer

Answer 139

cooperating with the acquirer

Question 140

what would come first during the process of a friendly acquisition?

Answer 140

confidentiality agreement

Question 141

true statement 7

Answer 141

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

Question 142

true statement 8

Answer 142

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

Question 143

which of the following is a poor motive for M&A as suggested by evidence?
- diversification
- economies of scale
- economies of scope
- complementary strengths

Answer 143

diversification in general is a poor motive for a merger

Question 144

in a vertical merger, the acquiring firm may be attempting to

Answer 144

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

Question 145

which of the following is not a reason for financial synergies?
- fewer info problems
- reduced average issuing costs
- reduced cash flow volatility
- increased need of external financing

Answer 145

increased need of external financing

Question 146

True statement 9

Answer 146

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

Question 147

true statement 10

Answer 147

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

Question 148

what are economic benefits do the foreign exchange markets provide?

Answer 148

• 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

Question 149

banque nationale de paris offered the following exchange rate quotes in india n rupees (Rs): Rs 94.53/ pound and $1.75/ pound. calculate the cross rate between the US and indian rupee.

Answer 149

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

Question 150

true statement 11

Answer 150

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

Question 151

true statement 12

Answer 151

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

Question 152

Blossom Corp. has just made a sale to a British customer. The sale was for a total value of £138,500 and is to be paid 60 days from now. Blossom management is concerned that the British pound will depreciate against the U.S. dollar and plans to hedge this risk. The company’s bank informs management that the spot rate is $1.2325/£ and the 60-day forward rate is $1.2225/£.

If Blossom sells its pounds receivable at the forward rate, what is the dollar value of its receivables?

If it did not enter into a forward contract and the spot rate 60 days later is $1.1950/£, how much would the company lose by not hedging?

Answer 152

• 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

Question 153

true statement 13

Answer 153

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

Question 154

true statement 14

Answer 154

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

Question 155

what is the difference between organizational and organized crime

Answer 155

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

Question 156

what is true regard to Cressy’s theory of crime causation

Answer 156

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

Question 157

identify which of the following is not considered a non shareable prob from Cressy’s research
- business reversal such as bankruptcy
- losses due to gambling
- justification of the fraud act by blaming the employer for poor work conditions
- personal problems such as uninsured medical claim

Answer 157

business reversal such as bankruptcy

Question 158

in the albrecht fraud scale, what is true?

Answer 158

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

Question 159

which of the following is not a beha indicator of fraud?
-buying new luxury cars or wearing expensive jewelry?
- acting irritable, defensive, or in a belligerent manner
- not taking vacations of more than 2 or 3 days
- failing to retain adequate financial records

Answer 159

failing to retain adequate financial records

Question 160

what best describes the relationship between an employee’s position and theft (according to Hollinger and Clark’s research)?

Answer 160

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

Question 161

in terms of the definition of occupational fraud and abuse, who is an employee?

Answer 161

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

Question 162

the difference between fraud and errors is

Answer 162

intent of those involved

Question 163

one of the most important contributions of criminology to the study of fraud is

Answer 163

the fraud triangle

Question 164

financial stat fraud is often attributed to pressures. these pressures include all of the following except:
- investment losses by managers
- meeting analysts’ expectations
- deadlines and cutoffs
- qualifying for bonuses

Answer 164

investment losses by managers

Question 165

marketable vs non marketable asset

Answer 165

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.

Question 166

concept review C9: which sector(s) of economy are not providers of financing and which are the net users of financing?

Answer 166

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.

Question 167

concept review C9: identify 3 main channels of savings

Answer 167

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.

Question 168

concept review C9: distinguish between market and financial intermediaries

Answer 168

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.

Question 169

concept review C9: discuss how the 4 most important types of financial intermediaries operate

Answer 169

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.

Question 170

concept review C9: identify the major sources of financing used by:
a) gov
b) businesses

Answer 170

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.

Question 171

concept review C9: distinguish between primary and secondary market

Answer 171

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.

Question 172

concept review C9: identify and briefly describe the 2 major stock markets in the US

Answer 172

NYSE, NASDAQ

Question 173

practice prob C9: Q12- list the 4 major financial sectors in the financial system and discuss how they relate to one another

Answer 173

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.

Question 174

practice prob C9: Q15 - describe the 2 major types of secondary markets

Answer 174

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.

Question 175

DECISION MAKING EXAMPLE 10.1
Pricing an IPO

Situation
You are the CFO of a small firm that is planning an IPO. You are meeting with your investment banker to discuss the offer price for your common-stock issue. The investment banker tells you that an IPO pricing model indicates that the current value of your stock is $20 per share. Furthermore, a firm with similar risk characteristics completed an IPO two months ago, and its stock price suggests a current market price of $21 per share. The investment banker says that the offer price should be set at $15 per share. What decision should you make with regard to the investment bank’s offer price?

