Cambodia Financial Market

Bond Investment Strategies

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Bond investors can choose from many different investment strategies, depending on the role or roles that bonds will play in their investment portfolios.

Passive investment strategies include buying and holding bonds until maturity and investing in bond funds or portfolios that track bond indexes. Passive approaches may suit investors seeking some of the traditional benefits of bonds, such as capital preservation, income and diversification, but they do not attempt to capitalize on the interest-rate, credit or market environment.

Active investment strategies, by contrast, try to outperform bond indexes, often by buying and selling bonds to take advantage of price movements. They have the potential to provide many or all of the benefits of bonds; however, to outperform indexes successfully over the long term, active investing requires the ability to form opinions on the economy, the direction of interest rates and/or the credit environment; trade bonds efficiently to express those views; and manage risk.

Passive strategies: Buy-and-hold approaches

Investors seeking capital preservation, income and/or diversification may simply buy bonds and hold them until they mature.

The interest rate environment affects the prices buy-and-hold investors pay for bonds when they first invest and again when they need to reinvest their money at maturity. Strategies have evolved that can help buy-and-hold investors manage this inherent interest-rate risk. One of the most popular is the bond ladder. A laddered bond portfolio is invested equally in bonds maturing periodically, usually every year or every other year. As the bonds mature, money is reinvested to maintain the maturity ladder. Investors typically use the laddered approach to match a steady liability stream and to reduce the risk of having to reinvest a significant portion of their money in a low interest-rate environment.

Another buy-and-hold approach is the barbell, in which money is invested in a combination of short-term and long-term bonds; as the short-term bonds mature, investors can reinvest to take advantage of market opportunities while the long-term bonds provide attractive coupon rates.

Other passive strategies

Investors seeking the traditional benefits of bonds may also choose from passive investment strategies that attempt to match the performance of bond indexes. For example, a core bond portfolio in the U.S. might use a broad, investment-grade index, such as the Barclays Capital U.S. Aggregate Index, as a performance benchmark, or guideline. Similar to equity indexes, bond indexes are transparent (the securities in it are known) and performance is updated and published daily.

Many exchange-traded funds (ETFs) and certain bond mutual funds invest in the same or similar securities held in bond indexes and thus closely track the indexes’ performances. In these passive bond strategies, portfolio managers change the composition of their portfolios if and when the corresponding indexes change but do not generally make independent decisions on buying and selling bonds.

Active strategies

Investors that aim to outperform bond indexes use actively managed bond strategies. Active portfolio managers can attempt to maximize income or capital (price) appreciation from bonds, or both. Many bond portfolios managed for institutional investors, many bond mutual funds and an increasing number of ETFs are actively managed.

One of the most widely used active approaches is known as total return investing, which uses a variety of strategies to maximize capital appreciation. Active bond portfolio managers seeking price appreciation try to buy undervalued bonds, hold them as they rise in price and then sell them before maturity to realize the profits – ideally “buying low and selling high.” Active managers can employ a number of different techniques in an effort to find bonds that could rise in price.

Credit analysis: Using fundamental, “bottom-up” credit analysis, active managers attempt to identify individual bonds that may rise in price due to an improvement in the credit standing of the issuer. Bond prices may increase, for example, when a company brings in new and better management.
Macroeconomic analysis: Portfolio managers use top-down analysis to find bonds that may rise in price due to economic conditions, a favorable interest-rate environment or global growth patterns. For example, as the emerging markets have become greater drivers of global growth in recent years, many bonds from governments and corporate issuers in these countries have risen in price.
Sector rotation: Based on their economic outlook, bond managers invest in certain sectors that have historically increased in price during a particular phase in the economic cycle and avoid those that have underperformed at that point. As the economic cycle turns, they may sell bonds in one sector and buy in another.
Market analysis: Portfolio managers can buy and sell bonds to take advantage of changes in supply and demand that cause price movements.
Duration management: To express a view on and help manage the risk in interest-rate changes, portfolio managers can adjust the duration of their bond portfolios. Managers anticipating a rise in interest rates can attempt to protect bond portfolios from a negative price impact by shortening duration, possibly by selling some longer-term bonds and buying short-term bonds. Conversely, to maximize the positive impact of an expected drop in interest rates, active managers can lengthen duration on bond portfolios.
Yield curve positioning: Active bond managers can adjust the maturity structure of a bond portfolio based on expected changes in the relationship between bonds with different maturities, a relationship illustrated by the yield curve. While yields normally rise with maturity, this relationship can change, creating opportunities for active bond managers to position a portfolio in the area of the yield curve that is likely to perform the best in a given economic environment.
Roll down: When short-term interest rates are lower than longer-term rates (known as a “normal” interest rate environment), a bond is valued at successively lower yields and higher prices as it approaches maturity or “rolls down the yield curve.” A bond manager can hold a bond for a period of time as it appreciates in price and sell it before maturity to realize the gain. This strategy has the potential to continually add to total return in a normal interest rate environment.
Derivatives: Bond managers can use futures, options and derivatives to express a wide range of views, from the credit-worthiness of a particular issuer to the direction of interest rates.
An active bond manager may also take steps to maximize income without increasing risk significantly, perhaps by investing in some longer-term or slightly lower rated bonds, which carry higher coupons.

Financial Market Instruments

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Money Market Instruments

United States Treasury Bills

These short-term debt instruments of the U.S. government are issued in 3, 6, and 12-month maturities to finance the federal government. They pay a set amount at maturity and have no interest payments, but they effectively pay interest by initially selling at a discount, that is, at a price lower than the set amount paid at maturity. For instance, you might pay $9,000 in May 2004 for a one year Treasury Bill that can be redeemed in May 2005 for $10,000.

Negotiable Bank Certificates of Deposit

A certificate of deposit (CD) is a debt instrument, sold by commercial banks, corporations, money market mutual funds, charitable institutions, and government agencies to depositors, that pays annual interest of a given amount and at maturity, pays back the original purchase price.

Commercial Paper

Commercial paper is a short-term debt instrument issued by large banks and well-known corporations.

Banker’s Acceptances

A banker’s acceptance is a bank draft (a promise of payment similar to a check) issued by a firm payable at some future date, and guaranteed for a fee by the bank that stamps it “accepted.” The firm issuing the instrument is required to deposit the required funds into its account to cover the draft. If the firm fails to do so, the bank’s guarantee means that it is obligated to make good on the draft. The advantage to the firm is that the draft is more likely to be accepted when purchasing goods abroad, because the foreign exporter knows that even if the company purchasing the goods goes bankrupt, the bank draft will still be paid off.

Repurchase Agreements

Repurchase agreements, or repos, are effectively short-term loans (usually with a maturity of less than two weeks) in which Treasury bills serve as collateral, an asset that the lender receives if the borrower does not pay back the loan.

Federal (Fed) Funds

These are typically overnight loans between banks to other banks. One reason why a bank might borrow
in the federal funds market is that it might find it does not have enough deposits at the Fed to meet the amount required by regulators. It can then borrow these deposits from another bank.the interest rate on these loans, called the federal funds rate, is a closely watched barometer of the tightness of credit market conditions in the banking system and the stance of monetary policy; when it is high, it indicates that the banks are strapped for funds, whereas when it is low, banks’ credit needs are low.

Capital Market Instruments

Capital market instruments are debt and equity instruments with maturities of greater than one year. They have far wider price fluctuations than money market instruments and are considered to be fairly risky investments.

Stocks

Stocks are equity claims on the net income and assets of a corporation.

Mortgages

Mortgages are loans to households or firms to purchase housing, land, or other real structures, where the structure or land itself serves as collateral for the loans.

Corporate Bonds

These are long-term bonds issued by corporations with very strong credit ratings.

U.S. Government Securities

These long-term debt instruments are issued by the U.S. Treasury to finance the deficits of the federal government.

