Topic 7 - Leveraged Investments

Question 1

Leveraged investments introduction.

Question 2

What does it mean to leverage an investment?

Answer 2

Question 3

What is the underlying tenet in investing?

Answer 3

Question 4

What is the original aim of a hedge fund? And how do they operate today?

Answer 4

Question 5

Why do people borrow to invest?

Answer 5

Question 6

How do income taxes affect geared investments?

Answer 6

Question 7

In Australia, what does positively and negatively geared mean, regarding property investments?

Answer 7

Question 8

What is a tax ‘deductible’ expense?

Answer 8

Negative gearing example:

• Kevin has an assessable income of $20 800 and allowable deductions of $21 600 from an investment thus leaving an $800 loss
• If we assume he is on the 30% marginal tax rate, he will have a tax shield of $240 to reduce his assessable income and reduce tax payable

Question 9

What are some risks of negative gearing?

Answer 9

Question 10

What is gearing ratio also known as?

Answer 10

Question 11

What is the loan-to-value ratio?

Answer 11

Question 12

What are some rules regarding the capital gains tax on investments, your own home and between an individual and a company?

Answer 12

Question 13

Describe what a mortgage is. What is the difference between a fixed- and a variable-rate loan?

Answer 13

Question 14

Differentiate between interest-only loans, equity release loans and reverse mortgages.

Answer 14

• Interest-only loans: interest-only loans with the entire principal payable at the end of the loan;
• Equity release loans: equity release loans, where surplus equity above agreed levels may be withdrawn;
• Reverse mortgages, where no repayments are made until the contract is settled when the homeowner dies or leaves the home

Question 15

What is a second-mortgage loan?

Answer 15

• Second-mortgage loans: second-mortgage loans for investing in other income-generating assets such as shares or other property or for other uses such as investing or consumption, e.g. car, holiday etc (though the latter falls into the area of ‘bad debt’).

Question 16

What is margin lending?

Answer 16

Question 17

What is a safety margin?

Answer 17

Question 18

What is a margin call?

Answer 18

Question 19

What are the benefits of margin lending?

Answer 19

Question 20

What are the risks of margin lending?

Answer 20

Question 21

What is a derivative?

Answer 21

• Derivative – a financial product whose value or price is derived from some other asset
• Derivatives include:

– Contracts for Difference (CFDs)

– Futures

– Options

– Warrants

Question 22

List some different types of derivatives.

Answer 22

Question 23

What are contracts for difference (CFD)?

Answer 23

• An agreement between a buyer and a seller to exchange the difference in the value of an underlying asset
• The buyer is going long and expects the price of the underlying asset to rise
• The seller is going short and expects the price of the underlying asset to fall
• ASX or over the counter (OTC) CFDs
• Can also be used to ‘hedge’ a physical position

Question 24

What are over the counter markets (OTC)?

Answer 24

Question 25

What are future contracts? And what does novation mean?

Answer 25

• Popular in global financial markets because an established futures contract makes it easy for traders and investors to buy and sell the contract
• This ability to find buyers and sellers easily is known as ‘liquidity’
• Traded on registered futures exchanges
• Investors make profits when they buy futures at a lower price than they sell it, or sell higher than they bought it back

Question 26

What would be the realised return of this futures contract?

Answer 26

Question 27

What is an option?

Answer 27

• An option is a security that gives the holder the right but not the obligation to buy or sell something in the future at a fixed price
• Buyer of an option has no obligation to buy/sell if the market price is below the option price
• Seller has an obligation to complete the transaction
• Two types of options:

– Put options

– Call options

Question 28

What is a call option?

Answer 28

Question 29

What is a put option?

Answer 29

Question 30

Where are options traded?

Answer 30

Question 31

What is a warrant?

Answer 31

Question 32

Differentiate between trading-style and investment-style warrants.

Answer 32

Question 33

What does it mean to attend a warrant?

Answer 33

Question 34

How much debt can you afford?

Answer 34

Question 35

What is a margin account?

Answer 35

Question 36

In summary, what is leveraged investing?

