Derivatives and Valuation of Derivatives

Derivatives are instruments that derive their value and payoff from another asset, called underlying asset. Derivatives include options, forward contracts, futures contracts and swaps. Investors, including firms, are risk averse. They aim at reducing risk by hedging through derivatives. Hedging helps to (i) reduce costs of financial distress, (ii) isolate the effects of changes in external factor like interest rates and foreign exchange rates on profitability, and (iii) allow managers to focus on improving operating efficiency rather worrying about changes in factors on which they have no control. Forward Contract is an agreement between two parties, called counterparties, to buy and sell an asset at a future date at a price agreed upon today. There is no immediate flow of cash. Cash is paid or received on the due date. Forward contracts are obligations. They are not traded on organised exchanges. Futures Contract is like a forward contract. But, unlike forward contracts, futures contracts are traded on organised exchanges. Thus, they are liquid. Yet another feature of futures contract is that they are marked to market. Prices differences every day are settled through the exchange clearing house. The clearinghouse pays to the buyer if the price of a futures contract increases on a particular day. The seller pays money to the clearing house. The reverse will happen if the prices decrease. Swaps are arrangements to exchange cash flows over time. Currency Swap The agreement provides for exchanging payments denominated in one currency for payments in another currency over a period of time. Interest Rate Swap one type of interest payments, say, fixed-rate payments, is exchanged for another, interest payments, say, floating-rate payments. The floating interest rates may be tied to LIBOR. Option is a contract that gives the holder a right, without any obligation, to buy or sell an underlying asset at a given exercise (or strike) price on or before a specified expiration period. The underlying asset (i.e., asset on which right is written) could be a share or any other asset. Call Option is a right to buy an asset. A buyer of a call option on a share will exercise his right when the actual share price at expiration (St) is higher than the exercise price (E), otherwise, he will forgo his right. Put Option is a right to sell an asset. The buyer of a put option will exercise his right if the exercise price is higher than the share price; he will not exercise his option if the share price is equal to or greater than the exercise price. American Option can be exercised at expiration or any time before expiration while European options can be exercised only at expiration.

 In/Out/At the Money

Value of a Share Option There are five factors that affect the value of a share option: (1) the share price, (2) the exercise price, (3) the volatility (standard deviation) of the share return, (4) the risk-free rate of interest, and (5) the options time to expiration. Value of a Call At expiration the maximum value of a call option is: Value of call option at expiration = Max [(St E), 0] Call Options Value will increase with increase in the share price, the rate of interest, volatility and time to expiration. It will decline with increase in the exercise price. Value of Put Option at expiration is: Value of put option at expiration = Max [(E St), 0] Put Options Value will increase with increase in the exercise price, volatility and time to expiration. It will decrease with increase in the share price, and the rate of interest. Several Trading Strategies (Hedged Position) An investor can create a hedged position by combining a long position in the share with a long position in a protective puta put that is purchased at-the-money (exercise and current share prices being the same). Straddle The investor can also create a portfolio of a call and a put with the same exercise price. This is called a straddle. Spread If call and put with different exercise price are combined, it is called a spread. Value of Call and Put in case of Dividend Paying Shares The value of call decreases and the value of put increases in the case of dividend paying shares Black and Scholes (BS) Model to value a European call option:

where C0 = the value of an option, S = the current market value of the share, E = the exercise price,

e = 2.7183, the exponential constant, rf = the risk-free rate on interest, t = the time to expiration (in years), s = the standard deviation of the continuously compounded annual return on the share and N(d1), N(d2) = the cumulative normal probability density function. d1 and d2 can be calculated as follows:

ln = the natural logarithm The term N(d1) in the BS model is interpreted as a hedge ratio, or the call options delta. The option delta indicates the number of units of a share to be bought for each call sold. Put-Call Parity There is a fixed relationship between put and call on the same share with similar exercise price and maturity period. This relationship, called put-call parity, is given as follows: Value of put + value of share = value of call + PV of exercise price Option in Case of an Ordinary Share There is a hidden option in the case of an ordinary share that arises because of the limited liability of the shareholders. Shareholders have a call option on the firm with an exercise price equal to the required payment for debt. Shareholders will exercise their option to keep the firm (by making required payment to debt-holders) if the value of the firm is higher than the debt payment.