Consumer and Bank Commercial Loans

These are loans to consumers and businesses made principally by banks, but in the case of consumer loans also by finance companies.

The Law of Increasing Opportunity Cost

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The law of increasing opportunity cost states that the opportunity cost of a good rises as more of the good is produced.

Example:

As we go down the table, butter production increases by a constant 100 tons in each new row. But notice
that gun production falls by larger and larger amounts each time butter production increases by 100 tons.

For example, moving from point A to point B along the PPF, butter production rises by 100 tons, and gun production falls by 100, from 1,000 to 900. So the opportunity cost of the first 100 tons of butter is 100 guns. the if we move from row B to row C,then the butter production again rises by 100 tons, gun production falls by 150, from 900 to 750. So the opportunity cost of the second 100 tons of butter is 150 guns.

As you continue down the rows, the opportunity cost of an additional 100 tons of butter continually increases. The more butter we produce, the greater the opportunity cost of producing more butter.

Now we apply this law ,Suppose a country begins at point A, where it produces only guns but no butter. At point A, all of the country’s resources are used to make guns. Even those resources that would be much more useful for making butter, such as farmers and their equipment, are employed in gun production.Now suppose the country decides to produce butter, too. To make its first 100 tons of butter, moving from A to B, the country will have to shift resources out of gun production and into butter production.

To make as much as possible of both goods, it will shift those resources that are the most useful for making butter and the least useful for making guns,those farmers and barns and milking machines. Gun production
will not fall much, because the resources taken away were not doing a lot of good in gun production anyway. So the opportunity cost of the fi rst 100 tons of butter is only 100 guns.

Now suppose the country wants to produce an additional 100 tons of butter, moving from point B to point C. This time, the country will have to shift some resources that are better suited for making guns and less suited for making butter— Shifting away these resources will cause gun production to fall by even more than before. This is why, as the figure shows, the opportunity cost of moving from point B to point C is 150
guns, which is higher than the opportunity cost of moving from point A to point B. So the more butter the country is already producing, the greater the opportunity cost of producing more butter.

An economy must choose where to operate among the many possible points on its current production possibilities frontier. That is, a country must decide how much food and how much other stuff to make.

What Causes Business Cycles ?

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Business cycles are alternating rises and declines in the level of economic activity, sometime over several years.

Phases of the Business Cycle

Peak The business activity has reached a temporary maximum. the economy is near or at full employment and the level of real output is at or very close to the economy’s capacity. The price level is likely to rise during this phase.
Recession is a period of decline in total output,income, and employment. it's normally lasts 6 months or more, is marked by the widespread contraction of business activity in many sectors of the economy. Along with declines in real GDP, significant increases in unemployment occur.
Trough the output and employment “bottom out” at their lowest levels. The trough phase may be either short-lived or quite long.
Expansion, a period in which real GDP, income, and employment rise.

Business cycles can be caused by two types of events: changes in aggregate demand or changes in aggregate supply.

Aggregate supply is the total output a country’s firms are willing and able to produce, contingent on the price level.Aggregate supply is based on the cost of production, which varies with the prices and availability of labor and other inputs, and of technology, human capital.any changes in aggregate supply can cause expansions or contractions.

Aggregate Supply Factors

Many changes in aggregate supply arise from external shocks, which are uncontrollable events or decisions made in other countries. The results can be negative or positive.for example an earthquake and tsunami hit Japan in 2011, tens of thousands of people were killed, power plants were destroyed, and ports, roads, bridges, and factories shut down.
The inflow of capital from China’s 2010 investment in Argentina, Brazil, Chile, and Venezuela provided a positive external shock in Latin America.
Weather Changes such as floods and droughts can cause a contraction by destroying crops and making it more difficult to produce goods that contain those crops.
Changes in the Price of Oil , these include increased demand for oil by other countries, decisions by foreign governments to cut oil exports, and disruptions of supplies caused by war or other threats. Higher oil prices cause a decrease in the quantity of output firms will supply at any given price level, so it decrease aggregate supply. The result can be a contraction.
Technological Changes increases productivity or output per worker per hour. When labor is more productive, firms find it less costly and more profitable to increase production.When the change is especially rapid, it can lead to a rapid increase in aggregate supply and start the expansion phase

Aggregate demand is the total amount of domestic output purchased by all sectors of a country’s economy, contingent on the price level.

Aggregate demand Factors

Changes in Household Wealth for example, when housing or stock prices rise, the many people who own them are wealthier, so they increase their spending and boost aggregate demand. But when housing or stock prices fall, their owners are less wealthy. They cut back on their spending, and aggregate demand falls.
Changes in Confidence when people confidence that the economy is doing well leads people to buy more consumer goods and firms to invest more in preparation for growing sales which increases aggregate demand.
Fear about a weak economy weakens the economy and confidence about a strong economy strengthens the economy.
Government Policy such as fiscal policy carried out by the government and monetary policy carried out by the central bank.

Macroeconomic Policy

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Fiscal Policy

The government’s attempt to influence the economy by setting and changing taxes, making transfer payments (For examples, gifts, scholarships, pensions), and purchasing goods and services

How will Fiscal Policy affect aggregate demand?

A tax cut or an increase in transfer payments such as unemployment benefits or welfare payments lead to increases aggregate demand. Both of these influences operate by increasing households’ disposable income.the greater the disposable income, the greater is the quantity of consumption goods and services that households plan to buy and the greater is aggregate demand.
Government expenditure on goods and services is one component of aggregate demand. So if the government spends more on satellites, schools, and highways, aggregate demand increases.

Changes in Aggregate Demand

When aggregate demand changes, the aggregate demand curve shifts.

The curve shift to the right from AD0 to AD1 when expected future income, inflation, or profit increases; government expenditure on goods and services increases; taxes are cut; transfer payments increase; the quantity of money increases and the interest rate falls; the exchange rate falls; or foreign income increases.
The curve shift to the left from AD0 to AD2 when expected future income, inflation, or profit decreases; government expenditure on goods and services decreases; taxes increase; transfer payments decrease; the quantity of money decreases and the interest rate rises; the exchange rate rises; or foreign income decreases.

Summarize below

Monetary Policy

Monetary policy is actions taken by the central bank to manage interest rates and the money supply in pursuit of macroeconomic goals.

Monetary policy tools

Open market operations
The discount rate
Reserve requirements.

Open market operations

The Discount Rate
The discount rate is the interest rate that the Federal reserve charges financial institutions for short-term loans.

By raising or lowering the discount rate, the Federal reserve can influence the activities of banks. Increasing the discount rate makes it more expensive for banks to borrow from the Fed. As with the cost of a higher federal funds rate, the cost of a higher discount rate is passed on to individuals and fi rms through higher interest rates. The result is fewer loans for business expansions and other investments to borrowers, and the economy slows down,however the effect of lowering the discount rate would be reversed and the economy would run faster.

Reserve Requirements
The reserve requirements is specify the percentage of demand deposits that banks must keep on hand.

Fed uses the reserve requirement more to ensure stability in the banking system than as a tool of monetary policy.
Raise or lower reserve requirements, the change affects the availability of loans and the money supply.
If the reserve requirement is lowered, banks hold less money in reserves and can lend more. This adds
to the money supply and the economy begins to expand,however the effect of raising the reserve requirement would be reversed and the economy would contract.

Externalities

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Positive externalities

Too little is produced
Demand-side market failures

Negative externalities

Too much is produced
Supply side market failures

Positive externalities occur when a third person, or persons, is affected by the transaction in a positive way. The good is underproduced when positive externalities are present. The equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must either aid the producer to encourage more output, or engage in its own production of the item with the external benefits.

Negative externalities occur when a third person, or persons, external to the transaction is affected from the transaction in a negative way. The good is overproduced and the equilibrium output will be greater than the efficient output. This is because the producer, who is not bearing the full cost of production, will be able to produce more at a lower price than the efficient level, which would exist if true costs were reflected in the production decision.

