198-245 Derivative Pricing, Corporate Finance, and Financial Statement Analysis

Vocabulary-style flashcards covering derivatives (Greeks, BSM, Swaps), Corporate Finance (WACC, Leverage, Capital Budgeting, Liquidity), and Financial Statement Analysis (Accrual Accounting, Inventory Methods).

Hedge ratio (delta)

Calculated as $\frac{c^{+} - c^{-}}{S^{+} - S^{-}}$; it represents the shares per option for a risk-free portfolio and is negative for puts.

Delta

The first-order sensitivity of an option's price to the underlying asset's price; it serves as the hedge ratio.

Gamma

The second-order rate of change of delta, measuring the curvature or secondary effect of an option's value.

Vega

The sensitivity of an option's value to volatility; an increase in volatility raises both call and put values.

Theta

The sensitivity of an option's value to time decay, where options lose value as the expiry date approaches.

Black-Scholes-Merton (BSM)

A continuous-time option pricing formula using $N(d_1)$ and $N(d_2)$. For L1, focus on conceptual value drivers rather than calculations.

Six option value drivers

Underlying price ($S$), exercise price ($X$), time, volatility, risk-free rate, and income. Higher volatility helps both calls and puts; high underlying helps calls and hurts puts.

Swap

An agreement to exchange cash flows (e.g., fixed for floating) with a value of $0$ at initiation, effectively acting as a series of forwards.

Off-market contract

A swap or forward priced away from fair value, requiring one party to pay upfront; standard swaps are "at-market" with zero value at start.

No-arbitrage principle

The foundation for all derivative pricing stating that identical payoffs must have identical prices and a riskless portfolio earns the risk-free rate.

Sole proprietorship

A business with one owner who has unlimited liability and uses pass-through taxation.

Partnership

A business with two or more owners where general partners have unlimited liability and taxation is pass-through (not at the entity level).

Limited partnership

A business structure with at least one general partner (unlimited liability) and limited partners whose liability is capped at their investment.

Corporation (limited company)

A separate legal entity offering limited liability, but subject to double taxation (at the firm level and then at the dividend level).

Limited liability

The principle where owners can only lose their initial investment, protecting their personal assets.

WACC

Weighted-average cost of capital, calculated as $w_d \times r_d(1-t) + w_p \times r_p + w_e \times r_e$. It is the discount rate for firm-level cash flows.

Cost of debt

The after-tax yield on borrowing, expressed as $r_d(1-t)$, which is cheaper than equity due to the tax shield.

Cost of preferred

Calculated as preferred dividend / preferred price, with no tax adjustment.

Cost of equity

The required return on equity, often calculated via CAPM; it is the highest cost of capital because equity is the riskiest.

Tax shield

The tax saving from deductible interest that lowers the effective cost of debt.

Business risk (operating risk)

The variability of operating income arising from the nature of the business operations.

Degree of operating leverage (DOL)

The ratio of $\%\text{change in EBIT}$ to $\%\text{change in sales}$; high fixed operating costs cause EBIT to swing more than sales.

Degree of financial leverage (DFL)

The ratio of $\%\text{change in net income}$ to $\%\text{change in EBIT}$; high interest/fixed financing causes net income to swing more than EBIT.

Degree of total leverage (DTL)

The product of DOL and DFL ($\text{DOL} \times \text{DFL}$), representing the full magnification from sales to net income.

Capital budgeting

The process of deciding which long-term projects to fund, with the goal of accepting positive-NPV projects.

NPV

Net Present Value; the present value of cash inflows minus outflows. A value $> 0$ indicates value added and the project should be accepted.

IRR

Internal Rate of Return; the discount rate at which NPV equals $0$. Accept the project if IRR is greater than the required return.

Going-concern (maintenance) project

Capital expenditure required to sustain current operations, such as replacing worn assets; usually low risk.

Regulatory/compliance project

Capital expenditure required by law, often mandatory without providing a direct financial return.

Expansion / new-line project

Investing in growth or new technology to potential generate new revenue; carries higher risk.

Working capital

Calculated as current assets minus current liabilities; represents short-term operating liquidity.

Cash conversion cycle (CCC)

The number of days cash is tied up, calculated as $\text{DOH} + \text{DSO} - \text{DPO}$. Shorter or negative values are more efficient.

Drag on liquidity

A reduction in available cash caused by lagging receipts, such as uncollected receivables or obsolete inventory.

Pull on liquidity

A premature drain on cash caused by disbursements happening too fast, such as paying early or reduced credit lines.

Capital structure

The specific mix of debt and equity financing used by a firm.

Modigliani-Miller (MM)

The theory that capital structure does not affect firm value in perfect markets without taxes/costs, assuming homemade leverage.

Stakeholders

Entities with an interest in the firm, including shareholders, managers, the board, creditors, employees, and the government.

Agency (principal-agent) problem

A conflict of interest where managers' interests diverge from shareholders, potentially leading to excessive risk-taking.

Corporate governance

A system of controls to balance stakeholder interests; strong governance is linked to better performance and lower cost of debt.

Accrual accounting

An accounting method where revenue and expenses are recorded when earned or incurred rather than when cash moves.

Unearned (deferred) revenue

Cash received before delivery of goods/services; it creates a liability and an asset (cash) but no revenue initially.

Retained earnings

The cumulative profits kept by a firm, calculated as: $\text{Beginning RE} + \text{net income} - \text{dividends}$.

FIFO

First-in-first-out inventory method. In rising prices, it results in lower COGS, higher profit, and higher inventory value.

LIFO

Last-in-first-out inventory method (US GAAP only). In rising prices, it results in higher COGS, lower profit, and lower taxes.

LIFO reserve

The difference between FIFO inventory and LIFO inventory; used to convert LIFO financial statements to FIFO.

Weighted average cost

An inventory valuation method that uses the average cost, resulting in values between FIFO and LIFO.

Net realizable value (NRV)

The estimated selling price minus costs to complete or sell; used for inventory write-downs under IFRS.

Inventory write-down

The process of reducing inventory value to its NRV, which negatively impacts profit, liquidity, and solvency.