P2B.2 Long Term Financial Management - Derivatives & Other Sources

Question 1

Derivatives Definition

Answer 1

1. Financial instrument that derive (or depend) their value from underlying assets. Price of underlying asset will depend on price of derivative instrument.
2. Traded on standardized exchange or over the counter (OTC)

Question 2

Uses of Derivatives

Answer 2

1. Hedging: to reduce or eliminate unwanted risk. Gains and losses are recognized immediately in income.
2. Speculation: to be on price changes
3. Arbitrage: to take advantage of short-term price anomalies.

Question 3

Types of Derivatives

Answer 3

1. Future contracts
2. Forward contracts
3. Options
4. Swaps

Question 4

Future Contract

Answer 4

1. Contractual (standardized) agreement to trade specific financial instruments or commodity at a specified price in the future.
2. Standardized to enable parties to update their market positions at the end of each day.
3. Traded on exchange and settled via clearinghouses
4. Regulated by governments

Question 5

Forward Contract

Answer 5

1. Customized (over the counter) agreement to trade a specific financial instrument or commodity at a specified price on a specific future date.
2. Customized to meet a specifics user’s needs
3. Are over the counter (OTC)
4. Not regulated.

Question 6

Long & Short Position - Future & Forward Contracts

Answer 6

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.

Question 7

Options

Answer 7

1. 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.
2. To acquire an option, buyer (holder) must pay an option premium.

Question 8

Call Option

Answer 8

1. Gives the option holder the right but not the obligation to buy a security at a predetermined (strike) price at a specified date.
2. Buyer can benefit when price of asset increases.
3. Seller must comply with buyers decision.

Question 9

Long & Short Position - Call Option

Answer 9

Price increases = Long gains, short loses, and vice versa

Question 10

Put Option

Answer 10

1. 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.
2. Buyer will benefit when asset price decreases.
3. Seller must comply with buyers decision.

Question 11

Long & Short Position - Put Option

Answer 11

Price decreases = Long gains, short loses, and vice versa

Question 12

Options - “Moneyness” of the Option

Answer 12

1. Exercise (strike) price: price at which asset will be bought or sold
2. Option premium: price paid for the option
3. Moneyness: relates to the relationship between exercise and market price and how its interpreted.

Question 13

Call Option - Moneyness

Answer 13

1. In the money: exercise price < market price
2. Out of the money: exercise price > market price
3. At the money: exercise price = market price

Question 14

Put Option - Moneyness

Answer 14

1. In the money: exercise price > market price
2. Out of the money: exercise price < market price
3. At the money: exercise price = market price

Question 15

Intrinsic Value - Value of a Call

Answer 15

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]

Question 16

Interest Rate Swap

Answer 16

1. Exchange of future interest rate risk at a specified face value for a period of time.
2. Fixed for floating (plain vanilla swap): exchanges at floating rate (LIBOR) with fixed interest rate loan.
3. Involves investors trading interest payments or cash flows from different securities without actually trading the securities directly.

Question 17

Foreign Currency Swap

Answer 17

1. Exchange of principal and interest denominated in one currency for principal and interest with a different currency.
2. Used to minimize exchange rate risks and trade internationally by borrowing currency needed for the transaction.

Question 18

Convertible Securities

Answer 18

1. Financial instruments (bonds & preferred stock) that can be converted to common stock.
2. Hybrid: possesses both debt and equity elements.
3. Lower cost of capital than non-convertible instruments due to conversion feature.
4. 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.

Question 19

Warrants

Answer 19

1. 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.
2. Lower rates and longer terms
3. Detachable: bonds and preferred stock
4. Naked: no associated security
5. Warrants serve as a “sweetener” that makes the bond more attractive.
6. The bond owner can use the warrant to become an equity investor.