Chapter 10-18 - csc PDF

Preview

Summary

csc...

Description

Chapter 10 - Derivatives DERIVATIVE PRODUCTS RIGHTS

- derive their value from the value of the underlying security & from remaining life span of derivative

- right to buy shares - also called a "pre-emptive right" - life span of 6 - 8 weeks - Company wants to sell additional shares, rather than issuing new shares to the public, company offers shares to existing shareholder through rights offering - existing shareholders are more likely to buy shares in company - subscription price < current market price - issue 1 right for every share held, require a # of rights to purchase an additional share eg. need 9 right to purchase 1 new share - issued in same manner as dividends, shareholders on record date will receive rights - if hold shares 2 business days before record date  receive the rights - cum rights or "rights on" - 2 business days before record date - ex rights - 1 business days & less prior to record date

- shareholder has 3 choices with rights 1) exercise rights & subscribe for additional shares 2) sell them in secondary market 3) do nothing & let expire

the price of any derivative is composed of intrinsic value & time value Intrinsic Value

- the amount by which market price of stock exceeds subscription price of derivative

Intrinsic Value Of Right (cum rights) Eg.

=

Market price of Stock - Subscription Price = S-X # of rights to buy 1 new share & 1 n+1

5 rights required to buy 1 new share, subscription price $17, market price of stock $20

- when cum rights, the stock & right are selling as a package 1 share & 1 right  when ex-rights, each has own value - the price of the stock will drop by approximately the value of the right when stock goes ex-rights - now hold 2 securities Intrinsic Value Of Right (ex rights) Eg.

=

Market price of Stock - Subscription Price = S-X # rights to buy 1 new share n

5 rights required to buy 1 new share, subscription price $17, market price of stock now $19.50

Trading - automatically listed on same exchange as common -- regular delivery - settled 2 business day after transaction

RIGHTS REVIEW QUESTIONS 1) Calculate the value of a right, when it is cum & ex rights, with a subscription price of $90, current stock price of $100 and which requires 4 rights to subscribe to 1 new share 2)

A company with 9 million shares outstanding & share price of $40 issues rights to existing shareholders with a subscription price of $30. They wish to raise $30 million for capital expansion. a) How many new shares do they need to issue? b) How many rights are required to purchase 1 new share?

3)

Alpha Company has 20 million common shares O/S which trade @ $25. It wishes to raise $100 million at a subscription price of $20. a) How many rights are required per new share? b) What is the value of a right when rights-on? c) Everything else equal, what is the share price ex-rights? d) If the record date is Tues Feb. 3rd, when do shares sell ex-rights?

Derivatives 2 WARRANTS - option to purchase specified # common shares at a stated price for specified time period - life span of 2 -3 years - issued as sweetener with debt or equity issue or separately - exercise price often 15% or more above current market price at issue LEVERAGE

- main reason investors buy warrants - warrant price usually much less than common price & two prices move together

Leverage Potential

=

Market price of Common Market price of Warrant Eg. (A) = $16.65/$0.42 = 39.58x (B) = $6.12/5.00 - evaluate leverage relative to prospects for underlying common stock

Intrinsic Value

= Market Price of Common - Exercise Price = Ps - E - can never be less than zero, intrinsic value is either positive or 0

Time Value

= Market Price of Warrant - Intrinsic Value - speculative value

Eg.

Market price of warrant $2.00, market price of stock $8.00, exercise price $6.50, 1:1 exercise Intrinsic value ? $8.00 - 6.50 = $1.50

Eg.

Time Value? $2.00 - 1.50 = $0.50

Mkt price of warrant $1.75, mkt price of common $5.50, exercise price $4.50 Intrinsic Value? Time Value?

 once mkt price of common > exercise price, a $1 increase in common price results in $1 increase in warrant price When Evaluating & Comparing Warrants - consider the following 1) Time Value - % of warrant value that is time value 2) Time to Expiry - expiry date & amount of time left - longer time preferred longer for common to increase 3) Liquidity - # warrants trading -- larger # better  larger market when want to sell warrants 4) Leverage - want high but reasonable leverage

Warrant Practice Questions 1) Calculate intrinsic & time value if: exercise price $10, common price $9, warrant price $0.50 2) For question #1, calculate intrinsic & time value if market price increases to $10.50, warrant price $1.00

Derivatives -3

What is a derivative? - financial contract that derives its value from the value of the underlying security & from its remaining life span

markets - OTC - exchange traded Differences between OTC & Exchange traded 1) Standardization & flexibility

2) Privacy

3) Ease of termination

4) Default risk

5) Regulation

Underlying Assets 1) Commodities

2) Financials a.

