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Investment - Introduction to Derivatives Contracts
When you plan a vacation, you do not normally wait until you reach to your chosen destination to book a lodging. Booking a hotel room in advance provides certainty that a room will be available and locks in the price. Your action minimizes uncertainty (risk) for you. It also lowers uncertainty for the hotel.
Now, pretend that you are a wheat farmer and wish to reduce some of the risk of farming. You might presell some of your crop at a fixed price. In fact, contracts to lessen the unpredictability of agricultural products have been dated back to the 16th century. These contracts on agricultural products may be the oldest form of what are known as derivatives contracts or, simply, derivatives.
Derivatives are contracts that draw their value from the performance of an underlying asset, event, or outcome – hence their name. Since the invention of derivatives contracts to assist minimize risk for farmers, the purposes and varieties of derivatives contracts, and the size of the derivatives market, have risen dramatically. Derivatives are no longer just about lowering risk, but constitute part of the investment plans of many fund managers.
When you plan a vacation, you do not normally wait until you reach to your chosen destination to book a lodging. Booking a hotel room in advance provides certainty that a room will be available and locks in the price. Your action minimizes uncertainty (risk) for you. It also lowers uncertainty for the hotel.
Now, pretend that you are a wheat farmer and wish to reduce some of the risk of farming. You might presell some of your crop at a fixed price. In fact, contracts to lessen the unpredictability of agricultural products have been dated back to the 16th century. These contracts on agricultural products may be the oldest form of what are known as derivatives contracts or, simply, derivatives.
Derivatives are contracts that draw their value from the performance of an underlying asset, event, or outcome – hence their name. Since the invention of derivatives contracts to assist minimize risk for farmers, the purposes and varieties of derivatives contracts, and the size of the derivatives market, have risen dramatically. Derivatives are no longer just about lowering risk, but constitute part of the investment plans of many fund managers.
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Investment - Comparing Equity and Debt Securities
There are considerable risk and return disparities between debt and equity instruments due of differences in cash flows, voting rights, and priority of claims.
Risk
Debt securities are the least dangerous because debt capital is borrowed money and represents a contractual liability of the corporation. Thus, debt investors have a larger claim on the company’s assets than stock investors. Investing in debt securities is also less risky than investing in equity securities since the predicted cash flows of fixed-rate and zero-coupon bonds are known in advance and are fairly reasonable to forecast in the case of floating-rate bonds.
Priority of Claims
After the claims of debt investors have been satisfied, preferred stock holders are next in line to get what they are due. Preferred stock is less riskier than common stock since it ranks higher than common stock when it comes to the payment of dividends. The risk of preferred shares is also lessened to some degree by the prospect of a dividend each year. Although the dividend is not a contractual obligation, firms are often reluctant to miss dividends on preferred shares.
Common shareholders are last in line and are known as the residual claimants of a firm. Common shareholders divide the leftover assets proportionately once all other claims have been fulfilled. If finances are insufficient to pay out all claims, equity owners will likely receive only a part of their investment back, or may potentially lose their entire investment. Accordingly, investment in equity securities is riskier than investing in corporate debt instruments. Common stock is regarded the riskiest of the three since it ranks last in the seniority hierarchy when it comes to the payment of dividends and distribution of net assets if the firm is liquidated.
Equity investors are, however, protected by limited liability, which means that higher claimants, particularly debt investors, cannot recover money from other assets belonging to the shareholders if the company’s assets are insufficient to fully cover their claims (except in cases of fraud and wilful negligence). Because a corporation is a legal entity apart from its owners, it is accountable, at the corporate level, for all company liabilities. By legally isolating the shareholders from the corporation, an individual shareholder’s responsibility is restricted to the amount he or she invested. So, stockholders cannot lose more money than they have invested in the company.
Return Potential
The return potential for both debt securities and preferred stock is limited because the cash flows (interest, dividends, and repayment of par value) do not increase if the company does well. The return potential to common shareholders is bigger since the share price rises if the company performs successfully. Relative to holders of debt securities and preferred stock, common stockholders expect a better return, but must tolerate greater risk. The voting rights of common shareholders may offer them some influence over the company’s business decisions and so somewhat lessen risk.
Given the fact that equity securities are riskier than debt securities, shareholders anticipate to receive higher returns on equity securities over the long term. Because equity is riskier than debt, risk-averse investors may choose debt assets to equity instruments. However, although debt securities are safer than equity securities for a particular organization, debt securities are not risk-free; they are vulnerable to several risk factors, as stated above.
Equity returns over the period are higher than government bond returns within every country. The real equity return was positive in every site, often at a level of 3% to 6% per year. The statistics are broadly consistent with the idea that riskier equities instruments should provide higher returns over the long run than lower risk debt securities.
There are considerable risk and return disparities between debt and equity instruments due of differences in cash flows, voting rights, and priority of claims.
Risk
Debt securities are the least dangerous because debt capital is borrowed money and represents a contractual liability of the corporation. Thus, debt investors have a larger claim on the company’s assets than stock investors. Investing in debt securities is also less risky than investing in equity securities since the predicted cash flows of fixed-rate and zero-coupon bonds are known in advance and are fairly reasonable to forecast in the case of floating-rate bonds.
Priority of Claims
After the claims of debt investors have been satisfied, preferred stock holders are next in line to get what they are due. Preferred stock is less riskier than common stock since it ranks higher than common stock when it comes to the payment of dividends. The risk of preferred shares is also lessened to some degree by the prospect of a dividend each year. Although the dividend is not a contractual obligation, firms are often reluctant to miss dividends on preferred shares.
Common shareholders are last in line and are known as the residual claimants of a firm. Common shareholders divide the leftover assets proportionately once all other claims have been fulfilled. If finances are insufficient to pay out all claims, equity owners will likely receive only a part of their investment back, or may potentially lose their entire investment. Accordingly, investment in equity securities is riskier than investing in corporate debt instruments. Common stock is regarded the riskiest of the three since it ranks last in the seniority hierarchy when it comes to the payment of dividends and distribution of net assets if the firm is liquidated.
Equity investors are, however, protected by limited liability, which means that higher claimants, particularly debt investors, cannot recover money from other assets belonging to the shareholders if the company’s assets are insufficient to fully cover their claims (except in cases of fraud and wilful negligence). Because a corporation is a legal entity apart from its owners, it is accountable, at the corporate level, for all company liabilities. By legally isolating the shareholders from the corporation, an individual shareholder’s responsibility is restricted to the amount he or she invested. So, stockholders cannot lose more money than they have invested in the company.
Return Potential
The return potential for both debt securities and preferred stock is limited because the cash flows (interest, dividends, and repayment of par value) do not increase if the company does well. The return potential to common shareholders is bigger since the share price rises if the company performs successfully. Relative to holders of debt securities and preferred stock, common stockholders expect a better return, but must tolerate greater risk. The voting rights of common shareholders may offer them some influence over the company’s business decisions and so somewhat lessen risk.
Given the fact that equity securities are riskier than debt securities, shareholders anticipate to receive higher returns on equity securities over the long term. Because equity is riskier than debt, risk-averse investors may choose debt assets to equity instruments. However, although debt securities are safer than equity securities for a particular organization, debt securities are not risk-free; they are vulnerable to several risk factors, as stated above.
Equity returns over the period are higher than government bond returns within every country. The real equity return was positive in every site, often at a level of 3% to 6% per year. The statistics are broadly consistent with the idea that riskier equities instruments should provide higher returns over the long run than lower risk debt securities.
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Investment - Forwards and Futures
Forwards and futures involve duties in the future on the part of both parties to the contract. Forward and futures contracts are frequently termed forward commitments or bilateral contracts because both parties have an obligation in the future. Bilateral contracts subject each party to the risk that the other side will not fulfil the contractual commitment.
Forwards
A forward contract is an agreement between two parties in which one party commits to acquire from the seller an underlying at a later period (i.e., expiration date) for a price agreed at the start of the contract. The future date can be in one month, in one year, in five years, or at any other given date. Investors generally utilize forward contracts to lock in the price of an underlying and to acquire clarity about future financial outcomes. The following example continues the story of the farmer and describes a forward contract between the farmer and a cereal producer.
Example: Forward Contract Between Farmer and Cereal Producer
The contract between the farmer and cereal producer for 50,000 bushels of wheat delivered in mid-September, began in March, at USD8.50 per bushel, is a forward contract.
The underlying is wheat.
The size is 50,000 bushels.
The exercise price is USD8.50 per bushel.
The expiration date is mid-September.
Settlement will be through physical delivery.
In September, the farmer will deliver the wheat to the cereal producer and receive USD8.50 per bushel.
By engaging into the advance contract, the farmer knows the wheat will sell and has eliminated ambiguity about how much money will be received for the wheat. The cereal producer knows that wheat will be available and has reduced ambiguity about how much the wheat will cost.
Forward contracts trade in the over-the-counter market. That is, the agreement is established directly between two persons, a buyer and a seller, although a dealer may help arrange the arrangement. Recall from Course 2, Types and Functioning of Markets, the risk that the other party to the contract will not fulfil their contractual commitments is termed counterparty risk. To limit counterparty risk, the parties to a forward contract examine the default risk of the other party before entering into a contract. If the risk of default is considerable, the parties may not agree to a forward contract.
Or one or both parties may request a performance bond. A performance bond is a guarantee, usually offered by a third party, such as an insurance company, to secure payment in case a party fails to fulfil their contractual duties (defaults). As an alternative to a performance bond, collateral may be sought. Collateral, as we learnt in Course 2, Types and Functioning of Markets, refers to pledged assets. That is, if one party cannot satisfy their contractual commitments, the other party can keep the collateral as compensation.
No payment on the forward contract is required by either side prior to delivery. At expiration, forward contracts normally settle with physical delivery. At settlement, one party will lose, while the other party will gain compared to the spot price at the expiration date – this potential future exposure also serves to heighten counterparty risk. The next example uses the forward contract between the farmer and the grain producer to illustrate how one party’s gains on a forward contract are the other party’s losses.
But if upon expiration of the forward contract, the price in the market for wheat is USD9.00 per bushel, the farmer loses USD0.50 per bushel relative to the spot price. under other words, the farmer might have sold the wheat for USD9.00 per bushel rather than the USD8.50 per bushel agreed on under the forward contract.
The grain producer gains USD0.50 per bushel relative to the spot price since the producer only pays USD8.50 per bushel rather than the USD9.00 current price.
Given the prospect of losing money relative to the future spot price, why do the farmer and grain producer enter into the forward contract? Because everyone is more worried about eliminating the uncertainty associated to the sale price and buy price of wheat in six months, which is valuable in making investment and production decisions. This assurance is more essential to them than winning or losing relative to the future spot price.
Futures
What if the farmer could not identify a party that wanted to be on the opposite side of the contract? Future markets may give the solution.
A futures contract is similar to a forward contract in that it is an agreement that obligates the seller, at a given future date, to deliver to the buyer a specified underlying in return for the set futures price.
The buyer of the contract is bound to take delivery of the underlying, and the seller of the contract is obligated to deliver the underlying, but settlement is often in cash.
The fundamental difference is that futures contracts are standardised contracts that trade on exchanges. The buyers and sellers do not necessarily know who is on the other side of the deal.
Because the contracts are exchanged on exchanges, they are liquid, and it is easy for a buyer or seller to close out a position by taking the opposing side. In other words, the buyer of a contract can subsequently sell the same contract, and likewise the seller of a contract can later buy the same contract.
Counterparty Risk
The inclusion of an exchange as an intermediary between buyers and sellers helps reduce counterparty risk. Counterparty risk cannot be reduced fully, however, because there is always a remote potential that the exchange fails to perform its own contractual commitments. To protect itself against one of the parties failing, the exchange often demands the parties to the contract deposit funds as collateral. The depositing of monies as collateral is called posting margin.
The amount placed on the day that the transaction occurs is called the starting margin. The initial margin should be sufficient to safeguard the exchange from movements in the underlying’s price. The exchange sets the margin amount dependent on the underlying’s price volatility – the greater the underlying’s price volatility, the higher the margin.
Another technique of lowering the counterparty risk for futures contracts is by marking to market daily. Marking to market means that profits or losses on futures contracts are paid at the end of every business day, which has the effect of resetting the contract price and cash flows to buyers and sellers. At the end of each day, the exchange establishes a settlement price based on the closing deals and determines the difference between the current settlement price and the previous day’s settlement price.
The buyer’s and seller’s margin accounts are then modified to reflect the change in settlement price and whether it was to their advantage (a gain) or disadvantage (a loss). Marking to market continues until the contract expires.
If at any moment the balance in an account falls below a pre-specified amount, the exchange will require the user to send additional funds. If the customer does not do so, the futures trade is closed. Daily marking to market decreases counterparty risk and administrative overhead for the exchange and provides the following:
Enhanced trading
Increased liquidity
Reduced transaction costs on futures contracts
Standardised Futures Contracts
Standardised terms of futures contracts comprise the underlying; size, price, and expiration date of the contract; and settlement.
