Lecture 3- Bonds, Stock and Options

2

Liquidation value represents the amount of money that could be realized if an asset or group of assets is sold separately from its operating organization.

Going-concern valueGoing-concern value represents the amount a firm could be sold for as a continuing operating business.

Book value represents either

an asset: the accounting value of an asset -- the asset’s cost minus its accumulated depreciation; a firm: total assets minus liabilities and preferred stock as listed on the balance sheet

Market value represents the market price at which an asset trades.

Intrinsic valueIntrinsic value represents the price a security “ought to have” based on all factors bearing on valuation.

Liquidation value represents the amount of money that could be realized if an asset or group of assets is sold separately from its operating organization.

Going-concern valueGoing-concern value represents the amount a firm could be sold for as a continuing operating business.

Book value represents either

an asset: the accounting value of an asset -- the asset’s cost minus its accumulated depreciation; a firm: total assets minus liabilities and preferred stock as listed on the balance sheet

Market value represents the market price at which an asset trades.

Intrinsic valueIntrinsic value represents the price a security “ought to have” based on all factors bearing on valuation.

What is Value?

3

Bond - evidence of debt issued by a corporation or a governmental body. A bond represents a loan made by investors to the issuer. In return for his/her money, the investor receives a legal claim on future cash flows of the borrower. The issuer promises to (a)

Make regular coupon payments every period until the bond matures, and Pay the face/par/maturity value of the bond when it matures.

Definition of a Bond

4

General Features of Bonds

The bond’sThe bond’s principal, par value or face value principal, par value or face value is the is the amount borrowed by the company and the amount owed amount borrowed by the company and the amount owed to the bond holder on the maturity date.to the bond holder on the maturity date.The bond’s The bond’s maturity datematurity date is the time at which a bond is the time at which a bond becomes due and the principal must be repaid.becomes due and the principal must be repaid.The bond’s The bond’s couponcoupon is the specified amount that must be is the specified amount that must be periodically paid. periodically paid. The The coupon ratecoupon rate is the coupon divided by the principle is the coupon divided by the principleThe bond’s The bond’s current yieldcurrent yield is the annual interest (income) is the annual interest (income) divided by the current price of the security. The bond’s divided by the current price of the security. The bond’s yield to maturityyield to maturity is the yield (expressed as a compound is the yield (expressed as a compound rate of return) earned on a bond from the time it is rate of return) earned on a bond from the time it is acquired until the maturity date of the bond.acquired until the maturity date of the bond.Default riskDefault risk: Risk that issuer will not make interest or : Risk that issuer will not make interest or principal paymentsprincipal payments.

5

The Mechanics of Bond Pricing

A fixed-rate bond is a contract detailing the par value, the coupon rate, and maturity date.The coupon rate is close to the market rate of interest on similar bonds at the time of issuance.In a fixed-rate bond, the interest income remains fixed throughout the term (to maturity). The value of a bond is the present value of future contractual cash flows discounted at the market rate of interest.

Cash flows are assumed to flow at the end of the period and are assumed to be reinvested at i (or r). Bonds typically pay interest semiannually.

Increasing i (or r) decreases the price of the bond (PB).

6To solve using excel use PV function

What’s the value of a 10-year, 10% coupon bond if rd = 10%?

V

rB

d

$100 $1,000

11 10 10 . . . +

$100

1+ r d

100 100

0 1 2 1010%

100 + 1,000V = ?

...

= $90.91 + . . . + $38.55 + $385.54= $1,000.

+++1 r+ d

7

The bond consists of a 10-year, 10% annuity of $100/year plus a $1,000 lump sum at t = 10:

$ 614.46 385.54

$1,000.00

PV annuity PV maturity value Value of bond

===

What would happen if expected inflation rose by 3%, causing r = 13%? When rd rises, above the coupon rate, the bond’s value falls below par, so it sells at a discount.

What would happen if expected inflation fell 3%, causing r = 7%? When rd falls, below the coupon rate, the bond’s value rise above par, so it sells at a premium.

8

Time and Value

9

Example - Many bonds pay interest twice a year (1/2 of the annual coupon).