Answer 36

• Leveraged investing is an effective use of small amounts of investment capital to magnify returns
• It refers to either the use of borrowed funds or the use of derivatives
• Leveraging is increasingly common in a personal investment portfolio
• Leveraging is reliant on expected returns, ability to service debt and tax advantages
• Leveraged investments come with a number of investment risks.

Question 37

What are the risks associated with gearing?

Page 283

Answer 37

• The anticipated annual income is less than expected
• The anticipated annual expenses are higher than expected.
• If the loan must be rolled over, the lender may change the rules or conditions of the loan which will affect the benefits of the gearing exercise.
• The investor might lose their job and struggle to generate the cash flow necessary to service the outgoings, particularly loan repayments.
• Circumstances may force the investor to sell the asset in less than favourable conditions.
• Asset specific factors can adversely affect the investment asset.
• The asset does not generate the capital gain anticipated.

Question 38

An investor wishes to buy some shares by using a combination of their own money and borrowed funds. They are unsure whether they should take out a margin loan which is secured against the shares or take out a mortgage against the family home.

What are the advantages/disadvantages of each approach?

Pages 289 and 292

Answer 38

recourse | rɪˈkɔːs | noun [in singular]

a source of help in a difficult situation: surgery may be the only recourse.

• [mass noun] (recourse to) the use of (someone or something) as a source of help in a difficult situation: a means of solving disputes without recourse to courts of law | all three countries had recourse to the IMF for standby loans.
• [mass noun] the legal right to demand compensation or payment: the bank has recourse against the exporter for losses incurred.

Question 39

Outline three ways that an investor can satisfy a margin call.

Page 291

Answer 39

1. Contributing cash to reduce the outstanding loan balance.
2. Pledging additional assets as security.
3. Selling investment assets and using the proceeds of the sale to reduce the outstanding loan balance.

Question 40

Mohamed has 10,000 CSL shares in his portfolio. Mohamed is currently working full time but plans to retire before the end of the current financial year. He plans to sell his CSL shares to help fund his retirement; however, to sell them now would mean that he would realise a significant capital gain. Therefore, Mohamed has decided to sell his CSL shares in the next financial year. Mohamed is, however, worried that the CSL share price might fall in the near future.

How can Mohamed use a CFD to hedge his risks?

Pages 294-295 for information on Contract for Difference

Answer 40

Mohamed is long in CSL shares. In order to hedge a long position, Mohamed will need to go short by selling CSL CFD’s.

If the price of CSL shares rise he will lose on the CFD which will offset his gain on his physical position – the net result being that Mohamed will be able to effectively capture the current CSL price.

Conversely, if the price of CSL shares falls he will gain on the CFD but this gain will be offset by a loss on his physical position – again the net result is he has locked in the current CSL price.

Question 41

Outline what impact each of the following events would have on a call option premium:

Higher strike price

Page 298 and 300

Answer 41

Higher strike price

The higher the price at which the call option can be exercised (the strike price) the less likely that the option will be exercised. The less likely that the call option will be exercised the lower the option premium.

Question 42

Outline what impact each of the following events would have on a call option premium:

Increase in the last sale price of the asset

Page 298 and 300

Answer 42

Increase in the last sale price of the asset

The higher the sale price of the asset the more chance that it will exceed the strike price and the higher the option premium.

Question 43

Outline what impact each of the following events would have on a call option premium:

A decrease in the duration for which the option remains open

Page 298 and 300

Answer 43

A decrease in the duration for which the option remains open

The less time that a call option remains open, the less chance that price volatility will push the sale price beyond the strike price to make the option worth exercising, therefore, the option premium will be lower.

Question 44

Outline what impact each of the following events would have on a call option premium:

Increased price volatility in the underlying asset

Page 298 and 300

Answer 44

Increased price volatility in the underlying asset

Increased price volatility means that it is more likely that during the life of the call option the sale price will exceed the strike price and the option will be worth exercising, therefore, the option premium will be higher.

Question 45

Outline what impact each of the following events would have on a call option premium:

Being able to choose an American option in preference to a European Option

Page 298 and 300

Answer 45

Being able to choose an American option in preference to a European Option

An option which can be exercised anytime (American) provides a window of opportunity where the sale price might exceed the strike price thereby making it worthwhile to exercise the option. A European option provides a single opportunity for the sale price to exceed the strike price and as such is a less valuable option and, therefore, would attract a lower option premium.