A variety of different standardised contracts may trade for an underlying on an exchange, although standardizing of futures contracts limits the number of contract types accessible for the same underlying. Typically, each of the contracts is the same with respect not only to the underlying, but also to the size and settlement. Exercise price and expiration date may vary among contracts.
Futures often expire every quarter, usually on the third Wednesday of March, June, September, and December in the United States. In addition, various end-of-month futures are available. Standardised contracts may exist that simply differ on the set exercise price. A futures contract’s net initial value to each party should be zero; cash may be paid by one of the parties to enter into the contract, depending on how the exercise price compares with the current settlement price.
The following example depicts futures contracts on wheat together with activities of and cash flows for the farmer and grain producer. The cash flows include those in the marking-to-market procedure. For simplicity, the price of wheat changes only twice over the term of the contract and upon expiration. In practice, the price is likely to change daily, with resultant changes to the margin accounts of the farmer and cereal producer.
Example: Futures Contracts on Wheat
Futures contracts trade on a variety of exchanges globally, including the Chicago Mercantile Exchange (CME).
The normal terms of a futures contract on wheat on the CME include the following:
Underlying: #2 Soft Red Winter wheat at contract price; #1 Soft Red Winter wheat with a 3-cent premium; or other deliverable grades
Size: 5,000 bushels (about 136 metric tons)
Settlement: monetary settlement
Pricing unit: cents in USD per unit
Expiration: March (H), May (K), July (N), September (U), and December (Z)
Example: Farmer Sells Futures at an Agreed Price of 850 cents/Bushel
The farmer and the grain producer locate contracts that expire in September with exercise values ranging from 550.0 cents to 1,100.0 cents. The farmer decides to sell 10 contracts with an exercise price of 850.0 cents. This signifies the farmer has a contract for the delivery of 50,000 bushels of wheat or their cash settlement equivalent. The cereal manufacturer decides to buy 10 contracts with an exercise price of 850.0 cents.
The farmer and the cereal producer do not trade directly with each other, but through an exchange. The current spot price of wheat is 900.0 cents per bushel. Because a contract’s net initial value to each party should be zero, the farmer has to send the exchange 50.0 cents per bushel and the exchange puts 50.0 cents into the cereal producer’s account. The effective receipt to the farmer and cost to the grain producer is 850.0 cents per bushel if the contract expires today. In addition, each is obliged to deposit an additional amount as collateral with the exchange to protect the exchange, which takes on the counterparty risk to the contract.
The price of wheat remains stable for two months and then changes to 875.0 cents per bushel, a fall of 25.0 cents from the initial spot price of 900.0 cents. The farmer’s margin account is increased by 25.0 cents per bushel while the grain producer’s margin account is reduced by 25.0 cents per bushel. After another two months, the price increases to 925.0 cents per bushel, an increase of 50.0 cents over the previous spot price of 875.0 cents. So, the farmer’s account is reduced by 50.0 cents per bushel and the cereal producer’s account is enhanced by 50.0 cents per bushel.
At expiration, the price is 910.0 cents per bushel, a decrease in price of 15.0 cents from the previous spot price of 925.0 cents. The farmer’s account is increased by 15.0 cents per bushel while the cereal producer’s account is reduced by 15.0 cents per bushel. The farmer has paid over time by paying in net 60 cents (= −50.0 + 25.0 – 50.0 + 15.0). The cereal producer has gotten over time net 60 cents. Each will receive back the excess cash deposited to protect the exchange.
The farmer and the cereal producer are each in the same situation as they would have been under the forward contract. The farmer can sell the wheat in the spot market for 910.0 cents per bushel and pay 60 cents per bushel to settle the futures contract. The farmer has a net receipt of 850.0 cents per bushel. Similarly, the grain producer can buy the wheat in the spot market for 910.0 cents per bushel and receive 60 cents per bushel to fulfill the futures contract. So, the cereal producer has a net cost of 850.0 cents per bushel.
Distinctions between Forwards and Futures
Forwards and futures differ in how they trade, the flexibility of important elements in the contract, liquidity, counterparty risk, transaction costs, timing of cash flows, and settlement. The following table provides more data regarding how forwards and futures differ.
Forwards Futures
Trading and Flexibility of Terms
Forward contracts transact in the over-the-counter market and terms are modified according to the contracting parties’ needs.
Futures contracts trade on exchanges. Each exchange normally establishes the terms of the contracts that trade on it. Futures contracts are standardised independent of buyers’ and sellers’ individual needs. As a result, the expiration date or contract size may not match that desired by the buyer or seller of the futures contract.
Liquidity
Forward contracts trade in the over-the-counter market and are illiquid.
Futures contracts are relatively liquid; they trade on exchanges and can be purchased and sold at times other than initiation. An investor can close out (cancel) a trade utilizing futures contracts quite quickly.
Counterparty Risk
Counterparty risk is potentially quite high in forward contracts. That is, the danger that one party may be unwilling or unable to meet their contractual responsibilities.
Futures contracts have lesser counterparty risk. The inclusion of an exchange or a clearing house as the intermediary for all buyers and all sellers helps reduce counterparty risk. Counterparty risk cannot be reduced fully, however, because there is always a remote potential that the exchange fails to perform its own contractual commitments. Daily marking to market considerably decreases counterparty risk for futures contracts compared with advance contracts.
Transaction Costs
There can be significant expenditures to arrange a forward contract. Transaction fees normally are contained in forward contracts and are not clearly accessible to the customer.
Futures contracts are exchanged on exchanges through brokerage firms or brokers (agents licensed to trade directly with the exchange), and the transaction expenses are visible. So, there is more transparency in the futures markets. A broker often earns the difference between the bid and ask prices as a commission to arrange the trade. Because futures contracts are standardised, transaction costs are relatively cheap.
Timing of Cash Flows
Forward contracts have no cash flows except at maturity. It is vital to remember that if forward and futures contracts with equal terms are held to maturity, the end outcome is the same. For a forward contract, the complete effect of shifting prices is taken into account at maturity.
Futures contracts are marked to market daily. It is vital to remember that if forward and futures contracts with equal terms are held to maturity, the end outcome is the same. For a futures contract, the effect of changing prices is taken into account on an ongoing (daily) basis.
Settlement
Forward contracts may settle with physical delivery or monetary payment.
Futures contracts are often settled with cash.
Comparison between Forward and Futures Contracts
SIMILARITIES
Both types of contracts exist on a wide range of underlying assets, including stocks, bonds, agricultural products, and precious and industrial metals.
For both sorts of contracts, both the buyer and seller have obligations.
Both forms of contracts allow locking in a price now for a transaction that will occur in the future.
DIFFERENCES
Forwards are bespoke contracts that trade in private over-the-counter marketplaces, whereas futures are standardised contracts that trade on exchanges.
Counterparty risk is substantial with forward contracts, but restricted with futures contracts. Requirements enforced by exchanges, such as initial and maintenance margins and daily marking to market, lower the counterparty risk associated with futures contracts.
It is easier to exit a position before to the settlement date with a futures contract than with a forward contract. A position in a futures contract can be settled (closed) by taking an opposite position in the same contract.
Forwards and futures involve duties in the future on the part of both parties to the contract. Forward and futures contracts are frequently termed forward commitments or bilateral contracts because both parties have an obligation in the future. Bilateral contracts subject each party to the risk that the other side will not fulfil the contractual commitment.
Forwards
A forward contract is an agreement between two parties in which one party commits to acquire from the seller an underlying at a later period (i.e., expiration date) for a price agreed at the start of the contract. The future date can be in one month, in one year, in five years, or at any other given date. Investors generally utilize forward contracts to lock in the price of an underlying and to acquire clarity about future financial outcomes. The following example continues the story of the farmer and describes a forward contract between the farmer and a cereal producer.
Example: Forward Contract Between Farmer and Cereal Producer
The contract between the farmer and cereal producer for 50,000 bushels of wheat delivered in mid-September, began in March, at USD8.50 per bushel, is a forward contract.
The underlying is wheat.
The size is 50,000 bushels.
The exercise price is USD8.50 per bushel.
The expiration date is mid-September.
Settlement will be through physical delivery.
In September, the farmer will deliver the wheat to the cereal producer and receive USD8.50 per bushel.
By engaging into the advance contract, the farmer knows the wheat will sell and has eliminated ambiguity about how much money will be received for the wheat. The cereal producer knows that wheat will be available and has reduced ambiguity about how much the wheat will cost.
Forward contracts trade in the over-the-counter market. That is, the agreement is established directly between two persons, a buyer and a seller, although a dealer may help arrange the arrangement. Recall from Course 2, Types and Functioning of Markets, the risk that the other party to the contract will not fulfil their contractual commitments is termed counterparty risk. To limit counterparty risk, the parties to a forward contract examine the default risk of the other party before entering into a contract. If the risk of default is considerable, the parties may not agree to a forward contract.
Or one or both parties may request a performance bond. A performance bond is a guarantee, usually offered by a third party, such as an insurance company, to secure payment in case a party fails to fulfil their contractual duties (defaults). As an alternative to a performance bond, collateral may be sought. Collateral, as we learnt in Course 2, Types and Functioning of Markets, refers to pledged assets. That is, if one party cannot satisfy their contractual commitments, the other party can keep the collateral as compensation.
No payment on the forward contract is required by either side prior to delivery. At expiration, forward contracts normally settle with physical delivery. At settlement, one party will lose, while the other party will gain compared to the spot price at the expiration date – this potential future exposure also serves to heighten counterparty risk. The next example uses the forward contract between the farmer and the grain producer to illustrate how one party’s gains on a forward contract are the other party’s losses.
But if upon expiration of the forward contract, the price in the market for wheat is USD9.00 per bushel, the farmer loses USD0.50 per bushel relative to the spot price. under other words, the farmer might have sold the wheat for USD9.00 per bushel rather than the USD8.50 per bushel agreed on under the forward contract.
The grain producer gains USD0.50 per bushel relative to the spot price since the producer only pays USD8.50 per bushel rather than the USD9.00 current price.
Given the prospect of losing money relative to the future spot price, why do the farmer and grain producer enter into the forward contract? Because everyone is more worried about eliminating the uncertainty associated to the sale price and buy price of wheat in six months, which is valuable in making investment and production decisions. This assurance is more essential to them than winning or losing relative to the future spot price.
Futures
What if the farmer could not identify a party that wanted to be on the opposite side of the contract? Future markets may give the solution.
A futures contract is similar to a forward contract in that it is an agreement that obligates the seller, at a given future date, to deliver to the buyer a specified underlying in return for the set futures price.
The buyer of the contract is bound to take delivery of the underlying, and the seller of the contract is obligated to deliver the underlying, but settlement is often in cash.
The fundamental difference is that futures contracts are standardised contracts that trade on exchanges. The buyers and sellers do not necessarily know who is on the other side of the deal.
Because the contracts are exchanged on exchanges, they are liquid, and it is easy for a buyer or seller to close out a position by taking the opposing side. In other words, the buyer of a contract can subsequently sell the same contract, and likewise the seller of a contract can later buy the same contract.
Counterparty Risk
The inclusion of an exchange as an intermediary between buyers and sellers helps reduce counterparty risk. Counterparty risk cannot be reduced fully, however, because there is always a remote potential that the exchange fails to perform its own contractual commitments. To protect itself against one of the parties failing, the exchange often demands the parties to the contract deposit funds as collateral. The depositing of monies as collateral is called posting margin.
The amount placed on the day that the transaction occurs is called the starting margin. The initial margin should be sufficient to safeguard the exchange from movements in the underlying’s price. The exchange sets the margin amount dependent on the underlying’s price volatility – the greater the underlying’s price volatility, the higher the margin.
Another technique of lowering the counterparty risk for futures contracts is by marking to market daily. Marking to market means that profits or losses on futures contracts are paid at the end of every business day, which has the effect of resetting the contract price and cash flows to buyers and sellers. At the end of each day, the exchange establishes a settlement price based on the closing deals and determines the difference between the current settlement price and the previous day’s settlement price.
The buyer’s and seller’s margin accounts are then modified to reflect the change in settlement price and whether it was to their advantage (a gain) or disadvantage (a loss). Marking to market continues until the contract expires.
If at any moment the balance in an account falls below a pre-specified amount, the exchange will require the user to send additional funds. If the customer does not do so, the futures trade is closed. Daily marking to market decreases counterparty risk and administrative overhead for the exchange and provides the following:
Enhanced trading
Increased liquidity
Reduced transaction costs on futures contracts
Standardised Futures Contracts
Standardised terms of futures contracts comprise the underlying; size, price, and expiration date of the contract; and settlement.
A variety of different standardised contracts may trade for an underlying on an exchange, although standardizing of futures contracts limits the number of contract types accessible for the same underlying. Typically, each of the contracts is the same with respect not only to the underlying, but also to the size and settlement. Exercise price and expiration date may vary among contracts.