(1) Divide r by 2 2 2) Multiply t by 2 2 (3) Divide C by 22

Consider a bond which pays semi - annual payments of $470 with a maturity of 3 years. The Par or Face Value of the bond is $10000. If market rate of interest is 9.4% the price of the bond is:

If the market rates of interest increases to 10%, the price of the bond falls to $9,847.72:

000,10$047.1

000,10

047.1

470Pr

6

6

1

t

tice

72.847,9$05.1

000,10

05.1

470Pr

6

6

1

t

tice

n = number of years = 3 time periods = 2n = 6

10

Yield to MaturityThe yield to maturity (YTM) is the investor's expected or promised yield if the bond is held to maturity and the cash flows are reinvested at the yield to maturity.Bond yields to maturity vary inversely with bond prices.

If the market price of the bond increases, the yield to maturity declines. If the market price of the bond decreases, the yield to maturity increases. When the bond is selling at par, the coupon rate approximates the market rate of interest.Bond prices above par are priced at a premium; below par, at a discount.

To solve using excel use RATE function.

11

Bond Price Sensitivity to YTM

4%

6%

8%

10%

12%

14%

16%

$1,800

$1,600

$1,400

$1,200

$1,000

$ 800

$ 600

Bond price

Yield to maturity, YTM

Coupon = $10020 years to maturity$1,000 face value

Key Insight: Bond prices and YTMs are inversely related.

12

Realized Yields

The realized yield is the expost, actual rate of return, given the cash flows actually received and their timing. Realized yields may differ from the promised yield to maturity due to:

A change in the amount and timing of the promised cash flows.A change in market interest rates since the purchase of the bond, thus affecting the reinvestment rate of the coupons.The bond may have sold before maturity at a market price varying from par.

13

Some More Definitions

Current yield =

Capital gains yield =

= YTM = +

Annual coupon paymentCurrent price

Change in priceBeginning price

Expected totalreturn

Expected Current yield

Expected capitalgains yield

+

14

Find current yield and capital gains yield for a 9%, 10-year bond when the bond sells for $887 and YTM = 10.91%.

Current yield =

= 0.1015 = 10.15%.

$90 $887

YTM = Current yield + Capital gains yield.

Cap gains yield = YTM - Current yield = 10.91% - 10.15% = 0.76%.

15

Pricing Zero Coupon and Perpetual Bonds

Bonds that do not pay periodic interest payments are called zero-coupon bonds. Zero coupon bonds trade at a discount and the value of the "zero" bond is

There is no reinvestment of coupon payments with zeros and thus, no reinvestment risk. The yield to maturity, r, is the actual yield received if held to maturity.The price of the perpetual bond or perpetuity is:

nB n

FP = (1 + r)

BCP = r

16

Review of Bond Theorems

Bond yields vary inversely with changes in bond prices.Bond price volatility increases as maturity increases.Bond price volatility decreases as coupon rates increase.

Par Bond yield to maturity = coupon rateDiscount Bond Yield to maturity > coupon ratePremium Bond Yield to maturity < coupon rate

17

Features of a Sample Bond

Term Explanation

Amount of issue $200 million The company issued $200 million worth off bonds.Date of issue 8/4/94 The bonds were sold on 8/4/94.Maturity 8/1/24 The principal will be paid 30ears after the issue date.Face Value $1,000 The denomination of the bonds is $1,000.Annual coupon 8.375 Each bondholder will receive $83.75 per bond per year (8.375% of the face value).

Offer price 100 The offer price will be 100% of the $1,000 face value per bond.

18

Features of a Sample Bond (concluded)

Term ExplanationCoupon payment dates 2/1, 8/1Coupons of $83.75/2 = $41.875 will be paid on these dates.Security None The bonds are debentures.

Sinking fund Annual The firm will make annual payments beginning 8/1/05 toward the sinking fund. (A A sinking fundsinking fund is simply a is simply a series of periodic payments to retireseries of periodic payments to retire part of a debt issue.part of a debt issue.

Call Provision None The bond are not callable

Rating Moody’s A2 This is one of Moody’s higher ratings. The bonds have a low probability of default.

19

Call ProvisionIssuer can refund if rates decline. That helps the issuer but hurts the investor.Therefore, borrowers are willing to pay more, and lenders require more, on callable bonds.Most bonds have a deferred call and a declining call premium.

