Principles of Finance

1
Principles of Finance

• Bartek Kubicki
• City University, Trencin
• March 22th, 2009

2
TODAYS SESSION

• Derivatives
• Foreign exchange
• Behavioral finance
• Course summary

3
DERIVATIVES

• A DERIVATIVE is a financial instrument whose
  value depends on the price of some other asset
• Exchange traded derivatives are standardized and
  backed by the clearing hose
• Over-the-counter (OTC) are custom made
  instruments and are traded/created by dealers in
  a market with no central location

4
DERIVATIVES

• FORWARD CONTRACT is a bilateral contract that
  obligates one party to buy and the other party to
  sell a specific quantity of an asset, at a set
  price, on a specific date in the future
• Long forward position the party that has decided
  to buy
• Short forward position the party that has
  decided to sell
• Each party of the forward contract is exposed to
  default risk, the probability that the other
  party (the counterparty) will not perform as
  promised

5
DERIVATIVES

• Example party A agrees to buy a 1,000 face
  value, 90-day Treasury bill from party B 30 days
  from now at a price of 990
• Party A agrees to buy 5 bushels of wheat from
  party B three months from not at a price of 20
• Party A agrees to buy from party B 10,000 shares
  of Microsoft 50 days from now at a price of 28.
• Settlement
• Delivery
• Cash settlement

6
DERIVATIVES

• A party to a forward contract can terminate the
  position prior to expiration by entering into an
  opposite forward contract with an expiration date
  equal to the remaining on the original contract

7
DERIVATIVES

• EQUITY INDEX FORWARD CONTRACT
• A portfolio manager desires to generate a return
  on 10 million 100 days from now from a portfolio
  that is quite similar in composition to the SP
  100 index. She requests a quote on a short
  position in a 100-day forward contract based on
  the index with a notional value of 10 million
  and gets a quote of 525.2. If the index level at
  the settlement date is 535.7, calculate the
  amount the manager will pay or receive to settle
  the contract
• -200,000

8
DERIVATIVES

• BOND FORWARD CONTRACT
• T-bill prices are often quoted as a percentage
  discount from a face value. The percentage
  discount is annualized so that 90-day T-bill at a
  4 discount will be priced at a 1 discount
  (90/3604) from a face value
• A forward contract covering a 10 million face
  value T-bill that will have 100 days to maturity
  at contract settlement is priced at 1.96 on a
  discount yield basis. Compute the USD amount the
  long has to pay at settlement for the T-bill
• 9,945,560

9
DERIVATIVES

• CURRENCY FORWARD CONTRACT
• One party agrees to exchange a certain amount of
  one currency for a certain amount of another
  currency at a future date
• Company X expects to receive EUR50 million 3
  months from now and enters into a cash settlement
  currency forward to exchange these euros for
  dollars at USD 1.48 per EUR. If the market fx
  rate is USD 1.50 per EUR at settlement, what is
  the amount of the payment to be received or paid
  by X
• Pay 1,000,000

10
DERIVATIVES

• FORWARD RATE AGREEMENT
• Can be viewed as a forward contract to
  borrow/lend money at a certain rate at some
  future day. The contract settles in cash and no
  actual loan is made. The contract is based on a
  notional value.
• The long position is the party that would borrow
  the money
• The short position is the party that would lend
  the money
• Cash payment at the settlement of the forward is
  the present value of the interest savings

11
DERIVATIVES

• FORWARD RATE AGREEMENT
• Consider FRA that
• Settles in 30 days
• Is based on a notional principal amount of 1
  million
• Is based on a 90-day LIBOR
• Specifies a forward rate of 5
• The actual LIBOR rate 30 days from now is 6
• Compute the cash payment at expiration and
  identify which party makes the payment
• Payment from the short to the long of 2,463.05

12
DERIVATIVES

• FORWARD RATE AGREEMENT
• a days fraction, i.e. number of days in the loan
  term / 360

