Financial Policy Final

Front 1

Who are all of the firm's stakeholders that contract with the firm? (There are 6)

Back 1

-customers
-suppliers
-creditors
-shareholders
-managers
-employees

Front 2

Who, among those contracting with the firm, are looking out for the firm's best interests?

Back 2

none of them

Front 3

Whose interest do managers look out for?

Back 3

their own

Front 4

What are agency costs?

Back 4

the costs of hiring people to do your work for you

Front 5

Whose interest are managers hired to look out for?

Back 5

shareholders

Front 6

What are two examples of agency costs?

Back 6

-the agent doesn't do your work as well as you would
-the cost of monitoring the agent to make sure they're doing what they're supposed to do (ex. nanny cam)

Front 7

What are three costs of management agents acting in their own best interests?

Back 7

-consumption of prerequisites (perks)
-shirking
-maximizing firm size

Front 8

What is shirking?

Back 8

not working as hard as the shareholders would if they were managing the company themselves

Front 9

What is the most costly of the three costs of management agents acting in their own best interests?

Back 9

maximizing firm size

Front 10

What is the usual cause of managers' maximizing firm size?

Back 10

overconfidence

Front 11

When is maximizing firm size a problem?

Back 11

if FCF is kept in the firm by investing in poor projects

Front 12

What are three costs of monitoring management?

Back 12

-board of directors
-auditors
-inefficient compensation and financial policies

Front 13

Who watches out for shareholder interest above the level of management?

Back 13

the board of directors

Front 14

Who is the objective third party that ensures a company is managed properly?

Back 14

auditors

Front 15

What are two options companies have to try to avoid inefficient compensation and financial policies?

Back 15

-you could borrow a lot
-you could pay managers with options so they are more concerned with stock price

Front 16

What would be the result if the company borrowed a lot to avoid inefficient compensation and financial policies?

Back 16

the risk of bankruptcy would increase

Front 17

What would be the result if the company paid managers in options so they would be interested in stock price, in order to avoid inefficient compensation and financial policies?

Back 17

-this could result in game playing to inflate earnings
-they would want to be paid more because their compensation is tied to a risky asset

Front 18

What effect do agency costs have on the value of the firm?

Back 18

agency costs decrease the value of the firm

Front 19

What happens to stock price, with the sudden death of a CEO? When is this effect greater?

Back 19

-it goes up
-this is more true, the more entrenched the CEO is

Front 20

What are two reasons stock price increases with the sudden death of a CEO?

Back 20

-the new CEO is less able to waste money and empire build
-the board exerts more control

Front 21

What does the announcement of an investment do to the value of the firm?

Back 21

decreases it

Front 22

Why did oil companies invest in department stores, office supplies, etc, in the 1980s? What effect did this have on their stock price?

Back 22

-oil companies in the 1980's had excess cash, and exploration wasn't sensible at the time
-the investments caused the companies' stock prices to fall

Front 23

How do shares with superior voting rights trade? What is this indicative of?

Back 23

-they trade at a premium
-this indicates the benefits of control, and gives a rough indication of the value you can extract from a firm if you can control it

Front 24

What are three ways to minimize agency costs?

Back 24

-align managers' interests through compensation
-borrow (increase debt)
-make sure free cash is paid out in dividends

Front 25

What is free cash?

Back 25

what's left over after required payments and worthwhile investments

Front 26

How do you align mangers' interests through compensation?

Back 26

stocks

Front 27

What are three limits to how effective paying managers with stock options is?

Back 27

-they want more compensation, because stock is risky
-they only bear 1% of the costs of shirking or perks, so this isn't much of a deterrent
-they only reap 1% of the benefits of wise decisions, so that's not much of an incentive

Front 28

If a call is out of the money, under which conditions can it still have value? Why?

Back 28

-if there is still time left
-there's still a chance that it will move into the money

Front 29

Why is a call less risky than a stock?

Back 29

if you buy a call at $30, and the stock price falls off, you lose only the call price; if you bought stock, you would lose everything

Front 30

Is a call worth more at expiration, or before it?

Back 30

a call is worth more prior to expiration

Front 31

What does time do for a call?

Back 31

provides insurance

Front 32

What is the difference between American and European options?

Back 32

-with American options, you can exercise at expiration or before?
-this isn't the case with European options

Front 33

What is the essential insight of Black-Scholes?

Back 33

-you can replicate the call option by borrowing and buying stock in proper proportions
-you can change the value of the portfolio, which changes the value of the call
-the value of the portfolio = the value of the call

Front 34

The value of the portfolio ____ the value of the call, according to Black-Scholes.

Back 34

=

Front 35

With Black-Scholes, how should you measure time?

Back 35

it doesn't matter, as long as you're consistent with the time, interest rate, and volatility

Front 36

What happens to the price of the call, when stock price increases?

Back 36

it increases, but it can be by a smaller dollar amount

Front 37

If there is a 100% of exercise, if the stock price goes up by $1, by how much would the call price go up? Why?

Back 37

-$1
-because you get that $1 at expiration

Front 38

If there is no chance of exercise, if the stock price goes up by $1, by how much would the call price go up?

Back 38

-the call price wouldn't be affected at all

Front 39

Because the chance of exercise is between 0% and 100%, how much does the call price increase when stock price increases?

Back 39

-by a percentage of the stock price increase
-in line with the percentage chance of exercise

Front 40

As the likelihood of exercise increases, call price increases _______ with stock price increases, and vice versa.

Back 40

more in line

Front 41

The option provides a bigger return on the call, on which of the following: the upside or the downside?

Back 41

both

Front 42

What happens to the value of the call if you increase the price? Why?

Back 42

-decreases the value of the call
-the right to buy something at a higher price is worth less

Front 43

Is a call worth more or less when you increase volatility?

Back 43

more

Front 44

Why is a call ALWAYS worth more if you increase volatility?

Back 44

-stock price goes up
-call is further in the money

Front 45

Is a call worth more or less when you increase volatility?

Back 45

less

Front 46

Why is a call ALWAYS worth less if you decrease volatility?

Back 46

-stock price goes down
-call is further out of the money

Front 47

You gain on the ______ of volatility, with calls.

Back 47

upside

Front 48

Does the probability of exercise increase when volatility increases?

Back 48

-it can, but not necessarily

Front 49

If you are out of the money, and have low volatility do you exercise?

Back 49

no

Front 50

If you are out of the money and have low volatility, you wouldn't exercise; what happens if you increase volatility?

Back 50

there is a chance of exercise

Front 51

If you are in the money, and have low volatility, do you exercise?

Back 51

yes

Front 52

If you are in the money and have low volatility, you would exercise; what happens if you increase volatility?

Back 52

you may decrease the chance of exercise

Front 53

The call is priced relative to what?

Back 53

the stock

Front 54

What do you get to do with the exercise price, when you buy a call?

Back 54

you get to save the exercise price and earn interest on it in the meantime

Front 55

What happens to the value of the call when you increase the interest rate? Is this always the case?