Provision to pay off a loan over its life rather than all at maturity.Reduces risk to investor, shortens average maturity.But not good for investors if rates decline after issuance.

Sinking Fund

20

Default Risk (DFP)Risk that the interest will not be paid Risk that the principal will not be paid Risk that the price of the bond will decline due to poor company prospects

Inflation Risk (IP)Call Risk or Maturity Risk (MRP)Interest Rate Risk. (LP)

Bond Risk

ri = r* + IP + LP + MRP (call) + DRP

for debt securities.

21

What’s Interest Rate (or Price) Risk? Does a 1-year or 10-year 10% Bond have More Risk?

rd 1-year Change 10-year Change

5% $1,048 $1,386

10% 1,0004.8%

1,00038.6%

15% 956 4.4% 749 25.1%

Interest rate risk: Rising rd causes bond’s price to fall.

22

Interest Rate (or Price) Risk

23

What is Reinvestment Rate Risk?

The risk that CFs will have to be reinvested in the future at lower rates, reducing income.

Illustration: Suppose you just won $500,000 playing the lottery. You’ll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%.

Year 1 income = $50,000. At year-end get back $500,000 to reinvest.

If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds, income would have remained constant.

24

General Formula:FVt = PV0(1 + [i/m])mt

t: Number of Yearsm: Compounding Periods per Yeari: Annual Interest RateFVt,m: FV at the end of Year t

PV0 : PV of the Cash Flow today

Frequency of Compounding

25

Ms. Hien has $1,000 to invest for 2 years at an annual interest rate of 12%.

Annual FV2 = 1,000(1+ [.12/1])(1)(2) = 1,254.40

Semi FV2 = 1,000(1+ [.12/2])(2)(2) = 1,262.48

Quarterly FV2 = 1,000(1+ [.12/4])(4)(2) = 1,266.77

Monthly FV2 = 1,000(1+ [.12/12])(12)(2) = 1,269.73

Daily FV2 = 1,000(1+[.12/365])(365)(2) = 1,271.20

Impact of Frequency

26

Continuous compounding implies m

If -- i = interest rate per period (one year) m = number of periods per year t = number of years

FVt = PV0 ( 1 +i/m)mt = PV0 {1 + 1/(m/i)}mt

= PV0 [{1 + 1/(m/i)}m/i]it

FVt = PV0 [{1 + 1/(m/i)}m/i]it

or

Continuous Compounding

27

By definition (1 + 1/n)n as n is equal to e = 2.7182 . . .

If interest is compounded continuously or m , {1 + 1(m/i)}m/i = e Thus, FVt = PV(e)it

Example: PV = 10000 i = 10% t = 5

FV = 10000(e).10(5) = 10000 e0.5 = 10000 (1.6487) = 16487 Finding PV: PV = FV/ (e)in

If you want to have 200,000 at retirement 10 years from now and you can invest at 10% interest, how much should you invest today?

PV = 200,000/ (e).10(10) = 200000/e = 73578

Solving the Equation

28

The Effective Annual Interest Rate is the actual rate of interest earned (paid) after adjusting the nominal rate for factors such as the number of compounding periods per year.

EAR = (1 + [i / m ] )m - 1

Effective Annual Rate

Ms. Hien has a $1,000 CD at the bank. The interest rate is 6% compounded quarterly for 1 year.

What is the Effective Annual Interest Rate (EAR)?

EAR = ( 1 + 6% / 4 )4 – 1 = 1.0614 - 1 = .0614 or 6.14%!

29

A 10%, 10-year, Annual Payment Bond vs. 10%, 10-year Semiannual

Bond

10.25% > 10% EFF% on annual bond, so buy semiannual bond.

EAR = EFF% = (1 + iNom

m )m

- 1= 0.10(1 +

2)2

- 1 = 10.25%

You could buy, for $1,000, either a 10%, 10-year, annual payment bond or an equally risky 10%, 10-year semiannual bond. Which would you prefer?

30

Corporate Bonds Bond RatingsBond Ratings

30

31

Bond Ratings

31

32

Varieties of Corporate Debt

Mortgage bonds are backed by real estate and/or the physical assets of the corporation. The real assets pledged will have a market value greater than the bond issue. If the company defaults on the bonds, the real assets are sold off to pay off the mortgage bond holders.

