What is a Warrant?
- A derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame.
- Often issued during IPO’s as a sweetener as the price may be expected to fall below the IPO price.
- Capital gains taxable upon excercize.
- Warrants are issued by the company (unlike a call option which is an exchange traded derivative)
What is a convertible security?
- Convertibles link two assets.
- They allow the holder to transfer a bond or preferred stock into a fixed number of shares of common stock regardless of market price.
- Conversion ratio is usually at a deep discount not profitable unless there is a significant increase in stock price/decrease in bond price.
What is Modified Duration?
Macaulay’s duration - Weighted average of the times until each payment is received, with the weights proportional to the present value of the payment.
- Modified duration uses Macaulay’s duration to calculate the % change in a bonds price to a % change in its yield.
What is convexity?
- Modified duration is a linear approximation of price-yield
- The relationship is in fact curved. Convexity captures this and measures the curvature of the price-yield curve.
- This increases accuracy of approximation.
What is Standard Deviation?
Standard Deviation is variation about the mean of a value a portfolio is subject to 68% of the time.
What is Value at Risk? VaR
VaR is expressed as maximum percentage loss in the value of a portfolio that occurs on 95% of loss occasions. ie. “1 year VaR in the UK is 25% so there is a 95% chance you will lose less than this and a 5% probability of loss worse”
What is Conditional Value-At-Risk? CVaR
-The average return in the portfolio in the worst 5% of cases
“If I end up in the tail of say, 5% of worst outcomes, what is the average loss I will incur”.
What is the Variance of Portfolio Formula?
VoP = Va(%a)^2+ Vb(%)^2+2(%a)(%b)Cov cc= correlation coeffecient Covab= SDa x SDb x cc
Mean, Median, Mode, Kurtosis and Skewdness?
If the mean is to the left of the Median you have negative skewdness avv.
Platykurtic means distribution of returns is less centered on the mean.
Mesokurtic means normal
Leptokurtic means distribution of returns in more centered on the mean than predicted by normal distribution.
What is a Futures Contract?
- Standardized contracts in terms of size and delivery date specifying quantity and quality of underlying.
- Profits and losses are realized immediately as they are marked to market.
- Margins are maintained to reflect price movements.
- When traded on exchange they are regulated.
What is a Forward contract?
- Customized tailored contacts in terms of size and delivery dates with the price agreed at the start.
- Private OTC contracts between two parties.
- Allows for more precise hedging for companies.
- Not regulated and Margins set once on the initial transaction.
- Profit or loss realized on delivery date.
What is the multiple Gordons Growth Model and Dividend Pay Out Ratio Formula possibilities?
DPR = DPS/EPS
GGM - Ex Div Share Price = DPS/(r-g)
Forecast return =risk free rate + equity risk premium
*Forward P/E = DPR/ (r-g)
How is a zero coupon bonds risk free rate more suitable than a coupon paying bond?
- Remember to explain the product
- Zero coupon bonds only have one cash flow, the bond is purchased at a discount with the price rising to par and therefore no re-investment risk.
- Hi yield coupon bonds even those from default risk free issuers will have reinvestment risk at unknown future rates.
List the data needed to calculate Equity Risk Premium.
-Risk Free Rate
-Return on the Market
The excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market.
List the Data needed to calculate required rate of return on equity.
CAPM -
Risk free rate
Return on the market
Beta
What factors could affect bid-ask spread?
- liquidity
- trading volume supply and demand
- recent price volatility = wider spread
- sector news eg profit warnings
- extremely large trades = wider spreads.
- number of market makers - more competitions = narrower spreads
3 Reasons a convertible may trade at a premium?
Convertibles exploit upside growth and protect against downside risk. Essentially an attached call option.
- Higher premium may be due to long time to run potential more growth to share price.
- Underlying stock expected to perform strongly
- Intrinsic value due to low probability of default.
Why are equities high risk class?
- Idiosycratic risk.
- Dividends only paid after bond holders and pref share holders
- Dividends are not guaranteed.
- Low priority over companys assets in a bankruptcy
What is immunization?
Matching durations with the liabilities you are trying to meet.
- Price risk and reinvestment risk cancel each other out.
- If portfolio duration equals the horizon date then accumlated value at the horizon date will be unaffected by interest rate fluctuations.
Calculation for real return vs nominal return
Real Return = (1+n)/(1+i)
n = nominal return i = inflation
How does the commodities return generation differ to other assets?
No natural return generating process
- Valuation based on supply and demand.
- No income generating or natural profit generating process.
- Speculation is a key driver.
Current Share Price of zero coupon bond with 20 years to maturity formula?
Price = Par/(1+rate)^(20
After tax accumulation compounding.
price invested at start x (1 + rate x tax rate eg. 0.75)^n
Preferred stock value
current annual dividend / required rate of return.
eg £1 / 0.07 as a %