With negative externalities borne by society, the producers’ supply curve S is to the right of (below) the total-cost supply curve St. Consequently, the equilibrium output Qe is greater than the optimal output Qo, and the efficiency loss is abc.

When positive externalities accrue to society, the market demand curve D is to the left of (below) the total-benefit demand curve Dt. As a result, the equilibrium output, Qe is less than the optimal output Qo, and the efficiency loss is xyz.

Government Intervention

Correct negative externalities

Direct controls
Specific taxes

Correct positive externalities

Subsidies and government provision

Correct negative externalities

Negative externalities result in an overallocation of resources. Government can correct this overallocation in two ways:

(1) using direct controls which reduce supply by driving up costs of production and would shift the supply curve and reduce output,

(2) imposing a specific tax, T, to the extent that the cost of producing the goods increases, which would also shift the supply curve to the left, eliminating the overallocation of resources and thus the efficiency loss.

When positive externalities are present, the equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must engage in its own production of the item or aid the producer with subsidies to encourage more production.

In either case, the supply curve shifts to the right which lowers the equilibrium price and leads to a greater equilibrium output level.

(a) Negative externalities result in an overallocation of resources.

(b) Government can correct this overallocation in two ways:

using direct controls, which would shift the supply curve from S to St and reduce output from Qe to Qo,
imposing a specific tax, T, which would also shift the supply curve from S to St, eliminating the overallocation of resources and thus the efficiency loss.

Correct positive externalities

(a) Positive externalities result in an underallocation of resources.

(b) This underallocation can be corrected through a subsidy to consumers, which shifts market demand from D to Dt and increases output from Qe to Q0.

(c) The underallocation can be eliminated by providing producers with a subsidy of U, which shifts their supply curve from St to S’t and increases output from Qe to Q0. This eliminates the underallocation of output

Supply and Demand in the Bond Market

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Factors cause the demand curve for bonds to shift

Wealth when the economy is growing rapidly in a business cycle expansion and wealth is increasing, the quantity of bonds demanded at each bond price (or interest rate) increases as shown below that, at a bond price of $900 and an interest rate of 11.1%, the quantity of bonds demanded is $200 billion.

Expected returns on bonds relative to alternative assets the higher expected interest rates in the future lower the expected return for long term bonds, decrease the demand, and shift the demand curve to the left and the lower expected interest rates in the future increase the demand for long-term bonds and shift the demand curve to the right

Risk of bonds relative to alternative assets An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left.

Liquidity of bonds relative to alternative assets Increased liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to the right.Similarly, increased liquidity of alternative assets lowers the demand for bonds and shifts the demand curve to the left.

Figure 1 Shift in the Demand Curve for Bonds

When the demand for bonds increases, the demand curve shifts to the right as shown. (Note: P and i increase in opposite directions. P on the left vertical axis increases as we go up the axis, while i on the right vertical axis increases as we go down the axis.)

Factors cause the demand curve for bonds to shift

Expected profitability of investment opportunities in a business cycle expansion, the supply of bonds increases, and the supply curve shifts to the right. also, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls, and the supply curve shifts to the left.
Expected inflation An increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the right.
Government activities Higher government deficits increase the supply of bonds and shift the supply curve to the right.also,the government surpluses decrease the supply of bonds and shift the supply curve to the left.

Figure 2 Shift in the Supply Curve for Bonds

When the supply of bonds increases, the supply curve shifts to the right. (Note: P and i increase in opposite directions. P on the left vertical axis increases as we go up the axis, while i on the right vertical axis increases as we go down the axis.)

Response to a Change in Expected Inflation

When expected inflation rises, the supply curve shifts right from Bs1to Bs2, and the demand curve shifts left from Bd1 to Bd2. The equilibrium moves from point 1 to point 2, with the result that the equilibrium bond price (left axis) falls from P1 to P2 and the equilibrium interest rate (right axis) rises from i1 to i2. (Note: P and i increase in opposite directions. P on the left vertical axis increases as we go up the axis, while i on the right vertical axis increases as we go down the axis.)

Response to a Business Cycle Expansion

When income and wealth are rising, the demand curve shifts rightward from Bd1 to Bd2, and the supply curve shifts rightward from Bs1 to Bs2. If the supply curve shifts to the right more than the demand curve, the equilibrium bond price (left axis) moves down from P1 to P2, and the equilibrium interest rate (right axis) rises from i1 to i2. (Note: P and i increase in opposite directions. P on the left vertical axis increases as we go up the axis, while i on the right vertical axis increases as we go down the axis.)

Future Value and Present Value Methods

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Suppose now you have $3000 in hand today,it must be worth more than someone promise to give you $3000 in the next 2 year.because with $3000 in hand today, it can be invested in a bank or fixed income securities(Bond) for example 5% interest rate,so in the next 2 year you will have the principle + interest income.

Formula

FV = PV(1 + r)t

FV = future value
PV = present value
r = period interest rate, expressed as a decimal
T = number of periods
Future value interest factor(FVIF) = (1 + r)t

Example:

Method 1

Future Value (FV) = $3,000(1 + .05)^2 = $3,306

Method 2

PV = present value =$3000
   r= 5%
   T=2 year
   Future value interest factor (FVIF) = (1 + r)t can be found in the table below is the interest rate   5% for 2 years is (1+r)t = 1.102

   Future Value (FV) = PV(FVIFi,n) or $3,000(1.102) = $3,306

Method 3

Using Financial calculator

Method 4

Using Excel spreadsheet

Present Value: is the The current worth of a future sum of money or stream of cash flows discounted by the Interest rate (Discount rate,Cost of capital, Opportunity cost of capital,Required return)

As we can see in the previous example that $3000 to be received in the next 2 year probably worth less than $3000 in hand today.because $3000 today can be saved with 5% interest rate and in the 2 years time we will receive $3,306. so to find the 3000$ to be received in the next 2 year and how much it's worth today,it have to be discounted with 5% as an opportunity cost.

Formula

PV = FV/(1 + r)t or FV*( 1/(1+r)t)

FV = future value
PV = present value
r = period interest rate, expressed as a decimal
T = number of periods
Present value interest factor(PVIF) = 1/(1 + r)t or Discount Factor

Example:

Method 1

Present Value (PV) = $3,000/(1 + .05)^2 = $2,721

Method 2

FV = Future value =$3000
r= 5%
T=2 year
Present value interest factor(PVIF) or Discount Factor = (1 + r)t can be found in the table below is the interest rate 5% for 2 years is 1/(1+r)t =0.907

Present Value (PV) = FV(PVIFi,n) or $3,000(0.907) = $2,721

Method 4

Using Excel spreadsheet

Capital Budgeting Techniques

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Capital Budgeting

To forecast a set of cash flows, find the present value of those cash inflows, and make the investment only if the PV of the cash inflows exceeds the investment’s cost.
The amount of money set aside for the purchase of fixed assets (e.g., equipment, buildings, etc.)
A request for authorization to purchase new fixed assets.
Decision of Replacement or needed to continue current operations.
Decision of expansion of existing products or markets.
Merger analysis.

Companies use the following criteria for deciding to accept or reject projects:

1. Payback period
      2. Internal rate of return
      3. Net present value
      4. Profitability index

Payback period (PBP) The period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.

Example:

The project have 5 years cash inflow but it takes only 3.41 years to recover the initial investment $3,000

Advantages

The first is its simplicity.
Using the payback method and reducing the evaluation to a simple number of years is an easily understood concept.
Easily to identify projects that provide the fastest return on investment to recover their money as quickly as possible.
Managers use the payback method to make quick evaluations of projects with small investment.

Disadvantages

The payback method ignores the time value of money. The cash inflows from a project may be irregular, with most of the return not occurring until well into the future.
A project could have an acceptable rate of return but still not meet the company's required minimum payback period.
The payback model does not consider cash inflows from a project that may occur after the initial investment has been recovered.
the payback method focuses on short-term profitability, an attractive project could be overlooked if the payback period is the only consideration.