Futures often expire every quarter, usually on the third Wednesday of March, June, September, and December in the United States. In addition, various end-of-month futures are available. Standardised contracts may exist that simply differ on the set exercise price. A futures contract’s net initial value to each party should be zero; cash may be paid by one of the parties to enter into the contract, depending on how the exercise price compares with the current settlement price.
The following example depicts futures contracts on wheat together with activities of and cash flows for the farmer and grain producer. The cash flows include those in the marking-to-market procedure. For simplicity, the price of wheat changes only twice over the term of the contract and upon expiration. In practice, the price is likely to change daily, with resultant changes to the margin accounts of the farmer and cereal producer.
Example: Futures Contracts on Wheat
Futures contracts trade on a variety of exchanges globally, including the Chicago Mercantile Exchange (CME).
The normal terms of a futures contract on wheat on the CME include the following:
Underlying: #2 Soft Red Winter wheat at contract price; #1 Soft Red Winter wheat with a 3-cent premium; or other deliverable grades
Size: 5,000 bushels (about 136 metric tons)
Settlement: monetary settlement
Pricing unit: cents in USD per unit
Expiration: March (H), May (K), July (N), September (U), and December (Z)
Example: Farmer Sells Futures at an Agreed Price of 850 cents/Bushel
The farmer and the grain producer locate contracts that expire in September with exercise values ranging from 550.0 cents to 1,100.0 cents. The farmer decides to sell 10 contracts with an exercise price of 850.0 cents. This signifies the farmer has a contract for the delivery of 50,000 bushels of wheat or their cash settlement equivalent. The cereal manufacturer decides to buy 10 contracts with an exercise price of 850.0 cents.
The farmer and the cereal producer do not trade directly with each other, but through an exchange. The current spot price of wheat is 900.0 cents per bushel. Because a contract’s net initial value to each party should be zero, the farmer has to send the exchange 50.0 cents per bushel and the exchange puts 50.0 cents into the cereal producer’s account. The effective receipt to the farmer and cost to the grain producer is 850.0 cents per bushel if the contract expires today. In addition, each is obliged to deposit an additional amount as collateral with the exchange to protect the exchange, which takes on the counterparty risk to the contract.
The price of wheat remains stable for two months and then changes to 875.0 cents per bushel, a fall of 25.0 cents from the initial spot price of 900.0 cents. The farmer’s margin account is increased by 25.0 cents per bushel while the grain producer’s margin account is reduced by 25.0 cents per bushel. After another two months, the price increases to 925.0 cents per bushel, an increase of 50.0 cents over the previous spot price of 875.0 cents. So, the farmer’s account is reduced by 50.0 cents per bushel and the cereal producer’s account is enhanced by 50.0 cents per bushel.
At expiration, the price is 910.0 cents per bushel, a decrease in price of 15.0 cents from the previous spot price of 925.0 cents. The farmer’s account is increased by 15.0 cents per bushel while the cereal producer’s account is reduced by 15.0 cents per bushel. The farmer has paid over time by paying in net 60 cents (= −50.0 + 25.0 – 50.0 + 15.0). The cereal producer has gotten over time net 60 cents. Each will receive back the excess cash deposited to protect the exchange.
The farmer and the cereal producer are each in the same situation as they would have been under the forward contract. The farmer can sell the wheat in the spot market for 910.0 cents per bushel and pay 60 cents per bushel to settle the futures contract. The farmer has a net receipt of 850.0 cents per bushel. Similarly, the grain producer can buy the wheat in the spot market for 910.0 cents per bushel and receive 60 cents per bushel to fulfill the futures contract. So, the cereal producer has a net cost of 850.0 cents per bushel.
Distinctions between Forwards and Futures
Forwards and futures differ in how they trade, the flexibility of important elements in the contract, liquidity, counterparty risk, transaction costs, timing of cash flows, and settlement. The following table provides more data regarding how forwards and futures differ.
Forwards Futures
Trading and Flexibility of Terms
Forward contracts transact in the over-the-counter market and terms are modified according to the contracting parties’ needs.
Futures contracts trade on exchanges. Each exchange normally establishes the terms of the contracts that trade on it. Futures contracts are standardised independent of buyers’ and sellers’ individual needs. As a result, the expiration date or contract size may not match that desired by the buyer or seller of the futures contract.
Liquidity
Forward contracts trade in the over-the-counter market and are illiquid.
Futures contracts are relatively liquid; they trade on exchanges and can be purchased and sold at times other than initiation. An investor can close out (cancel) a trade utilizing futures contracts quite quickly.
Counterparty Risk
Counterparty risk is potentially quite high in forward contracts. That is, the danger that one party may be unwilling or unable to meet their contractual responsibilities.
Futures contracts have lesser counterparty risk. The inclusion of an exchange or a clearing house as the intermediary for all buyers and all sellers helps reduce counterparty risk. Counterparty risk cannot be reduced fully, however, because there is always a remote potential that the exchange fails to perform its own contractual commitments. Daily marking to market considerably decreases counterparty risk for futures contracts compared with advance contracts.
Transaction Costs
There can be significant expenditures to arrange a forward contract. Transaction fees normally are contained in forward contracts and are not clearly accessible to the customer.
Futures contracts are exchanged on exchanges through brokerage firms or brokers (agents licensed to trade directly with the exchange), and the transaction expenses are visible. So, there is more transparency in the futures markets. A broker often earns the difference between the bid and ask prices as a commission to arrange the trade. Because futures contracts are standardised, transaction costs are relatively cheap.
Timing of Cash Flows
Forward contracts have no cash flows except at maturity. It is vital to remember that if forward and futures contracts with equal terms are held to maturity, the end outcome is the same. For a forward contract, the complete effect of shifting prices is taken into account at maturity.
Futures contracts are marked to market daily. It is vital to remember that if forward and futures contracts with equal terms are held to maturity, the end outcome is the same. For a futures contract, the effect of changing prices is taken into account on an ongoing (daily) basis.
Settlement
Forward contracts may settle with physical delivery or monetary payment.
Futures contracts are often settled with cash.
Comparison between Forward and Futures Contracts
SIMILARITIES
Both types of contracts exist on a wide range of underlying assets, including stocks, bonds, agricultural products, and precious and industrial metals.
For both sorts of contracts, both the buyer and seller have obligations.
Both forms of contracts allow locking in a price now for a transaction that will occur in the future.
DIFFERENCES
Forwards are bespoke contracts that trade in private over-the-counter marketplaces, whereas futures are standardised contracts that trade on exchanges.
Counterparty risk is substantial with forward contracts, but restricted with futures contracts. Requirements enforced by exchanges, such as initial and maintenance margins and daily marking to market, lower the counterparty risk associated with futures contracts.
It is easier to exit a position before to the settlement date with a futures contract than with a forward contract. A position in a futures contract can be settled (closed) by taking an opposite position in the same contract.
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Investment - Functions of Derivative Contracts
Uses of Derivatives Contracts
Derivatives can be established on any asset, event, or outcome, which is called the underlying. The underlying can be a physical item, such as wheat or gold, or a financial asset, such as the share of a firm. The underlying can also be a wide market index, such as the S&P 500 Index or the FTSE 100 Index.
The underlying can additionally be an outcome, such as a day with temperatures under or over a specific temperature (known as heating and cooling days), or an event, such as bankruptcy. Derivatives can be used to reduce risks connected with the underlying, but they may result in higher risk exposure for the other party to the contract.
Let’s continue the narrative of the wheat farmer. The farmer anticipates having at least 50,000 bushels (approximately 136 metric tons) of wheat available for sale in mid-September, six months from now.
A bushel of wheat is currently selling in the market at USD9.00, which is the spot price. The farmer has no means of knowing what the market price of wheat will be in six months.
The farmer finds a cereal producer that wants wheat and is willing to contract to buy 50,000 bushels of wheat at a price of USD8.50 per bushel in six months. The contract provides a hedge for both the farmer and the cereal producer. A hedge is an action that decreases uncertainty or risk.
But what if the farmer cannot find someone who genuinely needs the wheat? The farmer might still find a counterparty that is willing to engage into a contract to buy the wheat in the future at a price agreed on today. This counterparty may anticipate being able to sell the wheat at a greater price in the market than the price agreed on with the farmer. This counterparty may be labeled a speculator.
This counterparty is not hedging risk but is instead taking on risk in anticipation of receiving a return. But there is no guarantee of a positive return. Even if the future price in the market is lower than the price agreed on today with the farmer, the counterparty needs to buy the wheat at the agreed-on price and later may have to sell it at a loss.
Derivatives allow corporations and investors the flexibility to manage future risks connected to raw material costs, product pricing, stock prices or indices, interest rates, exchange rates, and even uncontrollable phenomena, such as weather. They also allow investors the chance to obtain exposure to underlying assets while committing much less capital and incurring fewer transaction costs than if they had invested directly in the assets.
Uses of Derivatives Contracts
Derivatives can be established on any asset, event, or outcome, which is called the underlying. The underlying can be a physical item, such as wheat or gold, or a financial asset, such as the share of a firm. The underlying can also be a wide market index, such as the S&P 500 Index or the FTSE 100 Index.
The underlying can additionally be an outcome, such as a day with temperatures under or over a specific temperature (known as heating and cooling days), or an event, such as bankruptcy. Derivatives can be used to reduce risks connected with the underlying, but they may result in higher risk exposure for the other party to the contract.
Let’s continue the narrative of the wheat farmer. The farmer anticipates having at least 50,000 bushels (approximately 136 metric tons) of wheat available for sale in mid-September, six months from now.
A bushel of wheat is currently selling in the market at USD9.00, which is the spot price. The farmer has no means of knowing what the market price of wheat will be in six months.
The farmer finds a cereal producer that wants wheat and is willing to contract to buy 50,000 bushels of wheat at a price of USD8.50 per bushel in six months. The contract provides a hedge for both the farmer and the cereal producer. A hedge is an action that decreases uncertainty or risk.
But what if the farmer cannot find someone who genuinely needs the wheat? The farmer might still find a counterparty that is willing to engage into a contract to buy the wheat in the future at a price agreed on today. This counterparty may anticipate being able to sell the wheat at a greater price in the market than the price agreed on with the farmer. This counterparty may be labeled a speculator.
This counterparty is not hedging risk but is instead taking on risk in anticipation of receiving a return. But there is no guarantee of a positive return. Even if the future price in the market is lower than the price agreed on today with the farmer, the counterparty needs to buy the wheat at the agreed-on price and later may have to sell it at a loss.
Derivatives allow corporations and investors the flexibility to manage future risks connected to raw material costs, product pricing, stock prices or indices, interest rates, exchange rates, and even uncontrollable phenomena, such as weather. They also allow investors the chance to obtain exposure to underlying assets while committing much less capital and incurring fewer transaction costs than if they had invested directly in the assets.
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Investment - Swap Contracts
Swap contracts, or swaps, are often derivatives in which two parties exchange (swap) cash flows or other financial instruments across numerous periods (months or years) for mutual gain, usually to control risk.
Swaps of this nature imply duties in the future on the part of both parties to the contract. These swaps, like forwards and futures, are forward commitments or bilateral contracts because both parties have a commitment in the future. Similar to forwards and futures, a contract’s net beginning value to each party should be zero, and as one side of the swap contract gains the other side loses by the same amount.
Swaps in which two parties exchange cash flows include interest rate and currency swaps. An interest rate swap, the most popular type, allows corporations to swap their interest rate commitments (typically a fixed rate for a floating rate) to manage interest rate risk, to better match their streams of cash inflows and outflows, or to cut their borrowing costs.
" " A currency swap enables borrowers to exchange debt service obligations denominated in one currency for similar debt service obligations denominated in another currency. By trading future cash flow responsibilities, the two parties can manage currency risk.
In a total return swap, the entire return from an asset - a stock or an index — is exchanged for a fixed rate, allowing an investor paying the fixed rate obligation to get the capital appreciation or depreciation, and dividend payments, of a stock or an index.
A credit default swap (CDS for a single name or CDX for an index) is an agreement by one party (the protection seller) to pay for the loss of principal and interest of an obligation to the protection buyer if the borrower fails on the obligation.
Credit default swaps are not genuinely swaps. Like options, credit default swaps are dependent claims and unilateral contracts. One party buys a CDS to protect itself against a loss of value in a debt security or index of debt securities; the loss of value is primarily the result of a shift (increase) in credit risk. The seller is giving security to the buyer against losses in value of the underlying. The seller does this in exchange for a premium payment from the buyer; the premium compensates the seller for the risk of the contract. The contract will stipulate under what conditions (known as a credit event) the seller needs to make payment to the buyer of the CDS.
The following example provides an illustration of a currency swap.
Example: Illustration of a Currency Swap
A hypothetical US insurance firm, AIAI, lends Thai Baht (THB) to a fictional private corporation in Thailand (ThaiCo). AIAI earns a spread above the THB risk-free rate by making the loan. But AIAI does not want to be exposed to the currency swings of THB versus USD on the periodic interest payments it gets from ThaiCo.
