Download An Option`s Intrinsic Value

Why do Companies Issue Stocks
and Bonds?
 To obtain capital (money) to complete the necessary
activities of a business and expand, a company uses
either equity or debt financing
 Equity Financing – issuing stock to investors
 An investor pays a company the price for the stock and, in
return, obtains partial ownership of the company
 Debt Financing – obtaining loans or issuing bonds in
order to fund investments
Equity Financing
Types of Stocks
Common Stock
Ownership of a share of publicly-traded company
Rights of Common Stockholders



Elect the board of directors
Vote in annual shareholder’s meeting
Generally exercise control of the
company
Limitations of Common Stockholders


If company goes bankrupt, common
stockholders get paid last
Not guaranteed dividend payments
Investments in common stock appreciates as the
company’s earnings grow
Preferred Stock
Hybrid between a stock and a bond
Represents equity/ownership in a corporation, but to a limited degree
Rights of Preferred Stockholders


If company pays dividends, preferred
stockholders will be paid before
common stockholders
Preferred stockholders have a greater
claim on company’s assets if the
company liquidates
Limitations of Preferred Stockholders


Have no voice in how the company is
managed
No voting rights
Stock Categorization
1.
Industry
 Examples:
 Consumer Goods
 ConAgra, General Mills
 Personal Computers
 Apple, Dell
Stock Categorization
2.
Market Capitalization
 Total market value of all of a company’s outstanding shares
Market Cap = Shares Outstanding x Share Price
 Large-cap: securities issued by companies that have a market
capitalization value of more than $10 billion
WMT
MSFT
GE
 Mid-cap: securities issued by companies that have a market
capitalization value between $2 and $10 billion
 Small-cap: securities issued by companies that have a market
capitalization value between $300 million and $2 billion
Stock Categorization
2.
Market Capitalization
 Total market value of all of a company’s outstanding shares
Market Cap = Shares Outstanding x Share Price
 Example:
Company ABC has a share price of $15 per share and has
20,000 shares outstanding.
The market capitalization is 20,000 x $15 = $300,000,000.
Therefore, Company ABC is considered a small cap company.
The “Key Statistics” section on YahooFinance will show you the
company’s market cap of the stock you look up.
Stock Categorization
3.
Company’s Sensitivity to the Business Cycle
 Describes different stages of growth and decline in an economy
 Peak: Economic activity is growing rapidly and production
facilities are operating at full capacity
 Contraction: Economy begins to slow down, unemployment
rises, consumer spending declines, and sales decline
 Trough: Economy is at the lowest point on the business cycle
 Recovery: Employment levels and sales start to increase again
 Expansion: A period when business activity surges and the
GDP expands until it reaches a peak (also known as an
economic recovery)
Stock Categorization
3.
Company’s Sensitivity to the Business Cycle
 Describes different stages of growth and decline in an
economy
Recession
Recovery
Expansion
GDP Growth
5%
Peak
Previous Peak Broken
0%
-5%
Trough
Business Cycle
What determines a Company’s
Sensitivity to the Business Cycle?
1. Defensive vs. Cyclical Stocks
2. Operating Leverage
3. Financial Leverage
Business Cycle
1.
Defensive vs. Cyclical Stocks
 Defensive Stock: not greatly affected by the business cycle. This is
because defensive stocks are in industries such as food, utilities,
and other consumer goods that are not considered “necessities”.
Defensive stocks do not increase in price when the market surges or
declines.
 Example: ConAgra Foods
Business Cycle
1.
Defensive vs. Cyclical Stocks (cont)
 Cyclical Stocks: largely affected by the business cycle.
Cyclical stocks will decrease when the market is weak and
increase when the market is favorable.
 Examples: Auto Makers (Ford), Airline Companies (Jet Blue Airlines)
What are some reasons airlines and auto-makers are cyclical
companies?
Business Cycle
2.
Operating Leverage
 Measures the amount of operating risk associated with a company’s
level of fixed costs compared to its variable costs.
 The greater the percentage of fixed costs to total expenses, the
higher a company’s degree of operating leverage.
Fixed Costs

Costs that do not change with the level of production. Examples of fixed
operating costs include salaries, insurance expenses, and rent because
regardless of how much you produce, these costs will not change.
Variable Costs