Back 55

-increasing the interest rate increases the value of the call
-yes, this is always the case

Front 56

What happens to the value of the call when you increase the time to expiration? Is this always the case?

Back 56

-increasing time to expiration increases the value of the call
-yes, this is always the case

Front 57

What are two reasons increasing time to expiration always increases the value of the call?

Back 57

-you delay paying the exercise price longer, so you are earning more interest on the money
-over a longer time period, you have a greater range of possible stock prices

Front 58

Why shouldn't you exercise call options early? Is this always the case?

Back 58

-this reduces the time to expiration, which reduces the value of the call
-essentially, you are reducing T to zero
-no, there are exceptions to this rule

Front 59

What is one circumstance in which exercising a call option early may be a good idea?

Back 59

after a dividend is announced, before it is paid - before the stock price is reduced

Front 60

Increase S means _____ C

Back 60

increase

Front 61

Increase X means _______ C

Back 61

decrease

Front 62

Increase r means ______ C

Back 62

increase

Front 63

Increase sigma means ____ C

Back 63

increase

Front 64

Increase T means ______ C

Back 64

increase

Front 65

How many trading days are there in a year?

Back 65

252

Front 66

With call options, you ____ on the upside, and ______ on the downside.

Back 66

-gain
-don't lose

Front 67

What is the main benefit of call options?

Back 67

you gain on the upside, and don't lose on the downside

Front 68

What is the implication if model price is higher than market price?

Back 68

market price is a little low

Front 69

How does employee options vesting usually work?

Back 69

-annual
-usually over four years

Front 70

How is vesting of employee options an important retention tool?

Back 70

employees don't usually leave if they have unvested options

Front 71

Why is vesting especially useful when the company is doing well?

Back 71

-options are worth more
-when the company is doing well, this is the time they will want to hold on to employees

Front 72

Why don't you want to exercise early when stock is volatile?

Back 72

the option is worth more

Front 73

Why do people exercise early when volatile stock is up, even though it isn't advisable?

Back 73

people are risk averse

Front 74

What gives the implied volatilities for S&P 500 options?

Back 74

VIX

Front 75

What is the method to get a handle on the volatility expectations for the market?

Back 75

VIX

Front 76

Why doesn't exercising call options affect the company?

Back 76

you are just buying someone else's shares from them

Front 77

What are two ways warrants affect the company?

Back 77

-company gets cash
-more shares outstanding

Front 78

Are warrants more common in Europe or the US?

Back 78

Europe

Front 79

What are two instances in which warrants have been issued in the US?

Back 79

-IPOs
-TARP issued warrants to the federal government

Front 80

If you increase the number of warrants, what happens to the value of each warrant? Why?

Back 80

-the value of each warrant goes down
-you have increased dilution

Front 81

What happens if you use the Black-Scholes price for the value of the conversion feature?

Back 81

you will over-value it

Front 82

What is the only instance in which you would want to convert a warrant early?

Back 82

if there's a large dividend

Front 83

What is the implication if you call a bond (warrant)?

Back 83

-bad news
-indicates you don't think the dividends will be large enough for you to want to convert

Front 84

At low prices, how many perks do you get per share of stock?

Back 84

one

Front 85

As you reach cap prices, how many perks do you get per share of stock?

Back 85

cap price divided by market price

Front 86

When stock price is less than cap price, would the firm rather have issued stock or perks?

Back 86

stock

Front 87

Why, when stock price is less than cap price, would the firm rather have issued stock?

Back 87

because the holder of the perk has one share of stock either way, but the perk has more dividends

Front 88

When stock price is more than cap price, would the firm rather have issued stock or perks?

Back 88

perks

Front 89

What is the implication, if a company issues perks rather than equity?

Back 89

-positive signal
-offsets information asymmetry that comes with issuing equity
-means you think stock price will be more than cap price

Front 90

When was the floating price convertible popular?

Back 90

the 90's

Front 91

What are two features of the floating price convertible?

Back 91

-convert at a discount to the average price over the last six months
-the dollar amount of the stock you get is set, but not the price that you pay (if the price per share goes down, you will get more shares at the lower price)

Front 92

What is a death spiral convertible?

Back 92

floating price convertible

Front 93

Why is the floating price convertible called the death spiral convertible?

Back 93

-if you are buying these, you are incentivized to short the stock, so you can get more shares at the lower price
-then you are incentivized to short that stock
-eventually, you could drive the stock price all the way down

Front 94

What is the implication if stock price goes up when you take on a long-term project?

Back 94

the market thinks the project will have positive long-term consequences

Front 95

What are 9 typical compensation package features?

Back 95

-stock options
-bonuses
-retirement
-loans
-perks
-commissions
-base pay/salary
-restricted stock
-golden parachutes

Front 96

What three compensation package features incentivize risk taking?

Back 96

-stock options
-bonuses
-golden parachutes

Front 97

If management doesn't have options, what is the impact on risk taking?

Back 97

you aren't incentivized to take enough risk

Front 98

Do stock options always lead managers to take on risky projects?

Back 98

no

Front 99

If a firm has a lot of debt, does it pay off to increase volatility?

Back 99

yes

Front 100

What do you look at, when considering real options?

Back 100

-incremental cash flow
-not accounting profit

Front 101

What are incremental cash flows?

Back 101

cash flows that result as a result of your decision to take on an investment

Front 102

How do sunk costs factor in to incremental cash flows?

Back 102

you ignore them

Front 103

What are three considerations, in figuring out incremental cash flows?

Back 103

-dont' ignore working capital needs
-be careful about how overhead is calculated
-consider incidental effects on the remainder of the business

Front 104

How do you incorporate overhead in determining incremental cash flows?

Back 104

only incorporate the change in overhead that occurs as a result of of taking on this project

Front 105

Opportunity gains are _____ the incremental cash flows.

Back 105

included in

Front 106

Opportunity costs are _____ incremental cash flows.

Back 106

subtracted from

Front 107

What do you give up, when you take a project now?

Back 107

the opportunity to take it at a later date

Front 108

If there is no competition, do we expand or abandon the project?

Back 108

expand

Front 109

Could delaying a project land you a higher NPV?

Back 109

-yes, sometimes
-ex. Timber

Front 110

Why does the value at which you increase your option go up when you increase the variance?

Back 110

you're giving up a more valuable option

Front 111

What is Delta?

Back 111

the yield on a project

Front 112

What do some companies do to avoid taking projects?

Back 112

use hurdle rates that are way too high

Front 113

With a stock, as time to expiration increases, what happens to total variance?

Back 113

it increases

Front 114

What are the uses for the Perpetual American Call?

Back 114

options to purchase that do not expire

Front 115

What do you give up by delaying exercise, with the Perpetual American Call?

Back 115

cash flow

Front 116

What is the primary suggestion when deciding whether to use the Perpetual American Call?