Question 46

WWF shares are currently trading on the stock exchange for $40. WWF shares are also offered as an instalment warrant; the current market value of the warrant is $20. This warrant gives the holder the right to buy one WWF share for $22 in 12 months’ time. Why would you effectively pay $42 for a share that you could buy in the market today for $40?

See page 302 for an example of the use of warrants

Answer 46

If you don’t have enough money to buy the share outright then you might decide to buy it in instalments.

Alternatively, you might like to leverage your exposure to the market by buying two warrants at $20 each.

Question 47

Selling a call option and buying a put option are both short positions. Does this mean that the payoff profiles for the investor are the same?

Answer 47

To buy a call option is to take a long position. It gives the buyer the right (not the obligation) to buy a specified number of shares at a given price (the strike price) within a given period of time. If the price of the shares rises within the agreed period, the buyer gains because he/she has to pay only the strike price for shares less the cost of the option itself. Referring back to example 8.3 of the chapter – if Fred buys a call option on PHC shares for $42 with an exercise price of $28.50 and the price of those shares rises to $30.00 he will make a gain of $108 = (($30.00 – 28.50) *100) - 42.

The seller of a call option is obliged to sell shares at the strike price. If Fred was to sell a call option, he would receive $42 in cash. If the value of the asset goes up Fred will lose on the option because he has to sell the asset at a lower (the strike price) than the market price and if it goes down his gain is capped at $42.

A buyer will buy a put option if she expects the price of the underlying asset to fall in future. A put option gives the buyer the right to sell the underlying asset at the agreed- price (the strike price) within the period of the contract to the seller of the option

If Fred was to buy a put option he would have to pay a premium to the seller of that option – the size of that premium will be influenced by the factors outlined in the chapter. If the price of the asset is falling Fred can enter the physical market and buy the asset and then sell that asset at the higher agreed price in the put option. The put option buyer’s gain can be very large and theoretically is only limited by the fact that the asset value cannot fall below zero.

In times of falling prices:

Sell a call option – maximum gain equals option premium

Buy a put option – no limit to gain (other than the fact prices cannot go below zero)

In times of rising prices:

Sell a call option – no limit to the loss

Buy a put option – maximum loss equals option premium

Therefore, the payoff profiles for the investor are not the same for the seller of a call option and the buyer of a put option.

Question 48

The estimated percentage of options exercised on the ASX Options Market is:

Select one:

a. less than 5%
b. less than 15%
c. less than 30%
d. less than 55%

Answer 48

b. less than 15%

Question 49

The benefits arising from margin lending over traditional principal and interest mortgage loans typically include:

Select one:

a. a lower interest rate than a mortgage loan
b. liquidity
c. investment diversification opportunities
d. both b and c

Answer 49

d. both b and c

Question 50

Over time, an investor making principal and interest loan repayments on an investment using borrowed funds which is increasing in value would expect their gearing ratio to:

Select one:

a. increase
b. decrease
c. remain unchanged
d. either a or c

Answer 50

b. decrease

Question 51

Loan-to-valuation ratios (LVRs) are set by:

Select one:

a. lenders
b. borrowers
c. the Reserve Bank of Australia (RBA)
d. none of the above

Answer 51

a. lenders

Question 52

The presence of rising asset prices and concessional tax rates on capital gains in a stable interest rate environment is more preferable for a negatively geared share investment than which of the following economic conditions?

Select one:

a. stable asset prices and rising interest rates
b. rising asset prices and rising interest rates
c. decreasing asset prices and relatively high tax rates on capital gains
d. all of the above

Answer 52

d. all of the above

Question 53

Negative gearing arises where:

Select one:

a. borrowings are not undertaken
b. annual income from an investment is greater than the deductible expenses
c. borrowings are on an interest-only basis
d. none of the above

Answer 53

d. none of the above

Question 54

The buyer of a contract for difference (CFD):

Select one:

a. is going short and expects the price to fall
b. is going long and expects the price to rise
c. has the right but not the obligation to buy the underlying asset in the future at a fixed price.
d. none of the above