So, it calls SGX Bank, and enters into a fix-fix currency exchange, wherein AIAI pays the fixed THB (earned from ThaiCo) to SGX Bank and receives fixed USD from SGX Bank. As a result of these cash flow exchanges, AIAI is hedged against the currency swings of THB versus the US dollar.
The usage of swaps has expanded because they allow investors to manage several sorts of risks, including interest rate risk, currency risk, and credit default risk. In addition, investors can utilize swaps to cut borrowing and transaction costs, bypass currency exchange restrictions, and manage exposure to underlying assets.
Swap contracts, or swaps, are often derivatives in which two parties exchange (swap) cash flows or other financial instruments across numerous periods (months or years) for mutual gain, usually to control risk.
Swaps of this nature imply duties in the future on the part of both parties to the contract. These swaps, like forwards and futures, are forward commitments or bilateral contracts because both parties have a commitment in the future. Similar to forwards and futures, a contract’s net beginning value to each party should be zero, and as one side of the swap contract gains the other side loses by the same amount.
Swaps in which two parties exchange cash flows include interest rate and currency swaps. An interest rate swap, the most popular type, allows corporations to swap their interest rate commitments (typically a fixed rate for a floating rate) to manage interest rate risk, to better match their streams of cash inflows and outflows, or to cut their borrowing costs.
" " A currency swap enables borrowers to exchange debt service obligations denominated in one currency for similar debt service obligations denominated in another currency. By trading future cash flow responsibilities, the two parties can manage currency risk.
In a total return swap, the entire return from an asset - a stock or an index — is exchanged for a fixed rate, allowing an investor paying the fixed rate obligation to get the capital appreciation or depreciation, and dividend payments, of a stock or an index.
A credit default swap (CDS for a single name or CDX for an index) is an agreement by one party (the protection seller) to pay for the loss of principal and interest of an obligation to the protection buyer if the borrower fails on the obligation.
Credit default swaps are not genuinely swaps. Like options, credit default swaps are dependent claims and unilateral contracts. One party buys a CDS to protect itself against a loss of value in a debt security or index of debt securities; the loss of value is primarily the result of a shift (increase) in credit risk. The seller is giving security to the buyer against losses in value of the underlying. The seller does this in exchange for a premium payment from the buyer; the premium compensates the seller for the risk of the contract. The contract will stipulate under what conditions (known as a credit event) the seller needs to make payment to the buyer of the CDS.
The following example provides an illustration of a currency swap.
Example: Illustration of a Currency Swap
A hypothetical US insurance firm, AIAI, lends Thai Baht (THB) to a fictional private corporation in Thailand (ThaiCo). AIAI earns a spread above the THB risk-free rate by making the loan. But AIAI does not want to be exposed to the currency swings of THB versus USD on the periodic interest payments it gets from ThaiCo.
So, it calls SGX Bank, and enters into a fix-fix currency exchange, wherein AIAI pays the fixed THB (earned from ThaiCo) to SGX Bank and receives fixed USD from SGX Bank. As a result of these cash flow exchanges, AIAI is hedged against the currency swings of THB versus the US dollar.
The usage of swaps has expanded because they allow investors to manage several sorts of risks, including interest rate risk, currency risk, and credit default risk. In addition, investors can utilize swaps to cut borrowing and transaction costs, bypass currency exchange restrictions, and manage exposure to underlying assets.
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Investment - Private Equity
Consider an entrepreneur who set up her new business five years ago. Back then, she went to her friends and neighbours for the money she needed. Now, five years later, her company is incredibly profitable. To raise the additional funds the company requires to support its expansion objectives, it could issue shares to the public via an initial public offering (IPO). But it was not yet ready to go public, and the company required more money to grow than the entrepreneur, her friends, neighbours, and banks were able or willing to supply. Who would have financed such a young and not well-established company? The answer is venture capitalists. The entrepreneur sold some of her company’s shares to a venture capital firm, a sort of private equity firm, to receive the additional funds essential to build her business.
Private equity firms invest in private companies that are not publicly traded on a stock exchange. Although people typically refer to private ‘equity’, private investments can include both equity and debt securities. Private debt is debt provided to private companies. Private debt comprises direct lending (private loans provided without intermediaries), mezzanine debt (private subordinated debt), venture debt (private loans to start-up or early-stage enterprises), and distressed debt lending (financing given to companies that are at risk of failing).
Private Equity Strategies
Private equity comprises numerous ways that may help offer money to companies at different phases of their development. The most often employed strategies are venture capital, growth equity, buyouts, and distressed.
Another private equity investment approach, which is independent to the stage of a company’s development, is called secondaries.
Venture Capital
As stated in the introduction, venture capital is a private equity investment strategy that consists of supporting the early stage of companies that have an original business plan. Venture capitalists regularly invest in ‘start-up’ enterprises that exist merely as an idea or a business strategy. The company may have only a few workers, have little or no revenue, and still be developing its product or business plan.
Entrepreneurs are typically looking not only for funding to start their firm (e.g., seed money), but also for guidance and knowledge about how to create and maintain their company.
Venture capital is regarded the riskiest sort of private equity investment strategy because more companies fail than succeed.
It can take many years before a company becomes successful, and most venture capital–funded enterprises have years of unprofitable activity before they reach the point of producing money. So, venture capital investing demands patience. And those companies that do prosper tend to significantly reward their investors.
Growth Equity
Growth equity is a private equity investment strategy that usually focuses on financing companies with proven business concepts, good client bases, and positive cash flows or profits.
These companies frequently have potential to grow by adding new production facilities or by making acquisitions, but they do not generating adequate cash flows from their activities to sustain their expansion goals. By contributing additional money in return for equity in the company, growth equity investors assist these enterprises expand and become more established.
Some growth equity investors specialise in helping companies prepare for an initial public offering. These investors give additional money at a later stage of a company’s development.
Additional equity dilutes existing shareholders’ ownership because there are more investors sharing the company’s cash flows. But because the later-stage growth equity investors often have expertise in structuring initial public offerings, they may bring financial rewards that offset the downsides of dilution. Initial public offerings, such as Facebook in 2012 (still the leader in the past decade for most amount raised) and Uber and DoorDash in 2020, are an opportunity for founders and existing shareholders to convert some or all of their investment in the firm into cash. So, the late inclusion of equity investors that have successful track records in structuring first public offerings may be useful for founders and existing shareholders.
Buyouts
Buyouts are a private equity investment strategy that consists on financing established companies that require money to restructure and facilitates a change of ownership.
Buyout agreements often include taking a publicly traded company private. For example, such corporations as UK-based Alliance Boots or US-based Twitter, Hertz, and Hilton Hotels were once public companies, but they underwent buyouts and are now privately owned companies.
Buyouts for which the financing of the deal involves a high proportion of debt are commonly called leveraged buyouts that financial leverage refers to the proportion of debt relative to equity in a company’s capital structure.
Because the high level of debt means hefty interest payments and principle repayments, companies that undertake a leveraged buyout must be able to generate robust and sustainable cash flows. So, they are frequently well-established enterprises with solid competitive standing in their field. Buyout investors generally seek companies that have lately underperformed, but that provide potential through restructuring to boost revenues and profitability.
When corporations suffer financial issues, they may be at danger of not being able to make full and timely payments of interest and/or principle. This risk, which is known as credit or default risk, was explored in the module on Debt Securities.
Distressed investment focuses on purchasing the debt of distressed companies that may have defaulted or are on the brink of defaulting. Frequently, investments are undertaken at a large discount to par value – that is, the amount repaid to the lenders upon maturity. For example, an investor who purchases the debt of a struggling company may only offer the existing lenders 20% or 30% of the amount they are due.
If the company can continue and grow, the value of the investment will increase — frequently by the conversion of such debt into equity of the new, surviving company — and the investor will realise significant value. Distressed investing does not often involve a cash flow to the company.
Structure and Mechanics of Private Equity Partnerships
As noted in the preceding section, private equity investments are frequently arranged in funds managed by partnerships. A private equity partnership usually contains two categories of partners.
A general partner (GP) is often a private equity firm that puts up the partnership. It is responsible for raising cash, locating acceptable investments, and making choices. General partners have unlimited personal liability for all the debts of the partnership – that is, general partners could lose more than their investment in the partnership since, if necessary, their personal assets could be utilized to settle the business’s debts.
Limited Partners
Limited partners (LPs) are investors who contribute capital to the partnership. They are not involved in the selection and management of the investments. Limited partners have limited personal liability – that is, limited partners cannot lose more than the amount of cash they put to the partnership
A private equity firm may create different private equity funds for different sorts of investments. The investments are normally not managed by the general partner itself, but by professional fund managers who are employed by the general partner. Each private equity fund may have its own fund manager who is responsible for the day-to-day management of the investments in the funds.
The private equity firm makes money through two mechanisms.
Management costs are fees that limited partners must pay general partners to reimburse them for managing the private equity assets. Management fees are often established as a proportion of the amount of money the limited partners have committed rather than the amount of money that has been invested. Additionally, limited partners must pay management fees even if an investment is underperforming and must continue paying management fees even if an investment has collapsed.
Carried Interest
Carried interest: This is a share of the profit on a private equity investment. It is a sort of incentive charge that general partners deduct before sharing to the limited partners the profit gained on investments. Carried interest is aimed to ensure that general partners’ interests are matched with limited partners’ interests.
Investments in private equity partnerships tend to be illiquid. That is, once the limited partners have committed capital to the partnership, it is difficult for them to exit the investment before the conclusion of the commitment term.
The following example explains the structure and mechanics of a private equity partnership.
Example: Structure and Mechanics of a Private Equity Partnership
Assume that a private equity firm has launched a USD4 million private equity fund to invest in start-up companies. As described previously, this private equity investment method is called venture capital investing.
The private equity firm is the general partner, and its first responsibility is to raise funds from investors. Suppose that it identifies four investors who are ready and able to contribute USD1 million each. These investors are the limited partners — represented by A, B, C, and D in the picture. The limited partners do not transfer USD1 million each to the general private equity firm immediately; initially, they merely pledge to contribute USD1 million each throughout the commitment term of the private equity fund’s tenure, say 10 years.
When the private equity business has secured the USD4 million, it can start investing. Assume that it discovers a suitable investment in Company W for USD400,000. The private equity firm contacts the limited partners and issues a capital call of USD100,000 per limited partner; capital calls sometimes happen with short notice. Limited Partners A, B, C, and D send USD100,000 apiece to the private equity business, which invests the USD400,000 in Company W. A few months later, the private equity firm identifies another appropriate investment in Company X for USD600,000. It makes another capital call, this time of USD150,000 per limited partner. This procedure may continue for several years until the private equity group has invested the USD4 million.
As depicted in the illustration, the private equity firm makes investments in four companies. These investments are often managed by a professional fund manager who costs the private equity company fees for his or her services, usually a combination of a fixed fee and an incentive fee. In turn, the private equity firm charges the limited partners management fees to pay the fund manager fees and other administrative fees. For example, assume that the annual management charge is 1.5% of the pledged capital. So, each limited partner who committed USD1 million must pay the private equity company an annual management fee of USD15,000, regardless of how much capital the private equity firm has already contributed. Thus, in the early years of the private equity fund’s life, the limited partners may be paying management fees on funds that have not really been invested.
After several years, say that the private equity company sells its interest in Company W for USD1 million. It can now distribute money plus earnings to the limited partners. Before it does so, it deducts a share of the profit, which is carried interest. Recall that carried interest is a sort of incentive charge that is designed to ensure that the private equity firm and the fund manager make the best possible decisions on behalf of the limited partners.
Suppose that carried interest is 15%. The profit on the investment in Company W is USD600,000 — that is, the difference between the selling price of USD1,000,000 and the initial investment of USD400,000. So, the private equity firm and the fund manager can keep USD90,000 (15% of USD600,000) in carried interest, which means that the amount of profit to be distributed amongst the limited partners is USD510,000 ($600,000 – $90,000). Thus, ignoring management expenses, each limited partner receives a cash distribution of USD227,500 — that is, USD100,000 of capital plus USD127,500 of profit, which implies a return on investment of 128% [($227,500 – $100,000) ÷ $100,000].
This return on investment is high, but remember that venture financing is hazardous. Assume that Company X meets financial problems, and the private equity firm wants to sell its ownership position in Company X. Another private equity firm is eager to buy this ownership interest, but for only USD100,000; note that such a transaction is called a secondary transaction.
The investment in Company X turns out to be a loss of USD500,000 (the selling price of USD100,000 minus the initial investment of USD600,000), hence there is no carried interest. Each limited partner receives a cash payout of USD25,000, which provides a return on investment of -83% [($25,000 – $150,000) ÷ $150,000], ignoring management fees. As indicated earlier, limited partners are not excluded from paying management fees on their whole commitment, including the USD150,000 payment to Company X, even if the venture is underperforming or fails.