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DERIVATIVES

• FUTURES CONTRACTS differ from the forward
  contracts
• Traded on the organized exchanges
• Are highly standardized
• A single clearing house is the counterparty to
  all future contracts
• Government regulates futures markets
• Futures contract can be easily closed by entering
  a reverse/offsetting trade
• Futures are marked to market on a daily basis

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DERIVATIVES

• INITIAL MARGIN the money that has to be
  deposited in a futures account before any trading
  takes place
• MAINTENANCE MARGIN is the amount of margin that
  must be maintained in a futures account. If the
  margin balance in the account falls below the
  maintenance margin, additional funds must be
  deposited to bring the margin balance back to the
  initial margin requirement
• VARIATION MARGIN is the funds that must be
  deposited into account to bring it back to the
  initial margin amount
• SETTLEMENT PRICE closing price for the futures
  contracts, based on which margins are calculated

15
DERIVATIVES

• consider a long position of five in July wheat
  contracts, each of which covers 5000 bushels. The
  contract price is 2.00. Each contract requires
  an initial margin deposit of 150 and a
  maintenance margin of 100. Compute the margin
  balance for this position after a 2-cent decrease
  in price on day 1, a 1-cent increase on day 2,
  and a 1-cent decrease in price on day 3

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DERIVATIVES
17
DERIVATIVES

• Ways to terminate a futures contract
• Delivery
• Cash settlement
• Offsetting trade
• Exchange for physicals
• Examples of futures contracts bond, stock index,
  single stocks, currency

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DERIVATIVES

• OPTION CONTRACTS gives its owner the right, but
  not the obligation, to conduct a transaction
  involving and underlying asset at a predetermined
  future date (the exercise date) and at a
  predetermined price (exercise or strike price).
  The seller of the option has the obligation to
  perform if the buyer exercises the option
• CALL OPTION has the right to purchase the
  underlying asset. Long Call vs. Short Call
• PUT OPTION has the right to sell the underlying
  asset. Long Put vs. Short Put

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DERIVATIVES

• AMERICAN OPTION may be exercised at any time up
  to and including the contract expiration date
• EUROPEAN OPTION can be exercised only on the
  contracts expiration date
• Therefore, the value of the American Option will
  equal or exceed the value of the European Option

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DERIVATIVES

• IN-THE-MONEY OPTION immediate exercise of the
  option will generate a positive payoff. For a
  call option current price gt strike price For a
  put option current priceltstrike price
• OUT-OF-THE-MONEY OPTION immediate exercise would
  result in a loss. For a call option current
  priceltstrike price for a put option current
  pricegtstrike price
• AT-THE-MONEY OPTION no loss or gain would be
  generated if exercised immediately.

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DERIVATIVES

• OPTION PREMIUM option value
• Option value intrinsic value time value
• INTRINSIC VALUE is the amount at which the
  option is in the money
• TIME VALUE is the mount of which the option
  premium exceeds the intrinsic value. Equals 0
  when the option reaches expiration date. The
  longer the time to expiration the greater the
  time value

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DERIVATIVES

• Consider a call option with a strike price of
  50. Compute the intrinsic value of this option
  for stock prices 55, 50, 45
• Consider a put option with a strike price of 20.
  Compute the intrinsic value of this option for
  stock prices 22, 19, 15

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DERIVATIVES

• LONG CALL

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DERIVATIVES

• SHORT CALL

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DERIVATIVES

• LONG PUT

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DERIVATIVES

• SHORT PUT

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DERIVATIVES

• Exchange traded vs. OTC options
• Financial options bonds, interest rates (caps,
  floors), index, equity, futures, swaptions,
  commodities
• Interest rate cap is a series of interest rate
  call options, place a maximum on the interest
  payment on a floating rate loan
• Interest rate floor is a series of interest rate
  put options. Place a minimum on the interest
  payment that are received from a floating rate

