S5 Financial Markets - Final L5 to L9 PDF

L5 - Fixed Income What is a fixed Fixed Income security is an instrument that allows governments, income security? companies and other types of issuers to borrow money from investors What is the difference Fixed income security is the same as debt securi...

L5 - Fixed Income What is a fixed Fixed Income security is an instrument that allows governments, income security? companies and other types of issuers to borrow money from investors What is the difference Fixed income security is the same as debt security and bond between a fixed income security, debt security and bond? What do investors 1) Bond’s features need to know when 2) Legal, regulatory and tax considerations investing in a bond? 3) Contingency provisions What are the types of 1) Government related issuers of fixed 2) Corporate issuers (financial and non-financial sectors) income securities? 3) Special legal entities that securitise assets to create Asset Backed Securities (ABS) What are the 1) Money market (short-term) maturities of fixed 2) Capital markets/ perpetuities income securities? What is par value of The amount at which issuers agrees to repay the bondholder at fixed income maturity securities? By convention, bonds are quoted as a percentage of their par value Other names = principal, face value, nominal value, redemption value, maturity value What is the coupon Most common form is semi-annually (for government and rate and frequency of corporate bonds issued in US) fixed income securities? Plain vanilla bonds have fixed coupon payments ⚠ coupon rate and YTM are different for the frequency of payments YTM accounts for TVM Coupon rate is just annualised interest rate Regarding the 1) If currency is not liquid or freely traded currency in which the 2) If currency is very volatile compared to major currency bond is denominated, (like dollars or euros) when does risk increase? Why are eurobonds If your home currency is not liquid, not freely traded or very interesting in this volatile, then investing in a bond denominated in a major regard? currency is more attractive What is a dual Bond for which the coupon payment is in one currency and the currency bond? nominal payment is in another Used to 1) Decrease currency risk 2) Speculate What is a bond A legal contract, trust deed of bond indenture? Describes all the bond’s characteristics 1) Form of bond 2) Obligation of issuer 3) Rights of bondholders Includes information regarding the funding sources for principal repayment and for coupon payments Includes collateral, credit enhancements and covenants if there are any What is a secured Bond that is backed by asset or financial guarantees bond? What happens in case Bondholders rely on seniority ranking → secured bonds are paid of default if the before unsecured bonds collateral is not an identifiable asset? What are the types of 1) Collateral trust bonds collateral backing? Secured by securities Ex: common shares, other bonds, other financial assets ABS, MBS (Mortgage Backed Securities) 2) Equipment trust certificates Specific types of equipment or physical assets 3) Covered bonds Bond is backed by a segregated pool of assets (‘cover pool’) → debt securities issued by a bank or mortgage institution and collateralised against a pool of assets that, in case of failure of the issuer, can cover claims at any point of time  This is similar to ABS but gives the bondholder more protection in case of default What are the types of 1) Internal credit feature → structural features of bond issue credit enhancement? 2) External credit enhancement → financial guarantees from a third party What are the types of 1) subordination/credit tranching internal credit → more than one bond with priority claims features? → Prioritising payments to senior tranches over junior tranches 2) Overcollateralization 3) Reserve accounts/ funds → cash reserve fund and excess spread account What is an excess The difference of the interest received from the asset used to spread? secure the bond issue and the interest paid to the investor What are the types of 1) Bank guarantees and surety bonds external credit → reimburse debt holders in case of loss features? 2) Letter of credit → credit line 3) Cash collateral account What is a covenant? Commitment in a bonds that certain actions will or will not be undertaken What are some 1) Restriction on debt examples of 2) Negative pledges covenants? 