Analysing Patterns
As indicated in the example, each limited partner’s capital of USD1 million is drawn down gradually over the commitment term of the private equity fund’s life. In the early years of the fund, the limited partners have negative cash flows since they get frequent capital calls to fund investments, and they must pay management fees on the committed capital. In later years, when investments produce dividends or are sold, the private equity firm provides cash distributions to the limited partners. When cash distributions net of carried interest exceed capital calls and management costs, the limited partners have positive cash flows.
A typical pattern of cash flows for a limited partner is represented in the example below. This image depicts a potential investment of USD1 million in a private equity fund with a life of 10 years. It is believed that the private equity firm makes investments in 10 companies between Year 1 and Year 6, these investments start producing dividends in Year 4, and they get sold between Year 6 and Year 10.
The blue bars reflect the sum of the capital calls and management fees, which are considered to be 1.5% of the committed capital. The green bars indicate the cash distributions, ignoring carried interest. The line indicates the cumulative net cash flow to the limited partner — that is, the sum of the cash distributions less the sum of the capital calls and management fees. This line is known as a J curve because its shape resembles the letter J.
Consider an entrepreneur who set up her new business five years ago. Back then, she went to her friends and neighbours for the money she needed. Now, five years later, her company is incredibly profitable. To raise the additional funds the company requires to support its expansion objectives, it could issue shares to the public via an initial public offering (IPO). But it was not yet ready to go public, and the company required more money to grow than the entrepreneur, her friends, neighbours, and banks were able or willing to supply. Who would have financed such a young and not well-established company? The answer is venture capitalists. The entrepreneur sold some of her company’s shares to a venture capital firm, a sort of private equity firm, to receive the additional funds essential to build her business.
Private equity firms invest in private companies that are not publicly traded on a stock exchange. Although people typically refer to private ‘equity’, private investments can include both equity and debt securities. Private debt is debt provided to private companies. Private debt comprises direct lending (private loans provided without intermediaries), mezzanine debt (private subordinated debt), venture debt (private loans to start-up or early-stage enterprises), and distressed debt lending (financing given to companies that are at risk of failing).
Private Equity Strategies
Private equity comprises numerous ways that may help offer money to companies at different phases of their development. The most often employed strategies are venture capital, growth equity, buyouts, and distressed.
Another private equity investment approach, which is independent to the stage of a company’s development, is called secondaries.
Venture Capital
As stated in the introduction, venture capital is a private equity investment strategy that consists of supporting the early stage of companies that have an original business plan. Venture capitalists regularly invest in ‘start-up’ enterprises that exist merely as an idea or a business strategy. The company may have only a few workers, have little or no revenue, and still be developing its product or business plan.
Entrepreneurs are typically looking not only for funding to start their firm (e.g., seed money), but also for guidance and knowledge about how to create and maintain their company.
Venture capital is regarded the riskiest sort of private equity investment strategy because more companies fail than succeed.
It can take many years before a company becomes successful, and most venture capital–funded enterprises have years of unprofitable activity before they reach the point of producing money. So, venture capital investing demands patience. And those companies that do prosper tend to significantly reward their investors.
Growth Equity
Growth equity is a private equity investment strategy that usually focuses on financing companies with proven business concepts, good client bases, and positive cash flows or profits.
These companies frequently have potential to grow by adding new production facilities or by making acquisitions, but they do not generating adequate cash flows from their activities to sustain their expansion goals. By contributing additional money in return for equity in the company, growth equity investors assist these enterprises expand and become more established.
Some growth equity investors specialise in helping companies prepare for an initial public offering. These investors give additional money at a later stage of a company’s development.
Additional equity dilutes existing shareholders’ ownership because there are more investors sharing the company’s cash flows. But because the later-stage growth equity investors often have expertise in structuring initial public offerings, they may bring financial rewards that offset the downsides of dilution. Initial public offerings, such as Facebook in 2012 (still the leader in the past decade for most amount raised) and Uber and DoorDash in 2020, are an opportunity for founders and existing shareholders to convert some or all of their investment in the firm into cash. So, the late inclusion of equity investors that have successful track records in structuring first public offerings may be useful for founders and existing shareholders.
Buyouts
Buyouts are a private equity investment strategy that consists on financing established companies that require money to restructure and facilitates a change of ownership.
Buyout agreements often include taking a publicly traded company private. For example, such corporations as UK-based Alliance Boots or US-based Twitter, Hertz, and Hilton Hotels were once public companies, but they underwent buyouts and are now privately owned companies.
Buyouts for which the financing of the deal involves a high proportion of debt are commonly called leveraged buyouts that financial leverage refers to the proportion of debt relative to equity in a company’s capital structure.
Because the high level of debt means hefty interest payments and principle repayments, companies that undertake a leveraged buyout must be able to generate robust and sustainable cash flows. So, they are frequently well-established enterprises with solid competitive standing in their field. Buyout investors generally seek companies that have lately underperformed, but that provide potential through restructuring to boost revenues and profitability.
When corporations suffer financial issues, they may be at danger of not being able to make full and timely payments of interest and/or principle. This risk, which is known as credit or default risk, was explored in the module on Debt Securities.
Distressed investment focuses on purchasing the debt of distressed companies that may have defaulted or are on the brink of defaulting. Frequently, investments are undertaken at a large discount to par value – that is, the amount repaid to the lenders upon maturity. For example, an investor who purchases the debt of a struggling company may only offer the existing lenders 20% or 30% of the amount they are due.
If the company can continue and grow, the value of the investment will increase — frequently by the conversion of such debt into equity of the new, surviving company — and the investor will realise significant value. Distressed investing does not often involve a cash flow to the company.
Structure and Mechanics of Private Equity Partnerships
As noted in the preceding section, private equity investments are frequently arranged in funds managed by partnerships. A private equity partnership usually contains two categories of partners.
A general partner (GP) is often a private equity firm that puts up the partnership. It is responsible for raising cash, locating acceptable investments, and making choices. General partners have unlimited personal liability for all the debts of the partnership – that is, general partners could lose more than their investment in the partnership since, if necessary, their personal assets could be utilized to settle the business’s debts.
Limited Partners
Limited partners (LPs) are investors who contribute capital to the partnership. They are not involved in the selection and management of the investments. Limited partners have limited personal liability – that is, limited partners cannot lose more than the amount of cash they put to the partnership
A private equity firm may create different private equity funds for different sorts of investments. The investments are normally not managed by the general partner itself, but by professional fund managers who are employed by the general partner. Each private equity fund may have its own fund manager who is responsible for the day-to-day management of the investments in the funds.
The private equity firm makes money through two mechanisms.
Management costs are fees that limited partners must pay general partners to reimburse them for managing the private equity assets. Management fees are often established as a proportion of the amount of money the limited partners have committed rather than the amount of money that has been invested. Additionally, limited partners must pay management fees even if an investment is underperforming and must continue paying management fees even if an investment has collapsed.
Carried Interest
Carried interest: This is a share of the profit on a private equity investment. It is a sort of incentive charge that general partners deduct before sharing to the limited partners the profit gained on investments. Carried interest is aimed to ensure that general partners’ interests are matched with limited partners’ interests.
Investments in private equity partnerships tend to be illiquid. That is, once the limited partners have committed capital to the partnership, it is difficult for them to exit the investment before the conclusion of the commitment term.
The following example explains the structure and mechanics of a private equity partnership.
Example: Structure and Mechanics of a Private Equity Partnership
Assume that a private equity firm has launched a USD4 million private equity fund to invest in start-up companies. As described previously, this private equity investment method is called venture capital investing.
The private equity firm is the general partner, and its first responsibility is to raise funds from investors. Suppose that it identifies four investors who are ready and able to contribute USD1 million each. These investors are the limited partners — represented by A, B, C, and D in the picture. The limited partners do not transfer USD1 million each to the general private equity firm immediately; initially, they merely pledge to contribute USD1 million each throughout the commitment term of the private equity fund’s tenure, say 10 years.
When the private equity business has secured the USD4 million, it can start investing. Assume that it discovers a suitable investment in Company W for USD400,000. The private equity firm contacts the limited partners and issues a capital call of USD100,000 per limited partner; capital calls sometimes happen with short notice. Limited Partners A, B, C, and D send USD100,000 apiece to the private equity business, which invests the USD400,000 in Company W. A few months later, the private equity firm identifies another appropriate investment in Company X for USD600,000. It makes another capital call, this time of USD150,000 per limited partner. This procedure may continue for several years until the private equity group has invested the USD4 million.
As depicted in the illustration, the private equity firm makes investments in four companies. These investments are often managed by a professional fund manager who costs the private equity company fees for his or her services, usually a combination of a fixed fee and an incentive fee. In turn, the private equity firm charges the limited partners management fees to pay the fund manager fees and other administrative fees. For example, assume that the annual management charge is 1.5% of the pledged capital. So, each limited partner who committed USD1 million must pay the private equity company an annual management fee of USD15,000, regardless of how much capital the private equity firm has already contributed. Thus, in the early years of the private equity fund’s life, the limited partners may be paying management fees on funds that have not really been invested.
After several years, say that the private equity company sells its interest in Company W for USD1 million. It can now distribute money plus earnings to the limited partners. Before it does so, it deducts a share of the profit, which is carried interest. Recall that carried interest is a sort of incentive charge that is designed to ensure that the private equity firm and the fund manager make the best possible decisions on behalf of the limited partners.
Suppose that carried interest is 15%. The profit on the investment in Company W is USD600,000 — that is, the difference between the selling price of USD1,000,000 and the initial investment of USD400,000. So, the private equity firm and the fund manager can keep USD90,000 (15% of USD600,000) in carried interest, which means that the amount of profit to be distributed amongst the limited partners is USD510,000 ($600,000 – $90,000). Thus, ignoring management expenses, each limited partner receives a cash distribution of USD227,500 — that is, USD100,000 of capital plus USD127,500 of profit, which implies a return on investment of 128% [($227,500 – $100,000) ÷ $100,000].
This return on investment is high, but remember that venture financing is hazardous. Assume that Company X meets financial problems, and the private equity firm wants to sell its ownership position in Company X. Another private equity firm is eager to buy this ownership interest, but for only USD100,000; note that such a transaction is called a secondary transaction.
The investment in Company X turns out to be a loss of USD500,000 (the selling price of USD100,000 minus the initial investment of USD600,000), hence there is no carried interest. Each limited partner receives a cash payout of USD25,000, which provides a return on investment of -83% [($25,000 – $150,000) ÷ $150,000], ignoring management fees. As indicated earlier, limited partners are not excluded from paying management fees on their whole commitment, including the USD150,000 payment to Company X, even if the venture is underperforming or fails.
Analysing Patterns
As indicated in the example, each limited partner’s capital of USD1 million is drawn down gradually over the commitment term of the private equity fund’s life. In the early years of the fund, the limited partners have negative cash flows since they get frequent capital calls to fund investments, and they must pay management fees on the committed capital. In later years, when investments produce dividends or are sold, the private equity firm provides cash distributions to the limited partners. When cash distributions net of carried interest exceed capital calls and management costs, the limited partners have positive cash flows.
A typical pattern of cash flows for a limited partner is represented in the example below. This image depicts a potential investment of USD1 million in a private equity fund with a life of 10 years. It is believed that the private equity firm makes investments in 10 companies between Year 1 and Year 6, these investments start producing dividends in Year 4, and they get sold between Year 6 and Year 10.
The blue bars reflect the sum of the capital calls and management fees, which are considered to be 1.5% of the committed capital. The green bars indicate the cash distributions, ignoring carried interest. The line indicates the cumulative net cash flow to the limited partner — that is, the sum of the cash distributions less the sum of the capital calls and management fees. This line is known as a J curve because its shape resembles the letter J.
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Investment - Option Contracts
What if the farmer does not want to lock in the price because the farmer feels the price of wheat is going to increase? But the farmer does want to make sure that at least a certain amount is obtained for the wheat. Similarly, the cereal producer anticipates that the price of wheat is likely to decline and wants to make sure that no more than a specific amount is paid. Option markets may give the solution for both parties.
Options provide one party (the buyer) to the contract the ability to demand an action from the other party (the seller) in the future. In an option contract, the buyer of the option has the right, but not the responsibility, to buy or sell the underlying. Options are dubbed unilateral contracts since only one party to the transaction (the seller) has a future promise that, if broken, marks a breach of contract. Unilateral transactions expose solely the buyer to the risk that the seller will not fulfil the contractual commitment.
The buyer of the contract will exercise the right or option if conditions are favourable or if certain conditions are met. For this reason, options are sometimes known as contingent claims — that is, claims are dependent on future conditions. If the buyer agrees to use (exercise) the option, the seller is bound to meet the option buyer’s claim. If the buyer decides not to exercise the option, it expires without any action by the seller.
Options may trade in the over-the-counter market, but they trade largely on exchanges. Here, we focus on options traded on exchanges. Options on the over-the-counter market are identical, except that they are customized. An option contract specifies the underlying, the size, the price to trade the underlying in the future (called the exercise price or striking price), and the expiration date. Option contracts in the United States normally expire in March, June, September, or December, but options are available for other months as well.
