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56 Cards in this Set

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What is a futures contract?
Contract re: seller of contract will sell a specified amount of a standardized commodity to the buyer at a specified price and date in the future.
Why might a farmer enter the futures market?
To guarantee a certain level of income in the future by locking in the price at which he can sell his commodities into the market.
What are initial and maintenance margins on a futures contract?
Initial margin: amount you are required to post with a dealer to take buy a futures contract.
Maintenance margin: margin you must maintain with dealer. You might have to top it up if the price of the contract drops wiping out a portion of your initial margin.
What are you expectations if you buy a bond futures contract?
You expect higher bond prices in the future (i.e. lower interest rates)
What are your expectations if you sell a bond futures contract?
You expect bond prices to go down (i.e. the rate of interest will go up)
Describe a long hedge on bond futures and the expectations
In the future you have $x to invest, but you believe interest rates have already peaked. Buy a bond future to lock in high interest rates - the future contract will increase in value as interest rates drop
Describe a short hedge on bond futures and the expectations
A company needs to borrow in the future, but believes interest rates will be higher then. It will sell a bond futures contract - this will decrease in value as interest rates increase. The gain will offset the cost of borrowing money at a higher interest rate.
Which financial instruments have futures markets?
Bonds, Treasury bills, Stock indexes, Currency exchange rates
What is a swap?
An agreement between two or more parties to exchange sets of cash flows over a set period
What are the two main varieties of swaps?
Interest rate and currency swaps
Describe the market for swaps
Custom tailored, counterparties must seek each other out, 80% interest rate, 20% currency
Describe an interest rate swap
Party A holds a fixed rate debt instrument, Party B holds a floating rate debt instrument. They exchange interest cash flows for a notional amount of the instruments. Principal (i.e. notional amount) is not exchanged.
Why might firms use interest rate swaps?
Lock in a spread between borrowing and lending.
Describe the cash flows involved in a currency swap.
1) Exchange currencies (principal)
2) Parties make periodic interest payments to each other for the life of the swap.
3) At the end of the agreement parties exchange principal amounts back.
Why would a firm enter into an currency swap?
Firms have different levels of accessibility to financing in other markets.
What is the difference between a primary market and a secondary market for shares?
Primary market: IPOs
Secondary market: buy and sel previously issued shares
What are 2 advantages of debt financing?
1) Does not dilute shareholder interests.
2) Interest on debt is tax deductible.
What are 2 disadvantages of debt financing?
1) Interest payments must be made when due (unlike dividends).
2) Principal sum must be repaid (unlike shares)
What 2 factors influence the right DEBT/EQUITY ratio?
1) The nature of the business (riskiness)
2) How stable is the stream of income? (pipeline = stable: more debt, airline = unstable: more equity)
Describe the Dow Jones Index
- 30 major stocks
- Not consistent over time
- Not weighted
Describe the S&P 500
- 500 large representative stocks
- Weighted by number of shares in the market
Describe preferred shares
- Issued at par value
- Pay a stable fixed dollar dividend in perpetuity
Why are preferred shares called preferred?
1) Preference on dividends compared to common shares
2) Preference on 'par value' repayment in bankruptcy compared to common shares
How is the price of a preferred share calculated?
Price = Dividend Size/Required Return
Describe the properties of a common share.
- Represent ownership
- No dividend requirement
- All retained earnings 'belong' to common share holder, so they benefit in good times, suffer in bad
What are the three accounting based methods of valuing a share?
1) Historical cost of net asset value (assets - liabilities)
2) Replacement cost of net asset value
3) Liquidation value of net asset value
What are the three profitability based methods of valuing a share?
1) Price to earnings ratio
2) Dividend valuation model
3) Present value of free cash flows into the future (CF/(1+WACC)
What is an income trust?
A legal structure that holds or more businesses. It receives the cash flows from the businesses and pays them out each month to the unit holders.
What are the tax advantages of income trusts?
Income trusts distribute almost all cash flows to unit holders and so trusts pay almost no income tax. (Unit holders pay taxes)
Describe how depreciation is handles by an income trust.
Cash flows associated with depreciation are passed on to unit holders as a capital gain (i.e. it lowers the value of the units held and will be taxed as a capital gain when sold)
Compare a bond to an income trust unit.
Bond represents a loan with a fixed income stream. An income trust unit is not a loan and the cash flow received is not fixed.
Compare a share to an income trust unit.
- Both represent ownership.
- Unit holders receive bulk of cash flows; share holders MAY receive dividends.
- Income trusts mostly finance through selling new units; corporations through retained earnings and debt
What is the ideal profile of an income trust?
- Dull/stable business
- Reliable/steady cash flows
- Maintaining/slowly growing sales
- High barriers to entry
- Low new capital investment required
How can an income trust grow in size?
1) Sell more units to raise equity
2) New loans
- Does not grow through retained earnings since it distributes almost all net cash flows
What factors make the price of an income trust unit go up?
1) Higher commodity prices
2) Lower long term interest rates (distributions from trusts more valuable in comparison to other options)
3) Cash flow per unit increases for any reason.
What factors can lower the price of an income trust unit?
1) A rise in long-term interest rates
2) Any factor that lowers the size of distributions
What are the four kinds of trusts?
1) Oil and Gas Trusts
2) Real estate investment trusts (REITs)
3) Pipeline and Power Trusts
4) Business Trusts
What happened to trusts in Canada on Oct 31, 2006?
1) No more conversions from corporations to trusts
2) Instituted tax on distributions for trusts; investors taxed the same as dividends - get dividend tax credits
3) Create same aftertax income between corporations and trusts
4) Most REITs exempt from changes)
5) Harmed tax exempt investors such as pension funds, they get no benefit from dividend credits and receive lower distributions
What is a call option?
Buyer = right to buy a stock
Seller = obligation to sell a stock
What is a put option?
Buyer = right to sell a stock
Seller = obligation to buy a stock
What option would you buy in a bull market?
Buy a call
What option would you sell in a bull market?
Sell a put
What option would you buy in a bear market?
Buy a put
What option would you sell in a bear market?
Sell a call.
What is the intrinsic value of a call?
Intrinsic Value of a Call = Current Market Price - Call Exercise Price
What is the intrinsic value of a put?
Intrinsic Value of a Put = Put Exercise Price - Current Market Price
What is the option premium?
Option Premium = Time Value + Intrinsic Value
What factors cause the price of an option to increase?
Increase in:
1) Time Value Remaining
2) Volatility of underlying security
3) Any intrinsic value
What underlying assets are options issued for?
1) Individual stocks
2) Stock indexes
3) LEAP (longterm equity appreciation participation shares)
4) Interest rates (Bonds)
5) Currency futures
6) Other commodity futures
When is a call in the money?
Underlying asset above the exercise price
When is a put in the money?
Underlying asset below the exercise price
What two things can options be used for?
1) Hedge
2) Speculate
Give an example of a hedge
Have a large position in stocks that you think will drop in value: buy a put
What is a European option?
An option that can only be exercised on the last day.
What is an American option?
An option that can be exercised anytime up to expiry.
In the Black-Scholes pricing model, what factors influence the price of a call?
1) Current price of underlying (+)
2) Exercise price of the option (-)
3) Variability of underlying (+)
4) Time to maturity (+)
5) Risk free interest rate (+)