Answer 175

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].

Question 176

DECISION MAKING EXAMPLE 10.2
Method of Sale

Situation
You are the CFO of a firm that plans to issue a number of securities during the upcoming year. You expect market conditions to remain stable during this period. To obtain the lower funding costs, which method of sale—competitive or negotiated—will you choose for the issues listed in the following?

a. An issue of common stock.
b. A 20-year bond with a fixed-rate coupon.
c. A 20-year revenue bond to fund a manufacturing facility in Brazil; payment of interest and principal is tied to revenues earned by the new facility.
d. A 10-year fixed-rate bond sold from a shelf registration issue.

Answer 176

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.

Question 177

LEARNING BY DOING APPLICATION 10.1
An Unsuccessful IPO

Problem
Let’s continue with our IPO example from the text. Suppose that the stock sale is not successful and the underwriter is able to sell the stock, on average, for only $19 per share. If the underwriter buys the stock from the issuer for $18.60, what will be the proceeds for each party from the sale?

Answer 177

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).

Question 178

LEARNING BY DOING APPLICATION 10.2
A Best-Effort IPO

Problem
Now let’s assume that the stock in our IPO is sold on a best-effort basis and that the underwriter agrees to a spread of 7 percent of the selling price. The average selling price remains at $19 per share. What are the net proceeds for the issuer and the underwriter in this best-effort offering?

Answer 178

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.

Question 179

LEARNING BY DOING APPLICATION 10.3
The Cost of an IPO

Problem
Suppose that Madrid Electronics from Madrid, New Mexico, sells $70 million of stock at $50 per share in an IPO. The underwriter’s spread is 7 percent, and the firm’s legal fees, SEC registration fees, and other out-of-pocket costs are $200,000. The firm’s stock price increases 15 percent on the first day of trading. In dollars, what is the total cost to the firm of issuing the stock?

Answer 179

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.

Question 180

self study Q C10:

10.2 Suppose a firm is doing an IPO and the investment bank offers to buy the securities for $39 per share with an offering price of $42. What is the underwriter’s spread? Assume that the underwriter’s cost of bringing the security to the market is $1 per share. What is its net profit per share?

Answer 180

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

Question 181

DECISION MAKING EXAMPLE 11.1
Choosing a Payout Method

Situation
You are the chief executive officer of San Marcos Pharmaceuticals, a generic drug manufacturing firm. With patents on a lot of brand-name drugs sold by other pharmaceutical firms expiring, San Marcos has been doing very well manufacturing generic copies of those drugs. In fact, business has been going so well that San Marcos is generating more cash flow than is required for investment in the positive NPV projects that are available to the company.
You have decided that you want to distribute the excess (free) cash flow to stockholders rather than accumulate it in the company’s cash accounts. You expect the company to continue to generate free cash flow in the future, but the amount is likely to vary considerably as the new national health law goes into effect. You want to be able to adjust distributions as free cash flows rise and fall but do not want to make San Marcos’s stock price any more volatile than it already is. Furthermore, relatively few of the company’s shares are held by investors that do not pay taxes, such as pension funds and university endowments, so you would prefer that the distributions be as tax efficient as possible.
Your chief financial officer tells you that the most feasible means of distributing the excess cash on an ongoing basis is to pay a regular cash dividend or to repurchase shares through open-market repurchases. Which of these two options should you choose?

Answer 181

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.

Question 182

Hedgers

Answer 182

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

Question 183

how to hedge in the future

Answer 183

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.

Question 184

speculator

Answer 184

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.

Question 185

the clearing corporation

Answer 185

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.

Question 186

15-1. What is a futures contract?
15-2. How do forward contracts differ from futures contracts?
15-3. Explain how futures contracts are valued daily and how most contracts are settled.
15-4. Describe the role of the clearing house in futures trading.
15-5. What determines whether an investor receives a margin call?
15-6. Explain the differences between a hedger and a speculator.

Answer 186

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.

Question 187

4-1. State three justifications given for the existence of options.
14-2. What does it mean to say an option buyer has a right but not an obligation?
14-4. Why is the call or put writer’s position considerably different from the buyer’s position?
14-6. Explain the following terms used with puts and calls:
Strike price
Naked option
Premium
Out-of-the-money option

14-7. Who writes puts and calls? Why?
14-9. What is the relationship between option prices and their intrinsic values? Why?
14-10. What is meant by the time value of an option?
14-14. How does writing a covered call differ from writing a naked call?
14-16. What are the potential advantages of puts and calls?
14-18. Give three reasons why an investor might purchase a call.

Answer 187

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.