CMFAS Module 4A Key Notes 2
A derivative is a security whose payoff is determined by the value, or payoff, of some other security (usually called the underlying security). The best known examples of derivatives are options.
2. How is knowing the prices of digital options useful?
A digital option is a security that pays one dollar if and only if a certain state occurs. Knowing the prices of digital options is very useful, because by value additivity they can be used to price any other security with known state-contingent cashflows.
3. What are some of the several types of options available?
There are several basic types of options, of which some important are:
- A Digital Option pays a fixed amount if a specific event occurs.
- A Call Option is an option that gives the owner of the option the right, but not the obligation, to buy a given asset (the underlying) for a given price K (the exercise, or strike price) at some future time T (the option maturity).
- A Put Option is an option that gives the owner of the option the right, but not the obligation, to sell a given asset for a given price K at some future time T.
4. How do you summarize the cashflows from put and call options at the maturity date of the option?
The cashflows from put and call options at the maturity date of the option can be summarized as
Call = max(0, ST – K)
Put = max(0,K -ST),
where ST is the price at maturity of the underlying security, and K is the exercise, or strike price.
5. What is the difference between American options and European options?
The difference between American options and European options is that the American ones can be exercised early, before the maturity date, while European options can only be exercised at the maturity date.
6. What does the pricing derivatives normally consist of?
Pricing derivatives merely consist of finding the future cash flows from the derivative as a function of the value of the underlying, and applying the same state price probabilities in the basic pricing relation.
7. Is there a relationship between state price probabilities and true probabilities?
The truth of the matter is that in general, there is
no relationship. Except for the obvious case when a state has zero chance of occurring. In that state the state price and the state price probability would be zero as well.
Like an equity call option, a warrant entitles its holder to purchase shares at a pre-specified strike, or exercise, price K.
9. What is the difference between a standard option and the warrant?
The difference between a standard option and the warrant is that when a warrant is exercised, new equity is issued by the firm, and this equity is purchased from the company itself at the warrant exercise.
10. Why State Prices Must be Equal?
We will first argue that state prices must be the same for all derivatives written on the same underlying security. To do this we make a simple arbitrage argument:
If state prices are not the same, it will be possible to create a free lunch. if the state price probabilities are not consistent across derivatives, it is possible to create arbitrage opportunities, or free lunches. Since it is an axiom of finance that free lunches do not exist, state price probabilities must be consistent.
11. What will affect the value of a firm only through effects on available cash flow assets?
The financing mix affects the value of the firm only through effects on available cash flows from assets. Under the axioms of corporate finance, changes in the financing mix can affect the value of the firm V only if it lowers or raises the cash flow from the firm’s assets that accrue to the traditional creditors.
12. Why is it iin the interest of corporations to increase debt obligations?
In the United States and some other countries, debt carries a distinctive tax advantage for the issuer, coupon payments are deductible from taxable earnings. It is therefore in the interest of corporations to increase debt obligations in order to minimize tax payments. Minimizing tax payments will maximize the cash flow from the assets of the firm that is available for distribution to the traditional creditors. In other words, debt enhances the value of the firm.
13. What other costs should one be aware of other than bankruptcy costs?
Besides bankruptcy costs, there are agency costs. In particular, managers may want to do things that are not in the interest of the traditional creditors. The ensuing drag on cash flow may be avoided in part by issuing debt, which forces management to go to the capital markets regularly to refinance debt.
14. What effects does the “general quilibrium” have in the market?
“General equilibrium” effects are the consequences at the market level of systematic actions at the individual (company, investor) level. the effect of the issuance of corporate bonds when personal income taxation is progressive, i.e., rp increases with income. Firms have an incentive to issue debt, until there are no more individuals in the economy with rp < rc. At that point, there is no more advantage to issuing debt, because the marginal investor pays TP = TC, so that the corporate debt tax shield is offset by the personal tax on coupon income. Then, at the margin, the individual company will be indifferent between issuing debt and equity.
15. What is the The Flow-To-Bquity (FTE)?
The Flow-To-Bquity (FTE) is defined to be the NPV of the cash flow to the equityholders.
16. What is the core idea of the Weighted Average Cost Of Capital (WACC)?
The idea of Weighted Average Cost Of Capital (WACC) is simple. One should discount the cash flows of the unlevered project (firm) using a weighted average cost of capital that reflects the advantages of the debt tax shield.
17. What is the general principle of the Net Present Value (NPV)?
It discounts cash flows according to their time stamp and risk. If cash flows from the project are risky, one needs to use the discount rate that adjusts for the risk appropriately. If the debt tax shield is risk-free, then the cash inflows it generates should be discounted at the riskfree rate.
18. Why Pay Dividends if only the IRS Gains?
Just like with debt/equity, taxation upsets the applecart for Miller and Modigliani. The nice dividend irrelevance result is only valid under assumptions of no taxes. In the US, and most other countries, corporate and personal taxation is very important for changing preferences for dividends.
In many countries, including the US, dividends are taxed “twice.” First there is the taxation of corporate earnings. The after tax results from these earnings are then reflected in the dividends and stock prices of the corporation. And then individuals are taxed on their dividends and returns from selling the corporation’s stocks. Double taxation!
20. Is there a way for a firm to avoid dividend taxation?
If a firm really has too much cash and believes that dividend taxation is a problem, it will do better by repurchasing stock. The stockholders would only be taxed at the (usually lower) capital gains rate, and have the option not to participate in the share repurchase, avoiding taxation altogether.
21. What are some of the prime examples of instruments for hedging?
Two prime examples of instruments for hedging are forward contracts and futures contracts. Both of these are agreements to buy (sell) given amounts of an underlying security at given prices (forward prices) and at given times (expiry dates).
22. Are options suited for hedging?
Options are of course well suited for hedging, typically to insure against negative outcomes while keeping an upside potential.
23. What is a synthetic static hedge?
If no forward contract is available, it’s possible to generate an artificial one. The artificial forward can be constructed at a single point in time and need not be adjusted later on.
24. Do dynamic hedges need to be static?
Dynamic hedging positions in a hedge portfolio have to be adjusted continuously. If one of the positions gets stuck, the hedge is likely to blow up.
25. What itsValue at Risk (VaR)?
To measure the risk of a portfolio with complex positions in derivatives, banks nowadays (have to) compute a number which is called their Value at Risk (VaR). This number is the maximum
loss that the portfolio would run with a certain probability, say, 95%. VaR is thus determined by the tail of the density of portfolio losses.
26. What does the Efficient Markets Hypothesis tell us?
The Efficient Markets Hypothesis really tells us that there won’t be abnormal returns once you adjust for risk. If someone has been consistently making more money than you, it’s because s/he has been taking more risk.
27. What is the most authentic way of valuing companies?
The only valid way to value companies, securities or projects is to compute net present value. That is, determine future cash flows, multiply them with the prices of pure discount bonds (i.e., discount them appropriately), and add everything together (as if it were a basket of fruit).
28. What matters most for valuation?
Only cash flows matter for valuation. Accounting earnings are relevant only because they determine taxes (which are cash flows).
29. What determines the required expected return on a security?
The CAPM states that the required expected return on a security is not determined by its own return variability, but only to the extent that it contributes to the total risk (variance) of the market as a whole, i.e., only in proportion to its “beta.”
30. Why is cash dividends considered as a bad idea?
Cash dividends are in general a bad idea because equity holders end up paying more taxes. Stock repurchases are better if you must pay dividends.