3) Restriction on priority claims 4) Restriction on distribution to shareholders (dividends) 5) Restriction asset disposals 6) Restriction on investments 7) Restriction on mergers and acquisitions L6 - Fixed Income What are bond A bond indenture is a legal document that fixes all the practice indentures? and regulatory aspects of the bond: 1) Basic components 2) Assets or collateral backing 3) Credit enhancement (internal and external) 4) Covenants What information can 1) Issuer you access about a 2) Face Value/Principal amount bond that is listed 3) Maturity date thanks to the DICI? 4) Credit quality 5) Coupon rate 6) Frequency of compounding What are the different 1) Coupon rate rates for fixed-income → Stated rate of the bond securities? Periodic Coupon = Coupon Rate * Face Value 2) Current yield/running yield → ratio between the annual coupon and actual price of the bond (it is comparable to the dividend yield of a stock) Current yield = Coupon Payment/ Actual Bond Price 3) Yield to maturity/yield to redemption/redemption rate → it is the IRR (internal rate of return) on a bond’s expected cash flows → reflects the annual return that an investor will earn on a bonds if they purchase the bond today and hold it until its maturity → inverse relationship between YTM and bond’s price → bond price goes up, YTM goes down → bond price goes down, YTM goes up What is the yield to It is the total rate of return earned when a bond makes all interest maturity? payments and repays the original principal Essentially it is a snapshot of the return on a bond What are three critical 1) The investor holds the bond to maturity assumptions regarding 2) The issuer never defaults (for the coupon payment or the yield to maturity? principal repayment) → YTM is a promised yield 3) The investor can reinvest the coupon received at the same rate How can you compute the YTM (if you know the bond price)? r = rate N = number of periods (NOT years) PV = the price of the bond  YTM is the total rate of return earn when a bond makes all interest payments and repays the original principal How do you calculate a bond’s price at issuance? r = market discount rate, required yield, required rate of return PMT = coupon = Coupon Rate * Principal What is the The discount rate r, held constant: relationship between the coupon rate and 1) Coupon rate = r ⇒ bond price = par value the market discount rate? 2) “Premium bond” Coupon rate > r ⇒ bond price > par value 3) “Discount bond” Coupon rate < r ⇒ bond price < par value What is the inverse The bond price is inversely related to the market discount rate effect regarding the → when market discount goes up, bond price goes down bond price? → when market discount goes down, bond price goes up What is the convexity Convexity effect is the way a bond price changes in response to effect regarding the interest rate movements bond price? Percentage price change is higher when market discount rate goes down than when market discount rate goes up Positive convexity (benefits bondholders) → bond price rises faster when interest rate falls  → bond price drops slower when interest rate rise What is the coupon Refers to how coupon rate of a bond influences the bond price on effect regarding the the market bond price? When market discount rates change by the same amount: lower coupon bond has a bigger percentage change than a higher coupon bond What is the maturity Refers to how maturity of a bond affect bond price when there are effect regarding the changes in interest rates bond price? When market discount rates change by the same amount: bond with a longer term has a bigger percentage price change than a bond with a short term How do you calculate a bond’s price with spot rates? What is a bond’s This refers to a bond’s price determined using the spot rates ‘no-arbitrage value’? If the bond’s price is different to the bond’s no arbitrage value then there is an arbitrage opportunity Only if there are no transaction costs What are the spot rates The spot rates are YTM on zero-coupon bonds maturing at the on zero-coupon date of each cash flow bonds? How do you call the Flat price, clean price bond’s price at each coupon date? What is accrued It is the growing amount of interest due until the coupon date interest? t, number of days from the last coupon payment to the settlement date T, the number of days in the coupon period What is the full price/ [Full price, invoice price, dirty price] invoice price/ dirty = accrued interest + [flat price, clean price] price? ⇒ PV (full) = PV (flat) + accrued interest Why is the quoted This is due to the calculation of the full price price always the flat The accrued interest would increase the full price every day until price? the coupon payment, regardless of the YTM What is duration? The duration: 1) Measure how sensitive the price of a bond is to changes in interest rates 2) Time to maturity affects bond duration 3) Bond’s coupon rate affects bond duration 4) Measures the approx amount of time for the bondholder to be repaid a bond’s price via the bond’s total cash flow A duration is a statistical estimate Assumes a linear relationship between price and yield changes in bonds What is the The higher the duration, the more a bond price will drop when relationship of the interest rate rise duration of a bond and the interest rate? If interest rates are high: The price of short-duration bonds won’t fall as much ⇒ less risky The price of long-duration bonds will