Equity

b.

Equity Indexes

c.

Interest Rates

d.

Currency

Who Uses Derivatives 1) Individual Investors 2) Institutional Investors 3) Derivatives dealers 4) Corporations

Derivatives - 4

OPTIONS Option - right to purchase or sell an asset at a stated price for a stated time period Call - entitles the holder to purchase shares in an underlying stock Put - entitles the holder to sell shares in an underlying stock Holder (buyer) - pays premium

Writer (seller) - receives premium

Call

- option to buy shares at fixed price - anticipates price will increase

- obligation to sell

Put

- option to sell shares at fixed price - anticipates price decrease

- obligation to buy

premium - price of option trading unit - 100 shares of the underlying security strike price - fixed price per share, at which buy/sell American-style European-style

-

opening transaction offsetting transaction expiry

- purchase or sale establishing a new position - prior to expiry, cancels investor's previous position -- sell/buy identical but opposite option - 3rd Saturday of expiry month

- options exercised

- holder/buyer submits exercise notice to clearing corporation - desire to buy/sell underlying security - irrevocable & assignment begins -- assigned to someone who has written that contract

- CDCC -- clearing corporation - trade on Montreal Exchange , ICE (agricultural) - trading & expiry cycles - different expiry dates -- 3, 6, 9 months when issued -- add new 9-month when 3-month expires - add new series if ↑ or ↓ in price -- outside the current series Leaps - long term equity anticipation securities - long term options-- 9 months to 2 years --- expiry January

How Options Work Call Buyer

Call Writer

Put Buyer

Put Writer

Derivatives -5

Pricing option premium = intrinsic value & time value

intrinsic value

- amount by which "in the money" - call = market price > strike price - put = market price < strike price - out-of-the-money - call = - put =

time value

- speculative value - hope that value will increase/decrease before expiry

$ Time Decay Curve

18

12

6

0

Time to Expiry

Why Investors Buy & Sell Options Buy a call (expect  price) - greater leverage vs purchasing stock - risk management - price insurance - set max price that will pay - protecting a short sale - alternative to buying if don't have money RISK - lose entire premium

Write a Call - earn income

Buy a Put (expect  price) - greater leverage than short sale (less risk) - protect existing profit position - lock in selling price RISK - lose entire premium

Write a Put - earn income - acquire stock -- at lower cost

Naked call - sell call & don't own stock Covered call - own stock and write options against it Covered put - short position combined with put Cash-secured put - set aside cash = stock price

RISK - unlimited loss if price increase (if naked) - lose capital gain if price increases (if covered)

RISK - substantial loss if price declines

Derivatives -6

Futures - legally binding commitment, made through futures exchange, to buy or sell something in future - buyer- agrees to stand for delivery of commodity (long) - seller - agrees to deliver commodity (short) -establishes price to be paid in future - usually offset prior to expiry - if don’t offset, delivery will occur - less than 2% actually delivered eg.  contract = 112,000 lbs sugar, 5,000 bu of corn, 37,500 lbs coffee, $million T-bills, $100,000 $C - margin 3% - 10% - performance bond - initial margin -

maintenance margin

-

marking to market

2 types of participants - hedger - guard against adverse price movements in commodity that produce or use - speculator - trading for profit Buy

- to profit from expected  price - lock in future purchase price of asset - eg hedge - eg speculate

Sell

- to profit form expected  price - lock in future sales price of asset - eg hedge - eg speculate

Cash Settled - - if difficult or impossible to deliver -- if hold to expiry, make a cash payment = difference between future contract price & price at expiry

Forward

- similar to future - OTC - contract between 2 parties - tailored to meet specific needs - eg. used by banks in interest & foreign exchange

Derivatives -7 OPTION QUESTIONS - use handout Derivatives - __ 1) a) Calculate the intrinsic value for the Barrick May 25 call. b)Calculate the time value for the Celestica 60 call for Apr, May, June, Sept. Observation? 2)

Is the BCE Aug 25 put "in the money"?

3)

Is the Bank of NS Leap 2003 50 call "in the money"?

4)

An investor writes an Air Canada Oct 6 call. a) What profit is made if the price is 5.50 at expiry? 4 b)What is the risk of this strategy? c)If this is a naked write and the price is $8 at expiry, what profit/loss was earned? d)If this was a covered write and the price is $8 at expiry, what are the implications for the writer?

4)

Explain the premium for the Biovail May 70 call.