Debentures are unsecured promissory notes that are supported by the general creditworthiness of the issuing company. Because no assets are pledged, these bonds are riskier than collateralized bonds. As a result, they are often referred to as subordinate debt and carry higher interest rates and/or other features to make them more desirable to investors.

33

Income bonds will only pay interest if income is earned by the issuing company and only to the extent that income is earned. Income bonds are the only bonds issued where failure to pay the interest in a timely fashion does not lead to immediate default.As a result, income bonds are considered to be extremely risky.In general, income bonds are issued by a company in bankruptcy. The company facing bankruptcy will meet with its creditors (usually bond holders) and agree to issue new income bonds in exchange for the old bonds. Because failure to pay interest would land the company back into bankruptcy court, the creditors agree that interest will only be paid to the extent earned.

Varieties of Corporate Debt

34

Convertible bonds are one type of hybrid security.They are like bonds in that they pay a fixed rate of interest and have a maturity date.They are also like stock because they give the investor an option to convert the bond into a specified number of shares of stock.The market price of a convertible bond therefore depends both on the firm’s stock price and prevailing interest rates. Bonds also are occasionally issued with with stock purchase stock purchase warrantswarrants attached to them to make them more attached to them to make them more attractive to investors.attractive to investors.

WarrantsWarrants give the bondholder the right to purchase a give the bondholder the right to purchase a certain number of shares of the same firm’s common certain number of shares of the same firm’s common stock at a specified price during a specified period of stock at a specified price during a specified period of time.time.

Including warrants typically allow the firm to raise debt Including warrants typically allow the firm to raise debt capital at a lower cost than would be possible in their capital at a lower cost than would be possible in their absenceabsence

Varieties of Corporate Debt

35

High-yield bonds are not a different type of bond -- simply a bond of lower quality.Bonds rated BB (S&P) or Ba (Moodys) or lower are considered to be junk.Junk bonds are usually debentures and are subordinated to the firm’s other debt.In general, junk bonds pay around 3 to 4 percent higher yields to investors than higher-grade bonds.

Varieties of Corporate Debt

36

International Bonds

Eurobonds are issued by a country like the U.S. and sold in another country like France In U.S. dollars May be less regulatory interference May be less disclosure requirements Are bearer bonds Anonymity

Foreign bonds are issued in a single foreign country with interest and principal paid in that foreign currency

37

Term to Final Maturity

In general, the longer the maturity, the greater are these risks.Yield Curves

A yield curve is a diagram that compares the market yields on securities that differ only in terms of maturity.The general relationship is also referred to as the term structure of interest rates.

38

The Term Structure of Interest Rates Once Again

Interest raterisk premium

Inflationpremium

Real rate

Interest raterisk premium

Inflationpremium

Real rate

A. Upward-sloping term structure B. Downward-sloping term structure

Interest rate

Interest rateNominal

interest rate

Nominalinterest

rate

Time tomaturity

Time tomaturity

39

Yield Curves

40

BankruptcyTwo main chapters of Federal Bankruptcy Act:

Chapter 11, ReorganizationChapter 7, Liquidation

Typically, company wants Chapter 11, creditors may prefer Chapter 7. If company can’t meet its obligations, it files under Chapter 11. That stops creditors from foreclosing, taking assets, and shutting down the business.Company has 120 days to file a reorganization plan.

Court appoints a “trustee” to supervise reorganization. Management usually stays in control. Company must demonstrate in its reorganization plan that it is “worth more alive than dead.” Otherwise, judge will order liquidation under Chapter 7.

http://www.investopedia.com/ask/answers/190.asp

41

If the company is liquidated, here’s the payment priority:Secured creditors from sales of secured assets.Trustee’s costsWages, subject to limitsTaxesUnfunded pension liabilitiesUnsecured creditorsPreferred stockCommon stock

In a liquidation, unsecured creditors generally get zero. This makes them more willing to participate in reorganization even though their claims are greatly scaled back.Various groups of creditors vote on the reorganization plan. If both the majority of the creditors and the judge approve, company “emerges” from bankruptcy with lower debts, reduced interest charges, and a chance for success.

Bankruptcy

42

Stocks and Their Valuation

43

Equity securities represent an ownership interest in a corporation. Holders of equity securities are entitled to the earnings of the corporation when those earning are distributed in the form of dividends; they are also entitled to a prorata share of the remaining equity in case of liquidation.