fall more ⇒ riskier (but can give a higher return if there is a interest rates decrease) What is the Macaulay duration? Expressed in days Weighted average of the time to receipt of the bond’s promised payments Weight is the share of the full price that correspond to each of the bond’s promised future payments What is the modified duration? It is an adjusted Macaulay duration Expressed in percentage (according to the number of periods)  Gives an estimate of the percentage price change for a bond given changes in its YTM How can you compute the percentage of change of your price using the modified duration? How can you approximate the modified duration? PV+ when YTM increases PV - when YTM decreases What is the effective Alternative approach to estimate the interest rate risk of a bond: duration? → estimates the percentage in price given a benchmark yield curve (usually the government’s) → calculates the actual change in duration of bonds Usually used for complex bonds (for example that has embedded option) PV -, bond price if yield falls by 1 basis point PV +, bond price if yield rises by 1 bassist point ᅀCurve, yield change PV0, PV of all cash flows of the bond What is the convexity Is it used to improve the estimate of the percentage price change statistic? provided by the modified duration In reality, convex relationship between price and yield changes in bonds Looks at the price yield-relationship What are the main Duration Convexity differences between duration and measures the bond’s sensitivity measure the how bond’s price convexity? to interest changes sensitivity changes as interest rates move → measure sensitivity of a bond’s price to small changes in interest rates Linear relationship between Non-linear relationship (refines bond price and interest rates estimation) Good for small interest Good for larger interest rate changes, gives basic changes → predicts how bond understanding of interest rate price will behave risk L7 - Equity What are the 4 stages 1) Embryonic/EarlyStage/Seed of the life cycle of a 2) Growth company? 3) Mature 4) Decline How is the seed stage Low growth defined? No or low activity No profit High need of money to 1) structure and expand activity 2) create and sell product/service 3) hire talent How is the growth Activity is launched but need to be expanded stage defined? Need to overcome entry barriers against competition Need to expand team Increasing turnover but still high need of money How is the mature Well established activity stage defined? High competition Process and team are completed Low need of money Profitable How is the decline Well established but declining activity stage defined? No profit Fire team First until here What is an ordinary Ordinary share = common stock share? Most common kind of share 1 common share gives to the investor the same value and same rights To get more power, need to buy more common shares Main rights offered: - Voting rights (ex: general assembly) - Dividend rights - Information rights - Capital appreciation - Residual claim on assets What is a preferred Preferred share is priced similarly to ordinary shares share? Based on jurisdiction, main right offered are: Priority of dividend - Double dividend - Cumulative dividend - No dividend Voting rights - Double (or more rights) - No or limited voting rights Priority in liquidation Potential for conversion or redemption What type of 1) Type of share (ordinary share or preferred share) information does an 2) Which category of ordinary share or preferred share (a investor need to company can issue multiple categories of preferred and register on the shares ordinary shares) they own? 3) Data and price of each share bought Why? In case of sale, capital appreciation/depreciation (LIFO, FIFO, weighted average) What defines venture Huge risk and potential high return (on average 0.9x) capital? What are risks 1) Risk of bankruptcy (approx 90% companies after 5 years) associated with 2) Liquidity risk venture capital? 3) Valuation risk How do you value a Complex and subjective analysis startup? Perform due diligence Compare to actual market (careful if it is a fast-moving market) Use own expertise Valuation usually stated regarding potential growth of the startup What due diligence 1) Legal due diligence needs to be performed 2) Financial due diligence to value a startup? 