A buyer selects whether to exercise an option depending on the underlying’s price compared with the exercise price. A buyer will exercise the option only when doing so is favorable compared with trading on the market, which puts the seller at a disadvantage. Because of the unilateral future obligation (only the seller has a responsibility), options have positive value for the buyer at the inception of the contract. The option buyer pays this value, or option premium, to the option seller at the time of the initial contract.
The premium paid by the option buyer compensates the option seller for the risk incurred; the option seller is the only party with a future obligation. The highest gain to the option seller is the premium. The option seller hopes the option will not be exercised.
Call Options and Put Options
There are two fundamental sorts of options:
Call Option
An investor who buys a call option has the right (but not the responsibility) to buy or call the underlying from the option seller at the exercise price until the option expires.
Put Option
An investor who buys a put option has the right (but not the responsibility) to sell or put the underlying to the option seller at the exercise price until expiration.
The cereal producer may acquire a call option to ensure the right, but not the responsibility, to buy wheat at the exercise price. The farmer may buy a put option to protect the right, but not the responsibility, to sell wheat at the exercise price. Note that the grain producer and farmer enter into various option contracts to control their risks.
Example: Illustration of a Call Option
Consider a call option in which the underlying is 1,000 shares of fictitious Company A trading on the London Stock Exchange (LSE). The call option’s exercise price is GBP6.00 per share, which indicates that the call option buyer can buy 1,000 shares of Company A at GBP6.00 per share until expiration, regardless of Company A’s share price in the market.
Note that the buyer will exercise this option only if Company A’s price on the LSE is more than GBP6.00 per share. If Company A’s share price at expiration is GBP7.00 per share, the buyer executes the option, pays GBP6,000, and receives 1,000 shares of Company A. The call option buyer can then sell those shares in the market for a profit of GBP1,000 (ignoring transaction fees, such as the premium initially paid for the call option and trading costs). The seller of the call option is compelled to sell the shares at GBP6.00 per share to the call option buyer, even if the market price is GP7.00 per share, incurring a loss of GBP1,000 (ignoring the premium received for the call option).
If Company A’s share price is less than GBP6.00 per share, the call option buyer has no motivation to execute the option; it would not make sense to voluntarily pay more than the market price. In this instance, the buyer will let the option expire. Because an option buyer is not obligated to exercise an option, an option’s value cannot be negative.
The example above indicates that, ignoring the premium paid, an option buyer’s pay-off is never negative. Option buyers pay premiums to option sellers to compensate option sellers for their risk. But if an option seller underestimates the risk associated with the option, the premiums paid may be substantially less than the losses they experience on exercise.
Buying call options protects the investor by establishing a maximum price the option buyer will have to pay to buy the underlying; the maximum price is the exercise price. Similarly, buying put options protects the investor by establishing a minimum price the option buyer will get to sell the underlying; the minimum price is the exercise price.
An option that yields a positive payoff if it is exercised is said to be ‘in the money’. When the underlying price is at the exercise price, the option is said to be ‘at the money’. When the underlying price has not reached the exercise price (lower for a call, higher for a put), the option is said to be ‘out of the money’. The definition of whether the option is in-, at-, or out-of-the-money is referred to as the option’s ‘moneyness’.
Example: Option Moneyness and Pay-offs
The entire value of an option consists of two components: an intrinsic value and a temporal value. The intrinsic value of an option is the difference between the strike price and the underlying asset price. The time value is the value associated with the amount of time left until an option expires and is derived by subtracting the intrinsic value from the overall value of the option.
For a call option, a buyer will benefit by exercising the option when the underlying asset price is more than the strike price (the intrinsic value is positive) and will not exercise when the spot price is below the strike price (intrinsic value is zero).
A buyer of a put option will exercise at a market spot price lower than the strike price (option is in-the-money, the intrinsic value is positive). When the underlying asset price is higher than the strike price, the buyer will not exercise (option is out-of-the-money, intrinsic value is zero).
Factors that Affect Option Premiums
Option premiums are meant to pay option sellers for their risk. The option premium indicates the greatest profit that the option seller can make. If an option seller underestimates the risk connected with the option, the premiums may be substantially less than the losses sustained if the option is exercised.
The lower the exercise price for a call option relative to the current spot price, the higher the premium because the likelihood that it will be exercised is greater. The higher the exercise price for a put option relative to the current spot price, the larger the premium because the likelihood that it will be exercised is greater.
The longer the time to expiration of an option, the higher the option premium since the possibility is greater that the underlying will move in favour of the option buyer and that it will be exercised. Similarly, the greater the volatility of the underlying, the higher the option premium since the likelihood is greater that the underlying will shift in favour of the option buyer and that it will be exercised.
In essence, an option’s premium depends on the current spot price of the underlying, exercise price, time to expiration, and volatility of the underlying.
The following table demonstrates the impact of an increase in each element on an option's premium for a call option and a put option.
Warrants
A warrant is an equity-like product that authorizes the holder to buy a pre-specified amount of common stock of the issuing business at a pre-specified per-share price (called the exercise price or strike price) prior to a pre-specified expiration date. Warrants often have expiration dates several years in the future. A corporation may issue warrants to investors to obtain funds or to employees as a form of compensation.
The holders of warrants may choose to exercise the rights prior to the expiration date. A warrant holder will exercise the right only when the price of a common share surpasses the exercise price. Otherwise, it would be cheaper to acquire the shares in the market. When a warrant holder exercises the right, the corporation issues the pre-specified number of new shares and sells them to the warrant holder at the exercise price.
When warrants are utilized as employee remuneration, they are referred to as employee stock options. The goal of employing warrants as pay is to connect the interests of the employees with those of the owners.
What if the farmer does not want to lock in the price because the farmer feels the price of wheat is going to increase? But the farmer does want to make sure that at least a certain amount is obtained for the wheat. Similarly, the cereal producer anticipates that the price of wheat is likely to decline and wants to make sure that no more than a specific amount is paid. Option markets may give the solution for both parties.
Options provide one party (the buyer) to the contract the ability to demand an action from the other party (the seller) in the future. In an option contract, the buyer of the option has the right, but not the responsibility, to buy or sell the underlying. Options are dubbed unilateral contracts since only one party to the transaction (the seller) has a future promise that, if broken, marks a breach of contract. Unilateral transactions expose solely the buyer to the risk that the seller will not fulfil the contractual commitment.
The buyer of the contract will exercise the right or option if conditions are favourable or if certain conditions are met. For this reason, options are sometimes known as contingent claims — that is, claims are dependent on future conditions. If the buyer agrees to use (exercise) the option, the seller is bound to meet the option buyer’s claim. If the buyer decides not to exercise the option, it expires without any action by the seller.
Options may trade in the over-the-counter market, but they trade largely on exchanges. Here, we focus on options traded on exchanges. Options on the over-the-counter market are identical, except that they are customized. An option contract specifies the underlying, the size, the price to trade the underlying in the future (called the exercise price or striking price), and the expiration date. Option contracts in the United States normally expire in March, June, September, or December, but options are available for other months as well.
A buyer selects whether to exercise an option depending on the underlying’s price compared with the exercise price. A buyer will exercise the option only when doing so is favorable compared with trading on the market, which puts the seller at a disadvantage. Because of the unilateral future obligation (only the seller has a responsibility), options have positive value for the buyer at the inception of the contract. The option buyer pays this value, or option premium, to the option seller at the time of the initial contract.
The premium paid by the option buyer compensates the option seller for the risk incurred; the option seller is the only party with a future obligation. The highest gain to the option seller is the premium. The option seller hopes the option will not be exercised.
Call Options and Put Options
There are two fundamental sorts of options:
Call Option
An investor who buys a call option has the right (but not the responsibility) to buy or call the underlying from the option seller at the exercise price until the option expires.
Put Option
An investor who buys a put option has the right (but not the responsibility) to sell or put the underlying to the option seller at the exercise price until expiration.
The cereal producer may acquire a call option to ensure the right, but not the responsibility, to buy wheat at the exercise price. The farmer may buy a put option to protect the right, but not the responsibility, to sell wheat at the exercise price. Note that the grain producer and farmer enter into various option contracts to control their risks.
Example: Illustration of a Call Option
Consider a call option in which the underlying is 1,000 shares of fictitious Company A trading on the London Stock Exchange (LSE). The call option’s exercise price is GBP6.00 per share, which indicates that the call option buyer can buy 1,000 shares of Company A at GBP6.00 per share until expiration, regardless of Company A’s share price in the market.
Note that the buyer will exercise this option only if Company A’s price on the LSE is more than GBP6.00 per share. If Company A’s share price at expiration is GBP7.00 per share, the buyer executes the option, pays GBP6,000, and receives 1,000 shares of Company A. The call option buyer can then sell those shares in the market for a profit of GBP1,000 (ignoring transaction fees, such as the premium initially paid for the call option and trading costs). The seller of the call option is compelled to sell the shares at GBP6.00 per share to the call option buyer, even if the market price is GP7.00 per share, incurring a loss of GBP1,000 (ignoring the premium received for the call option).
If Company A’s share price is less than GBP6.00 per share, the call option buyer has no motivation to execute the option; it would not make sense to voluntarily pay more than the market price. In this instance, the buyer will let the option expire. Because an option buyer is not obligated to exercise an option, an option’s value cannot be negative.
The example above indicates that, ignoring the premium paid, an option buyer’s pay-off is never negative. Option buyers pay premiums to option sellers to compensate option sellers for their risk. But if an option seller underestimates the risk associated with the option, the premiums paid may be substantially less than the losses they experience on exercise.
Buying call options protects the investor by establishing a maximum price the option buyer will have to pay to buy the underlying; the maximum price is the exercise price. Similarly, buying put options protects the investor by establishing a minimum price the option buyer will get to sell the underlying; the minimum price is the exercise price.
An option that yields a positive payoff if it is exercised is said to be ‘in the money’. When the underlying price is at the exercise price, the option is said to be ‘at the money’. When the underlying price has not reached the exercise price (lower for a call, higher for a put), the option is said to be ‘out of the money’. The definition of whether the option is in-, at-, or out-of-the-money is referred to as the option’s ‘moneyness’.
Example: Option Moneyness and Pay-offs
The entire value of an option consists of two components: an intrinsic value and a temporal value. The intrinsic value of an option is the difference between the strike price and the underlying asset price. The time value is the value associated with the amount of time left until an option expires and is derived by subtracting the intrinsic value from the overall value of the option.
For a call option, a buyer will benefit by exercising the option when the underlying asset price is more than the strike price (the intrinsic value is positive) and will not exercise when the spot price is below the strike price (intrinsic value is zero).
A buyer of a put option will exercise at a market spot price lower than the strike price (option is in-the-money, the intrinsic value is positive). When the underlying asset price is higher than the strike price, the buyer will not exercise (option is out-of-the-money, intrinsic value is zero).
Factors that Affect Option Premiums
Option premiums are meant to pay option sellers for their risk. The option premium indicates the greatest profit that the option seller can make. If an option seller underestimates the risk connected with the option, the premiums may be substantially less than the losses sustained if the option is exercised.
The lower the exercise price for a call option relative to the current spot price, the higher the premium because the likelihood that it will be exercised is greater. The higher the exercise price for a put option relative to the current spot price, the larger the premium because the likelihood that it will be exercised is greater.
The longer the time to expiration of an option, the higher the option premium since the possibility is greater that the underlying will move in favour of the option buyer and that it will be exercised. Similarly, the greater the volatility of the underlying, the higher the option premium since the likelihood is greater that the underlying will shift in favour of the option buyer and that it will be exercised.
In essence, an option’s premium depends on the current spot price of the underlying, exercise price, time to expiration, and volatility of the underlying.
The following table demonstrates the impact of an increase in each element on an option's premium for a call option and a put option.
Warrants
A warrant is an equity-like product that authorizes the holder to buy a pre-specified amount of common stock of the issuing business at a pre-specified per-share price (called the exercise price or strike price) prior to a pre-specified expiration date. Warrants often have expiration dates several years in the future. A corporation may issue warrants to investors to obtain funds or to employees as a form of compensation.
The holders of warrants may choose to exercise the rights prior to the expiration date. A warrant holder will exercise the right only when the price of a common share surpasses the exercise price. Otherwise, it would be cheaper to acquire the shares in the market. When a warrant holder exercises the right, the corporation issues the pre-specified number of new shares and sells them to the warrant holder at the exercise price.
When warrants are utilized as employee remuneration, they are referred to as employee stock options. The goal of employing warrants as pay is to connect the interests of the employees with those of the owners.
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Investment - Introduction to Alternative Investments
If a public company needs funds to invest in a project, say to establish a new manufacturing facility or to extend its operations abroad, it may turn to the financial markets and issue the forms of debt and equity instruments mentioned in the earlier modules of this course.
