P2B.2 Long Term Financial Management - Derivatives & Other Sources Flashcards
Derivatives Definition
- Financial instrument that derive (or depend) their value from underlying assets. Price of underlying asset will depend on price of derivative instrument.
- Traded on standardized exchange or over the counter (OTC)
Uses of Derivatives
- Hedging: to reduce or eliminate unwanted risk. Gains and losses are recognized immediately in income.
- Speculation: to be on price changes
- Arbitrage: to take advantage of short-term price anomalies.
Types of Derivatives
- Future contracts
- Forward contracts
- Options
- Swaps
Future Contract
- Contractual (standardized) agreement to trade specific financial instruments or commodity at a specified price in the future.
- Standardized to enable parties to update their market positions at the end of each day.
- Traded on exchange and settled via clearinghouses
- Regulated by governments
Forward Contract
- Customized (over the counter) agreement to trade a specific financial instrument or commodity at a specified price on a specific future date.
- Customized to meet a specifics user’s needs
- Are over the counter (OTC)
- Not regulated.
Long & Short Position - Future & Forward Contracts
Long: party agrees to buy underlying asset due to expectation that price will increase in future.
Short: party agrees to sell underlying asset due to expectation that price will decrease in future.
Options
- Gives the holder the right but not the obligation to buy or sell a security at a predetermined price at a specific future date or within a period.
- To acquire an option, buyer (holder) must pay an option premium.
Call Option
- Gives the option holder the right but not the obligation to buy a security at a predetermined (strike) price at a specified date.
- Buyer can benefit when price of asset increases.
- Seller must comply with buyers decision.
Long & Short Position - Call Option
Price increases = Long gains, short loses, and vice versa
Put Option
- Type of option that gives option holder the right but not the obligation to sell a security at a predetermined price at a specified future date.
- Buyer will benefit when asset price decreases.
- Seller must comply with buyers decision.
Long & Short Position - Put Option
Price decreases = Long gains, short loses, and vice versa
Options - “Moneyness” of the Option
- Exercise (strike) price: price at which asset will be bought or sold
- Option premium: price paid for the option
- Moneyness: relates to the relationship between exercise and market price and how its interpreted.
Call Option - Moneyness
- In the money: exercise price < market price
- Out of the money: exercise price > market price
- At the money: exercise price = market price
Put Option - Moneyness
- In the money: exercise price > market price
- Out of the money: exercise price < market price
- At the money: exercise price = market price
Intrinsic Value - Value of a Call
Intrinsic value: amount the option buyer will receive if option is exercised. Only realizable if option is “in the money”.
C = Max [0, Market Price - Strike Price]
Interest Rate Swap
- Exchange of future interest rate risk at a specified face value for a period of time.
- Fixed for floating (plain vanilla swap): exchanges at floating rate (LIBOR) with fixed interest rate loan.
- Involves investors trading interest payments or cash flows from different securities without actually trading the securities directly.
Foreign Currency Swap
- Exchange of principal and interest denominated in one currency for principal and interest with a different currency.
- Used to minimize exchange rate risks and trade internationally by borrowing currency needed for the transaction.
Convertible Securities
- Financial instruments (bonds & preferred stock) that can be converted to common stock.
- Hybrid: possesses both debt and equity elements.
- Lower cost of capital than non-convertible instruments due to conversion feature.
- Converted using conversion ratio and included conversion price.
Advantages to the firm of using convertible bonds include deferring equity financing until equity prices are higher and a lower interest rate because of the convertible provision.
Disadvantage to the firm of convertible bonds is that investors may choose to continue their investment as a fixed-interest bond and assure their income stream rather than convert to stocks, on which the firm may choose not to pay out dividends.
Warrants
- Financial instrument that gives holder the right but not obligation to purchase from issuer a certain number of units of a security at a specified price before the expiration of warrant.
- Lower rates and longer terms
- Detachable: bonds and preferred stock
- Naked: no associated security
- Warrants serve as a “sweetener” that makes the bond more attractive.
- The bond owner can use the warrant to become an equity investor.