3) Business due diligence 4) Peer due diligence 5) Diligence on management Once you invest in a Need to register your shares at the purchase price (same as listed startup, what do you shares) have to do? You cannot change the valuation until the next financing operation of the start up UNLESS there are provisions ( = Provisions represent funds put aside by a company to cover anticipated losses in the future → it is a liability of uncertain timing and amount) What choices can you 1) Want to participate make during the next → your new shares are registered at their purchase price of the financing round of a current round startup? → your old shares are reevaluation at the new price of the current price (unrealised gain) 2) Have to participate → startup is in a tough spot → new shares are registered at the new price → old shares price does not change 3) Don’t participate - good round → can reevaluate shares you own to the actual price 4) Don’t participate - little round → no change to your shares 5) Can participate → to sell your shares to other investors at a discount What is a scale up? During the growth stage of a company, when the company expands their activities Why is the growth 1) Bankruptcy risk stage still considered → because company faces established competition risky? → different strategy and management of the company compared to the seed stage 2) Liquidity risk → still private equity → still needs time to grow  3) Valuation → no strong models What is the potential Lower than in venture capital but still interesting gain for the company The global risk level is lower than at the seed stage in the growth stage? Same objectives as venture capital - M&A and IPO What are the valuation 1) Multiple models for companies → P/E ratio (trailing/forecasted/diluted) in the growth stage? 2) Comparable → useful for companies that already started to scale up → EV/EBITDA Rationale between both models → compute rations about company and compare it to the average ratio of the industry or to a peer group What is main Finding information for the company and/or the peer group difficulty of the valuation models for companies in the growth stage What model is used DCF model = Discounted Cash Flows Model for a company valuation in the maturity stage? What are the steps of 1) Study firm → find KPIs the DCF model? Private companies - online sources, management, market studies Identify internal and external drivers 2) Estimate FCF 3) Compute WACC 4) Compute firm value What is the DDM? DDM (Dividend Discount Model) One of the main DCF model To compute the share price of a company using the forecasted dividends (idea is that the share price of a company is represented by the PV of its expected dividends) What is the Gordon DDM with the assumption that the growth rate is held constant in Growth model? the forecasted dividends What you need 1) Estimate the dividends 2) Choose the appropriate discount rate Most of the time, it’s cost of equity (=required rate of return) What is the FCFE? FCFE (Free Cash Flow to Equity) This reflects the dividend paying capacity Used for non-dividend paying stock and dividend paying stock FCFE = CFO - CFI + Net borrowing CFO on the cash flow statement of company Firm Value = Sum of PV of FCFE/ (1+r)^t r, appropriate discount rate What are the 1) Lost of ownership of your company disadvantages to Capital is opened consider with IPOs? Financing round in equity 2) Lost of control of your company Creation of new controlling organs so CEO has less power Can’t keep majority of rights  3) A lot of regulation, legal constraint, legal and accounting requirements Audited Certify book in a short delay Disclose to public a lot of info and decisions 4) Lost of control of share price What are the 1) Public company is an important piece of communication advantages to consider allowing its long-term sustainability with IPOs? 2) Reinforces trust in the company from the public, clients 3) Many financing opportunities Easier to rise debt No need to rely only on private investors 4) Gives liquidity for founder and historical investors What are the 3 kinds 1) Firm commitment IPO of IPOs? Most popular Underwriter buys all share concerned by the issue (at a lower price) to directly sell it to investors Underwriters has all the risk (they guarantee the number of shares sold and the price) 2) Best-efforts IPO Underwriter does their best to sell the max number of share at the best price but without any guarantee 3) Auction What is the IPO process? 1) Choose the underwriter – investment bank(s) managing the issue. Underwriter usually forms a syndicate and retains role of lead manager 2) Due diligence 3) Registration with the financial market regulator. Filing of prospectus Underwriter states the valuation Investors want capital gains thus want a specific price Stock price has a lot of consequences (too cheap vs too expensive) 4) Roadshow to meet buy-side (portfolio managers and analysts of institutional investors who might consider buying the stock into their portfolios) as well as sell-side (analysts from banks that might consider advising their clients to buy shares) ‘Marketing’ For shares registration  5) Book building: banks managing the issue collect intentions of interest from prospective buyers (prices and quantities of shares) 6) Pricing meeting between underwriters and the managers of the firm to decide on final price of the issue 7) Shares begin trading. What is distress When a company enters the decline stage capital? Activity declines Bankruptcy risk remains Can be due to systemic