Internal Rate of Return (IRR) is the discount rate that forces a project’s NPV to equal zero.

Formula:

The process of finding the IRR

By Trial and Error ,We could use a trial-and-error procedure,to try a discount rate; see if the equation solves to zero; and if it doesn’t, try a different rate. We could continue until we found the rate that forces the NPV to zero.

Example:

For Project S, the IRR is 14.489%.

Using Excel

Acceptance Criterion

The acceptance criterion generally employed with the internal rate of return method is to compare the IRR to a required rate of return. If the IRR exceeds the required rate, the project is accepted; if not, the project
is rejected. If the required rate of return is 12 percent and the IRR method is employed, the investment proposal will be accepted.because IRR=14.489% > 12%, A project with an internal rate of return in excess of the required rate of return should result in an increase in the market price of the stock. This is because the firm accepts a project with a return greater than that required to maintain the present market price per share.

Independent projects: If IRR exceeds the project’s WACC, accept the project. If IRR is less than the project’s WACC, reject it.

Mutually exclusive projects(Consideration of two or more assets that perform the same function. If one is chosen for purchase, the others are automatically rejected.). Accept the project with the highest IRR, provided that IRR is greater than WACC. Reject all projects if the best IRR does not exceed WACC.

The IRR is useful to know the rates of return on proposed investments,IRR can produce conflicting conclusions when a choice is being made between mutually exclusive projects; and when conflicts occur, the NPV is generally better.

Net Present Value (NPV) A method of ranking investment proposals using the NPV, which is equal to the present value of future net cash flows, discounted at the cost of capital.

Formula

CFo = Initial Investment(Cash outlay or Cash out flow) which is always negative
CF1= Cash inflow in year 1
CF2= Cash inflow in year 2
CFn= Cash inflow in year n
r= discount rate or opportunity cost of capital or required rate of return

Steps to calculate

Find the present value of all cash inflows, discounted at the project’s cost of capital.
Sum these Present Value or discounted cash flows
To find the project’s NPV.= Sum of these Present Value minus Initial Investment(Cash outlay)
If the NPV is positive, the project should be accepted, if the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen.

Example:

Project S have initial investment $1000 which expected to generate cash inflow for 4 years, year 1=$500,year2=$400,year3=$300,year4= $100. this project have cost of capital 10%.Calculate NPV of the project S?

Answer:

Method 1

we plug those number into the formula

= - $1000 + 500/(1.10)^1 +400/(1.10)^2+300/(1.10)^3+100/(1.10)^4
=> NPV =$78.82

Method 2

Using Excel

The formula in Cell B5 is: NPV(B2,C4:F4), and it results in a value of $78.82.

Acceptance Criterion

The decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV.
The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and so not certain, A project with NPV = $78.82 implies that the total shareholder wealth of the firm will increase by $78.82 if the project is accepted.

a) NPV vs IRR: Independent projects

Independent projects: are projects whose cash flows are not affected by one another. both NPV and IRR lead to the same accept/reject decisions.

If cash flows of project S are discounted at cost of capital (r),example from 0% to 14.5% , NPV is positive up to (r) equal IRR=14.5% that make the project S NPV=0 => accept the project.
The project S will be rejected when the cost of capital (r) > IRR ,because it also make the NPV negative. example in the graph if (r) = 15% > IRR=14.5% ,its NPV is ($8.33)
If cash flows of project L are discounted at cost of capital (r),example from 0% to 11.8% , NPV is positive up to (r) equal IRR=11.8% that make the project L NPV=0 => accept the project.
The project L will be rejected when the cost of capital (r) > IRR ,because it also make the NPV negative. example in the graph if (r) = 13% > IRR=11.8% ,its NPV is ($31.35)

The profitability index(PI) is the present value of cash inflows relative to the project cost. It is a benefit/cost ratio, providing a measure of the relative profitability of a project. The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one.

Formula:
PI = 1 + (NPV/Initial investment)

Acceptance Criterion

If the NPV is positive, the project is acceptable and the PI is more than 1
If the NPV is negative,the project is rejected and the PI is less than 1

The Security Market Line (SML)

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The security market line (SML) is the line that reflects an investment's risk versus its return, or the return on a given investment in relation to risk. The measure of risk used for the security market line is beta.

The line begins with the risk-free rate (with zero risk) and moves upward and to the right. As the risk of an investment increases, it is expected that the return on an investment would increase. An investor with a low risk profile would choose an investment at the beginning of the security market line. An investor with a higher risk profile would thus choose an investment higher along the security market line.

Given the SML reflects the return on a given investment in relation to risk, a change in the slope of the SML could be caused by the risk premium of the investments. Recall that the risk premium of an investment is the excess return required by an investor to help ensure a required rate of return is met. If the risk premium required by investors was to change, the slope of the SML would change as well.

When a shift in the SML occurs, a change that affects all investments' risk versus return profile has occurred. A shift of the SML can occur with changes in the following:

Capital market conditions.
Expected real growth in the economy.

Expected inflation rate.

Why Do Companies Issue Stock?

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Public Companies throughout the world issue new stock or shares every day. But what is stock, and why does a company issue it?

What is Capital ?

Let’s imagine that you decide to start up your own ice cream shop business. You will need to invest in equipment, food supplies and property. All the money that you invest to start your business is called capital. Essentially, the capital of a business consists of all of its assets (or items to assist in the creation of wealth). What if it dawns on you that you don’t have enough cash to buy all the needed assets? Let’s see how new businesses and companies deal with this problem.

Equity vs. Debt

To start a new business (or fund a new project) a company can raise money in two ways – by selling shares of equity or by incurring debt. If the owner of our ice cream parlor invested all their own savings to buy the materials necessary to start the business, they made an equity investment in the company. Equity is simply ownership of a corporation. Typically, ownership units in a corporation are referred to as stock. However, if our owner did not have necessary funds to start their own business they could finance their operation in one of two ways:

Issue stock (or certificates of partial ownership in his company) to people who may be interested in helping their venture out in return for a proportional share of the profits that the company might generate.
Borrow money that will need to be paid back with interest. So, what are the advantages of selling stock?

Why Do Corporations Issue Stock?

Businesses issue stock to raise capital. It’s as simple as that.

Advantages of issuing stock:

A Company can raise more capital than it could borrow.
A Company does not have to make periodic interest payments to creditors.
A Company does not have to make principal payments.

Disadvantages of Issuing Stock:

The principal owners have to share their ownership with other shareholders.
Shareholders have a voice in policies that affect the company operations.

Advantages for Stockholders

As part owner of a corporation, you may be entitled to share in the profits of the company. There is also a chance that the company will grow and the price of the stock may rise. If the company achieves economic success, the stock value will go up and stockholders will benefit. For example, if you invested $1,000 to buy 100 shares of a company at $10 each and the shares rose to $13 each you would gain $300. This is equivalent to a 30% return. In cases like this, both the stockholders and the business would be pleased.

(See more) Primary and Secondary market

How to Use the Relative Strength Index

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One of the most useful tools employed by many technical commodity traders is a momentum oscillator which measures the velocity of directional price movement.

When prices move up very rapidly, at some point the commodity is considered overbought; when they move down very rapidly, the commodity is considered oversold at some point. In either case, a reaction or reversal is imminent. The slope of the momentum oscillator is directly proportional to the velocity of the move, and the distance traveled up or down by this oscillator is proportional to the magnitude of the move.

The momentum oscillator is usually characterized by a line on a chart drawn in two dimensions. The vertical axis represents magnitude or distance the indicator moves; the horizontal axis represents time.

Learning to use this index is a lot like learning to read a chart. The more you study the interaction between chart movement and the Relative Strength Index, the more revealing the RSI will become. If used properly, the RSI can be a very valuable tool in interpreting chart movement.