5)

Explain the premium for the Barrick Oct 30 put

Chapter 10 Review 1)

Indicate whether the following are greater (than)/ less (than)/ same as: A The exercise price of a warrant is ______________ market price when issued. B If a put has positive intrinsic value, strike price is ________________ current market price C The risk of a covered call is ______________ that of a naked call D The premium for a volatile stock will be _____________ than that more a less volatile stock E During a declining market, put premiums are _______________ than during an increasing market F The life span of a right is ____________ that of a warrant. G The # of new shares issued with options is _____________ those with a rights offering H The default risk of OTC derivatives ___________ than that of exchange traded derivatives.

2)

The price of any derivative is composed of ______________ and ________________. Time value increases as _______________________. Intrinsic value of any derivative can never be less than _________. One of the main reasons investors buy warrants is for _______________. Leverage is calculated as ______________ divided by ____________________. Time value of a derivative is calculated as ______________ minus ____________.

3)

The primary reason an investor writes a call is ______________. The risk of a naked call is __________. The buyer of a call has the ________ to buy shares at a _____________. This investment would be undertaken because the investor expects _________________. The writer of a put has the ___________ to ___________ at a specified price. A put has positive intrinsic value if the current market price is __________ strike price. The risk of the put writer is ____________ if price declines.

4)

A warrant with an exercise price of $22.50, a warrant price of $1.25 and a current sock price of $18 has leverage of _______________.

5)

A stock sells cum rights up to _______________ before the record date. The formula for intrinsic value of a right when the stock is selling cum rights is ________________________________________. The stock price will ____________________ when it starts selling ex rights. Calculate the intrinsic value of a right when the stock is selling cum rights for the following example: 3 rights to buy a new share, subscription price $18, market price $20. ____________________

6)

In a future contract, the buyer agrees to _________________ of the commodity. A hedger is in the futures market to ______________________________________. While a speculator is trading for __________. The Futures Exchanges guarantee __________________ of the contract. Companies buy futures to _____________ and they sell futures to ______________. Interest rate derivatives are generally based on _____________________. LEAPS are simply _____________________________________. Individual investor usually trade ________________ derivatives.

Derivatives -8 MORE OPTION QUESTIONS --- Chapter 10

Price

1)

$100

a)Based on graph 1, what could an investor do at point A? b)

What alternative action could be taken at point A?

c)

What happens if the price changes to point B?

d)

What happens if the price changes to point C?

B A

$20

X bought here C Time

2)

On September 15th, if a stock price is $45, what are the intrinsic and time values of a Dec 40 put with a $2.35 premium? a)

3)

If the stock price is $57 on April 10 th, what are the intrinsic and time values of a July 55 call with a $3.20 premium? b)

4)

On September 22nd, if the stock price is $38, what might the intrinsic and time value be?

On April 15th, if the stock price is now $61, what might the intrinsic and time values be?

The size of one gold future is 100 oz. of gold. The buyer of a gold future agrees to __________________. The seller of a gold future agrees to __________________. An example of a hedger who might buy a gold future is ____________ ; an example of a seller is _______________. A speculator buys/sells futures __________________. An example of a gold speculator might be ____________. A forward is like a ____________ but it trades ____________ and is tailored to meet __________ needs.

5)

True/false. a) Options are issued by the company _______ b) A primary reason to write a put is leverage. _______ c) A primary reason to buy a call is leverage d) Put premiums rise in declining markets _______ e) Premiums are higher for more volatile stocks _______ f) Options expire on the last day of the expiry month g) The risk of writing a covered call is unlimited _______ h) The risk of buying a put is loss of the entire premium _______ i) At issue, the exercise price of right < market price j) One reason to buy a call is to protect a short _______ k) The primary reason to write a call is income _______ l) A forward is a long-term future m) The call writer has the option to buy _______ n) Time value increases as time to expiry decreases _______ o) CDCC is the clearing corporation for exchange traded derivatives in Canada. p) OTC derivatives are quite significantly regulated. _______ q) ETF is another name for an equity future

_______

_______

_______

_______

________ _______

Price 6)

A)Based on graph 2, what could an investor do at point D? (b) What alternative action could be taken at point D?

E $60

(c) After short, what happens if the price changes to point E? (d) What happens if the price changes to point F?

D shorted

$20 F

Time 7)

If an investor thinks that the market (or a particular stock) is going to increase, what 4 investment alternatives are consistent with this expectation?

8)

If an investor thinks that the market ( or a particular stock) is going to decrease, what 4 investment alternatives are consistent with this expectation?...