risk Which valuation 1) Price of last round models cannot be used Companies in decline no longer have access to equity financing for companies in the The last round price is no longer accurate decline stage and why? 2) DDM Company in financial distress has a structural negative net income 3) DCF Uncertain activity + companies divesting to survive → difficult to estimate future cash flows Nonsense to discount with required rate of return Which valuation Multiple/Comparable method but difficult models can be used for companies in the decline stage? How can you use the P/E ratio →negative equity so compromised meaning of the ratio valuation model for EV/EBITDA → unchanged companies in the Beta asset → use the Beta of a healthy company and apply it to decline stage? the D/E of the distressed company (levered beta) CAPM → add a distressed premium Beta Flip → change sign of the Beta to use on negative cash flows Lesson 8 - Money Management What is an alternative An alternative fund is made up of money pooled by a number of fund? investors and managed on their behalf by a fund manager What are some 1) Private Equity funds (includes Venture Capital, examples of development capital, distressed capital) alternative funds? 2) Hedge funds 3) Real estate funds 4) Commodities funds 5) Infrastructure funds What are the Fund represents a partnership between the general partner and the characteristics of investors investment funds? 1) Usually has no legal existence 2) Managed by an investment company (general partner) 3) Investors are called limited partner 4) Money promised is called commitment What is the investment 1) Fund should reach a minimum amount of commitment to structure of alternative be created funds? 2) Funds generally have a hard cap aka number of LPs is limited 3) Expected commitment is stated regarding the strategy of the fund - From LP POV, commitment is an engagement over the life of the fund What are the Payments to general partner (because the investment fund world management fees with thanks to their resources) regard to the structure of alternative funds? Management fee is usually a percentage of either: 1) Total commitment 2) NAV 3) Total value of the portfolio Is the general partner Yes, by: rewarded for excess - Incentive fees (20% of the performance above the return of the commitment) alternative fund? - Carried interest What is the waterfall with regards to the common investment structure of alternative funds? What is the life of the 1) Fund starts its activity once the minimum commitment is fund for common reached investment structure of 2) Commitment remains open until the hard cap or after 2 alternative funds? years 3) Initiation to year 5 → fund builds its portfolio (initial investing in companies) 4) After year 5 → no more initial investment in new companies; can reinvest in companies as follow-up 5) After year 8 → fund in pre-liquidation → cannot reinvest in companies and to be in liquid positions 6) Year 9 → liquidation process What are the key 1) venture capital invest at the early stage of a company features of venture (pre-seed to series B) capital? 2) Investments range from 200-300k to few millions 3) The fund’s initial investment in companies to build its portfolio 4) The fund’s following investment is to follow the life of the company What is the strategy of To be hands-on venture capital? 1) Help company be structured/ properly launched 2) Support company in activity 3) Support financing rounds → venture capital needs to have an important percentage in the cap table (10-50%) throughout life of company (so avoid dilution in following financing rounds) What are the Venture capital is characterised by high risk and high return objectives of venture - High bankruptcy rate → high risk capital investment? - Unlimited potential return So invest on high potential projects at initiation and follow/help with the development Limit dilution by continuing to invest Targeted exits after several investment rounds → IPO, M&A, Private Equity acquisition Can also do a cash out if there is opportunity or forced to How do venture In equity with preferred shares or common shares capital make investments? In debt with PV or convertible In bridge financing What is development Features include: capital? 1) Private equity 2) General partner and limited partners  3) Management fees 4) Incentive fees or carried interest 5) Invests in start-ups that are more mature (from series B) with the goal to help the further expansion of the company 6) Higher investment than venture capital 7) Number of participation is higher (due to passive strategy) What is leveraged Features include: buyout? 