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DERIVATIVES

• FACTORS AFFECTING THE VALUE OF THE OPTION
• Strike price
• Current market price
• Volatility of the underlying asset
• Time to expiration
• Risk free rate (increases the value of call and
  decreases the value of put)
• C S P X/(1RFR)T
• P C S X/ (1RFR)T

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DERIVATIVES

• SWAP is an agreement to exchange a series of
  cash flows on periodic settlement dates over a
  certain time period (tenor).
• Require no payment by either party at the
  initiation
• Custom instruments
• Are not traded on any organized exchange
• Are largely unregulated
• Default risk is important
• Most participants are large institutions

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DERIVATIVES

• INTEREST RATE SWAP one party makes a fixed-rate
  interest payment on a notional principal
  specified in the swap in return for a
  floating-rate payment from the other party.
• Notional principal is not swapped
• Net interest is paid by the party who owes it
• It is called plain vanilla interest rate swap

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DERIVATIVES

• Bank A enters into a 1,000,000 quarterly-pay
  plain vanilla interest rate swap as the
  fixed-rate payer at a fixed rate of 6 based on a
  360-day year. The floating-rate payer agrees to
  pay 90-day LIBOR plus 100bps margin 90-day LIBOR
  is currently 4, 90 days from now 4.5, 180 days
  from now 5, 270 days from now 5.5, 360 days
  from now 6
• Calculate the amounts Bank A pays or receives 90,
  180, 270, 360 days from now. THE PAYMENT 90 DAYS
  FROM NOW DEPENDS ON CURRENT LIBOR!!!!!
• 90 2,500 180 1,250 270 0 360 -1,250

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DERIVATIVES

• CURRENCY SWAP one party makes payments
  denominated in one currency, while the payments
  from the other party are made in a second
  currency.
• Notional amounts of the contracts are exchanged
  at the initiation at the current exchange rate
• Notional amounts are returned at the contract
  termination
• Full interest payments are exchanged at each
  settlement date, each in different currency
• Interest rates floating-floating, fixed-fixed,
  floating-fixed

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DERIVATIVES

• X can borrow in US for 9, while Y for 10, Y can
  borrow in Australia for 7, while X would have to
  pay 8. X needs AUD, while Y needs USD. The
  current exchange rate is AUD/USD 2. X needs AUD 2
  million, while Y needs USD 1 million. Structure
  the transaction, assume the tenor is 1 year and
  only one periodic payment is made.

34
DERIVATIVES

• EQUITY SWAP the return on a stock, a portfolio,
  or a stock index is paid each period by one party
  in return for a fixed-rate or a floating-rate
  payment.
• The return can be the capital appreciation or the
  total return including dividends on the stock,
  portfolio or index

35
DERIVATIVES

• Investor X enters into a 2-year 10 million
  quarterly swap as the fixed payer and will be
  receiving the index return on the SP500. The
  fixed rate is 8 and the index is currently at
  986. At the end of next three quarters the index
  level is 1030, 968, 989.
• Calculate the net payment for each of the next
  three quarters and identify the direction of the
  payment
• q1 246,000 q2 -802,000 q3 17,000

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DERIVATIVES

• HEDGING involves taking an offsetting position
  by buying or selling a financial instrument whose
  value changes in the opposite direction from the
  value of the asset being hedged

37
FOREIGN EXCHANGE

• EXCHANGE RATE is a ratio that describes how many
  units of one currency you can buy per unit of
  another currency
• The appreciation of one currency makes that
  countrys goods more expensive to residents of
  another countries while depreciation makes a
  countrys goods more attractive to foreign buyers

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FOREIGN EXCHANGE

• Direct quotes domestic currency per foreign
  currency
• Indirect quotes foreign currency per domestic
  currency
• Bid price is the price the bank will pay for FC
• Ask price is the price the bank will sell FC

39
FOREIGN EXCHANGE

• The cross rate is the rata of exchange between
  two countries, computed from the exchange rates
  between each of these two countries and a third
  country
• The spot exchange rate between CHF and USD is
  1.7799, and the spot exchange rate between NZD
  and USD is 2.2529. Calculate the direct CHF/NZD
  spot cross exchange rate
• 1.26575

