Derivatives
contract between two individuals that has cash flows based on the value of some underlying asset; used in corporate hedging to ensure prices, protect from economic uncertainty, and structure deals; win-lose game.
Types of Derivatives
swaps, options, futures, and forwards
Swap
derivative used to trade expenses with another party (interest rate fixed vs variable or currency)
Option
contracts that give the owner the right (NOT obligation) to buy or sell the underlying asset at an exercise(strike) price on the maturity/expiration date; call is right to buy, put is right to sell; pay a premium to obtain this right.
Calls vs Puts
purchase calls at current price if expecting price to rise; purchase puts at current price if expecting price to fall.
Long vs Short the contract
long owns right to exercise option; short is paid to accept risk long might exercise (can only really make money on long)
In vs out the money
option could be exercised today for positive payoff vs not
Intrinsic Value
payoff option would receive if exercised right now (positive if in, zero if out)
Time Value
extra value created by having remaining time before option expires; the longer till expiration, the more valuable; don't exercise early!!!
American Vs European
exercisable any time vs only on maturity date
Price of an Option
Payout to Long Call: Price - Exercise Price or 0
Payout to Short Call: - or 0
Payout to Long Put: Exercise Price - Price 0r 0
Payout to Short Put: - or 0
Effects of Variables on Call and Put Values
Stock Price + -
Exercise Price - +
Time till Exp. + +
Stock Volatility + +
Interest Rate s + -
Should you hedge risk?
Only if downside is potentially fatal to firm; don't ever eliminate all; the more risky you become the more expensive hedging becomes.
Bionomial pricing says assets with same payouts and same risk have
the same price
Binomial
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Futures and Forwards
obligated to go through with option, useful in hedging and investments; both parties must agree to locked price.
Forwards
private contract, not standardized, specific date, settled at end, delivery happens at maturity.
Futures
traded on exchange, standardized, range of delivery dates, marked to market daily, usually closes before maturity.
Futures Profit to Long
Spot price at maturity - original futures price; forward price is always higher than current price
Futures Profit to Short
Original futures price - Spot price at Maturity
Futures Pricing
FV = PV^(rfr x t)
The Corporate Hedging Process
1. Identify the risks (operating vs financial)
2. Distinguish between hedging and speculating
3. Evaluate the costs of hedging vs not
4. Use the right measuring stick for hedge performance
5. Don't base hedge program on your market view
6. Understand your
Game Trees
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Good reasons for mergers
Increased market share, efficiencies of scale, elminination of redundancies, removing excess capacity, overvalued stock
Bad reasons for mergers
Have money must spend, diversification, ratcheting up earnings (PE ratio drops even if EPS goes up)
Merger Effects
Target shareholders and debtholders win; acquiring shareholders are worse off!
Merger Valuation (Stock)
Shares Out = (Shares B * Price B / Price A) + Shares A
EPS = NI / Shares Out
PE= Share Price/EPS
Merger Valuation (Cash)
NewMarket Cap = OG PE * Syn Gain
Summed Market Caps - Net Income
Accept if highterm-37er!
Proxy Fights
usually fail; sign voting rights to groups other than management; institutional competition and hedge funds makes it work.
Leveraged Buy-Out
group buys out struggling company w/ tender offer; funded by new debt, goes private or dark; target has stable cash flows, low debt, low price, high current assets and value; debt-holders of target lose.
Divestiture
firm sells off divisions; carve out (new independent) or spin off (new piece)
Bankruptcy
missing a payment (if cash to pay interest, not just when more liabilities than assets); let creditors know, ask for extensions, compositions, or creditor control; try voluntary liquidation; then file formally.
Chapter 7 Liquidation
Secured debt holders, court, debtor-in-possession financing, unpaid employee stuff, customers, fisherman farmers, taxes, unsecured debt, preferred stock, common stock
Chapter 11 Reorganization
judge approves plan, claimants vote majority and represent 2/3 claim value, possible cram down procedures, equity holders lose everything, debt converts to equity.
Pre-Packs
parties privately agree to restructuring terms before formal filing; judicial approval, tax benefits.