1) Private equity 2) To acquire public companies/ well-established private companies that have a lot of debt 3) Process of delisting the company hance name ‘going private transaction’ 4) Strategy is to create value, increase activity, increase growth and increase cash flow 5) Successful leveraged buyout does NOT automatically mean success for targeted company What are the types of 1) MBO, Management Buyout leverage buyout? → Management is involved in the transaction 2) MBI, Management Buyin → Management is replaced by the acquiring persons What are the sources 1) Organic revenue → by adding expertise of growth targeted for 2) Reducing costs → restructuring staff leveraged buyout? 3) Acquisition → external growth How is leveraged Debt usually represents about 70% of the deal (central buyout financed? component) Debt could be raised in financial markets (high yield) or a combination of bank loans or both Mezzanine financing → debt or preferred shares with a relationship with common shares thanks to derivatives (warrant or option) Bought out company’s assets often used as collateral for debt Bought out company’s cash flows usually enough to reimburse debt What happens to the Usually supported by the target company which includes it on its debt of the target balance sheet company after the leveraged buyout? What are the 1) Low leverage characteristics of the 2) Strong assets targeted firm for a 3) Strong cash flows leveraged buyout? 4) Undervalued stock price (such as actual value > market price) 5) Inefficient companies Situation, size and structure of targeted company determine whether leveraged buyout is a success or failure What is the distressed Features include: capital? 1) Private equity 2) Not common due to level of risk and lower potential gains Which valuation 1) Price of last round models cannot be used Companies in decline no longer have access to equity financing for companies in the The last round price is no longer accurate decline stage and why? 2) DDM Company in financial distress has a structural negative net income 3) DCF Uncertain activity + companies divesting to survive → difficult to estimate future cash flows Nonsense to discount with required rate of return Which valuation Multiple/Comparable method but difficult models can be used for companies in the decline stage? How can you use the P/E ratio →negative equity so compromised meaning of the ratio valuation model for EV/EBITDA → unchanged companies in the Beta asset → use the Beta of a healthy company and apply it to decline stage? the D/E of the distressed company (levered beta) CAPM → add a distressed premium Beta Flip → change sign of the Beta to use on negative cash flows What are the types of 1) Good ones actors in the distress Strategy which is riskier and lower expected return → buy at low capital industry? price, be hands-on to save company Goal → make money with dividends later 2) Activist funds (vulture funds) Most present  Strategy → buy distressed firm at low price, fire all staff, sell all assets, keep cash, let company in a liquidation process Goal is to make maximum return on the transaction disregarding consequences on the target company What is a listed fund? Investment fund traded on a stock exchange What are the active Active strategies rely on asset picking strategies for listed funds? Rely on an active portfolio manager → manages portfolio with regular rebalancing More risky strategy due to the intervention of the asset manager Alpha regenerating strategies → absolute return What are the passive Most common strategy used strategies for listed funds? Used for ETF (Exchange Traded Fund) Strategy → select benchmark and track it to reproduce its exposition and performance What are the main 1) Important use of leverage and short positions characteristics of 2) Use of derivatives hedge funds? 3) Aggressive management of the portfolio across different asset classes and regions 4) Goal is to generate high returns (absolute or over a specified benchmark) 5) Few to no investment restrictions 6) General partner and limited partners (BUT limiter partners have more restrictions) Why are hedge funds 1) Lack of information (even as an investor) considered as a dark 2) Lack of transparency sector? 3) Lack of investment restrictions 4) Lack of regulations What are the main 1) Event-driven strategies strategies for hedge 2) Relative value strategies funds? 3) Equity hedge strategies What are event-driven Take profit from short term events (M&A, significant change in strategies? company’s strategy, warning profit)  Merger arbitrage → long the acquired company and short the acquiring company Profit by → deal spread (uncertainty of closing) or overpricing Distressed/Restructuring → buy bonds with high discount and be reimbursed in case of bankruptcy or short company Activist → buy enough shares to take control of company Special situations → shares repurchases, special distributions etc What are relative Take profit from short term arbitrage (pricing discrepancy) value strategies? Fixed income convertible arbitrage → market neutral strategies (zero beta strategy) Find discrepancy between convertible bond and its components (underlying bond and embedded stock option) Fixed income asset backed → relative