Investments Exam 3

Book Value

the net worth of common equity according to a firm’s balance sheet

liquidation value

net amount realized by selling assets of firm and paying off debt. Floor.

replacement cost

cost to replace firm’s asset. Ceiling.

tobin’s q

ratio of firm’s market value to replacement cost.

intrinsic value of a firm

the present value of cash flows its owner will receive.  

market capitalization rate

consensus value of the required rate of return.

dividend discount model

a formula stating that the intrinsic value of a firm equals the present value of all expected future dividends

constant growth DDM

a form of the dividend discount model that assumes dividends grow at a constant rate. Stocks price increases at the same rate as its dividends leads to a breakdown of expected returns.

dividend payout ratio

fraction of earnings paid out as dividends

plowback ratio

the proportion of the firm’s earnings that is reinvested in the business.

sustainable growth rate

growth rate of earnings and dividends if the firm reinvests a constant fraction of earnings and maintains both a constant return on equity and constant debt ratio.

present value of growth opportunities

net present value of a firm’s future investments

two stage DDM

dividend discount model in which dividend growth is assumed to level off to a steady sustainable rate only at some future date.

Price earnings multiple

the ratio of a stock’s price to its earnings per share.

PEG ratio

ratio of P/E multiple to earnings growth rate. Should be close to 1

Earnings management

the practice of using flexibility in accounting rules to manipulate the apparent profitability of the firm.

What does the P/E ratio reflect

the market assessment of the firm’s growth opportunities

What is the P/E ratio of a firm that has no growth opportunities

the reciprocal of the capitalization rate

Book value is based on

historical cost of assets and liabilities not current values

Why are P/E ratios unreliable sometimes?

They are depressed during inflationary periods.

call option

the right to buy an asset at a specified exercise price on or before a specified expiration date. Unlimited risk.

strike price

price set for calling (buying) an asset or putting (selling) an asset.

premium

purchase price of an option, compensation the call buyers pay for the ability to exercise only when it is in their interest to do so.

put option

the right to sell an asset at a specified exercise price on or before a specified expiration date. Risk caps.

in the money

an option where exercise would generate a positive cash flow.

out of the money

an option that, if exercised, would produce a negative cash flow. Out of the money options are therefore never exercised.

at the money

exercise price and asset price are equal.

american option

can be exercised on or before its expiration. Generally more valuable.

european option

can be exercised only at expiration.

protective put strategy

an asset combined with a put option that guarantees minimum proceeds equal to the put’s exercise price.

risk management

strategies to limit risk in a portfolio.

covered call

writing a call on an asset together with buying the asset.

straddle

a combination of a call and a put, each with the same exercise price and expiration date. Profitabile in periods of high volatility.

spread

the combination of two or more call options on the same asset with differing exercise prices or times to expiration.

spreads allow investors to

take advantage of perceived mispricing and establish a position in the stock with smaller initial investments.

collar

A collar financing strategy involves holding an underlying asset (usually stock) while simultaneously buying a protective put option and selling a covered call option to protect against downside risk while capping upside potential. 

warrants

an option issued by the firm to purchase shares of the firm’s stock.

calls are worth more when

the exercise price is lower

puts are worth more when

the exercise price is higher

both calls and puts are worth more when

the time until expiration is longer

index options

allows an investor to bet on the movement of an index, to be settled in cash instead of all the stocks the index tracks.

futures options

allows an investor to bet on the price of a futures contract, allowing for settlement in cash.

interest rate options

based on the prices of debt securities or specific interest rates themselves

bullish strategies

provide profits when stock prices rise. Purchasing calls.

bearish strategies

provide profits when stock prices fall.  Purchasing puts.

protective puts

puts purchased on an underlying asset owned by the investor. Insures the investor against the stock falling below the put’s strike price.

covered calls

calls written on an underlying asset owned by the investor. Provides immediate income to the investor (call premium) while giving them the ability to respond to an exercise without having to pay current market prices.

callable bonds

bonds that the issuer can call back prior to maturity for a premium above par value.

collateralized loans

act as puts purchased by the borrower with the collateral as the underlying asset and the outstanding loan value at the exercise price. If the collateral’s value falls between the amount to be repaid the borrower can exercise the put by defaulting on the loan.

asian options

provide a payoff based on the average price of the underlying asset during a time frame instead of the price at exercise or expiration. Useful hedges against assets that are bought or sold with some regularity.

digital options

provide a payoff if the call or put is in the money as opposed to being based on the gap between the asset and exercise price.

foreign exchange options

use currencies as the underlying asset with the exchange rate as the exercise price.

Time Value

The difference between an option’s price and its intrinsic value. It represents the potential payoff to fluctuate due to price volatility of the underlying asset.

Determinants of call options

• stock price

• exercise price

• volatility

• time to expiration

• interest rate

• dividend payouts

binomial model

an option valuation model predicated on the assumption that stock prices can move to only two values over any short time period.

Black Scholes Pricing Formula

a formula to value an option that uses the stock price, risk free interest rate, time to expiration, and the standard deviation of the stock return.

implied volatility

the standard deviation of stock returns that is consistent with an option’s market value

Put to call parity relationship

an equation representing the proper relationship between put and call prices. Allows us to price a put option by knowing the price of its associated call option

hedge ratio

the number of shares of stock required to hedge the price risk of holding one option

delta

the number of shares of stock required to hedge the price risk of holding one option

option elasticity

the percent change in option price per percent change in stock price.

portfolio insurance

portfolio strategies that limit investment losses while maintaining upside potential

dynamic hedging

the constant updating of hedge positions as market conditions change

What is the maximum loss an option holder has

options holders cannot lose more than the cost of the option regardless of stock price performance

call options are more valuable when

exercise price is lower, stock price is higher, interest rate is higher, time to expiration is higher, and dividends are lower

portfolio insurance can be obtained by

purchasing a protective put option on an equity position

what is the intrinsic value of an option that is out of the money?

Options that are out of the money or at the money have no intrinsic value because they would not be exercised.

VIX

an index that estimates the implied volatility of the market using the S&P 500 and options on that index. Exist for investors who wish to trade on market risk.