There are two types of equity securities: common stock and preferred stock, The key distinction between these two forms of equity securities is the degree to which they may participate in any distribution of earnings and capital and the priority given to each in the distribution of earnings. Typically, preferred stockholders are entitled to a fixed dividend that they receive before common stockholders may receive dividends. Preferred stock is referred to as a senior corporate security in the sense that preferred stock interests are senior to the interests of common stockholders

The Stock Market

44

Common Stock Represents ownership.Ownership implies control.Stockholders elect directors.Directors hire management.Since managers are “agents” of shareholders, their goal should be: Maximize stock price.

May be various classes of stock, but will depend on firm

Common Stock: Owners, Directors, and Managers

45

The first time shares are sold in the market is an initial public offering (IPO); additional shares may be sold later as a seasoned offering.

Equities may be:sold directly to investors by the firmpurchased and sold at a higher price (underwriter’s spread) by investment bankers in an underwriting offeringsold to existing shareholders in a rights offering

The size of the underwriter’s spread is:Breadth of the market or the number of varied traders of the stockDepth of the market or the extent to which there are conditional orders to buy and sell below and above the current price, respectively

Primary Market for Securities

46

The Secondary Market for Equity Securities -- Subsequent Trading in

SecuritiesStock may trade on:ExchangesOver the counter

Broker -gets buyer and seller togetherDealer - takes ownership

A buyer may incur search costs and find a seller on their own, called a direct search.A broker may bring buyer and seller together, charging a commission.A dealer may sell/buy (bid/ask) securities from an inventory of securities, reducing search costs. The dealer’s return is the bid/ask spread.An auction market allocates the selling shares to the highest bidder, providing a buyer/seller.

http://finance.yahoo.com

47

When is a stock sale an initial public offering (IPO)?

• A firm “goes public” through an IPO when the stock is first offered to the public.

• Prior to an IPO, shares are typically owned by the firm’s managers, key employees, and, in many situations, venture capital providers.What is a seasoned equity offering

(SEO)?• A seasoned equity offering occurs when a

company with public stock issues additional shares.

• After an IPO or SEO, the stock trades in the secondary market, such as the NYSE or Nasdaq.

48

Foreign Securities

Some Differences:terminologyfrequency of dividend paymentslimitations on ownershipcorporate financial structuredepreciation methods

http://www.escapeartist.com/Offshore/Stock_Markets

49

ssss r

D

r

D

r

D

r

DP

1. . .

111ˆ

33

22

11

0

Stock Value = PV of Dividends

1 (1 )

t

o tt s

DP

r

1 (1 )

t

o tt s

DP

r

Dividend Discount Models:General Model

50

For a constant growth stock (dividends grow at a constant growth rate g)

D D gD D gD D gt t

t

1 01

2 02

111

gr

D

gr

gDP

ss

100

1ˆ

If g is constant, then:

51

Constant Growth Model1

0s

DP

r g

1

0s

DP

r g

g = constant perpetual growth rate of dividend

D1 = expected dividend = D0 (1 + g)

Constant Growth Model: Example

D0 = $3.00 g = 8% rs = 15%

0

$3.00(1 .08)$3.44 / .07 $49.14

.15 .08P

0

$3.00(1 .08)$3.44 / .07 $49.14

.15 .08P

52

What happens if g > rs?

If rs< g, get negative stock price, which is nonsense.

We can’t use model unless (1) g rs and (2) g is expected to be constant forever.

Because g must be a long-term growth rate, it cannot be rs.

.r requires ˆs

10 g

gr

DP

s

53

Assume beta = 1.2, rRF = 7%, and RPM = 5%. What is the required rate of return on the firm’s stock?

rs = rRF + (RPM)bFirm

= 7% + (5%) (1.2)

= 13%.

Use the SML to calculate rs:

54

If D0 was $2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. Remember rs = 13%.

0 1

2.2472

2

2.3820

3g=6%

4

1.8761

1.7599

1.6508

D0=2.00

13%

2.12

55

What’s the stock’s market value? D0 = 2.00, rs = 13%, g = 6%.