value between asset backed securities and mortgage backed securities to profit from misprices between different asset backed securities Fixed income general → take profit from the different priced along the yield curve Volatility → use options to long or short volatility of a specific market/asset Multi strategy → trade relative value inside and across asset classes/ instruments What are equity hedge Market neutral → profit from individual securities whilst hedging strategies? against market risk Long undervalued companies and short overvalued companies Fundamental analysis (examining a company’s financial statements and broader economic indicators to find the security’s intrinsic value) for fundamental growth and for fundamental value Quantitative directional → technical analysis to long and short undervalued and overvalued but with a measured level Lesson 9 - Derivatives What are the Equity and fixed income differences between → claims on the assets of the company the common capital markets and Currencies derivatives markets? → monetary units issued by a government or central banks Commodities → natural resources → theses assets are said trade in cash markets or spot markets at the cash price or spot price What is a derivative? A financial instruments that derive its performance from the performance of an underlying asset ⚠ derivative performance NOT derivative value Legal contract between a buyer (long) and the seller (short, the writer) Financial contract that allows to transfer the risk from the seller to the buyer (risk management) → to provide protection against loss What are the main 1) Performance of the derivative is derived from the characteristics of underlying asset derivatives? 2) High leverage → only need to invest a small amount of capital compared to the value of the underlying asset 3) Low transaction cost 4) Highly liquid (more volatile than the underlying asset) 5) Used for risk transfer (decrease or remove risk) Can also be to remove a single component of the risk What are the different 1) Equity underlying assets for Socks derivatives? Indexes 2) Fixed income 3) Interest rates (most widely used) Libor 4) Currencies 5) Commodities (historically first one) 6) Credit Credit Default Swap Collateralised Debt Obligation What are the types of 1) Forward commitment derivatives? Gives the ability to lock a price at which buyer/seller can buy/ sell the underlying asset in the future → Obligation stated in advance Main forward commitments products are forward contract, futures and swap  2) Contingent claim Provide the right (not obligation) to buy/sell underlying asset at a pred-determined price Choice of buying/selling or doing nothing depends on a random outcome Main contingent claim product is options What are the markets 1) Exchanges for derivatives? 2) Over the counter (decentralised network) What are the features Main actors: market makers (dealers) and speculators of the exchange traded derivatives market? Main characteristics: 1) Standardisation 2) Liquidity 3) Efficient clearance and settlement operation due to the clearing house Clearing (process to verify execution of transaction and record identity of participants) Settlement (process by which the exchange transfers the money from one to another or to the exchange) 4) Transparent 5) Credit quality What are the features Daily settlement → every night, position is netted of the clearing house → every night, margin deposit is used to rebalance position → for the exchanges mark-to-market process market for derivatives? Transaction transferred every night is stated according to the initial margin Initial margin = amount in deposit Maintenance margin = level of the margin call (process of topping up account up to the required minimum) What are the features Main actors: banks from international swaps and derivatives of the over the counter association that act as buyers and sellers market for derivatives? Main characteristics 1) Informal market (for profit and not out of obligation) 2) Customised  3) Highly liquid (if you want to terminated your contract, can create a new one in the opposite direction with your counterpart) 4) Low regulation 5) High degree of risk → widely hedged What is the end of the At maturity, end of the derivative contract implies the physical derivative contract and delivery or the cash settlement of the underlying asset its implications? → legal obligation from both parties to fulfill these commitments Implies logistical challenges and costs to transport and store the underlying asset How do you avoid the Close the position before expiration of contract (→ reason why physical delivery at derivative market is liquid) maturity of the Choose cash-settlement contracts derivative contract? Roll-over position What is the valuation Compute fundamental value of the product and compare this for options? value to the market price What is the valuation Forward product contracts start at 0 for forward products? As underlying asset value changes, contract’s value is eithe positive or negative ‘Price’ represents the fixed price or rate at which the underlying asset will be purchased at later → forward value is 0 ≠ forward price is stated at initiation What is the definition An over the counter derivative contract in which two parties agree of a forward contract? that the buyer will purchase an underlying asset from the seller at a later date and at a fixed price agreed upon the signature of the contract Forward price ≠ forward value What are the features 1) No money exchanged → not an asset nor a liability of a forward contract? 