Back 116

if you don't have sole rights to a project, it isn't a perpetuity

Front 117

What is the most important consideration when deciding whether to use the Perpetual American Call? What is the implication of this consideration?

Back 117

-is the value of the project, minus cost of the project, and minus the value of foregone opportunity to take the project later, positive?
-you will only tend to take on the project when the value is pretty high

Front 118

If you increase volatility, what happens to the value of the real option?

Back 118

it increases

Front 119

If volatility increases, should you take on a project? Why?

Back 119

-you should wait until the project value is higher
-otherwise, you will give up the more valuable option to take it at a later date

Front 120

What is yield?

Back 120

-the actual income we get from taking a project
-ex: rents on a building

Front 121

If interest rates increase, what happens to the value of the real option? Why?

Back 121

-it increases
-because we will earn more interest on the cost of implementing the project, so we'll wait

Front 122

If there is competition, when should you take on a project?

Back 122

as soon as NPV is positive

Front 123

When should a company exercise the real option to go public?

Back 123

you should wait a long time, until the value is high

Front 124

What does greater volatility mean in the world of real options?

Back 124

greater volatility means the greater the value the project has to be before you will take it

Front 125

As the market goes up, which firms exercise their option to go public?

Back 125

crappier firms with higher volatility

Front 126

What type of option is the option to abandon production?

Back 126

put option

Front 127

What three things do you give up when you decide to abandon a project?

Back 127

-losses
-cost of abandoning
-option

Front 128

What is P*, in the option to abandon production?

Back 128

the revenue level at which we stop production

Front 129

What are two reasons companies will operate at a loss for a period of time?

Back 129

-there's always a chance that revenues will return
-you always have the real option to abandon later, but once you do that, it's all over

Front 130

If variance in revenues increases, what happens to the real option to abandon production (and thus, any real put option)?

Back 130

-it increases

Front 131

When will you give up the real put option, in terms of revenues?

Back 131

When revenues are lower

Front 132

All else equal, do we like the project more or less, the more volatile the cashflows? Why?

Back 132

-the more volatile the cash flows, the more we like the project
-because we gain on the upside, and on the downside, we just stop producing

Front 133

When it's cheaper to abandon a project, is the project worth more or less? What about the value of the put option to abandon?

Back 133

-more
-we can abandon at a higher value
-the value of the put option increases, as well

Front 134

With higher volatility, what happens to the value of the put option to abandon?

Back 134

increases

Front 135

With higher interest rates, what happens to the likelihood of exercising of the put option to abandon? Why?

Back 135

-decreases
-when you exercise a put, you get cash, so increasing the interest rate means you will wait to exercise so you can get more cash later

Front 136

As price increases, what happens to the value of the put option to abandon a project?

Back 136

decreases

Front 137

When revenues increase, what happens to the value of the option to abandon? What happens to the value of the project?

Back 137

-value of the option falls
-value of the project increases

Front 138

When variance increases, what happens to the value of the option to abandon? What happens to the value of the project?

Back 138

they both increase

Front 139

When interest rates increase, what happens to the value of the option to abandon? What happens to the value of the project? (Why?)

Back 139

-value of the option falls
-value of the project increases (because you can discount your costs at a higher rate)

Front 140

When yield decreases, what happens to the value of the option to abandon? What happens to the value of the project?

Back 140

-value of the option falls
-value of the project increases

Front 141

What dictates the cost of arbitrage?

Back 141

risk-free interest rate

Front 142

If we decrease revenues, what happens to the value of the option to stop production costlessly and restart?

Back 142

-we will stop producing
-value of the project remains equal

Front 143

What is the relationship between correlation of two inputs and epsilon?

Back 143

-positive
-higher correlation = higher epsilon

Front 144

If correlation is higher, what happens to the value of the option to switch between inputs?

Back 144

decreases

Front 145

With regards to the option to switch between inputs, if the current cost of the alternative increases, what happens to the value of the project? Why?

Back 145

-value of the project decreases
-because, even though we aren't using the alternative at this time, the value of the option to switch between the two has decreased

Front 146

With regards to the value of the option to switch between inputs, if variance decreases, what happens to the value of the project?

Back 146

decreases

Front 147

When you take on projects, what options are you acquiring? What options are you giving up?

Back 147

-you are acquiring opportunities, which is the same as acquiring options
-there are opportunity costs, which are the same as giving up options

Front 148

What do we consider variance of debt to be, for the sake of ease of calculation, in option pricing and capital budgeting in practice?

Back 148

0

Front 149

For what purpose are credit ratings most being used, currently?

Back 149

regulatory purposes

Front 150

What is the lowest possible investment grade?

Back 150

BBB-

Front 151

What two ratings are assigned to speculative, or junk bonds?

Back 151

BB or B

Front 152

What is Moody's primary concern, in the event of default? Is S&P concerned about this, as well?

Back 152

-rate of recovery in the event of default
-S&P is less concerned

Front 153

Are credit agency ratings defined as qualitative or quantitative?

Back 153

-qualitative
-to protect themselves from liability

Front 154

How can credit rating agencies claim that only one AAA rated bond has defaulted over the last ten years?

Back 154

they downgrade bonds once they recognize a chance of default

Front 155

When a bond is downgraded, what is the abnormal return of the stock?

Back 155

-2.67%

Front 156

In the 300 days prior to the downgrade of a stock, what is the abnormal return of the stock? What is the implication?

Back 156

--21%
-in large part, bond downgrade is reactionary; because the abnormal returns after downgrade are -2.67%
-rating agencies are sometimes criticized for taking too long to downgrade bonds

Front 157

Why is bond rating important to companies?

Back 157

it is a big part of capital structure decisions

Front 158

Is a company with A- rating more or less likely to issue debt than a company with A rating? Why?

Back 158

-less likely
-bond ratings have a significant effect on interest rates

Front 159

Can interest rates change automatically with changes in your credit ratings?

Back 159

yes

Front 160

What did the 1973 SEC Net Capital Rule state?

Back 160

-brokerage firms have to hold on to a certain amount of capital
-the amount of capital required depends on the ratings of the bonds they hold
-ratings have to be provided by a nationally recognized statistical rating organization

Front 161

What effect did the 1973 SEC Net Capital Rule have on the bond rating industry?

Back 161

-created barriers to entry
-the only way to become nationally recognized was to rate bonds, but no one wanted you to rate their bonds if you weren't nationally recognized
-there were only 3 rating agencies

Front 162

What portion of all corporate bonds are held by insurance companies?

Back 162

about 40%

Front 163

Who controls who is allowed to hold bonds?

Back 163

credit rating agencies have a great deal of control over this

Front 164

What is the problem with charging users of credit ratings? Who do agencies sell to instead, in order to avoid this problem?

Back 164

-credit information is expensive to produce and cheap to reproduce
-agencies now sell to issuers of bonds instead
-they have done this for the last 30 years

Front 165

Why does charging issuers of bonds for credit ratings work?