Debt and Equity Valuation

Discount Rate being the rate of return that investors expect from securities of comparable risk. Bonds or Debentures are debt instruments or securities. In case of a bond/debenture the stream of cash flows consists of annual interest payments and repayment of principal. These flows are fixed and known. The Value of the Bond can be found by capitalising cash flows at a rate of return, which reflects their risk. The market interest rate or yield is used as the discount rate in case of bonds (or debentures). The basic formula for the bond value is as follows:

Yield to Maturity A bonds yield to maturity or internal rate of return can be found by equating the present value of the bonds cash outflows with its price in the above equation. Zero-Interest Bonds (called zero-coupon bonds in USA) do not have explicit rate of interest. They are issued for a discounted price; their issue price is much less than the face value. Therefore, they are also called deep-

discount bonds. The basic discounting principles apply in determining the value or yield of these bonds. Preference shares have a preference over ordinary shareholders with regard to dividends. The preference dividend is specified and known. Similarly, in the case of redeemable preference share the redemption or maturity value is also known. Preference share value can be determined in the same way as the bond value. Here the discount rate will be the rate expected by the preference shareholders given their risk. This risk is more than the risk of bondholders and less than the equity shareholders. Value of the Share (General) Cash flows of an ordinary (or equity) share consist of the stream of dividends and terminal price of the share. Unlike the case of a bond, cash flows of a share are not known. Thus, the risk of holding a share is higher than the risk of a bond. Consequently, equity capitalisation rate will be higher than that of a bond. The general formula for the share valuation is as follows:

PV =

+ + (1 + .12)1 (1 + .12) 2 (1 + .12)3 PV = Rs.75.00

Example Current forecasts are for XYZ Company to pay dividends of Rs.3, Rs.3.24, and Rs.3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of Rs.94.48. What is the price of the stock given a 12% expected return? 3.00 3.24 3.50 + 94.48

As the time horizon, n, becomes very large (say, extends to infinity) the present value of future price approaches zero. Thus the term Pn disappears from the formula, and we can use the following equation to find the value of a share today:

Value of the Share (Zero Growth) If dividends do not grow, then capitalizing earnings can determine the share value. Under no-growth situation, earnings per share (EPS) will be equal to dividends per share (DIV) and the present value is obtained by capitalizing earnings per share:

Value of the Share (Constant Growth) In practice, dividends do grow over years. If we assume dividends to grow at a constant rate, g, thenDIV1 = DIV0 (1 + g), DIV2 = DIV1 (1 + g), DIV3 = DIV2 (1 + g)..., and the share price formula can be written as follows:

This formula is useful in calculating the equity capitalisation rate (ke) when the price of the share (P0) is known. If the same stock is selling for Rs.100 in the stock market, what might the market be assuming about the growth in dividends? Rs.100 = g = .09 Answer The market is assuming the dividend will grow at 9% per year, indefinitely. Rs.3.00 .12 g

Under the assumption of constant growth, the share value is equal to the capitalized value of earnings plus the value of growth opportunities as shown below:

Value of Growth Opportunities (Vg) Given a firms EPS, ROE, the equity capitalisation rate, retention ratio and constant growth, the growth opportunities can be valued as follows:

E/P Ratio and Ke Relationship between the earnings-price ratio and capitalisation rate as follows:

The E/P ratio will equal the capitalisation rate only when growth opportunities are zero, otherwise it will either overestimate or underestimate the capitalisation rate.

Efficient Market Hypothesis

Random Walk Theory The movement of stock prices from day to day DO NOT reflect any pattern.

 Statistically speaking, the movement of stock prices is random (skewed positive over the long term).

Efficient Market Theory

In the mid-1960s Eugene Fama introduced the idea of an efficient capital market. The efficient capital market hypothesis says that intense competition in the capital market leads to fair pricing of securities. A sweeping statement, it continues to stimulate insight and controversy even today. Eugene Fama suggested that it is useful to distinguish three levels of efficiency: weak form, semi strong form and strong form. The weak form efficient market hypothesis says that the current price of a stock reflects all information found in the record of past prices and volumes. By and large the empirical evidence, relying on tests like the serial correlation test, runs test and filter rule test, supports the weak form of efficiency. The semi strong form efficient market hypothesis holds that stock prices rapidly adjust to all publicly available information. Two kinds of studies have been conducted to test the semi strong form of efficient market hypothesis: event studies and portfolio studies. An event study examines the market reactions to and excess returns around a specific information event like an earnings announcement or a stock split. A portfolio study examine the returns earned by a portfolio of stocks having some observable characteristic like low price-earnings multiple. The results of event studies as well as portfolio studies are mixed. The strong form efficient market hypothesis holds that all available information, public or private, is reflected in stock prices. Obviously, this represents an extreme hypothesis and we would be surprised if it were true. Empirical evidence too does not support it.