2) Can be structured as a perfect hedge 3) Can settle with cash (non-deliverable forwards, cash-settled forwards, contract for differences) 4) Payoff derived from the performance of the underlying asset What are the hopes of Buyer → wants price of the underlying asset> forward price the buyer and seller Seller → wants price of the underlying asset < forward price for a forward contract? How do you value the A) Price of the underlying asset> forward price forward contract at Value of contract at expiration = Price of the underlying asset - time of expiration? forward price  B) Price of the underlying asset < forward price - Value of contract at expiration = - Price of the underlying asset + forward price What is the value of Value of forward contract = spot price of underlying asset - PV of the forward contract forward price during its life? What is the definition Standardised derivative contract created and traded on a future of a futures contract? exchange in which two parties agree: 1) Buyer will purchase an underlying asset from the seller at at a later date 2) At a price agreed upon when contract is initiated 3) Daily settling of gains and losses and credit guarantee by the futures exchange by its clearinghouse (→ no money transaction ) What is the price of Futures price = price at which the underlying asset will be the futures contract? exchanged → there are identical contracts traded at different prices (reflections of time passing and new info) What is the role of the Mark-to-market process happens for daily settlements clearinghouse for → clearinghouse determines a settlement price (based on average futures contracts? of final futures trade of the day) → settlement price is used to increase/decrease account of buyer/seller → this process resets the value to 0 for each party In highly liquid markets → clearing house can do a margin call (instead of waiting for daily settlement) Protects in case of default → clearinghouse guarantees amount (due to insurance fund and tax on other market participants if not enough) What is the definition Derivative contract in which the buyer pays a sum of money to of an option? the seller (writer) and received right to buy/sell and underlying asset at a fixed price either leading to or on a specified expiration date What are the key 1) Call (right to buy) OR put (right to sell) option characteristics of options? 2) American (can exercise right any time before expiration) OR european (can only exercise at time of expiration) 3) Settlement either by physical delivery of underlying asset or cash payment  4) Option premium is paid by the buyer to the writer at initiation → option premium = PV of expected cash flows during option’s life 5) Only the seller can default → right not obligation for buyer What value can In the money options have? underlying asset > call option price underlying asset < put option price At the money underlying asset = call or put option price Out of the money option has no value → never negative (right not obligation) What are the different 1) Long call options strategies? Buyer has right to buy stock at a fixed price in future Risk → limited to premium paid Reward → unlimited potential gains 2) Short call Seller agrees to sell share at fixed price in future Risk → unlimited potential loss if stock price rises a lot Reward → limited to premium received 3) Long put Buyer has right to sell stock at fixed price Risk → limited to premium paid Reward → gains increase as stock price falls 4) Short put Seller agrees to buy shares at fixed price if buyer exercises right Risk → loss if stock price falls much lower than strike price (agreed upon price at initiation of contract) Reward → limited to premium received How can individuals Not possible: invest in derivatives? Cannot directly trade on over-the-counter market Could invest via official exchanges (but need a lot of funds and access to wealth management or private bank) Available derivatives to irregular individuals: 1) Contracts for Difference Similar to forward contracts (with potential high leverage) Structure product 2) Turbos/Warrant Related to options Wattants are similar to options as they offer right to buy or sell at a specific price Turbos are leverage products with knock-out feature (value goes to 0 if price hits a certain level)