Constant growth model: 0 1

0

1 $2.12 $2.12ˆ $30.290.13 0.06 0.07s s

D g DP

r g r g

• D1 will have been paid, so expected dividends are D2, D3, D4 and so on. Thus,

21

$2.2472ˆ $32.100.07s

DP

r g

What is the stock’s market value one year from now, P1?

56

Find the expected dividend yield and capital gains yield during the first year.

1

0

$2.127%

$30.29

D

P

1 0

0

$32.10 $30.296%

$30.29

P P

P

Capital Gain Yield

Dividend Yield

57

Find the total return during thefirst year.

Total return = Dividend yield + Capital gains yield.Total return = 7% + 6% = 13%.Total return = 13% = rs.For constant growth stock: Capital gains yield = 6% = g.

Rearrange model to rate of return form:

.r to ˆ0

1s

10 g

P

D

gr

DP

s

Then, rs = $2.12/$30.29 + 0.06= 0.07 + 0.06 = 13%.

^

58

Specified Holding Period Model

PN = the expected sales price for the stock at time NN = the specified number of years the stock is expected to be held

31 2

0 1 2 3ˆ . . .

1 1 1 1N N

N

s s s s

D D PD DP

r r r r

59

Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks. Example:

Estimate the average P/E ratio of comparable firms. This is the P/E multiple.Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price.

Using the Stock Price Multiples to Estimate Stock Price

60

It is often hard to find comparable firms.

The average ratio for the sample of comparable firms often has a wide range.

For example, the average P/E ratio might be 20, but the range could be from 10 to 50.

How do you know whether your firm should be compared to the low, average, or high performers?

Problems with Market Multiple Methods

61

Preferred Stock

Hybrid security.

Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock.

However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.

62

What’s the expected return on preferred stock with Vper share = $50 and annual dividend = $5?

%.0.1010.050$

5$

5$50$

ps

ps

ps

r

rV

63

Efficient Market Hypothesis (EMH)

Do security prices reflect information ?Why look at market efficiency

Implications for business and corporate financeImplications for investmentRandom Walk and the EMH

Random Walk - stock prices are random•Expected price is positive over time•Positive trend and random about the trend

64

Why are price changes random?Prices react to informationFlow of information is randomTherefore, price changes are random

Random Price Changes

EMH and Competition

• Stock prices fully and accurately reflect publicly available information

• Once information becomes available, market participants analyze it

• Competition assures prices reflect information

65

Efficient Capital Markets An Efficient Market is one in which prices

adjust quickly after the arrival of new information and the price change reflects the economic value of the information.

In an efficient market, only unexpected news or information should cause prices to significantly move up or down.

Expected news or information should not cause a significant price reaction because that information will already have been factored into the price of a security.

Because news is random by definition, security price changes should appear random or follow a “random walk.”

66

Because news is almost instantaneously reflected in the prices of securities, investors can not consistently earn above average returns from trades made based on the arrival of new information.

The price adjustment occurs so rapidly that no buy or sell order placed after the announcement can, over the long run, result in above-average risk adjusted returns.

Thus, an efficient market requires a large number of profit-seeking active investors.

Efficient Capital Markets

A weak form efficient market is a market in which prices reflect all historical information.

Historical information would include last year’s annual financial information, dividends, and earnings.

If a market is weak form efficient market implies that investors cannot earn above-average risk adjusted returns by trading based on this information.

Weak Form EfficiencyWeak Form Efficiency

67

Semi-Strong Form EfficiencySemi-Strong Form Efficiency

A semi-strong form efficient market is a market in which all public information, both current and past, is reflected in current security prices.

This information would include not only historical financial information, but ALL current public information.

If a market is semi-strong form efficient, investors cannot hope to earn above-average risk adjusted returns by trading based on this information.

In general, most U.S. financial markets are thought to be semi-strong efficient

Efficient Capital Markets

68

Strong Form EfficiencyStrong Form Efficiency

A strong form efficient market is a market in which ALL information, both current and past, no matter the source or nature, is reflected in current security prices.

In this case, even detailed, exclusive information is reflected instantaneously in stock prices as soon as it occurs.

If a market is strong form efficient, even corporate officers or other corporate insiders cannot earn above average risk-adjusted returns

In general, few markets can pass this test and it is the reason U.S. markets have insider trading laws.