But what if an entrepreneur wants money to start a great new business? Or what if a small firm needs cash to grow, but it is not established enough to seek an initial public offering? The entrepreneur and the young company do not have the functioning track record needed to offer debt or equity securities to the public. In addition, although they may seek loans from banks, the amount of money they may borrow is frequently limited. Banks typically do not finance new and young enterprises since the risk of not getting the money back is considerable.
So, entrepreneurs or young enterprises may resort to the venture capital industry to receive the money they need.
Venture capitalists concentrate in investing new and fledgling firms. They give entrepreneurs and fledgling enterprises with both the funding and the skills to begin and build their businesses and to develop track records of successful operations.
Venture capital is a form of private equity, which is itself a type of alternative investment. From an investor’s point of view, alternative investments are diversified and often comprise the following:
Investments in private enterprises — that is, companies that are not listed on a stock exchange are known as private equity investments.
Direct or indirect investments in land and buildings are defined as real estate.
Investments in physical things, such as precious and base metals (e.g., gold, copper), energy products (e.g., oil), and agricultural products that are typically eaten (e.g., maize, livestock, wheat) or used in the creation of goods (e.g., lumber, cotton, sugar), are known as commodities.
Private equity, real estate, and commodities are all considered alternative investments since they represent an option to investing only in ‘traditional’ asset classes, such as debt and equity instruments. Although alternative investments have acquired importance in the 21st century, they are not new; in fact, real estate and commodities are among the oldest sorts of investments.
As we will discuss shortly, alternative investments are an opportunity to potentially enhance returns and obtain diversification benefits; recall that diversification is the practice of combining different types of assets or securities in a portfolio to reduce risk, without sacrificing expected returns. The hunt for higher returns and reduced risk explains why alternative investments have become a vital component of the portfolios of many investors, both institutional and individual, who regard private equity, real estate, and/or commodities as potential to deliver both.
Why Invest in Alternatives?
In addition to the issues connected to the COVID pandemic crisis that started in 2020 and increasing geopolitical risks, investors are ready for increased volatility, higher inflation, and upward pressure on interest rates. Against this context, investors are increasingly seeking to private markets and other alternative assets to accomplish their investment return targets. Real estate and private equity are the asset classes with the greatest portfolio allocations by institutional investors. For example, in 2021, 80% and 73% of institutional investors who allocate to alternatives responding to Nuveen’s EQuilibrium survey, placed a portion of their portfolios in real estate and private equity, respectively (see the image below). Private credit is also a significant asset class for such investors, demonstrating the highest year-over-year growth in current allocation.
The numerous sorts of alternative investments can look utterly unconnected to one other. But they have potential common advantages, and they also share similar constraints.
Advantages
They may help boost profits and minimize risk by providing diversification benefits.
Limitations
Typically, they are less regulated, less transparent, less liquid, and more difficult to value than debt and equity investments.
Advantages of Alternative Investments
Investors add alternative investments to their portfolios for two key reasons:
To enhance returns
To reduce risk by getting diversity benefits
Enhancing Returns
The following tables illustrate historical returns for various asset classes. The first and second tables illustrate that throughout the past 25-year period, investments in US private equity and North American real estate (as proxied by real estate investment trusts, or REITS), respectively, have outpaced investments in US equities securities. But you should not extrapolate from these outcomes that alternative investments always offer higher returns than traditional asset classes.
During the global financial crisis of 2008–2009, many investors suffered losses on their private equity and real estate investments, and some losses were larger than those on traditional assets, such as publicly listed securities.
Reducing Risk
Investors rarely allocate all their money to one form of asset or security. Instead, they diversify their portfolios by investing in assets and securities that act differently from each other. How investments act relative to each other leads us back to the concept of correlation, as you learnt about in Module 1, Quantitative Concepts.
As a reminder, if two assets or securities do not have a correlation of +1 (that is, if they are less than fully positively correlated), then combining the two assets or securities in a portfolio provides diversification benefits and hence decreases risk in the portfolio. In other words, the risk to the portfolio after incorporating these two assets or securities is lower than the weighted sum of the risks of the two assets or securities when they are assessed separately.
Because there is a generally low connection between different forms of alternative investments, and also between alternative investments and other asset classes (such stocks and bonds), adding private equity, real estate, and commodities to portfolios helps investors decrease risk. As previously mentioned, during periods of financial crisis, returns on diverse investments may become more connected and the benefits of diversification may be lessened.
Limitations of Alternative Investments
Although alternative investments have the potential to boost returns and minimize risk, they also have limitations. Typically, alternative investments are less regulated and less transparent than regular investments, illiquid, and difficult to appraise.
Because alternative investments are less regulated and less transparent than traditional investments, such as stock and debt instruments, individual individuals are less likely to invest in them. Institutional investors may regard this as an opportunity to take advantage of market inefficiencies.
In addition, most alternative investments are illiquid – that is, they are impossible to sell fast without accepting a drastically discounted price. For example, it is considerably easier to sell shares of a public corporation listed on a stock exchange than to sell shares in a private firm, a piece of land, or a building. Some institutional investors, depending on their cash flow needs, may be ready and able to keep investments for long periods, therefore liquidity may be less critical for them than for individuals or institutional investors that have liquidity limits.
Alternative investments are especially difficult to value because data availability to assess how much they are worth is restricted. Purchases and sales of start-up enterprises, land, or buildings are unusual, thus valuation is tough and is generally based on an evaluation. An appraisal is an assessment or estimation of the value of an item and is subject to specific assumptions, which may not always be practical.
For example, a property may be estimated to be worth GBP100,000 based on its location, square footage, and price per square foot paid in similar deals. But if the property market slows down, the assumption regarding the price per square foot may be unduly optimistic and the value of the property could be less than projected.
If a public company needs funds to invest in a project, say to establish a new manufacturing facility or to extend its operations abroad, it may turn to the financial markets and issue the forms of debt and equity instruments mentioned in the earlier modules of this course.
But what if an entrepreneur wants money to start a great new business? Or what if a small firm needs cash to grow, but it is not established enough to seek an initial public offering? The entrepreneur and the young company do not have the functioning track record needed to offer debt or equity securities to the public. In addition, although they may seek loans from banks, the amount of money they may borrow is frequently limited. Banks typically do not finance new and young enterprises since the risk of not getting the money back is considerable.
So, entrepreneurs or young enterprises may resort to the venture capital industry to receive the money they need.
Venture capitalists concentrate in investing new and fledgling firms. They give entrepreneurs and fledgling enterprises with both the funding and the skills to begin and build their businesses and to develop track records of successful operations.
Venture capital is a form of private equity, which is itself a type of alternative investment. From an investor’s point of view, alternative investments are diversified and often comprise the following:
Investments in private enterprises — that is, companies that are not listed on a stock exchange are known as private equity investments.
Direct or indirect investments in land and buildings are defined as real estate.
Investments in physical things, such as precious and base metals (e.g., gold, copper), energy products (e.g., oil), and agricultural products that are typically eaten (e.g., maize, livestock, wheat) or used in the creation of goods (e.g., lumber, cotton, sugar), are known as commodities.
Private equity, real estate, and commodities are all considered alternative investments since they represent an option to investing only in ‘traditional’ asset classes, such as debt and equity instruments. Although alternative investments have acquired importance in the 21st century, they are not new; in fact, real estate and commodities are among the oldest sorts of investments.
As we will discuss shortly, alternative investments are an opportunity to potentially enhance returns and obtain diversification benefits; recall that diversification is the practice of combining different types of assets or securities in a portfolio to reduce risk, without sacrificing expected returns. The hunt for higher returns and reduced risk explains why alternative investments have become a vital component of the portfolios of many investors, both institutional and individual, who regard private equity, real estate, and/or commodities as potential to deliver both.
Why Invest in Alternatives?
In addition to the issues connected to the COVID pandemic crisis that started in 2020 and increasing geopolitical risks, investors are ready for increased volatility, higher inflation, and upward pressure on interest rates. Against this context, investors are increasingly seeking to private markets and other alternative assets to accomplish their investment return targets. Real estate and private equity are the asset classes with the greatest portfolio allocations by institutional investors. For example, in 2021, 80% and 73% of institutional investors who allocate to alternatives responding to Nuveen’s EQuilibrium survey, placed a portion of their portfolios in real estate and private equity, respectively (see the image below). Private credit is also a significant asset class for such investors, demonstrating the highest year-over-year growth in current allocation.
The numerous sorts of alternative investments can look utterly unconnected to one other. But they have potential common advantages, and they also share similar constraints.
Advantages
They may help boost profits and minimize risk by providing diversification benefits.
Limitations
Typically, they are less regulated, less transparent, less liquid, and more difficult to value than debt and equity investments.
Advantages of Alternative Investments
Investors add alternative investments to their portfolios for two key reasons:
To enhance returns
To reduce risk by getting diversity benefits
Enhancing Returns
The following tables illustrate historical returns for various asset classes. The first and second tables illustrate that throughout the past 25-year period, investments in US private equity and North American real estate (as proxied by real estate investment trusts, or REITS), respectively, have outpaced investments in US equities securities. But you should not extrapolate from these outcomes that alternative investments always offer higher returns than traditional asset classes.
During the global financial crisis of 2008–2009, many investors suffered losses on their private equity and real estate investments, and some losses were larger than those on traditional assets, such as publicly listed securities.
Reducing Risk
Investors rarely allocate all their money to one form of asset or security. Instead, they diversify their portfolios by investing in assets and securities that act differently from each other. How investments act relative to each other leads us back to the concept of correlation, as you learnt about in Module 1, Quantitative Concepts.
As a reminder, if two assets or securities do not have a correlation of +1 (that is, if they are less than fully positively correlated), then combining the two assets or securities in a portfolio provides diversification benefits and hence decreases risk in the portfolio. In other words, the risk to the portfolio after incorporating these two assets or securities is lower than the weighted sum of the risks of the two assets or securities when they are assessed separately.
Because there is a generally low connection between different forms of alternative investments, and also between alternative investments and other asset classes (such stocks and bonds), adding private equity, real estate, and commodities to portfolios helps investors decrease risk. As previously mentioned, during periods of financial crisis, returns on diverse investments may become more connected and the benefits of diversification may be lessened.
Limitations of Alternative Investments
Although alternative investments have the potential to boost returns and minimize risk, they also have limitations. Typically, alternative investments are less regulated and less transparent than regular investments, illiquid, and difficult to appraise.
Because alternative investments are less regulated and less transparent than traditional investments, such as stock and debt instruments, individual individuals are less likely to invest in them. Institutional investors may regard this as an opportunity to take advantage of market inefficiencies.
In addition, most alternative investments are illiquid – that is, they are impossible to sell fast without accepting a drastically discounted price. For example, it is considerably easier to sell shares of a public corporation listed on a stock exchange than to sell shares in a private firm, a piece of land, or a building. Some institutional investors, depending on their cash flow needs, may be ready and able to keep investments for long periods, therefore liquidity may be less critical for them than for individuals or institutional investors that have liquidity limits.
Alternative investments are especially difficult to value because data availability to assess how much they are worth is restricted. Purchases and sales of start-up enterprises, land, or buildings are unusual, thus valuation is tough and is generally based on an evaluation. An appraisal is an assessment or estimation of the value of an item and is subject to specific assumptions, which may not always be practical.
For example, a property may be estimated to be worth GBP100,000 based on its location, square footage, and price per square foot paid in similar deals. But if the property market slows down, the assumption regarding the price per square foot may be unduly optimistic and the value of the property could be less than projected.
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Investment - Types of Bonds
Fixed-Rate Bonds
Fixed-rate bonds are the major type of debt securities issued by enterprises and governments. A fixed-rate bond has a defined life that ends on the bond’s maturity date, has a coupon rate that does not change over the life of the bond, and has a par value that does not change. That is, fixed-rate bonds pay fixed, periodic coupon payments during the life of the bond and a final par value payment at maturity.
Floating-Rate Bonds
Floating-rate bonds, commonly referred to as variable-rate bonds or floating-rate notes (FRNs) or floaters, are identical to fixed-rate bonds except that the coupon rate on floating-rate bonds increases over time.
The coupon rate of a floating-rate bond is frequently linked to a market reference rate, such as the risk-free rate or other benchmark rate.
The variable rate reflects the reference rate and the riskiness (or creditworthiness) of the issuer at the time of issuing. The floating rate is equal to the reference rate plus a percentage that is a function of the issuer’s creditworthiness and the bond’s attributes.
The percentage above the reference rate is termed the spread and normally remains constant over the life of the bond.
In other words, for an existing issue, the spread used to and normally remains constant over the life of the bond.
In other words, for an existing issue, the spread used to compute a floating-rate bond’s coupon payment does not alter over the bond’s life to reflect any change in creditworthiness that occurs after issue. But the reference rate does alter over time with changes in the level of interest rates in the economy.
Floating rate = Reference rate + Spread
In bond markets, the practice is to refer to percentages in terms of basis points. One hundred basis points (or bps, pronounced ‘bips’) equal 1.0%, so one basis point is equal to 0.01%, or 0.0001.