Costs that change with the level of production. Examples include the costs
of goods sold or sales. Generally the larger the production, the less each
individual product costs to make because of “economies of scale”.
An Option’s Intrinsic Value
 Example:
Sky High Airlines has a high level of operating leverage. Aircraft and gate
costs at airports are very large fixed costs incurred by Sky High Airlines.
Regardless of how sales do, these costs do not change.
Therefore, when sales increase, the variable costs will increase but to a lesser
degree.
These costs are comprised of fuel and maintenance of the planes.
Sky High Airlines’ operating leverage would decrease because its
percentage of fixed costs to total cost is not as large during an
increase in sales.
Fixed Costs = $15 million
Variable Costs (low sales) = $18 million
Variable Costs (high sales) = $25 million
Operating Leverage (low sales) = 15/(15+18) = 45.5%
Operating Leverage (high sales) = 15/(15+25) = 37.5%
Business Cycle
3.
Financial Leverage
 A way for a company to gain large returns without investing a lot of
capital. Firms with a high degree of financial leverage are more
sensitive to the business cycle.
 Leverage = Debt/Equity
 As you will learn in the next section, debt financing uses capital from
outside the company to finance an investment, whereas equity
financing comes from selling shares of ownership of the company.
Debt Financing
Parts of a Bond
 Principal – the face value of the bond
 Maturity – the established time for the issuer to repay
the bond
 Coupon – the interest payments of a bond (usually
every 6 months)
 Yield – the rate of return realized from investing in the
bond
The term coupon comes from the early days of bonds. The physical paper bond was a certificate
with coupon tickets that, when brought to the issuer, could be redeemed for the interest payment.
Owners of the bond would clip the coupons in order to obtain their interest payments.
Who Issues Bonds and Why?
Governments
 The U.S. Government issues Treasury bonds in order to pay for
government activities and to pay off government debt.
 Treasury bonds are backed by the “full faith and credit” of the U.S.
Government. Thus, these bonds are essentially free from default
risk.
Government Bonds
U.S. Government Issued Bonds
Treasury
Bills
 Maturities: 4 weeks, 13 weeks, 26 weeks, and 52 weeks
 Face value: $1,000
 Purchased at a discount and the full amount is repaid at maturity
Treasury
Notes
 Maturities: over 1 to 10 years
 Issued in denominations of $1,000 to $5,000
 Coupons paid semi-annually
Treasury
Bonds
 Maturities: over 30 years
 Denominations: $1,000 to $1 million
 Coupons paid semi-annually
Agencies
 Organizations that are wholly owned and supported by
the government
 Issue bonds that have a direct government guarantee
 Housing agencies are the most active issuers of bonds,
among all agencies
 Example: Government National Mortgage Association (GNMA), known
as Ginnie Mae, is a U.S. housing agency.
Government Sponsored Enterprise
(GSE’s)
 Organizations that have an implied government
guarantee but are not directly owned by the government
 Example: Federal Home Loan Mortgage Corporation (FHLMC), known
as Freddie Mac and Federal National Mortgage Association (FNMA)
commonly known as Fannie Mae
 GSE implies that the enterprise’s bonds are less risky
than other bonds because the government would not
allow them to fail because of their “implied” guarantee
Municipalities
State and local governments issue Municipal bonds to
borrow money to build and expand:
 Schools
 Government buildings
 Water, power, and sewage systems
 Prisons and hospitals
 Colleges
 Roads
 Bridges
 Public transportation
 Airports
 Highways
Why Buy Muni Bonds?
Tax Free Income
 Interest payments obtained from Municipal Bonds are exempt from
federal tax and from state income tax if you reside in the specific
state issuing them
Safe Investment
 United States Treasuries are the safest and municipals are
considered second
Types of Muni Bonds
Mu Types of Bonds
Municipalities – Two
General Obligation Bonds
(GO)

Issued to raise funds for projects that
no not provide direct sources of
revenue




Examples: Roads, bridges, parks
Issued in order to fund projects that
will serve the entire community, not
only those who pay for the services
Backed by the full faith and credit of
the issuing municipality
Interest and principal are paid through
tax receipts
Revenue Bonds