Back 165

-AAA holders will want to distinguish themselves from the next rating level down, and so on...
-all but the lowest quality bonds will find it worthwhile to pay to be rated

Front 166

Why would bond buyers want ratings to be inflated?

Back 166

higher rated bonds have lower capital requirements

Front 167

What was the biggest problem with rating mortgage backed securities?

Back 167

correlations between performance of individual mortgages were higher than agencies thought

Front 168

Other than correlation misconception, what was another problem with ratings of mortgage back securities?

Back 168

-ratings shopping
-people would shop around to find who would give them the best rating

Front 169

What percentage of mortgage backed securities only had one agency rate them? What was the implication there?

Back 169

-20%
-these were more likely to default

Front 170

What is the current push regarding rating agencies?

Back 170

-more regulation of the agencies
-make it easier to sue agencies for inaccurate information

Front 171

Are credit default spreads a good alternative to credit ratings?

Back 171

-not really
-if spreads increased rapidly, response would be quick - you would see massive selling at the same time, which could have catastrophic effects
-bond rating reductions take more time, and thus spread out the selling

Front 172

If stock price goes up by $1, what happens to the call price?

Back 172

it goes up by less than $1

Front 173

If exercise price increases, what happens to the value of the call option?

Back 173

decreases

Front 174

If volatility decreases, what happens to the value of the call option? Why?

Back 174

-increases
-if volatility goes up, if stock price increases, you are further in the money, and the call option is worth more; if stock price decreases, you are further out of the money, but the call option is worth the same

Front 175

If interest rates increase, what happens to the value of the call option?

Back 175

increases

Front 176

A call is priced relative to what?

Back 176

stock

Front 177

What should you do with your call option if the stock goes down?

Back 177

hold on to the call, and invest at the higher interest rate

Front 178

If time to expiration increases, what happens to the value of the call?

Back 178

increases

Front 179

What are the two reasons that the value of the call increases as time to expiration increases?

Back 179

-more time to accrue interest
-over the year, you gain on the upside and only lose a little on the downside; with more time to expiration, you have more time to capture the upside

Front 180

________ exercise the option early

Back 180

don't

Front 181

Why are stock options the exception to the don't exercise early rule?

Back 181

you can't sell them

Front 182

How do you find out the price of a put?

Back 182

-find the price of the call using Black-Scholes
-plug that number into the put-call parody formula

Front 183

What is a convertible bond similar to?

Back 183

it's like a straight call plus a warrant

Front 184

Convertible bond =

Back 184

= straight call + warrant

Front 185

What is the difference between a warrant and a call option?

Back 185

-a warrant is like a call option except for dilution
-company gets cash AND issues more shares with a warrant

Front 186

What is a bad reason for issuing convertibles?

Back 186

lower yield means they're cheaper

Front 187

What are three good reasons for issuing convertibles?

Back 187

-minimizes the conflict of interest between debt & equity
-indirect way of issuing equity
-staged financing argument

Front 188

How do convertibles minimize the conflict of interest between debt & equity?

Back 188

-equity prefers risky investments
-when you issue convertibles, you have to share the upside, so there's less incentive for risk

Front 189

What makes options valuable?

Back 189

volatility

Front 190

In what cases should you use Black-Scholes?

Back 190

-in cases where uncertainty doesn't grow with time
-like drug trials

Front 191

When you undertake test marketing, what, in effect, are you getting?

Back 191

an option to produce the drug

Front 192

What determines whether it is worth doing a drug trial?

Back 192

the value of the option to produce the drug

Front 193

What is the main concern of risk management?

Back 193

when is it worthwhile to hedge, and when should we manage risk

Front 194

How worthwhile is it to lower the volatility of stock, in risk management

Back 194

not worthwhile overall

Front 195

Why wouldn't Apache want to hedge?

Back 195

shareholders' incentive to invest is the risk of oil prices increasing

Front 196

What is a main consideration in risk management?

Back 196

market imperfections like taxes

Front 197

When taxes increase at an increasing rate with income, what do we want to do? What is the implication here?

Back 197

-we want to minimize variation of income
-this may provide one reason for hedging

Front 198

What are three reasons for hedging?

Back 198

-when taxes increase at an increasing rate with income, we want to minimize variation of income
-managerial risk aversion
-costly external financing

Front 199

Why is managerial risk aversion a reason to hedge?

Back 199

-you can pay managers less and pay with stock if value of stock is based on factors within their control
-you can achieve this through hedging

Front 200

Why is costly external financing a reason to hedge?

Back 200

-internal cash flows are the cheapest way to finance any investment
-by hedging, we can generate cash when we need it for investments, and use it up when we don't

Front 201

What are three possible reasons ratings agencies failed so miserably in 2007 and 2008?

Back 201

-correlation misperceptions
-ratings shopping
-agencies were too busy to handle all the business

Front 202

What is a useful way to look at a company?

Back 202

-a legal fiction that serves as a nexus of contracts
-a simple connecting point for contracts

Front 203

Why do firms exist?

Back 203

to minimize the costs of contracting between owners of productive inputs

Front 204

What are the two types of agency costs?

Back 204

-agents don't behave as you would if you were acting on your own behalf
-you have to monitor agents to make sure they are behaving as they should

Front 205

What are three costs of agents acting in their own best interests?

Back 205

-consumption of prerequisites
-shirking
-maximizing firm size

Front 206

When is maximizing firm size a problem?

Back 206

when free cash flow is kept in the firm by investing in poor projects

Front 207

What are three costs of monitoring management?

Back 207

-board of directors
-auditors
-inefficient compensation and financial policies (if you pay in options, it's risky, so managers will want to be paid more to compensate for that risk)

Front 208

What are three ways to minimize agency costs?

Back 208

-align managers' interests with shareholders through compensation
-borrow
-make sure they pay out fcf in the form of dividends

Front 209

What is the underlying security?

Back 209

the specified security

Front 210

What is the exercise, or strike price?

Back 210

the specified price

Front 211

What is the expiration date?

Back 211

the last day the holder can use th e option to buy stock

Front 212

How are exchange traded puts used?

Back 212

-hedging and risk management
-not relevant for executive compensation

Front 213

What does the Chicago Board Operations Exchange (CBOE) list?

Back 213

-put options
-call options
-hundreds of stocks

Front 214

Where are equity options other than calls and puts listed?

Back 214

-American Stock Exchange
-Philadelphia Exchange
-Pacific Exchange

Front 215

On what indices do options trade?

Back 215

-S&P 500
-S&P 100
-DJIA
-several other industry indices

Front 216

What is a futures contract?

Back 216

a contract negotiated today to exchange some good at a fixed price at a future date

Front 217

What types of futures contracts do options now trade on?

Back 217

-agricultural products
-metals
-treasury securities
-currencies

Front 218

What is an American Option?

Back 218

can be exercised on or before expiration

Front 219

What types of options are traded on the S&P 500?