RSI points are plotted daily on a bar chart and, when connected, form the RSI line. Here are some things the index indicates as shown by examples from the following silver chart:

Tops and bottoms - These are often indicated when the index goes above 70 or below 30. The index will usually top out or bottom out before the actual market top or bottom, giving an indication a reversal or at least a significant reaction is imminent.

The major bottom of Aug. 15 was accompanied by an RSI value below 30. The major top of Nov. 9 was preceded by an RSI value above 70. The top made on Jan. 24 was preceded by an RSI value of less than 70. This would indicate this top is less significant than the previous one and either a higher top is in the making or the long-term uptrend is running out of steam.

Chart formations - The index will display graphic chart formations which may not be obvious on a corresponding bar chart. For instance, head-and-shoulders, tops or bottoms, pennants or triangles often show up on the index to indicate breakouts and buy and sell points.

A descending triangle was formed on the RSI chart during October and early November that is not evident on the bar chart. A breakout of this triangle indicates and intermediate move in the direction of the breakout. Note also the long-term coil on the RSI chart with the large number of support points.

Failure swings - Failure swings above 70 or below 30 are very strong indications of a market reversal.

After the RSI exceeded 70 during October, the immediate downswing carried to 65. When this low point of 65 was penetrated the following week, the failure swing was completed.

After the low of Aug. 15, the RSI shot up to 41. After two downswings, this point was penetrated on the upside on Aug. 26, completing the failure swing.

Support and resistance - Areas of support and resistance often show up clearly on the index before becoming apparent on the bar chart. Trendlines on the bar chart often show up as support lines on the RSI. The mid-November break penetrated the uptrend line on the bar chart at the same time as the support level on the RSI chart.

Divergence - Divergence between price action and the RSI is a very strong indicator of a market turning point and is the single most indicative characteristic of the Relative Strength Index. Divergence occurs when the RSI is increasing and price movement is either flat or decreasing. Conversely, divergence occurs when the RSI is decreasing and price movement is either flat or increasing. Divergence does not occur at every turning point.

On the silver chart, there was divergence between the bar chart and RSI at every major turning point. The top made in November was "warned" by the RSI exceeding 70, a failure swing and divergence with the RSI turning sideways while prices continued to climb higher.

Can you pick out the two potential reversals on the RSI indicator?

Answer

Throughout May and into early June the RSI signaled an oversold condition, indicating a potential upward turn - which ended up occurring throughout June, July, and into early August.

From mid-September through early November it signaled an overbought condition, indicating a potential downswing - which occurred immediately afterward.

Issuing Common Stock at Par and Premium

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Stocks of public companies are bought and sold on a stock exchange, such as the New York Stock Exchange (NYSE) or Cambodia Securities Exchanges(CSX).

Tombstone

A written advertisement placed by investment bankers in a public offering of a security. It gives basic details about the issue and, in order of importance, the underwriting groups involved in the deal.

Example

Smart Touch’s tombstone shows that the company hoped to raise approximately $200,000,000 of capital (10,000,000 shares times $20 per share).

Issuing Common Stock at Par

Suppose Smart Touch’s common stock carried a par value of $1 per share. The stock issuance entry of one million shares at par value on January 1 would be as follows:

Issuing Common Stock at a Premium

The amount above par is called a premium or Paid-in capital in excess of par or Additional paid-in capital.

Example 1

Assume Smart Touch sells an additional one million shares for $20 a share on January 2. The $19 difference between the issue price ($20) and par value ($1) is a premium or additional paid-in capital. The entry would be as follow:

Example 2

Assume Smart Touch sells an additional 2 million shares for $25 a share on April 15. The $24 difference between the issue price ($25) and par value ($1) is a premium or additional paid-in capital. The entry would be as follow:

Smart Touch would report stockholders’ equity on its balance sheet after the January 1,January 2 and April 15 stock issuance as follows, assuming that its charter authorizes 20,000,000 shares of common stock and also assuming the balance of retained earnings is $9,000,000.

Weighted Average Cost of Capital

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Corporations need money daily to finance their operating activities, embark on investment activities and pay taxes, interest expense, etc. corporations can raise capital in 2 ways:

1) Bonds (debt financing)

2) Issue common and preferred shares

What if a corporation does both of these? It can issue bonds (which are a source of debt) and more common shares (which is a source of equity). But what's the right mix between the two? How much debt and how much equity should a company carry? We answer this question next:

Note: The mix of bonds (debt) and common shares of a corporation is known as its Capital Structure.

The amount of debt and equity that a company must maintain can be calculated via the WACC.

Weighted Average Cost of Capital (WACC) is therefore an overall return that a corporation MUST earn on its existing assets and business operations in order to increase or maintain the current value of the current stock. For example, if Microsoft's WACC is 15% and current stock price is 28$, then the company must earn a 15% return on its existing assets and business operations (net income) in order to MAINTAIN the stock price at $28. The last thing that corporations would wish to happen is their stock price falling down!

Weighted Average Cost of Capital (WACC)

The formula for WACC is:

[Rd x D/V x (1-T)] + [Re x E/V]

Rd = Bond's yield to Maturity (I/Y in Calculator)

D = Market Value (Present Value) of Bonds

(1 - T) = 1 - tax rate = Interest tax shield deductibility of interest expense

Re = Shareholder's return requirement

V = Total value of all capital (Debt + Equity)

Example

Coco Corp. has issued 10,000 units of bonds that are currently selling at 98.5. The coupon rate on these bonds is 6% per annum with interest paid semi-annually. The maturity left on these bonds is 3 years.

The company has 2,000,000 common shares outstanding with the current stock price at $10 / share. The stock beta is 1.5, risk free rate for government bonds is 4.5% and the Expected Return on the Stock Market is 14.5%.

The tax rate for the corporation is 30%

Bond Calculations	Stock Calculations
N = 3 x 2 = 6 I/Y = ? (Rd) PV = 0.985 x 10,000 x $1000 = $9,850,000 (D) PMT = (-10,000,000 x 0.06) / 2 = $-300,000 FV = $-10,000,000 P/Y = 2 C/Y = 2 Solution: I/Y = 6.56%	Re = Rf + B[Rm - Rf] Re = 0.045 + 1.5 [0.145 - 0.045] Re = 0.045 + 0.15 = 0.195 (19.5%) Market Value of Equity = Stock price x common shares outstanding $10 x 2,000,000 = $20,000,000

V = Total Capital Structure

V = 9,850,000 (bonds debt) + 20,000,000 (equity of common shares)

V = 29,850,000

Summary of Important Terms

Rd = 6.56% = 0.0656

D = 9,850,000

V = 29,850,000

D/V = 9,850,000 / 29,850,000

Re = 0.195

E = 20,000,000

E/V = 20,000,000 / 29,850,000 = 0.67

(1-T) = (1 - 0.3) = 0.7

WACC = [Rd x D/V x (1-5)] + [Re x E/V]

[(0.0656) (0.33) (0.7)] + [(0.195) (0.67)]

= 0.01515 + 0.1307 = 0.1458 -> 14.58%

Interpretation of WACC

A WACC of 14.58% means Coco Corp. must earn a return of 14.58% on all its assets and business operations in order to MAINTAIN the current stock price at $10 per share. If Coco Corp. wants its stock price to go higher, it must achieve a return rate greater than 14.58%

Pricing of Bonds

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When bonds are issued, they are usually sold at their par value, which is also referred to as their face value. For most corporate bond issues, this par value is $1,000, while some of the government bonds can have a par value of $10,000. This is the principal amount of a bond and it is returned to the investors when the bond matures. However, during the term of a bond, market forces make the value of the bond change. At any time, the bond could be selling at a value higher than its par, lower than its par or at its par value.