Finance income-producing projects



Examples: Airports, Power and Water
municipalities
Income generated by these projects
pays the bondholders their interest and
principal revenue
Projects that are backed by revenue
bonds provide services to only those in
the community who pay for their
services
Who Issues Bonds and Why?
Corporations
 Issue long-term debt to expand and finance their activities
 Pay semi-annual coupons and repay face value of the bond at
maturity
 Corporate bonds are traded “over the counter”
Bond Ratings
 Different rating agencies exist for bonds
 Standard & Poor’s and Moody’s are the two most recognizable
rating agencies
 Bonds are rated according to their risk
 Different factors affect the riskiness of a bond, one of the largest
being default risk
 Default risk is the ability of a company to repay the bond at maturity
 If there exists a large default risk (more uncertainty the company will
be able to repay its debt), the investor should require a greater
return to compensate for the risk it is taking on
STRONGEST
NON-INVESTMENT
GRADE
INVESTMENT
GRADE
CREDIT RATINGS*
WEAKEST
MOODY’S
STANDARD & POOR’S
FITCH
Aaa
AAA
AAA
Aa
AA
AA
A
A
A
Baa
BBB
BBB
Ba
BB
BB
B
B
B
Caa
CCC
CCC
Ca
CC
CC
C
C
C
C
D
D
*These credit ratings are reflective of obligations with long-term maturities.
Bond Structure
Debenture vs. Collateralized
 Debenture Bonds – An unsecured, meaning it is not
backed by any collateral. It can be a real asset (ex.
Building) or a financial asset (ex. Loan or Bond).
 Collateralized Bonds – Are backed by either a financial
asset or a real asset. In the case of bankruptcy, the
assets are sold and the proceeds are used to pay back
the holder of the collateralized bonds. Collateralized
bonds are safer than debenture bonds and, therefore,
offer lower yield.
Bond Structure
Currency Denomination
 Refers to the currency in which the bond is issued and its coupon
and principal payments are paid
 The most common currencies are:
 U.S. Dollars
 EU Euros
 Japanese Yen
Redemption Characteristics
Callable Bonds
 When a bond issued with a call option, the issuer has
the option to retire the bond before maturity at a set
price, known as the call price
 Issuers exercise call options when interest rates are
low and they can refinance at lower interest rates
Redemption Characteristics
Convertible Bonds
 Gives the bondholder the option to exchange the bond
for a set number of shares of common stock in the
issuing company
Bond
Bondholder
Common
Stock
Redemption Characteristics
Sinking Fund Bonds
 A means of repaying funds that were borrowed through a
bond issue
 The issuer makes periodic payments to a trustee who
retires part of the issue by purchasing the bonds in the
open market
Coupon Structure
The coupon structure is the interest rate stated on a bond when the
bond is offered. It is the percentage of the bond that will be paid,
usually semi-annually or annually, as the coupon payment to the owner
of the bond. The bond will either pay a fixed rate coupon or a floating
rate coupon.
Fixed Rate Bond

Majority of bonds are fixed rate bonds

The coupon rate does not fluctuate
Floating Rate Bond

Bonds that have a coupon rate that is adjusted periodically, or “floats”, in
conjunction with a short term rate, such as LIBOR (London Inter-Bank Offer
Rate).
Payment of Principal
The bond’s principal can be repaid with a “balloon payment” or through
amortization.
Balloon Payment

Treasuries, Munis, and Corporate Bonds are based off of balloon payments

A balloon payment system occurs when small payments are made
throughout the duration of the bond and a large, “balloon” payment is made
at maturity
Amortization

The process by which the principal balance gradually declines over time
and is at zero at maturity

Interest and principal make up a mortgage payment

In the beginning of the mortgage, the majority of the payment is interest

As the payments continue, a large portion of the payment is made up of
principal repayment and a smaller portion is comprised of interest payment
Payment of Principal
Example:
30 Year Fixed Rate Mortgage
$300,000 mortgage with $1,000 yearly payments
Year 1
Payment
Year 2
Payment
Year 30
Payment
Interest
Portion
Interest
Portion
Interest
Portion
$900
$875
$0
Mortgage
$300,000
Mortgage
$290,000
Mortgage
$280,000
Mortgage
$1,000
Mortgage
$0 (repaid)
$100
$125
$1,000
Principal
Portion
Principal
Portion
Principal
Portion
Mortgage Backed Securities
 A type of bond representing an investment in a pool of
real estate loans.
 This is a way for banks to free up capital to make
additional loans and provide a way for market
participants to invest in mortgages.
 A pro rata share of the pool is sold to investors as bonds
 The pooling together of illiquid assets, such as mortgage
loans, and selling off shares in the pool as bonds is
known as securitization
Mortgage Backed Securities
Mortgage 1
Mortgage 3
Mortgage 5
Mortgage 7
Mortgage 2
Mortgage 4
Mortgage 6
Mortgage 8
Pool of
Mortgages
MBS
MBS
MBS
MBS
MBS
Mortgage Backed Securities
Prepayment Risk
 The largest risk when investing in a MBS
 Prepayment occurs when the principal is repaid earlier
than the scheduled maturity of the loan. Often, a
borrower will prepay when they want to refinance their
mortgage in a lower interest rate environment.
Mortgage Backed Securities
 Example:
I.N. Vestor wants to buy a house with a purchase price of $500,000.
I.N. Vestor approaches his bank to secure a mortgage.
He funds the purchase of the house with a 30-year mortgage at a 4% interest
rate.
Over the next 30 years, the bank will continue to receive principal and interest
payments from I.N. Vestor.
The bank wants to sell the stream of interest (4%) and principal
payments from his loan to other investors.
The bank is making money by devising and servicing the mortgages.
In order to sell the interest stream to other investors, the bank bundles I.N.
Vestor’s loan together with 5,000 other mortgages.
Then the bundle, consisting of I.N. Vestor’s loan and the 5,000 other
mortgages, are sold to investment banks as mortgage-backed securities.
The investment bank then divides the pool of loans and sells these as separate
bonds to investors.
Stocks vs. Bonds
Companies that issue preferred stock are not obligated to
pay dividends to their stockholders.
 Issuers of bonds are required to pay coupons (interest payments) to
their bondholders. Furthermore, if an issuer suspends payment on
preferred stock dividends, common stock dividends cannot be paid