Back 219

European Options

Front 220

What is a European Option?

Back 220

can only be exercised at expiration

Front 221

What type of settlement do options on indices have?

Back 221

cash settlement

Front 222

How does a call buyer usually take profits?

Back 222

by writing an equivalent call to cancel out the position

Front 223

What does it mean to say an option has a cash settlement?

Back 223

if you have a call option, you can't exercise it and receive stocks in the index; instead, you only receive difference between the index value and the exercise price in cash

Front 224

How are options on individual stocks settled?

Back 224

only by receiving shares

Front 225

Before expiration, for how much must a call option sell?

Back 225

more than S-X

Front 226

Before expiration, for how much must a put option sell?

Back 226

more than X-S

Front 227

Why does a call option still have value if, prior to expiration, stock price (S) is less than exercise price (X), and thus, the option is out of the money?

Back 227

there's always a chance that the option will be in the money at expiration

Front 228

If S<X at expiration, do you exercise the call?

Back 228

no

Front 229

What model do we use to value European Options prior to expiration?

Back 229

Black-Scholes

Front 230

What is the implication of Black-Scholes?

Back 230

-if you borrow money and buy shares in the proper proportions, you can duplicate the return on a call option for infinitely short intervals
-thus, the call today must have the same value as the combination of borrowing and buying shares

Front 231

What are the 4 assumptions of Black-Scholes?

Back 231

-no transaction costs or limitations on borrowing and shortselling (nothing will prevent option traders from taking advantage of arbitrage opportunities)
-underlying stock pays no dividends (ensures no early exercise)
-riskless rate of interest is constant
-distribution of stock prices is log-normal over any time interval, meaning stock returns are normally distributed in continuous time

Front 232

What is the implication of the first assumption behind Black-Scholes?

Back 232

it is possible to put together a portfolio that provides the same return as the call at no cost

Front 233

In Black-Scholes, what is C?

Back 233

the price of the European call

Front 234

In Black-Scholes, what is S?

Back 234

the price of the underlying stock

Front 235

In Black-Scholes, what is X?

Back 235

the exercise price

Front 236

In Black Scholes, what is r?

Back 236

riskless interest rate

Front 237

In Black-Scholes, what is sigma?

Back 237

standard deviation of the underlying stock's return

Front 238

In Black-Scholes, what is T?

Back 238

time until the option expires

Front 239

What time units must the T in B-S be expressed?

Back 239

any, as long as r and sigma are expressed in the same units

Front 240

In B-S, what is ln(S/X)?

Back 240

the natural logarithm of the ratio of the stock price to the exercise price

Front 241

In B-S, what is N(d)?

Back 241

-the cumulative normal distribution function evaluated at d
-SO, if d is equal to 1.5, N(d) is the area under the normal distribution curve to the left of 1.5 standard deviations above the mean

Front 242

If you increase exercise price, value of the call ______

Back 242

decreases

Front 243

True or False: when volatility increases, probability of exercise increases

Back 243

false

Front 244

True or False: when you decrease time, call price always decreases

Back 244

true

Front 245

Why should you sell a call if stock price is going down?

Back 245

it is going to be worth more

Front 246

What are the 5 inputs needed to price options using Black-Scholes?

Back 246

-stock price
-time to expiration
-exercise price
-risk-free interest rate
-volatility of the underlying security

Front 247

What is the problem with needing the volatility of the underlying security for B-S?

Back 247

we don't know the volatility, and can only estimate it

Front 248

How sensitive to interest rates are option prices?

Back 248

pretty insensitive

Front 249

What do people use for the risk-free interest rate, in B-S?

Back 249

the yield on a T-bill that matures about the time that the option expires

Front 250

What are two ways to estimate volatility of the underlying security for B-S?

Back 250

-use past returns to calculate volatility
-calculate standard deviation implied by one option and use it to price other options on the same stock that expire at the same time

Front 251

If the B-S model is correct, what can we use it to calculate?

Back 251

the market's expectation of the stock's volatility

Front 252

When do you know you have the standard deviation implied by the option prices?

Back 252

When the Black-Scholes price equals the market price

Front 253

When a company pays a dividend of $1, what happens to the stock price?

Back 253

it falls by $1

Front 254

Why, from the stockholders' standpoint, does the dividend not matter?

Back 254

every dollar lost on the stock is matched by a dollar received in dividends

Front 255

How large does a dividend have to be before it impacts the value of options significantly?

Back 255

even small dividends have a huge impact on option values

Front 256

What use is the put-call parity formula?

Back 256

for European options, this formula can be used to get the value of a put before expiration

Front 257

Why does put-call parity hold?

Back 257

-arbitrage

Front 258

At expiration, the value of a put must have the same value as a portfolio consisting of what three things?

Back 258

-a call option with the same strike price and expiration date
-$X
-a short position in a share of stock

Front 259

When is the only time you would exercise an exchange-traded option early?

Back 259

right before a large dividend

Front 260

What should you do if you own call options but think the stock is overpriced? (or if you just need the money)

Back 260

-don't exercise
-sell it

Front 261

What should you do if you own employee options, and need the money?

Back 261

-you can't sell them
-exercise them and sell the stock

Front 262

How good is B-S at valuing employee options?

Back 262

-it overstates their value
-according to B-S, employees usually exercise their options too early

Front 263

What is worth more: executive options or exchange traded options? Why?

Back 263

-exchange traded options
-execs may be forced to surrender or exercise early if they leave the company

Front 264

What are two reasons for talking about B-S when we are ultimately interested in the value of employee options?

Back 264

-it is the model that is usually used to price options in financial statements
-it shows clearly how different factors affect option prices

Front 265

Why do B-S values for options in financial statements almost always overstate the option's values?

Back 265

because of the likelihood of early exercise

Front 266

When are employees most likely to exercise?

Back 266

-3 months following vesting
-just before options are about to be cancelled
-if stock price has increased in the past 15 days
-if S/X is high
-if stock is particularly volatile

Front 267

When are employees less likely to exercise?

Back 267

if there is a long time to expiration

Front 268

When are executives likely to exercise early?

Back 268

-if they are risk averse
-if they have liquidity needs

Front 269

What is the relationship between option prices and time to exercise?

Back 269

-concave
-option prices increase with time to exercise, but at a decreasing rate

Front 270

A four year option and a 10 year option are worth ______ than two 7 year options.

Back 270

less

Front 271

What's the best way to value executive options, considering the issues with early exercise?

Back 271

calculate the value of options with different times to expiration and take a weighted average with the probability of exercise at different times for the weights

Front 272

What are convertible bonds?

Back 272

bonds the holder can exchange for common stock

Front 273

When will convertible bondholders convert?

Back 273

when the stock price has risen so much that the stock they are getting is worth more than the bond they are giving up

Front 274

If you issue debt now, what happens in the future, when debt matures if the firm has more investments? If they do not?