Why Do Bond Prices Change

The main reason behind this change in bond value is change in interest rates. Interest rates in the economy are dynamic and they are constantly adjusted by the Federal Reserve in response to changing economic situation. When the economy is not doing well, the Fed can lower interest rates to encourage lending and to give a boost to economic activity.

But when there are serious inflationary expectations in the economy, the Fed can lower interest rates to cool things down. Such decisions can have a significant impact on the bond market, and prices of bonds always respond to changes in interest rates.

Inverse Relationship with Interest Rates: Bond prices have an inverse relationship with interest rates. When interest rates in the economy go up (all other things being equal), bond prices go down, and vice versa. It is easy to understand why this happens.

Let’s say you have invested in a plain vanilla bond at a par value of $1,000 and a coupon rate of 5%. When interest rates in the economy go up, future bond issues will have to pay a higher coupon rate, let’s say 6%. In such a scenario, an investor will be willing to buy your bond from you only if you sell it at a value lower than its par such that the buyer is compensated for the lower interest payments.
The opposite of this happens when interest rates go down. Now future bonds will be issued at a lower interest rate and buyers will be willing to pay you more as your bond offers higher interest earnings. This will increase the price of the bond in the market.

Impact of Creditworthiness:
Another reason that can have a huge effect on bond prices is a change in the creditworthiness of the issuer. For example, if a company is facing financial difficulties that can adversely impact its ability to repay its obligations, credit rating agencies can decide to lower its credit rating.When that happens, markets will react by lowering the prices of bonds issued by the company as there is now a much greater risk of default associated with those bonds. The same thing can happen to countries ,to see the prices of bonds issued by a national government change drastically in response to bad economic data,as the risk is high ,it makes the bond price go down and the demand for high yield go up.

It should be noted that the bond market does not always wait for a credit rating agency to lower the rating of the issuer before lowering the price of its bonds. Large market participants are well aware of the risks that an issuer faces and expectations of default are always factored in bond prices.

Premium and Discount

When a bond is selling at a value higher than its par, it is said to be selling at a premium. On the other hand, when the price of a bond falls below its par, it is said to be selling at a discount. When listing bond prices, the prices are mentioned in terms of percentage of premium or discount

When a bond is selling at par value, it’s price is listed as 100.When it is selling at a 10% discount, its price is listed at 90. Let’s say when it’s selling at a 5% premium, its price is listed as 105,the bond listed as 105 and having a par value of $1,000 can be calculated as 105% of $1,000, which comes to $1050.

Calculating Bond Prices

The price of a bond is equal to the present value of all its future interest payments and the repayment of par value at maturity. We can use the formula for present value of future payments to determine the value of a bond. But keep in mind that as coupon payments come at different points in time, the discounting factor for each of them will be different, with payments coming later having a heavier discount. The price of a bond can be represented as the following formula:

Price = [I / (1+r)] + [I / (1+r)^2] + … + [I / (1+r)^n] + [Par Value / (1+r)^n]

Here:

I is the interest or coupon payment paid at the end of every period

r is the required rate of return

n is the number of periods after which the bond will mature

This series of periodic payments in a plain vanilla bond is referred to as an ordinary annuity. This formula assumes that the first coupon payment will be made one period from the present time and the end of every subsequent period, the next coupon payments will be made.

Note that period here could be anything, but typically bonds pay coupon semi annually or annually, so one period will be 6 months or 12 months long. Also note that the last coupon payment and the par value of the bond are paid together. It is clear from the formula that the payments that come farther in the future have a lower present value.

Another thing evident from the formula is the inverse relationship between bond prices and interest rates. As interest rates go up in the economy, the required rate of return (r) also goes up. This increases the discounting factors in the formula and the price of the bond will be lower.

The bond pricing formula given above can be simplified as:

Price = I x [1- [1 / (1+r)^n ] ] / r + [Par Value / (1+r)^n]

Example

Let’s consider a plain vanilla bond with a par value of $5,000, maturity period of 5 years, and a coupon rate of 5%, paid semi-annually. Let’s assume that the required rate of return is 10%. Here are the values of different variables that we’ll need in the formula.

n = 10 (Coupon payments are made with a periodicity of 6 months. There are 10 such periods in 5 years)

I = $5,000 * 2.5% = $125 (Although coupon rate is 5%, this is the annual interest rate. For semi annual payments, coupon rate will be half of the annual rate)

r = 5% (For a 10% annual required rate of return, the semi-annual required rate will be 5%)

Par Value = $5,000

Plugging these values in the bond price formula:

Price = $125 x [1- [1 / (1+.05)^10 ] ] / .05 + [$5,000 / (1+.05)^10] = $4,034. 7

You can see this value in light of our previous discussion on bonds selling for a premium or a discount. In this case, the required rate of return is significantly higher than the coupon paid by the bond. That is why the bond is selling at a heavy discount, as otherwise investors will have no reason to purchase this bond.

Now, let’s see what happens when the coupon rate of the bond is 15%. The coupon payment in this case (I) will be $5,000 * 7.5% = $375. All the other variable for the formula remain the same. This will result in the bond being priced as:

Price = $375 x [1- [1 / (1+.05)^10 ] ] / .05 + [$5,000 / (1+.05)^10] = $5,965.2.

The bond is offering a higher coupon rate than the interest rate investors can earn in the market, which is why the bond is now selling at a premium.

Summary

Weighted Average Cost of Capital with Expected Return

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The management of a local corporation believes there will be 3 states of the economy in the next year, along with their probabilities and rates of return.

Economy	Probability	Return
Great	0.4	0.16
Average	0.5	0.08
Bad	0.1	-0.10

The corp has 15,000,000 common shares outstanding currently trading at $3 per share on the Nasdaq. The company also has bonds with a face value of $30,000,000 yielding a market rate of 7% and trading at 99. Given this above information, calculate the WACC. Assume a tax rate of 40%

Bond Calculations	Stock Calculations
N =? I/Y = 7% (Rd) PV = 0.99 x 30,000,000 = 29,700,000 (D) FV = -30,000,000	Re = Expected Return Great -> 0.4 x 0.16 = 0.064 Average -> 0.5 x 0.08 = 0.04 Bad -> 0.1 x -0.10 = -0.1 Re = 0.064 + 0.04 + -0.1 Re = 0.094 Total Equity = $3 x 15,000,000 Total Equity = $45,000,000 (1-t) = (1 - 0.4) = 0.6

Weighted Average Cost of Capital (WACC)

Formula

[Rd x D/V x (1-T)] + [Re x E/V]

Rd = Bond's yield to Maturity (I/Y in Calculator)

D = Market Value (Present Value) of Bonds

(1 - t) = 1 - tax rate = Interest tax shield deductibility of interest expense

Re = Shareholder's return requirement

V = Total value of all capital (Debt + Equity)

Summary of Important WACC

Rd = 7% or 0.07
D = 29,700,000
(1-t) = 0.6
D / V = 29700 / 74,700 = 0.3976

Re = 0.094
E = 45,000,000
V = 74,700,000
E/V = 45000 / 74700 = 0.6024

WACC = [Rd x D/V x (1-t)] + [Re x E/V]

WACC = [0.07 x 0.3976 x 0.6] + [0.094 x 0.6024]

WACC = 0.0166992 + 0.0566256

WACC = 0.0733248 -> 7.33%

Interpretation of WACC

A WACC of 7.33% means the local corp must earn a return of 7.33% on all its assets and business operations in order to MAINTAIN the current stock price at $3 per share. If the Corp. wants its stock price to go higher, it must achieve a return rate greater than 7.33%

What is a Bull Market and Bear Market?

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There are two classic market types used to characterize the general direction of the market. Bull markets are when the market is generally rising, typically the result of a strong economy. A bull market is typified by generally rising stock prices, high economic growth, and strong investor confidence in the economy. Bear markets are the opposite. A bear market is typified by falling stock prices, bad economic news, and low investor confidence in the economy.