Answer 54

b. is going long and expects the price to rise

Question 55

The strike price of an option is:

Select one:

a. the price paid for the option premium
b. the trading price of the option at the inception of the option contract
c. the price at which an option contract will be transacted if the option is exercised
d. none of the above

Answer 55

c. the price at which an option contract will be transacted if the option is exercised

Question 56

If an investor believes that the price of an asset is going to decrease in the future they would:

Select one:

a. prefer to currently own the asset and hold
b. prefer not to currently own the asset if they are long-term investor
c. prefer to sell the asset if currently held
d. both b and c

Answer 56

d. both b and c

Question 57

When an investor invests in an income producing asset:

Select one:

a. interest on any loans associated with the income producing asset are tax deductible
b. interest is not a tax deductible expense
c. interest may be deducted from the income derived from an income producing to the extent of the level of income less any other associated expenses
d. none of the above

Answer 57

a. interest on any loans associated with the income producing asset are tax deductible

Question 58

An option:

Select one:

a. is an agreement to trade something in the future, either to buy or to sell a specific amount of a specific asset
b. is an agreement that gives the buyer (holder) of the option the right but not the obligation to buy or sell something in the future at a fixed price
c. is an agreement that gives the holder the right to buy or sell the underlying asset, so, as with all investment assets, the investor wishes to be long if they expect prices to rise and wishes to be short if they expect them to fall
d. none of the above

Answer 58

b. is an agreement that gives the buyer (holder) of the option the right but not the obligation to buy or sell something in the future at a fixed price

Question 59

The buyer of a futures contract will prefer prices of the underlying asset in the future to:

Select one:

a. remain constant
b. fall
c. rise
d. either a or c

Answer 59

c. rise

Question 60

The general risk/reward trade-off associated with warrants shows that:

Select one:

a. capital protected warrants are more risky than self-funding instalment warrants
b. self-funding instalment warrants are more risky than hot instalment warrants
c. instalment warrants are more risky than hot instalment warrants
d. none of the above

Answer 60

d. none of the above

Question 61

In Australia, index options can be exercised:

Select one:

a. only on specified dates not including the expiry date
b. only after one month following acquisition
c. at any time up to and including the expiry date
d. none of the above

Answer 61

d. none of the above

Question 62

Where the value of secured assets falls below an agreed debt-to-asset ratio for a margin loan, what action will be required to be taken?

Select one:

a. the lender must meet a margin call on the loan
b. the borrower must meet a margin call on the loan
c. the lender will require the loan to be discharged in full
d. none of the above

Answer 62

b. the borrower must meet a margin call on the loan

Question 63

A margin loan exposes the borrower to which source(s) of risk for interest repayments?

Select one:

a. timing issues arising from the receipt of investment income and the repayment of loan interest
b. the ability of the borrower to replace or add to security provided in the event of a margin call
c. the loan servicing ability of the borrower to meet repayments from existing income
d. both a and c

Answer 63

d. both a and c

Question 64

The lender in a mortgage contract is referred to as the:

Select one:

a. mortgagee
b. pledger
c. both a and b
d. mortgagor

Answer 64

a. mortgagee

Question 65

Futures contracts:

Select one:

a. rarely end in the physical delivery of the underlying asset
b. require a deposit or initial margin
c. are typically reversed out prior to expiry
d. all of the above

Answer 65

d. all of the above

Question 66

Investment products or instruments that derive their value from underlying assets include:

Select one:

a. contracts for difference (CFDs)
b. options
c. warrants
d. all of the above

Answer 66

d. all of the above

Question 67

Some variations of standard interest and principal mortgages available to investors include:

Select one:

a. equity release loans, where surplus equity above agreed levels may be withdrawn
b. interest-only loans with the entire principal payable at the end of the loan
c. reverse mortgages
d. all of the above

Answer 67

d. all of the above

Question 68

Contracts for difference **

Sandy has $4 500 in cash available and wishes to buy RNC CFD contracts. RNC shares are currently trading at $15.00 and the CFD provider requires a 10% margin to be paid up-front. How many RNC CFDs can Sandy buy? What is Sandy’s gain/loss in dollar and percentage terms if the contract remains open and the price of RNC shares moves to:

(a) $12.30?
(b) $17.25?
(c) $15.00?