Back 274

-more investments: debt is retired; pay costs to issue more debt
-no more investments: debt is retired; take cash out of the firm, which is what you want

Front 275

If you issue equity now, what happens in the future, if the firm has more investments? If they do not?

Back 275

-more investments: don't need to repay equity, so can fund investments from internal cf
-no more investments: generates cash not needed; managers may waste money

Front 276

If you issue convertible debt now, what happens in the future, when convertibles mature, if the firm has more investments? If they do not?

Back 276

-more investments: stock is up; debt is converted to equity; no need to repay debt
-no more investments: stock price is low; debt retired; pay back bondholders and don't waste money

Front 277

Why is it dumb to issue convertibles because the yield is lower than on similar straight bonds?

Back 277

-coupon payments are only part of the cost
-the other part is the potential dilution of equity that occurs when bonds are converted

Front 278

What are 3 convertible bond structures?

Back 278

-exchangeable
-zero-coupon convertible
-double zero or no-no convertible

Front 279

What is an exchangeable convertible bond?

Back 279

-bond issued by one company that can be converted into shares of another company
-can monetize large stake held in another company

Front 280

What is a zero-coupon convertible?

Back 280

-doesn't pay cash coupon
-issued at a discount to the face value
-at maturity, if the bond isn't converted, the holder receives the full face value, which includes the issue price and accumulated interest

Front 281

What is a double zero or no-no convertible?

Back 281

-zero coupon convertibles that are issued at face value
-bonds include a series of short-dated put options that allow the holder to sell the bond back to the issuer at par

Front 282

What are 4 common features of convertibles?

Back 282

-call protection
-put feature
-contingent conversion or co-co
-contingent payment or co-pay

Front 283

What is call protection on a convertible?

Back 283

-most convertibles are callable
-when a bond is called, holders have a short time to convert or accept a call price, usually about 5% above face value of the bond

Front 284

What is a hard call period?

Back 284

time when a bond can't be called

Front 285

What is a soft call period?

Back 285

time when a bond can't be called unless the stock price exceeds a threshold price for a specified period

Front 286

What is a make-whole provision?

Back 286

forces the issuer to pay investors the present value of the remaining coupons if the bond is called during the soft call period

Front 287

What is the put feature of a convertible?

Back 287

-allows holder to put the bond back to issuer at a predetermined price
-creates floor value for bond

Front 288

What is a contingent conversion or co-co on a convertible?

Back 288

-holder's right to convert triggered by specific event

Front 289

What is the most common contingency for a co-co?

Back 289

bond isn't convertible until share price has exceeded a certain average trading price for a set period

Front 290

What is an advantage of a co-co, from the issuer's standpoint?

Back 290

the shares into which the bond is convertible do not dilute EPS

Front 291

What is a contingent payment, or co-pay, on a convertible?

Back 291

-one or more of payments are contingent on stock price exceeding a certain level
-company is able to deduct interest payments that may not actually occur

Front 292

When do co-pays occur?

Back 292

later in the life of the bond, after the hard call provision has expired

Front 293

What happens, with a co-pay, if, at maturity, there are interest payments that haven't been made, but the company has received tax deductions for?

Back 293

-may have to repay tax savings on payments not made
-no interest penalty for taking deductions that are later reversed

Front 294

What happens to recipients of 'phantom interest' with a co-pay?

Back 294

-they may be taxed
-taxed at lower tax rate than issuing company

Front 295

What are the 3 situations at maturity of a convertible?

Back 295

-firm is bankrupt and bondholders split the firm
-firm can pay off bondholders in full, but it isn't worth converting
-firm is worth a lot and bondholders convert

Front 296

What happens when V<mB?

Back 296

-bankruptcy
-V is firm value
-m is number of bonds outstanding
-B is par value

Front 297

In the case of V<mB, how much is each bond worth?

Back 297

V/m

Front 298

What happens when (yV/(ym+n))>B?

Back 298

-firm is worth a lot and bondholders convert
-ym+n is total shares after converts
-you get B if you don't convert (par value)
-y is shares each bond is worth

Front 299

What happens when mB<V<{(ym+n)/y}B?

Back 299

-bonds are worth the face value of $B
-firm value is too high for bankruptcy but too low for conversion
-mB is the value at par
-{(ym+n)/y}B is the value if you convert

Front 300

In the first two maturity situations, when the bond isn't converted, what is the value of the convertible bond?

Back 300

same as the value of a straight bond with no conversion feature

Front 301

In the third maturity situation, when the bondholder gives up face value of the bond for shares, what is the value of the convertible bond?

Back 301

-it increased linearly with firm value
-similar to call option, except for dilution

Front 302

When V/n<X, what is the implication for a warrant?

Back 302

out of the money

Front 303

When V/n>X, what is the implication for a warrant?

Back 303

in the money

Front 304

When will warrants be exercised?

Back 304

only if V/n>X

Front 305

What happens to the value of the firm when warrants are exercised?

Back 305

increases

Front 306

With m warrants exercised, if each busy y shares at a price of X, by how much does the total value of the firm increase?

Back 306

by ymX

Front 307

How many shares are there, when warrants are exercised?

Back 307

n+ym

Front 308

How much is each share worth, after warrants are exercised?

Back 308

(V+ymX)/(N+ym)

Front 309

What is the per share cost of exercise for warrants?

Back 309

$X

Front 310

If V/n<X, what is the value of the warrant at expiration?

Back 310

0

Front 311

If V/n>X, what is the value of the warrant at expiration?

Back 311

{[V/(n/y+m)]-[n/(n/y+m)]X}

Front 312

What is the warrant's value, in terms of the call value (ALWAYS)?

Back 312

n/(n/y+m) times the call value

Front 313

The warrant's value today must be what?

Back 313

n/(n/y+m) times the value of a call with the same exercise price and time to expiration

Front 314

How is the value of the warrant obtained using B-S?

Back 314

-replace the S in the B-S model by S+(m/n)W and multiplying the entire value by n/(n/y+m)

Front 315

What is the standard deviation when you are valuing a warrant using B-S? Is it the standard deviation of the stock's return?

Back 315

-no
-it is the standard deviation of the return of a portfolio of one share of stock and m/n warrants

Front 316

How do you get W, in valuing warrants using B-S? How do you know if you have it right?

Back 316

-you have to guess
-if the value on the left hand side is the same as the value of W that you put into the right hand side, you have the right value of W

Front 317

What is a simple way to value convertible bonds?

Back 317

calculate the value of a straight bond that matures at the same time, and add on the warrant portion

Front 318

How is the exercise price of a convertible bond obtained?

Back 318

divide the face value of the bond by the number of shares that the bond can be converted into

Front 319

If dividends are sufficiently large, should you call bonds?

Back 319

no

Front 320

When dividends are small, what happens to conversion of bonds?

Back 320

-you won't convert early
-shareholders will call and make you convert early

Front 321

What is the implication if you call a bond?