A bull market is a financial market where prices of instruments (e.g., stocks) are, on average, trending higher. The bull market tends to be associated with rising investor confidence and expectations of further capital gains.

A market in which prices are rising. A market participant who believes prices will move higher is called a "bull". A news item is considered bullish if it is expected to result in higher prices.An advancing trend in stock prices that usually occurs for a time period of months or years. Bull markets are generally characterized by high trading volume.

Simply put, bull markets are movements in the stock market in which prices are rising and the consensus is that prices will continue moving upward. During this time, economic production is high, jobs are plentiful and inflation is low. Bear markets are the opposite--stock prices are falling, and the view is that they will continue falling. The economy will slow down, coupled with a rise in unemployment and inflation.

A key to successful investing during a bull market is to take advantage of the rising prices. For most, this means buying securities early, watching them rise in value and then selling them when they reach a high. However, as simple as it sounds, this practice involves timing the market. Since no one knows exactly when the market will begin its climb or reach its peak, virtually no one can time the market perfectly. Investors often attempt to buy securities as they demonstrate a strong and steady rise and sell them as the market begins a strong move downward.

Portfolios with larger percentages of stocks can work well when the market is moving upward. Investors who believe in watching the market will buy and sell accordingly to change their portfolios.Speculators and risk-takers can fare relatively well in bull markets. They believe they can make profits from rising prices, so they buy stocks, options, futures and currencies they believe will gain value. Growth is what most bull investors seek.

What is a Bear Market?

The opposite of a bull market is a bear market when prices are falling in a financial market for a prolonged period of time. A bear market tends to be accompanied by widespread pessimism.A bear market is slang for when stock prices have decreased for an extended period of time. If an investor is "bearish" they are referred to as a bear because they believe a particular company, industry, sector, or market in general is going to go down.

(See more) How does Stock Market work?

Dilutive Securities

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Dilutive securities are "hybrid securities" that have both debt and equity characteristics. They combine:

(1) an unconditional receivable/payable (the debt attribute) with

(2) a financial option contract that, if exercised, enables the holder to obtain an equity interest in the issuing firm.

Example:

The stock warrants can be used to purchase the issuing company's stock at a fixed price.

These compound financial instruments are called dilutive securities because if the option is exercised, additional common stock is issued and this causes a decrease, or dilution in earnings per share.

Types of Dilutive Securities

Executive stock option An executive stock option is a special type of warrant. An executive granted a stock option has the right to:
-     purchase a fixed number of shares of her company's stock

-     at a fixed exercise price (The exercise price is usually set equal to the market price of the stock on the date the options are granted.)

-     during a fixed time period (usually five to ten years).

Stock option plans are an effective means of conveying an ownership interest in the firm to its executives. This motivates the executives to act in the shareholders' interest.
Stock Warrants are certificates that entitle the holder to acquire shares of stock at a certain price within a stated period.
Convertible Debt gives the holder the option of converting the bond or note into a fixed number of common shares within a specified time period, typically 10 years.
Convertible Preferred Stock is like convertible debt. It gives the holder the option of converting the preferred shares into a fixed number of common shares within a specified time period.

If a security after conversion causes the EPS figure to increase rather than decrease, such a security is an anti-dilutive security, and it should be excluded from the computation of the dilutive EPS.

For example, assume that the company XYZ has a convertible bond issue: 100 bonds, $1,000 par value, yielding 10%, issued at par for the total of $100,000. Each bond can be converted into 50 shares of the common stock. The tax rate is 30%. XYZ's weighted average number of shares, used to compute basic EPS, is 10,000. XYZ reported an NI of $12,000, and paid preferred dividends of $2,000.

What is the basic EPS? What is the diluted EPS?

1) Compute basic EPS:
i. Basic EPS = (12,000 - 2,000) / (10,000) = $1.00

2) Compute diluted EPS:
i. Find the adjustment to the denominator: 100 * 50 = 5,000
ii. Find the adjustment to the numerator: 100 * $1000 * 0.1 * (1 - 0.3) = $7,000

3) Find diluted EPS:
i. Diluted EPS = (12,000 - 2,000 + 7,000) / 10,000 + 5,000 = $1.13

If the fully dilused EPS > basic EPS, then the security is antidilutive. In this case, Basic EPS = $1.00 is less than the fully diluted ESP, and the security is antidilutive.

Market Equilibrium

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The operation of the market clearly depends on the interaction between suppliers and demanders.

At any moment, one of three conditions prevails in every market:

(1) The quantity demanded exceeds the quantity supplied at the current price, a situation called

excess demand.

(2) the quantity supplied exceeds the quantity demanded at the current price, a situation called excess supply;

(3) the quantity supplied equals the quantity demanded at the current price, a situation called equilibrium. At equilibrium, no tendency for price to change exists.

Example:

Excess demand

Example:

Excess supply

Figure 3.10 illustrates another excess supply/surplus situation. At a price of $3 per bushel, suppose farmers are supplying soybeans at a rate of 40,000 bushels per year, but buyers are demanding only 20,000.With 20,000 (40,000 minus 20,000) bushels of soybeans going unsold, the market price falls. As price falls from $3.00 to $2.50, quantity supplied decreases from 40,000 bushels per year to 35,000. The lower price causes quantity demanded to rise from 20,000 to 35,000.At $2.50, quantity demanded and quantity supplied are equal. For the data shown here, $2.50 and 35,000 bushels are the equilibrium price and quantity, respectively.

Market equilibrium

In Figure 3.11, the new supply curve (the supply curve that shows the relationship between price and quantity supplied after the freeze of coffee) is labeled S1 at new equilibrium price 2.40$ .At the initial equilibrium price, $1.20, there is now a shortage of coffee . If the price were to remain at $1.20, quantity demanded would not change; it would remain at 13.2 billion pounds.

Supply and Demand

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What is Microeconomics?

Microeconomics is the branch of economics which looks at choices made by narrowly defined units, such as individual buyers/consumers, and firms that produce goods.

Two of the most important principles used by economists are the Law of Supply and the Law of Demand:

Law of Supply

The law of supply says that, all other things remaining equal, as the price of a good increases (decreases), the quantity of that good supplied will increase (decrease).

Law of Demand

The law of demand states that, all other things remaining equal, as the price of a good increases (decreases), the quantity of that good demanded will decrease (increase).

Economists often use graphs as a way to demonstrate what is being discussed. The laws of supply and demand can be represented by a simple graph such as the one below.

In figure 3.1, we can see that at the price of $1, the suppliers are willing to provide one million widgets (Point A), while the quantity demanded will be much higher - eight million (Point B).

At a higher price, such as $5, suppliers will be willing to provide six million widgets (Point D), while the quantity demanded is only one million (Point E).

Finally, at the price of $3, the quantity demanded is equal the quantity supplied (Point C). This price is also referred to as the "market clearing" or equilibrium price because no suppliers are left with the desire to provide goods at that price and no buyers are left wishing to purchase the goods at that price either.

Change in Consumer Preference

Suppose there was a significant change in consumer preferences. For example, consumers suddenly have an increased desire for corn. This change in taste may be due to a new health study touting the benefits of corn, alternative grains such as wheat may have gotten more expensive, or corn growers may have conducted an effective advertising campaign.

Regardless of the reason, the increase in demand results in a greater quantity demanded at particular price levels. This is an example of a demand shift.

Figure 3.2: Shift in the Demand Curve

In the graph above D₀represents the original demand curve, while D₁ shows the new demand curve. Note that at a particular price level, such as $4, the quantity demanded increases from three million to five million.

Suppose something happens where the quantity of a good supplied changes at many particular price levels. For example, technological changes might occur whereby computer memory manufacturers would be able to produce a particular type of memory at a lower cost. So for many price levels, the quantity suppliers are willing to provide will increase. This situation could be diagrammed as below:

Figure 3.3: Shift of the Supply Curve

S₀ represents the original supply curve, while S₁ represents the new supply curve. At the price of $30 per 256MB chip, the quantity supplied will increase from three million to four million units per month.