Most preferred stock are “cumulative,” that is, if dividends are suspended,
the dividends accumulate and must be paid before any common stock
dividends are paid
Stocks vs. Bonds
 “Senior” means that the debt has priority over other
types of debt in the case of bankruptcy.
 “Unsecured” means that specific collateral does not
exist and, therefore, has a lower priority in the case of
bankruptcy.
Stocks vs. Bonds
More Risk, More Return
Less Risk, Less Return
In case of liquidation, a company will pay back its debt in the following order:
Senior Secured Debt
This debt is collateralized. In the event of liquidation, a company will
repay this debt FIRST because the loan is backed by real/financial
assets.
Senior Unsecured Debt
This debt is not collateralized. Purchasing this form of debt has more
risk than senior debt. The senior unsecured debt does not have a
specific asset backing the loan. The individual/corporation that
purchases this debt will be compensated for taking on more risk by
receiving a higher interest rate.
Preferred Stock
Preferred shareholders get paid after senior secured and unsecured
debt holders but before common shareholders.
Subordinated/Unsecured
Debt
Represents a claim on a company’s assets, which is senior only to
common shares. This debt is only paid once all senior debt holders
have been paid.
Common Stock
Owners of common stock are the last to be paid in case of bankruptcy
or liquidation.
Stocks vs. Bonds
Collateral

An asset that backs the loan

If you fail to pay back the loan to the bank, then the lender can liquidate the
collateral to repay the loan
Money Market Instruments
Money Market Instruments are characterized as debt obligations
with maturity up to one year.
Treasury Bills (sometimes called T-bills)

Short-term debt, with a maturity of up to one year

Backed by the U.S. government

Sold in denominations of $1,000

Maturities of one month, three months, six months, or twelve months
Commercial Paper

An unsecured, short-term debt instrument

Issued by a corporation

Typically for financing of accounts receivable, inventories and meeting
short-term liabilities

Maturities range from 1 to 270 days
Alternatives to Direct Stock
Market Investment
Exchange Traded Funds
(ETFs)

Closed-ended fund that tracks and
index
Can be traded like a stock
ETFs are stocks within specific
sectors that mimic the market



Example: Spider (SPDR), which
tracks the S&P 500 Index
American Depository
Receipts (ADRs)



A way to invest in foreign equity
that is considered safer for U.S.
investors
U.S. banks keep a certain amount
of stock of a foreign company in
its vaults (depository)
Investor can buy shares in that
collection of stocks, priced in U.S.
dollars.
American Depository
Receipts (ADR)
Alternatives to direct investment in the stock market
 ADR
 Way to invest in foreign equity that is considered safer for U.S.
investors
 U.S. banks place a certain amount of stock of a foreign
company into its vault (depository)
 Investors can buy shares in that collection of stocks, priced in
U.S. dollars
Derivatives
A financial instrument (security) that derives its value
from an underlying asset. The price of the underlying
asset determines the price of the derivative.
Underlying assets include:
 Stocks
 Bonds
 Commodities (gold, cattle, etc.)
 Exchange rates
 Indexes (NASDAQ 100)
Why Invest Using Dervatives?
Hedging
 Allow corporations and individuals to protect themselves against
risk. For example, the risk that the stock will decline in value in the
future.
Speculation
 The practice of partaking in risky financial transactions in order to
profit from short- or medium-term fluctuations in the market value of
tradable goods such as a financial instruments. In essence, it’s a
guess.
Types of Derivatives
Forwards

A forward is a private contract to buy or sell a security at a specific date in
the future at a set price
Futures

A future is a financial contract obligating the buyer to purchase an asset (or
the seller to sell an asset), such as a physical commodity or a financial
instrument, at a predetermined future date and price. Future contracts
specify the quality and quantity of the underlying asset. Future contracts
are standardized to enable trading on a futures exchange.