Back 321

-bad news
-means you don't think dividends will be big enough

Front 322

When dividends are paid, what happens to the value of the firm? Warrant? Bond portion of the convertible?

Back 322

-firm value decreases
-SO warrant value decreases
-AND bond portion of convertible decreases

Front 323

Why don't owners of convertibles usually exercise early?

Back 323

-you give up future interest payments
-you give up downside protection you have if the stock drops and you hold a senior security

Front 324

What proportion of convertible bonds are callable?

Back 324

the majority

Front 325

Forcing early conversion transfers wealth from whom to whom?

Back 325

from bondholders to stockholders

Front 326

When does early conversion not transfer wealth from bondholders to stockholders?

Back 326

-when bondholders should convert anyway because dividends are high
-then it is in the stockholders' interest to avoid calling the bonds in hopes that 'sleeping bondholders' will not convert

Front 327

What are perks?

Back 327

preferred stock that pays a higher dividend than the common and is automatically converted into common after a period of time

Front 328

Perk Value =

Back 328

common stock + PV of extra dividends - warrant with X equal to the cap

Front 329

What is K?

Back 329

cap price

Front 330

Why, if stock performs poorly, is the perk holder be better off than the holder of a share of stock?

Back 330

extra dividends

Front 331

Why, if stock price is well above cap price, is the perk holder worse off than a holder of a share of stock?

Back 331

they end up with fewer than one share of stock

Front 332

Why are perks a good way to issue equity?

Back 332

they don't signal that managers feel the stock is over-priced

Front 333

If shareholders don't expect stock to perform well, would they rather issue shares or perks? Why?

Back 333

-shares
-they don't have to pay out so much in dividends

Front 334

If shareholders expect stock price to rise, would they rather issue shares or perks? Why?

Back 334

-perks
-their positions won't be diluted as much since fewer shares are issued

Front 335

How were conversion prices for floating priced convertibles set?

Back 335

at a discount to the average of past stock prices in a look-back period

Front 336

Who generally issues floating priced convertibles, and how?

Back 336

-small firms and high-tech companies
-privately

Front 337

What is an example of last resort financing?

Back 337

floating priced convertibles

Front 338

What is a death spiral convertible?

Back 338

floating priced convertible

Front 339

Why do floating priced convertibles seem ideal for a company that wants to issue stock, but feels the stock is currently underpriced?

Back 339

-shares will only be sold at a later date when the market has had time to figure out the real value of the stock
-bondholders are protected on teh downside

Front 340

What is certain and uncertain in floating priced convertibles?

Back 340

-certain: company knows how much cash they will receive and bond buyers know the value of the stock they will receive
-uncertain: proportion of the firm that bondholders will get

Front 341

If a project's NPV is $1m, and the company takes it on, what happens to the value of the firm?

Back 341

increases by $1m

Front 342

What is the basic rule for using NPV?

Back 342

calculate present values of all incremental cash flows from the investment

Front 343

What are the two problems with using accounting profits instead of cash flows, in calculating NPV?

Back 343

-revenues are credited when earned, not when cash is received
-depreciation is subtracted from revenues, when there has been no cash expenditure

Front 344

What are 7 considerations in using NPV to evaluate investments?

Back 344

-use incremental cf
-ignore sunk costs
-consider incidental effects on remainder of business
-don't ignore working capital needs
-be careful about how overhead is calculated
-opportunity gains must be included in incremental cf
-opportunity costs must be subtracted from incremental cf of a project

Front 345

What are 5 options models useful in capital budgeting?

Back 345

-Black-Scholes
-Perpetual American Call Option
-perpetual american put option to abandon a project
-option to costlessly stop producing and restart
-option to switch to a different input

Front 346

When should B-S be used in capital budgeting?

Back 346

-options only exercised at one time
-timing is not a consideration

Front 347

When should the perpetual american call option be used in capital budgeting?

Back 347

-options to purchase that don't expire
-by delaying exercise you give up a cf

Front 348

When should the perpetual american put option to abandon a project be used in capital budgeting?

Back 348

-a project that pays of P and has costs of C
-it costs K to abandon the project
-the option doesn't expire

Front 349

When should the option to costlessly stop producing and restart be used in capital budgeting?

Back 349

-a perpetual option to start and stop producing
-if production halts, resumptions are costless

Front 350

When should the option to switch to a different input be used in capital budgeting?

Back 350

-a perpetual option to switch from one input to another, depending on which one is cheaper
-switching is costless

Front 351

In using B-S for capital budgeting, what is S?

Back 351

whatever is uncertain

Front 352

When is it particularly worthwhile to obtain information?

Back 352

-when X is low (don't need a lot to be worthwhile)
-when there's a ton of uncertainty

Front 353

What is the NPV rule?

Back 353

take a project with positive NPV after subtracting out opportunity costs

Front 354

When revenue foregone = interest, what decision do we make regarding the project?

Back 354

take on the project

Front 355

What happens to the discounted value of future cf when the economy is doing particularly well?

Back 355

increases

Front 356

As the value of the project today goes to zero, what happens to the value of the right to take the project?

Back 356

it goes to zero

Front 357

What is the project value V*?

Back 357

-the value at which you are indifferent between exercising the option and holding it
-the value at which you make the investment and take on the project

Front 358

What happens to the project value at which you exercise as volatility increases?

Back 358

increases with volatility

Front 359

Why are you more reluctant to exercise the option with greater volatility?

Back 359

-the greater the volatility, the greater the value of the option you are giving up

Front 360

If yield is low, in what form is most of the return on a project? What is the implication?

Back 360

-in the form of appreciation in the value of the project
-costs very little to wait to exercise the option and the option is valuable

Front 361

If yield is high, in what form is most of the return on a project? What is the implication?

Back 361

-in the form of a cash flow
-by waiting to take the investment we miss cf, so we exercise the option and make the investment when the project value is relatively low

Front 362

If exercise price doubles, does the value of the real call option fall to half its previous value?

Back 362

no

Front 363

When required investment doubles, what happens to the project value the triggers investment?

Back 363

also doubles

Front 364

If an entrepreneur is going public to take an investment, what is the question of when to go public equivalent to?

Back 364

the question of when to take an investment

Front 365

Firms with volatile projects should wait more/less before going public?

Back 365

more

Front 366

With regards to the option to abandon production costlessly and restart, if P<C, from where does the value of the project come?

Back 366

solely the result of the option to restart production.

Front 367

With regards to the option to abandon production costlessly and restart, if P>C, from where does the value of the project come?

Back 367

-the option to stop producing
-PLUS the present value of the revenues
-MINUS the present value of the costs

Front 368

When you can stop and start production, the value of a project is ______ than the discounted value of cash flows based on average revenues and costs.

Back 368

far greater

Front 369

What are peak load power plants' production model a good example of?