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FOREIGN EXCHANGE

• Spot rate is the exchange rate for immediate
  delivery of the currency
• Forward rate is the rate for currency
  transactions that will occur in the future

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FOREIGN EXCHANGE

• A US firm is obliged to make a future payment of
  CHF 100,000 in 60 days. To manage its exchange
  risk the firm contracts to buy CHF in 60 days in
  the future rate at 1.7530 CHF/USD. The current
  exchange rate is 1.7799 CHF/USD.
• How much would the firm lose/gain if the rate
  fell to 1.6556, what about 1.8250 (with/without
  hedging)

42
FOREIGN EXCHANGE

• A foreign currency is at a forward discount if
  the forward rate expressed in USD is less than
  the spot rate. Foreign currency units will be
  cheaper in the future
• A foreign currency is at a forward premium if the
  forward rate expressed in USD is greater than
  the spot rate. Foreign currency will be more
  expensive in the future
• forward
  rate spot rate 360
• Forward premium/discount spot rate
  number of forward contract days

43
FOREIGN EXCHANGE

• Assume the 90-day forward rate for NZD is USD
  0.4439 and the spot rate is USD 0.4315. Determine
  if the NZD is trading at a premium of discount to
  the USD. Calculate the annualized premium or
  discount
• 11.49

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FOREIGN EXCHANGE

• INTEREST RATE PARITY
• The only difference between exchanging currencies
  in the spot market and exchanging currencies in
  the forward market is the timing of the
  transaction, where time is presented by interest
  rates
• There is a relationship between the spot and
  forward exchange rates and the domestic (rd) and
  foreign (rf) interest rates
• Covered interest parity holds because investors
  will take advantage of interest rate
  differentials to move funds between countries
  where spot and forward rates are not in balance

45
FOREIGN EXCHANGE

• INTEREST RATE PARITY
• 
  (1rd)
• Forward DC/FC spot DC/FC (1rf)

46
FOREIGN EXCHANGE

• Suppose you can invest in NZD at r5.127, or you
  can invest in CHF at r5.5. You are a resident
  of New Zealand, and the current spot rate is
  0.79005 NZD/CHF. Calculate the one-year forward
  rate expressed in NZD/CHF
• 0.78726

47
FOREIGN EXCHANGE

• Covered interest arbitrage is a trading strategy
  that expoits currency positions when interest
  rate parity equation is not satisfied
• (1rf)(forward rate)
• (1rd) spot rate
  covered interest differential
• If domestic interest rate is less than the hedged
  foreing interest rate, an arbitrageur will borrow
  in the domestic cah market, buy foreign currency
  at a spot rate, and enter into a forward contract
  granting him the ability to convert the foreign
  funds back to domestic funds at some future date

48
FOREIGN EXCHANGE

• The forward rate between GBP and USD is 0.7327
  GBP/USD, and the current spot rate is 0.7045
  GBP/USD. The UK interest rate is 6.056, and the
  US rate is 5.95. Find the arbitrage opportunity
  if there is any

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FOREIGN EXCHANGE

• FACTORS INFLUENCING EXCHANGE RATES
• Current and financial account balance
• Differences in income growth
• Differences in inflation rates
• Differences in real interest rates
• Monetary and fiscal policies
• Overall country investment attractiveness

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BEHAVIORAL FINANCE

• PORTFOLIO THEORY ASSUMPTIONS
• Investors are risk-averse the prefer less risk
  to more risk for a given level of expected return
• Investors will only accept a riskier investment
  if they are compensated in the form of greater
  expected return
• Investors have homogeneous expectations, they
  have the same risk/return distribution
• Investors have the same information, interpret
  the same, and make the same forecasts
• INVESTORS ARE RATIONAL
• ARE THEY????