Therefore, rather than describing a floating rate as the applicable reference rate + 0.75%, the floating rate would be presented as the reference rate plus 75 bps.
A floating-rate bond’s coupon rate will change, or reset, at each payment date, often every quarter. Floating-rate coupon payments are paid in arrears — that is, at the conclusion of the period on the basis of the level of the reference rate set at the beginning of the period.
On a payment day, the coupon rate is set for the next period to reflect the current level of the reference rate plus the stated spread. This new coupon rate will decide the amount of the payment at the next payment date.
The following example illustrates the effect of changes in a reference rate on coupon rates and coupon payments for a floating-rate bond.
Example: Floating-Rate Bonds
On 31 March, a UK company raises GBP2 million by issuing floating-rate notes with a maturity of nine months.
The reference rate is the three-month Sterling Overnight Index Average (SONIA).
The coupon rate is SONIA plus 140 bps (1.40%).
Note that although though it is labeled three-month SONIA, the rate given is an annual rate. It is usual practice to quote interest rates as an annual rate. Therefore, the total rate (SONIA + 1.40%) must be divided by four to calculate the quarterly coupon payment. The coupon rate is reset every quarter.
The exhibit below illustrates the three-month SONIA rate at the beginning of each quarter and the total coupon payment made each quarter by the corporation.
Fixed-Rate Bonds
Fixed-rate bonds are the major type of debt securities issued by enterprises and governments. A fixed-rate bond has a defined life that ends on the bond’s maturity date, has a coupon rate that does not change over the life of the bond, and has a par value that does not change. That is, fixed-rate bonds pay fixed, periodic coupon payments during the life of the bond and a final par value payment at maturity.
Floating-Rate Bonds
Floating-rate bonds, commonly referred to as variable-rate bonds or floating-rate notes (FRNs) or floaters, are identical to fixed-rate bonds except that the coupon rate on floating-rate bonds increases over time.
The coupon rate of a floating-rate bond is frequently linked to a market reference rate, such as the risk-free rate or other benchmark rate.
The variable rate reflects the reference rate and the riskiness (or creditworthiness) of the issuer at the time of issuing. The floating rate is equal to the reference rate plus a percentage that is a function of the issuer’s creditworthiness and the bond’s attributes.
The percentage above the reference rate is termed the spread and normally remains constant over the life of the bond.
In other words, for an existing issue, the spread used to and normally remains constant over the life of the bond.
In other words, for an existing issue, the spread used to compute a floating-rate bond’s coupon payment does not alter over the bond’s life to reflect any change in creditworthiness that occurs after issue. But the reference rate does alter over time with changes in the level of interest rates in the economy.
Floating rate = Reference rate + Spread
In bond markets, the practice is to refer to percentages in terms of basis points. One hundred basis points (or bps, pronounced ‘bips’) equal 1.0%, so one basis point is equal to 0.01%, or 0.0001.
Therefore, rather than describing a floating rate as the applicable reference rate + 0.75%, the floating rate would be presented as the reference rate plus 75 bps.
A floating-rate bond’s coupon rate will change, or reset, at each payment date, often every quarter. Floating-rate coupon payments are paid in arrears — that is, at the conclusion of the period on the basis of the level of the reference rate set at the beginning of the period.
On a payment day, the coupon rate is set for the next period to reflect the current level of the reference rate plus the stated spread. This new coupon rate will decide the amount of the payment at the next payment date.
The following example illustrates the effect of changes in a reference rate on coupon rates and coupon payments for a floating-rate bond.
Example: Floating-Rate Bonds
On 31 March, a UK company raises GBP2 million by issuing floating-rate notes with a maturity of nine months.
The reference rate is the three-month Sterling Overnight Index Average (SONIA).
The coupon rate is SONIA plus 140 bps (1.40%).
Note that although though it is labeled three-month SONIA, the rate given is an annual rate. It is usual practice to quote interest rates as an annual rate. Therefore, the total rate (SONIA + 1.40%) must be divided by four to calculate the quarterly coupon payment. The coupon rate is reset every quarter.
The exhibit below illustrates the three-month SONIA rate at the beginning of each quarter and the total coupon payment made each quarter by the corporation.
Inflation-Linked Bonds
An inflation-linked bond is a particular sort of floating-rate bond. Inflation-linked bonds feature a provision that adjusts the bond’s par value for inflation and thereby protects the investor against the consequences of inflation. Inflation will often lower an investor’s purchasing power from bond cash flows. Changes to the par value lessen the effects of inflation on the investor’s purchasing power from bond cash flows.
For most inflation-linked bonds, the par value — not the coupon rate — of the bond is modified at each payment date to reflect changes in inflation (which is normally monitored by a consumer price index).
The bond’s coupon payments are adjusted for inflation since the fixed coupon rate is multiplied by the inflation-adjusted (higher) par value.
Examples of inflation-linked bonds are Treasury Inflation-Protected Securities (TIPS) in the United States, index-linked gilts in the United Kingdom, and iBonds in Hong Kong.
Because of the inflation protection afforded by inflation-linked bonds, the coupon rate on an inflation-linked bond is often lower than the coupon rate on a fixed-rate bond with otherwise equivalent characteristics.
Zero-Coupon Bonds
As with fixed-rate and floating-rate bonds, zero-coupon bonds have a finite life that ends on the bond’s maturity date. But zero-coupon bonds do not offer periodic interest payments during the life of the bond. The only cash flow offered by a zero-coupon bond is a single payment equal to the bond’s par value that is paid on the bond’s maturity date.
Zero-coupon bonds are often issued at a discount to the bond’s par value — that is, at an issue price that is lower than the par value. Thus, the investor’s return for owning the bond is the difference between the issue price and the par value payment received at maturity.
Many debt securities issued with maturities of one year or less are issued as zero-coupon debt securities.
For example, Treasury notes having maturities of one year or less issued by the US government are issued as zero-coupon securities.
In rare situations, firms and governments issue zero-coupon bonds that have maturities of greater than one year. Because of the risk inherent when the only payment is the payout at maturity, investors are frequently reluctant to buy zero-coupon bonds with long periods to maturity. If they are willing to do so, the projected return must be quite high compared to the interest rate on coupon-paying bonds, and many issuers are reluctant to pay such a high cost for borrowing.
The following example describes the issue of a 20-year zero-coupon bond.
Example: Zero-Coupon Bonds
Suppose a corporation issues zero-coupon bonds, each with a par value of EUR1,000. Further assume that, at issuance, investors agree to pay EUR268.31 for each bond. Thus, the investor’s projected return for buying the bond will be €1,000 – €268.31 = €731.69, to be received on the bond’s maturity date.
This example explains why investors often favor high rates of projected return for zero-coupon bonds with long terms to maturity.
An inflation-linked bond is a particular sort of floating-rate bond. Inflation-linked bonds feature a provision that adjusts the bond’s par value for inflation and thereby protects the investor against the consequences of inflation. Inflation will often lower an investor’s purchasing power from bond cash flows. Changes to the par value lessen the effects of inflation on the investor’s purchasing power from bond cash flows.
For most inflation-linked bonds, the par value — not the coupon rate — of the bond is modified at each payment date to reflect changes in inflation (which is normally monitored by a consumer price index).
The bond’s coupon payments are adjusted for inflation since the fixed coupon rate is multiplied by the inflation-adjusted (higher) par value.
Examples of inflation-linked bonds are Treasury Inflation-Protected Securities (TIPS) in the United States, index-linked gilts in the United Kingdom, and iBonds in Hong Kong.
Because of the inflation protection afforded by inflation-linked bonds, the coupon rate on an inflation-linked bond is often lower than the coupon rate on a fixed-rate bond with otherwise equivalent characteristics.
Zero-Coupon Bonds
As with fixed-rate and floating-rate bonds, zero-coupon bonds have a finite life that ends on the bond’s maturity date. But zero-coupon bonds do not offer periodic interest payments during the life of the bond. The only cash flow offered by a zero-coupon bond is a single payment equal to the bond’s par value that is paid on the bond’s maturity date.
Zero-coupon bonds are often issued at a discount to the bond’s par value — that is, at an issue price that is lower than the par value. Thus, the investor’s return for owning the bond is the difference between the issue price and the par value payment received at maturity.
Many debt securities issued with maturities of one year or less are issued as zero-coupon debt securities.
For example, Treasury notes having maturities of one year or less issued by the US government are issued as zero-coupon securities.
In rare situations, firms and governments issue zero-coupon bonds that have maturities of greater than one year. Because of the risk inherent when the only payment is the payout at maturity, investors are frequently reluctant to buy zero-coupon bonds with long periods to maturity. If they are willing to do so, the projected return must be quite high compared to the interest rate on coupon-paying bonds, and many issuers are reluctant to pay such a high cost for borrowing.
The following example describes the issue of a 20-year zero-coupon bond.
Example: Zero-Coupon Bonds
Suppose a corporation issues zero-coupon bonds, each with a par value of EUR1,000. Further assume that, at issuance, investors agree to pay EUR268.31 for each bond. Thus, the investor’s projected return for buying the bond will be €1,000 – €268.31 = €731.69, to be received on the bond’s maturity date.
This example explains why investors often favor high rates of projected return for zero-coupon bonds with long terms to maturity.
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Investment - Bond Seniority Ranking
The bond indenture offers bondholders the right to take legal action if the issuer fails to fulfill the promised payments or fails to satisfy other requirements mentioned in the contract. If the bond issuer fails to make the promised payments, this failure is referred to as a default and the debt holders often have legal action to reclaim the promised payments. In the case the issuing firm is liquidated, assets are allocated following a priority of claims, or seniority ranking.
This priority of claims can affect the amount that an investment receives at liquidation.
Priority of Claims
The bond indenture offers bondholders the right to take legal action if the issuer fails to fulfill the promised payments or fails to satisfy other requirements mentioned in the contract. If the bond issuer fails to make the promised payments, this failure is referred to as a default and the debt holders often have legal action to reclaim the promised payments. In the case the issuing firm is liquidated, assets are allocated following a priority of claims, or seniority ranking.
This priority of claims can affect the amount that an investment receives at liquidation.
Priority of Claims
The par value (principal) of a bond plus missing interest payments represents the highest amount a bondholder is entitled to collect upon liquidation of a corporation, assuming there are sufficient assets to fulfill the claim. Because debt constitutes a contractual commitment of the corporation, debt holders have a larger claim on a company’s assets than stock holders.
But not all debt holders have the same priority of claim; borrowers may issue debt securities that differ in terms of seniority ranking.
In general, bonds may be issued in the form of secured or unsecured debt securities.
Select the following tabs to learn more about the distinctions between debt securities.
Secured Debt Securities
When a borrower issues secured debt securities, it commits certain specific assets as collateral to the bondholders. As stated in Course 2, Types and Functioning of Markets, collateral is often a tangible item, such as property, plant, or equipment, that the borrower guarantees to the bondholders to secure the loan. In the event of default, the bondholders are legally entitled to take control of the pledged assets.
In effect, the collateral decreases the chance that bondholders will lose money in the case of default because the pledged collateral can be sold to recover some or all of the bondholders’ claim (missing coupon payments and/or recovery of par value).
Unsecured Debt Securities
Unsecured debt securities are not backed by collateral; these bonds are referred to as debentures. Consequently, bondholders will often seek a larger coupon rate on unsecured debt instruments than on secured debt securities. A bond indenture may indicate that an unsecured bond has a lesser priority in the event of default than other unsecured obligations.
A lower priority unsecured bond is termed subordinated debt. Subordinated debt holders receive payment in the case of default only when higher priority debt claims are satisfied in full. Subordinated debt may also be ranked according to priority, from senior to junior.
But not all debt holders have the same priority of claim; borrowers may issue debt securities that differ in terms of seniority ranking.
In general, bonds may be issued in the form of secured or unsecured debt securities.
Select the following tabs to learn more about the distinctions between debt securities.
Secured Debt Securities
When a borrower issues secured debt securities, it commits certain specific assets as collateral to the bondholders. As stated in Course 2, Types and Functioning of Markets, collateral is often a tangible item, such as property, plant, or equipment, that the borrower guarantees to the bondholders to secure the loan. In the event of default, the bondholders are legally entitled to take control of the pledged assets.
In effect, the collateral decreases the chance that bondholders will lose money in the case of default because the pledged collateral can be sold to recover some or all of the bondholders’ claim (missing coupon payments and/or recovery of par value).
Unsecured Debt Securities
Unsecured debt securities are not backed by collateral; these bonds are referred to as debentures. Consequently, bondholders will often seek a larger coupon rate on unsecured debt instruments than on secured debt securities. A bond indenture may indicate that an unsecured bond has a lesser priority in the event of default than other unsecured obligations.
A lower priority unsecured bond is termed subordinated debt. Subordinated debt holders receive payment in the case of default only when higher priority debt claims are satisfied in full. Subordinated debt may also be ranked according to priority, from senior to junior.