Answer 68

Question 69

Futures contracts **

Wal is a wheat farmer from out west. When he harvests his crop in three months’ time, he will have approximately 1,500 tonnes of wheat. The current price of Eastern Australian Wheat futures is $260 per tonne for delivery in three months. Wal decides to sell 75 Eastern Australian Wheat futures contracts at $260 per tonne. What is Wal’s gain/loss on the futures contract in dollar terms if in three months’ time the price of wheat is:

(a) $285?
(b) $232?
(c) $260?

Answer 69

Tonnes per contract = 1 500/75 = 20 tonnes

Cost per contract = 260 * 20 = $5,200.00

Question 70

Don believes that the current market price of TLE mining shares will skyrocket. He has decided to buy an American-style call option with 90 days to expiry. The current share price of TLE shares is $8.27 and the 90-day call option with a strike price of $12 is trading at $0.04. What is Don’s gain/loss in dollar and percentage terms if the price of TLE shares is:

(a) $6.27? - Don will not exercise the option and will buy at $6.27
(b) $14.30?

Answer 70

Assume Don buys call options for 100 shares

Cost is the option premium = $0.04 * 100 = $4.00

If the price is $6.27? - Don will not exercise the option but will lose $4

Percentage is -4/4 *100 = 100%

If the price is $14.30? - Don will exercise the option and buy the shares at $12.00

Gain = 14.30 – 12.00 = 2.30 *100 = 230 – 4 = $226

Percentage is 226/4 *100 = 5,650%

Question 71

Warrants **

Bashar pays $20 for a European-style warrant which gives the holder of the warrant the right to buy one share in CRU for $22, 1 year from today. If the price of CRU shares is currently $40 what is the implicit interest cost in both dollar and percentage terms contained within the warrant?

Answer 71

The seller of the warrant has effectively sold you a share for $40, you have paid half in cash and the seller of the warrant has lent you the other $20 to finance the purchase. By paying back $22 you are repaying the principal of $20 plus $2 in interest. If the warrant is open for a year then the interest rate is 10% ($2/$20).

Question 72

Taking out a margin loan

Carly is 26 and has just received a promotion at work. She now earns $10,000 more than the threshold at which the 37 per cent marginal tax rate cuts in. Carly is unhappy at losing 37 per cent of her money in tax. She hopes that by investing in a share portfolio she will be able to reduce this tax liability.

Carly has spoken to a margin lender who has suggested that she negatively gear her share portfolio by concentrating on stocks that place more emphasis on capital gains rather than income. The lender has recommended a portfolio with a weighted LVR of 70% and Carly is happy to contribute $60,000 of her own money and borrow the maximum amount that this equity contribution allows using an interest-only loan.

Carly lives with her partner in rented accommodation – they like living in rented accommodation as this gives them the freedom to move around, take holidays and not worry about maintaining a house and meeting mortgage repayments. Carly believes that her investment time horizon is about 7 years and would like you to do some financial projections on this basis.

Carly provides you with the following information and assumptions:

• Grossed-up dividend income will be 2% p.a.
• Capital gain will be 10% p.a.
• Interest cost will be 8% p.a.
• For the sake of arithmetic simplicity MTR will stay at 37% even when capital gains are realised.

(1) If Carly does decide to take out the margin loan what will be her:

1. net annual gain or loss?
2. accumulated net annual gain or loss over 7 years?
3. compounded capital gain over 7 years?
4. compounded capital gain net of CGT based on the assumption that she sells the share portfolio after 7 years?
5. total net gain (the accumulated net annual loss and the compounded capital gain net of CGT) after 7 years after the principal of the loan has been repaid?
6. annualised rate of return on equity?

(2) Redo the calculations in part 1, above, based on the assumption that Carly does not borrow any money and instead invests her $60,000 in equity only.
(3) How does the annualised return on equity differ between scenarios 1 and 2 above? Write a brief report to Carly which explains why these figures differ.

Answer 72

Where the total after-tax returns are greater than the after-tax costs an increase in the level of gearing will magnify the gains.