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BEHAVIORAL FINANCE

• Rather than research financial statements and
  other relevant data, individuals form investment
  rules and make investments using information that
  is most prominent in the media or otherwise most
  readily available

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BEHAVIORAL FINANCE

• Representativeness investors base expectations
  upon past experience, applying stereotypes
• Ex good earnings announcement is a good
  predictor of good future performance

53
BEHAVIORAL FINANCE

• Overconfidence placing too much confidence in
  the ability to predict
• To narrow confidence intervals
• Investors tend to systematically underestimate
  the risk
• Investors tend to trade more frequently than can
  be justified by the information
• Professionals feel they are good because of their
  training and experience, so any inaccuracies in
  their forecasts are due to outside factors
• Inividuals feel that if they are good at one
  thing they will be good in another thing as well
• Portfolios are not properly diversified,
  containing small new stocks

54
BEHAVIORAL FINANCE

• Frame dependance investors judge the information
  within the information it is received rather then
  on its own merits
• Treating The Wall Street Journal as a better
  source than The New Your Times
• When the market is up, investors loss aversion
  falls and they jump in, further pushing prices up

55
BEHAVIORAL FINANCE

• Loss aversion individuals are reluctant to
  accept a loss
• A stock may be down considerably from its
  purchase price, but investors holds on to it
  hoping it will recover
• Investors monitor stocks performance too often
  and based on that make irrational decisions
• Feeling to regret

56
BEHAVIORAL FINANCE

• Risk-seeking behaviour accepting more risk in
  order to generate return
• Portfolio manager who has recently experienced
  losses, will take riskier position, increase
  leverage etc.

57
BEHAVIORAL FINANCE

• Anchoring-and-adjustment inability to fully
  incorporate the impact of new information
• Analysts have they own forecasts and they do not
  revise fully
• Individual investors tend to anchore to
  forecasts, even knowing that the forecasts are
  probably inaccurate, because they provide a
  measure of assurance

58
BEHAVIORAL FINANCE

• 1/n diversification naïve diversification.
• Emloyees put equal amount into each of the
  alternative funds provided

59
BEHAVIORAL FINANCE

• Familarity investors invest in stocks they know
  (from they region, employees employer
• Home bias when allowed to choose between
  international and domestic securities, the
  typical individual will select domestic (home)
  securities

60
BEHAVIORAL FINANCE

• Status qou bias sticking to the original asset
  allocation
• Defined contribution plan participants make an
  original allocation and do not change it

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COURSE SUMMARY

• Organization of financial markets and financial
  instruments
• Financial statemements (balance sheet, income
  statement, cash flow statement)
• Time value of money future value, present value,
  effective annual rate, annuity, perpetuity
• Bonds characteristics
• Bonds valuation, yield to maturity, duration
  (interest rate risk), credit spread
• Yield curves and theories behind
• Preferred stock and its valuation
• Common stock and its valuation (dividend discount
  model constant growth, supernormal growth)

62
COURSE SUMMARY

• Stock price multiples (P/E, P/BV, D/P)
• Average, standard deviation, covariance and
  correlation calculation and interpretation
• Portfolio theory (return and risk of the
  portfolio, systematic vs unsystematic risk)
• CAPM beta calculation, SML equation, stock
  valuation, model interpretation
• Efficient capital market, degrees of efficiency
  and practical implications
• Cost of capital calculation (debt, preferred
  stock, common stock, WACC) debt after tax,
  yield to maturity!!!!!!!!!!!!!!!!!

63
COURSE SUMMARY

• -What is operating and financial leverage
• -Beta of assets and equity calculations
• -Capital structure policy (MM no taxes, MM with
  taxes, bankruptcy costs, Pecking Order Theory)
• -Dividends (definitions), impact of dividends on
  valuation (theories)
• -Capital budgeting (payback period, d payback
  period, NPV, IRR, PI, relevant cash flows)
• -Derivatives (futures, forwards, options, swaps)
• -Foreign currency (cross rates, interest rate
  parity, forward rates)
• -Behavioral finance