CMA Part 2 Financial Decision Making

Study Unit 5 - Financial Instruments and Cost of Capital

Ronald Schmidt, CMA, CFM

• Derivative Instrument– Investment in which gain or loss is derived from some other

economic event. – One party speculates (incur risk) and the other hedges (avoid

risk).– Are not claims on business assets such as equity securities.

• Hedging– Using offsetting commitments to minimize impact of adverse

price movements.– Long Position: would like to sell an asset in the future to benefit

from the rise in value. (participate in short hedge)– Short Position: would like to buy an asset in the future to

benefit from fall in value. (participate in long hedge)

5.4 Derivatives

2

3

• Options– Buyer has the right to demand some action from seller. But is

not obligated!– Exercise is always at the discretion of the option holder. – Expiration Dates

• European• American

– Exercise Price (strike price): price at which the option holder can purchase or sell the asset.

– Option Price: amount the buyer pays to acquire the option.– Covered Option: seller already has possession of asset– Naked (uncovered) Option: does not have possession of asset.

Speculative.

5.4 Derivatives

4

• Call Options– Right to purchase the underlying asset at a fixed price.– Price > Exercise Price, in the money.– Price < Exercise Price, out of the money.– Price = Exercise Price, at the money– Buyer has a long position and the seller has a short

position.– Buyer’s Gain/Loss = – Seller’s Gain/Loss = – Examples p.186 (d & e)– Graph p.187 (f)

5.4 Derivatives

5

• Call Options

5.4 Derivatives

6

• Call Options

5.4 Derivatives

7

• Put Options– Right to sell the underlying asset at a fixed price.– Price < Exercise Price, in the money.– Price > Exercise Price, out of the money.– Price = Exercise Price, at the money– Holder has a short position and the seller has a long

position.– Buyer’s Gain/Loss = – Seller’s Gain/Loss = – Examples p.187-188 (d & e)– Graph p.188 (f)

5.4 Derivatives

8

• Put Options

5.4 Derivatives

9

• Put Options

5.4 Derivatives

10

• Put Call Parity– Depicts the combinations of investment

strategies that can be devised using Euro options.

– Restated to provide a risk-free return:

5.4 Derivatives

11

• Valuing an Option• Black Scholes• Binomial

– Exercise Price• xP increase causes decrease in value of call and increase in value of

put.

– Price of Underlying Asset• Price increase causes call value to increase

– Interest Rates• Rise in interest rates results in rise in value of call

– Time until Expiration• Increase in time causes options value to increase

– Table on p.189

5.4 Derivatives

12

• Forward Contracts– Two parties agree that, at a future date, one

will perform and the other will pay a specified amount.

– Retailer / Wholesaler example– Buyer has taken a long position while the

seller has taken a short position.– Both parties are contractually obligated to

perform

5.4 Derivatives

13

• Futures Contracts– Trading of commodities– Commitment to buy or sell an asset at a fixed price

during a specific future month.• Counterparty unknown

– Delivery during a given month, no exact date. Flexibility

– Active trading results in a liquid market where participants can net out their positions. Hedging

– Contract prices are marked to market everyday. Daily settlement.

5.4 Derivatives

14

• Swaps– Contracts by which the parties exchange cash

flows.– Interest Rate Swaps: agreements to exchange

interest payments based on one interest structure for payments based on another structure.

– Currency Swaps: agreements to exchange cash flows denominated in one currency for cash flows denominated in another.

– Credit Default Swaps

5.4 Derivatives

15

SU 5.4 – Practice Question 1

A. A short hedge.B. A long hedge.C. Selling futures to protect the company from

loss.D. Selling futures to protect against price

declines.

An automobile company that uses the futures market to set the price of steel to protect a profit against price increases is an example of

16

SU 5.4 – Practice Question 1 Answer

Correct Answer: B

A change in prices can be minimized or avoided by hedging. Hedging is the process of using offsetting commitments to minimize or avoid the impact of adverse price movements. The automobile company desires to stabilize the price of steel so that its cost to the company will not rise and cut into profits. Accordingly, the automobile company uses the futures market to create a long hedge, which is a futures contract that is purchased to protect against price increases.

17

SU 5.4 – Practice Question 2

A. Increased risk regardless of motive.

B. Decreased risk regardless of motive.

C. Offsetting risk when hedging and increased risk when speculating.

D. Offsetting risk when speculating and increased risk when hedging.

The use of derivatives to either hedge or speculate results in

18

SU 5.4 – Practice Question 2 Answer

Correct Answer: C

Derivatives, including options and futures, are contracts between the parties who contract. Unlike stocks and bonds, they are not claims on business assets. A futures contract is entered into as either a speculation or a hedge. Speculation involves the assumption of risk in the hope of gaining from price movements. Hedging is the process of using offsetting commitments to minimize or avoid the impact of adverse price movements.

19

SU 5.4 – Practice Question 3

A. On a specific future date at a price to be determined some time in the future.

B. At some time during the current day at its present price.

C. On a specific future date at a price determined today.

D. Only when its price increases above its current exercise price.

A forward contract involves a commitment today to purchase a product

20

SU 5.4 – Practice Question 1 Answer

Correct Answer: C

A forward contract is an executory contract in which the parties involved agree to the terms of a purchase and a sale, but performance is deferred. Accordingly, a forward contract involves a commitment today to purchase a product on a specific future date at a price determined today.