Transcript Review for Midterm

BU 111 Review
Qualitative Review
(no numbers – just theory)
Bull Market
• Think the stock prices will increase
– Go long in stock
– But on Margin
– Buy call options
– Write put options
Bear Market
• Think the share prices will decrease
– Short the stock
– Buy Put options
– Write Call options
Reasons for Investing
• Hedge against inflation
• Extra retirement money – protect against
living forever
• Insure family against an early death
• Savings for future purchases
• Too lazy to work – like the free money
Short Sale
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Think the shares will decrease (bearish)
You borrow shares from the broker
Sell the shares in the market
Deposit the proceeds as well as a 50% deposit
with the broker.
If shares go up – you will receive a broker call.
Remember – you need to have 50% on deposit
therefore the short call will be:
Short Call
• New deposit = Current market value (# of
shares * share price) * 50%
• Short call = New Deposit – Old Deposit
• To cover a short you must go into the
market and buy the shares.
Short Calls and Dividends
• When you short a stock, you are selling the
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shares that are borrowed from the broker.
Therefore, you do not own the shares and do
not have any of the rights associated with the
shares.
Therefore, when a dividend is declared you will
not receive it. In fact, since you sold someone
else’s shares without their knowledge, you now
owe them the dividend.
Short Call Risks
• Responsible for dividends if declared
• Unlimited loss – price can go up forever
• Market conditions – bull vs. bear
• Forced to cover at an inopportune time
Margin Buy
• You think the stock price will increase
(bullish)
• You borrow a set percentage from the
broker and purchase X number of shares
• Amount usable (50% margin, $5000 to
invest):
– 50% * X = $5000
– X = $10,000
Margin Call
• When the stock price declines you will receive a
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margin call.
The amount loaned by the broker is a certain
percentage of the market value of the stock.
To determine the margin call:
– Compute the current market value
– Multiply the margin percentage to determine what the
broker will loan as of today
Margin Call
• Margin call = Amount of old loan –
amount of new loan.
• When margin call is paid, the loan is
deducted by that amount, and you only
pay interest on the new loan amount.
Margins and Dividends
• When you buy a stock on margin you own
the stock (with all the rights) and owe the
broker the amount of the loan.
• If the stock declares a dividend, then,
since you own the stock you will receive
the dividend in the entire amount.
Options
• Call Options – the right to buy shares
(100 shares per contract) at a stated price
(exercise price)
• Put Options – the right to sell shares at a
stated price
• Price of an option is a combination of the
intrinsic value and time value.
Factors affecting Option Prices
• Strike Price
• Stock Price
• Risk free interest rate
• Time to maturity
• Volatility
• Dividends
Intrinsic Value
• Intrinsic Value
– Call = Stock Price – Exercise Price
– Put = Exercise Price – Stock Price
– Value of the option if exercised today, or 0.
– The intrinsic value can never be negative
In the Money
• A call option is in the money when the price of
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the underlying shares has increased above the
exercise price.
A put option is in the money when the price of
the underlying shares has decreased below the
exercised price.
Options are at the money when the price of the
underlying shares are equal to the exercise price
of the option.
Bonds
• Bonds are a fixed income investment
• Debenture – an unsecured bond (not
guaranteed by mortgage)
• Price of the bond is the present value of
all future interest payments and the
average capital gain/loss of the principle.
Bond Features
• Conversion – bond can be converted into a
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specific number of shares – option of the owner
of the bond
Redemption – Company can redeem the bonds
at their discretion
Retractable – bondholder has the option to
redeem the bond before maturity
Extendable – bondholder has the option to
extend the maturity of the bond
Callable – firm recalls the bonds before maturity
Bond Prices and Interest Rates
• Discount – bond price is below $1,000
– Interest rates have risen in the economy
• Premium – bond price is above $1,000
– Interest rates have dropped in the economy
• Par – bond price is equal to $1000
– Interest rates have not moved
Bond Prices vary inversely with
Interest rates
• Because the price is made up of both a
capital gain/loss and interest payments
the bond prices will move with the
prevailing interest rate.
• Since the interest rate is fixed, only the
capital gain can move and therefore the
price of the bond must change with the
interest rates.
Bond Prices and Interest Rates
• If the interest rates in the market go up,
then the old bonds at the lower rate are
less attractive and therefore need a
discount in price in order to sell.
• The capital gain achieved from this
discount, helps to bring the yield of the
bond to that of the going market rate.
Stocks
• Common stock
– Usually have full voting rights
– Not guaranteed dividend payments
• Preferred Stock
– Usually have no voting rights
– Usually guaranteed dividends
• Dividends can accumulate (arrears)
• Participative – get extra dividends when more money is
declared and a certain level of common dividends are done.
Value of Stocks
• Overvalued – the stock is trading at a
price that is greater then that of stocks of
comparable risk.
• Undervalued – the stock is trading at a
price that is less then that of stocks of
similar risk.
Investor Preferences
• Different investors will require different
mechanisms to invest:
– Older people are generally on a fixed income
and therefore cannot absorb a loss as readily
as younger investors. Therefore, they would
be more interested in fixed income securities
such as bonds/GIC’s/preferred shares that
have limited risk.
Investment Preferences cont…
• Younger people on the other hand are still
working and therefore can make back
potential losses and are willing to take
more risk. They would then be more
interested in high growth stocks and
speculation.
• Remember it is best to have a well
diversified portfolio no matter the age.
Critical Success Factors
• Financial Performance
• Satisfied customers
• Quality product and service
• Innovation and Creativity
• Knowledgeable and dedicated staff
Relationship among CSF’s
• You will achieve financial performance
when you have satisfied customers.
• You will have satisfied customers when
you have quality products/services.
• You will have quality products/services
when you have innovation and creativity.
• You will have innovation and creativity
when you have a knowledgeable and
dedicated staff.