Back 369

-the option to stop producing and restart
-they are only operated in periods of peak demand when prices are high
-they shut down when prices decline

Front 370

3 guidelines for thinking about real options

Back 370

-options are valuable; even options that are unlikely to be exercised can be very valuable
-the greater the uncertainty, the more valuable are options
-never exercise early unless you are giving up cash by holding on to your option

Front 371

What are 3 derivatives that can be used to hedge?

Back 371

-futures or forward contracts
-swaps
-options

Front 372

What is a future or forward contract?

Back 372

we contract to buy or sell a specified amount of a specified commodity or assets at a set price at a future date

Front 373

What is a swap?

Back 373

we contract to swap one currency, commodity, or cash flow for another at a prearranged price or rate
-it is identical to a whole series of futures contracts

Front 374

On what do options sell?

Back 374

-currencies
-many kinds of futures contracts

Front 375

True or false: in a world of perfect markets and costless information, there is no need for hedging.

Back 375

true

Front 376

What are 4 market imperfections that make hedging make sense?

Back 376

-corporate taxes
-bankruptcy costs
-managerial risk aversion
-costly external financing

Front 377

Does reducing volatility of earnings reduce expected amount paid in taxes?

Back 377

-only if corporate taxes are a convex function of income, meaning if taxes increase at an increasing rate with income
-NOT if they are linear

Front 378

What makes tax rates convex?

Back 378

-there are limits on how many years losses can be carried forward or carried back
-this implies that the effective tax rate on losses is less than the effective rate on gains

Front 379

In what situation would tax rates be linear?

Back 379

when we are shifting income from states where we have a lot of income and are in a high tax bracket to states when our income is low and we are in a low tax bracket

Front 380

True or false: hedging can allow firms to issue far more debt than they otherwise could. Why?

Back 380

-true
-because it reduces the likelihood of bankruptcy and incurring bankruptcy costs

Front 381

How are stockholders compensated for the transfer of assets to bondholders in financial distress?

Back 381

-by receiving a higher price when they sell the debt in the first place
-this is NOT a bankruptcy cost

Front 382

What are two reasons external funding may be more costly than internal funds?

Back 382

-fees to lawyers, i-bankers, and auditors (especially high for equity offerings)
-information asymmetries between issuing firm and investors (costly if the firm's stock is correctly priced before the offering)

Front 383

On what does the decision depend regarding how a firm should hedge to minimize external financing?

Back 383

the correlation between the variable to be hedged and the firm's investment opportunities

Front 384

When the amount required for investment is uncorrelated with the variable to hedge, should you hedge?

Back 384

yes - it is best to eliminate variability in total cash flows

Front 385

In the case where cash flows and investment demand are positively correlated, should you hedge?

Back 385

-you should use derivatives to increase the volatility of cash flows if cash needed for investments is sufficiently variable
-partly hedge

Front 386

When cash flows and investment opportunities are negatively correlated, should you hedge?

Back 386

-you don't eliminate or reduce variability of cf by hedging
-you just reverse states in which the firm has high and low cf

Front 387

If investment opportunities are linear in the variable to be hedged, what instruments should be used to hedge?

Back 387

-futures or forward contracts
-swaps

Front 388

What are 4 derivative risks?

Back 388

-market risk
-operational risk
-counterparty or credit risk
-legal risk

Front 389

What is market risk, with regards to derivatives?

Back 389

-the risk of market prices moving against you in your derivative position
-if you are hedging, the losses on your derivative positions should be offset by gains from the company's businesss

Front 390

What is operational risk, with regards to derivatives?

Back 390

risks associated with human error and poor control systems

Front 391

What are two lessons learned from Barings?

Back 391

-companies who are using derivatives need adequate safeguards and controls
-top management needs to be aware of the activities of their derivative traders and to exercise control of these activities

Front 392

What were 6 warning signs of Leeson's bad behavior?

Back 392

-his trading activity was supposed to be risk-free, but he was claiming huge trading profits
-he requested hundreds of millions of pounds to meet margin requirements
-he claimed requested funds were to meet customer margin calls, but never provided info on the accounts
-SIMEX rules prohibit exchange members from meeting margin calls for customers
-outside auditors discovered discrepancies in his accounts
-there were wide-spread rumors that the company was experiencing large losses

Front 393

What is a stack and roll hedge?

Back 393

buying short-term contracts and rolling them over as they mature

Front 394

If you are hedging against oil price increases and prices instead fall, what happens?

Back 394

you lose money on your derivative positions at the same time that your fixed price contracts become more valuable

Front 395

What does it mean to say that credit rating agencies are exempt from Reg FD?

Back 395

management can share info with them that would effectively be inside info

Front 396

Do ratings changes reveal info that the market didn't know?

Back 396

-yes
-they do have an impact on stock prices

Front 397

What kind of debt can have shelf registration with the SEC?

Back 397

only investment grade debt

Front 398

What is the main business of credit rating agencies?

Back 398

granting regulatory licenses

Front 399

What is the tranche with the lowest priority?

Back 399

the equity tranche

Front 400

For a firm operating in a competitive market without externalities, more profit means what?

Back 400

greater benefits to society

Front 401

Michael Jensen suggests option contracts can hurt shareholders. What is his proposed solution?

Back 401

use options in which the exercise price is adjusted for the cost of capital and dividends

Front 402

How accurate is B-S in valuing executive options. Why?

Back 402

-overstates
-they tend to exercise early

Front 403

What are three advantages of options as compensation?

Back 403

-save cash for the firm
-option holders make money if stock price rises and lose money if it falls
-options can help retain employees

Front 404

Corporate risk management can make sense if:

Back 404

it decreases the need for external financing

Front 405

What are the two reasons general partners in private equity funds are motivated to provide a return on the limited partners' investment?

Back 405

-the general partner will start new funds in the future
-the general partner's compensation is tied directly to the return of the limited partners

Front 406

In what instance will a firm avoid calling a convertible bond?

Back 406

when the common pays large dividends

Front 407

How do you calculate values of employee stock options?

Back 407

calculate B-S value for different exercise times and use the distribution of times until exercise to calculate an expected value of the options

Front 408

What are 4 ways a leveraged buyout by a private equity fund creates value?

Back 408

-provides better incentive for managers
-sets up a board of directors that provides better oversight
-reduces taxes
-forces companies to focus on the intermediate term

Front 409

What can an implied standard deviation estimate be used for?

Back 409

-to price other options on the same underlying stock - to see if options are mispriced relative to one another
-can also be compared with historic volatilities to see if options have high or low prices relative to historical norms

Front 410

What does it mean to say that the VIX index of the CBOE has been at record highs in recent days?

Back 410

-VIX (or fear index) is weighted avg. of implied standard deviations of S&P 500 options with one month to expiration
-high VIX means high uncertainty about market's course over next 30 days

Front 411

How does giving options affect managers' incentive to take risky projects? Exceptions?

Back 411

-option values increase with volatility
-giving options to managers increases incentives to take risky projects
-exception: if managers have a lot of deep in the money options, they may be concerned about protecting the value of their options, making them more risk averse