Futures exchange – The central marketplace where futures contracts and
options on futures contracts are traded
Difference between Forwards
and Futures
Standardization
 Trades on an exchange and is subject to standards of the exchange
 Futures are standardized.
 Forward contracts are not standardized
Difference between Forwards
and Futures
Long Position
 If you buy a future contract, called buying long, then you have an
obligation to buy the security at a set price at the specific date. That
price is called the strike price.
Short Position
 If you sell the future contract, called selling short, you have the
obligation to sell the security at a set price at the specified date.
That price is also called the strike price.
Difference between Forwards
and Futures
 Example:
On August 3rd, I.N. Vestor buys a futures contract to buy 100
shares of Company ABC at $30 per share on October 31st.
On October 31st, Company ABC is trading at $15 per share.
I.N. Vestor must pay $15 per share.
His loss is $1,500
[($30-$15) x 100 shares]
Options
 An agreement that gives the investor a choice of whether
or not to buy (called a call) or sell (called a put) an
asset at the strike price and set time period in the future
 There is no contract in place that obligates the investor
to exercise the option
Options
 Option Premium – Price of the option
 Strike Price – Price where the owner of an option can
purchase (call), or sell (put) the underlying security
 Put Option (Put) – Option to sell stock at a specific price
by a specific date in the future. Investors purchase a put if
they think that the price of the underlying asset will drop
 Call Option (Call) – An option to buy stock at a specific
price on a specific date in the future
 Expiration Date – The last date that an options or futures
contract is valid
An Option’s Intrinsic Value
In the Money
If the current price of the stock is above the call option price, the
investor will exercise the option and buy the stock at the strike
price. The investor is “in the money” because the investor can then
sell the stock at the current price and make a profit.
Current Stock Price > Strike Price
An Option’s Intrinsic Value
 Example:
I.N. Vestor buys a call option on Company ABC stock with a
strike price of $11. The price of the stock is trading at $14.
The option is therefore, “in the money” and I.N. Vestor can
exercise the option. This is because the option gives I.N.
Vestor the right to buy the stock for $11. He can then
immediately sell the stock for $14, a gain of $3 per share.
An Option’s Intrinsic Value
At the Money
A situation where an option’s strike price is the same as the price of
the underlying security
Current Stock Price = Strike Price
Out of the Money
An option that would be worthless if it expired today because the
price of the underlying security is below the strike price
Current Stock Price < Strike Price
An Option’s Intrinsic Value
 Example:
I.N. Vestor thinks the Chatpad, a new web developing
company, is a good company and that the stock price will
increase from its current trading price of $60 per share.
I.N. Vestor has two options:
1. He can buy Chatpad stock for $60 right now.
2. He can pay $10 to buy the option to buy Chatpad stock
anytime over the next month for the strike price of $70 per
share. The option costs him $1,000 whereas purchasing 100
shares at $60 per share would be $6,000.
I.N. Vestor chooses to buy the option.
Within the next month, Chatpad stock plummets to $30 per share.
I.N. Vestor does not exercise the option because it is “out of the
money”.
He is happy he bought the option rather than the shares.
An Option’s Intrinsic Value
Call Option
Put Option
In the Money
Current Stock Price > Strike Price
Current Stock Price < Strike Price
Out of the Money
Current Stock Price < Strike Price
Current Stock Price > Strike Price
At the Money
Current Stock Price = Strike Price
Current Stock Price = Strike Price
Interest Rate Swaps
In an interest rate swap, two market participants, known as
counterparties, agree to exchange interest payments for a
set period of time, typically from 1-5 years.
One counterparty makes a payment based on a fixed rate
of interest, while the other counterparty makes a payment
based on a floating rate of interest.
Credit Default Swaps (CDS)
Swap that transfers the credit exposure of
fixed income products between parties
 Buyer of the swap receives credit protection and the
seller of the swap guarantees the credit worthiness of
the fixed income security
 The risk of the default is transferred from the holder of
the fixed income security to the seller of the swap
Risk of default
Credit Protection
Swap
Seller
Buyer
Credit Default Swaps (CDS)
 Example:
I.N. Vestor buys a $1,000,000 Frizzle,Inc. bond.
I.N. Vestor wants protection against loss of principal in the
event Frizzle, Inc. defaults on payment.
I.N. Vestor buys a credit default swap contract from a third
party.
I.N. Vestor makes periodic payments to the third party and in
return has insurance on his debt instrument.
If Frizzle, Inc. defaults, then the third party reimburses I.N.
Vestor the face value of the Frizzle, Inc. bond ($1,000,000).
Credit Default Swaps (CDS)