Efficient Capital Markets

69

Contrasting Debt & Equity

Characteristic Debt Equity

Voice in Management No Yes

Claims on income and assets Senior to equity Subordinat to debt

Maturity Stated None

Tax Treatment Interest deduction No deduction

Type of Capital

70

Financial Options and Their Valuation

71

An option is a contract which gives its holder the right, but not the obligation, to buy (or sell) an asset at some predetermined price within a specified period of time.

It does not obligate its owner to take any action. It merely gives the owner the right to buy or sell an asset.

What is a financial option?

What is the single most importantcharacteristic of an option?

72

Call option: An option to buy a specified number of shares of a security within some future period.

Put option: An option to sell a specified number of shares of a security within some future period.

Exercise (or strike) price: The price stated in the option contract at which the security can be bought or sold.

Option price: The market price of the option contract.

Expiration date: The date the option matures.

Exercise value: The value of a call option if it were

exercised today = Current stock price - Strike price.

Note: The exercise value is zero if the stock price is

less than the strike price.

Option Terminology

73

Covered option: A call option written against stock held in an investor’s portfolio.Naked (uncovered) option: An option sold without the stock to back it up.In-the-money call: A call whose exercise price is less than the current price of the underlying stock. Out-of-the-money call: A call option whose exercise price exceeds the current stock price.

74

Consider the following data:

Exercise price = $25.

Stock Price Call Option Price

$25 $3.00

30 7.50

35 12.00

40 16.50

45 21.00

50 25.50

75

Exercise Value vs. Stock PricePrice of stock (a)

Strike price (b)

Exercise Valueof option (a)–(b)

$25.00 $25.00 $0.00

30.00 25.00 5.00

35.00 25.00 10.00

40.00 25.00 15.00

45.00 25.00 20.00

50.00 25.00 25.00

Exercise ValueOf option (c)

Mkt Price Of option (d)

Time Value(c) – (d)

$0.00 $3.00 $3.00

5.00 7.50 2.50

10.00 12.00 2.00

15.00 16.50 1.50

20.00 21.00 1.00

25.00 25.50 0.50

Option Value vs. Exercise Value

765 10 15 20 25 30 35 40 45 50 Stock Price

Option value

30

25

20

15

10

5

Market price

Exercise value

Call Time Value DiagramThe time value, which is the option price less its exercise value, declines as the stock price increases.This is due to the declining degree of leverage provided by options as the underlying stock price increases, and the greater loss potential of options at higher option prices.

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Option Trading Strategies

1. Buying Call Options

Buying to achieve leverage - The price of a call of 100 shares is significantly lower than buying the shares outright.Example: Stock XYZ sells at $50/share and a $50 call costs $5/share. The Investor can buy the call for $500 instead of the 100 shares for $5,000. If XYZ goes to $60, the value of the option is $1000.

Return on option: $500/$500 = 100%Return on stock purchase: $1000/$5000 = 20%

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2. Buying call options to limit risk

Investor dislikes the risk of buying XYZ and watching it go down in value. Therefore, Investor purchases XYZ 50 call at $5 and puts remaining $ in risk-free securities. Hence, given the same $5,000, the Investor buys call and puts $4,500 into Rf securities.Example: If XYZ goes to $60, the Investor can buy or exercise the option to net $500 plus interest from Rf investment.

If XYZ stays at $50 or falls below, the investor has lost his option premium which is partly offset by interest income.

Option Trading Strategies

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4. Put Option StrategiesBuying Put options for leverage and limited riskInvestor anticipates significant decrease in the stock price but does not have the margin money for a short sale, and does not want to be exposed to unlimited risk of stock price increases. Investor buys a put.

NOTE: Stock price must decline enough to break even.

Option Trading Strategies3. Buying call option to hedge short stock position

Investor believes XYZ will decline. Investor sells XYZ short to obtain total profit potential but he is exposed to unlimited loss from stock price increase. The Investor buys a call to eliminate loss.

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5. Buying Put options to hedge against a stock price decline

Investor holds IBM and has already taken a paper profit. Investor believes IBM will go higher and would like to participate in upside without risking a loss on paper profit. So he buys a put. If price goes up, the potential is only diminished by the cost of the put, whereas the paper profits are protected by the put and decreased only by the put price.

Option Trading Strategies