Supply and Demand Movements

Changes in quantity demanded strictly as a function of price are referred to as movement along a demand curve. A shift of the entire demand curve is referred to as a change in demand; this could be due to any factor(s) that affects demand, other than price.

Changes in quantity supplied strictly as a function of price are referred to as movement along a supply curve. A shift of the entire supply curve is referred to as a change in supply; this could be due to any factor(s) that affects supply, other than price.

Demand Curve Shifts Some of the factors that can cause a demand curve to shift include:

Change in income - If consumer incomes increase, we might reasonably expect that demand for some luxury goods will increase.
Change in preferences/tastes - If a product becomes more (less) liked, the quantity demanded will increase (decrease).
Change in prices of goods that are complimentary - If the price of gasoline goes up substantially, the demand curve for large SUV's should shift down.
Changes in prices of goods that are substitutes - If the price of pork increases (decreases), demand for beef would likely increase (decrease).
Advertising - An effective advertising campaign could increase the quantity demanded of a particular good. It could also decrease the demand for a competing good.
Expectations - If consumers expect a good to become more expensive or hard to get in the future, it could alter current demand
Shifts in market demographics - As segments of the population age or their composition changes, their demands also change. Because segments are not equally distributed – that is, there are not a consistent number of people in every age category – larger segments have a more noticeable impact on demand. The baby boomers are an excellent example of this.
Distribution of income - For example, if the rich get richer, and the poor get poorer, demand for luxury goods could increase.

Supply Curve Shifts Factors that would cause a shift in the supply curve include:

Cost - An increase in crude oil costs for a plastic manufacturer would shift the supply curve up and to the left. Changes in technology can dramatically decrease costs.
Government tax policy - Increases in business taxes will cause the supply curve to shift up and to the left. A government subsidy to producers will cause more supply to be available - the supply curve will shift down and to the right.
Weather/climate - Changes in weather and/or climate will especially influence agricultural product supply.
Prices of substitute products - If farmers can grow wheat instead of corn, and the price of wheat goes up, then the supply curve for corn will shift up and to the left as more farmers switch from corn to wheat.
Number of producers - As the number of firms/individuals producing a product increases, we would expect more supply to be available.

Short- and Long-Run Market Equilibrium

In the short run, market equilibrium is achieved when the quantity demanded is equal to quantity supplied and the market clears. The market is said to be cleared because there is no additional quantity supplied, or quantity demanded, at the market clearing price.

However, that particular market price may not lead to equilibrium in the long run. In the short run, producers do not have time to fully adjust to current market conditions. Some current producers may not be making a profit or covering all their costs at the current market price.

Producers in that situation will consider leaving the industry, or at least will not allocate further capital to that industry. If producers are making profits, then we would expect more resources to be allocated to the industry such as the building of additional factories. In the long run, all factors of production can be varied.

Long-run equilibrium is something we expect the market to move towards over time. The process could take years. It actually may never be achieved because demand and supply curves are constantly shifting.

Suppose there is an increase in demand, as shown by the graph below.

Figure 3.4: Effects of a Shift in Demand

D₀ is the original demand curve, and D₁ is the new demand curve. The market equilibrium price will increase from P₀ to P₁, at least in the short-run. The quantity will also increase from Q0 to Q1.

Over time, in a market economy, two forces will come into play:

Buyers will have an incentive to search for substitutes, thereby decreasing their purchase of the original good; this effect will tend to lower the quantity demanded and the market price
Suppliers will have an incentive to supply more of the good, and more resources will be allocated towards production of this good; this effect will tend to increase the quantity and lower the market price

Shortages and Surpluses and their Effect on Equilibrium Prices

A “shortage” exists when the quantity demanded at the current price is greater than the quantity supplied. In the case of shortage, we would expect the market price to go up. In this case, less motivated buyers do not purchase the good and producers have a strong incentive to supply more at the higher market price.

This process will continue until the quantity demanded is equal to the quantity supplied.

A “surplus” exists when the quantity supplied is greater than the quantity demanded. In this case, we would expect the market price to go down. The lower market price entices more consumers into buying, but lower profits create an incentive for producers to reduce the quantity supplied.

Invisible Hand Principle

Market prices deliver information to producers on how to allocate capital and other resources. Prices tell producers about consumer needs and wants by showing them how much consumers are willing to pay for a particular good or service. Prices also inform consumers by sending signals about how much of a given product is available.

These market prices act as an “invisible hand” that pushes self-interested individuals toward the correct allocation of resources, benefiting both the individuals and society as a whole. No one person is consciously making these decisions.

Types of Bond Issuer

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A firm can issue a bond either in its home country or in another country. Bonds that are sold to local investors in another country’s bond market are known as foreign bonds. Foreign bonds have a variety of nicknames: A bond sold by a foreign company in the United States is known as a Yankee bond; a bond sold by a foreign firm in Japan is a samurai.

To raise money through issuing bond, the publicly traded corporation needs to register with the regulator of that country, for example in the US, if the IBM corporation issuing bond in the US, it will register with Securities Exchange Commission(SEC) before the bond can be publicly bought and sold by large financial institutions.

The bonds that are issued outside the US by IBM Corporation are not subject to register with SEC.this is the international issuing bonds which are Eurobond. And Eurobonds are made in one of the major currencies, such as the U.S. dollar, the euro, or the yen. Eurobond issues are marketed by international syndicates of underwriters, such as the London branches of large U.S., European, and Japanese banks and security dealers.

These days very large bond issues are often marketed both internationally (in the Eurobond market) and in individual domestic markets. For example, IBM could sell its dollar bonds internationally and also register the issue for sale in the United States. Such bonds are called global bonds.

Types of Issuer – there are three issuers of bonds:

(1) The federal government and its agencies

(2) Municipal governments

(3) Corporations

Sectors of the U.S. Bond Market

· Treasury sector – securities issued by the U.S. government

· Agency sector – securities issued by federally related institutions and government-sponsored enterprises

· Municipal sector – securities issued by state and local governments bonds

· Corporate sector – securities issued in the U.S. by U.S. corporations and foreign corporations

· Asset-backed sector – securities backed by a pool of assets

· Mortgage sector – securities backed by mortgage loan

Portfolio Calculations

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Individual Investment

The expected return for an individual investment is simply the sum of the probabilities of the possible expected returns for the investment.

Formula 17.3
Expected Return E(R) = p₁R₁ + p₂R₂ + .....+ p_nR_n

Where: p_n= the probability the return actually will occur in state n
R_n = the expected return for state n

Example:

For Newco's stock, assume the following potential returns.

Figure 3.3: Expected returns for Newco's stock price in the various states

Scenario Probability Expected Return

Worst Case 10% 10%

Base Case 80% 14%

Best Case 10% 18%

Given the above assumptions, determine the expected return for Newco's stock.

Answer:

E(R) = (0.10)(10%) + (0.80)(14%) + (0.10)(18%)

E(R) = 14.0%

The expected return for Newco's stock is 14%.

Portfolio

To determine the expected return on a portfolio, the weighted average expected return of the assets that comprise the portfolio is taken.

Formula 17.4
E(R) of a portfolio = w₁R₁ + w₂R_q + ...+ w_nR_n

Example:

Assume an investment manager has created a portfolio with the Stock A and Stock B. Stock A has an expected return of 20% and a weight of 30% in the portfolio. Stock B has an expected return of 15% and a weight of 70%. What is the expected return of the portfolio?

Answer:
E(R) = (0.30)(20%) + (0.70)(15%)
= 6% + 10.5% = 16.5%
The expected return of the portfolio is 16.5%

Computing Variance and Standard Deviation for an Individual

To measure the risk of an investment, both the variance and standard deviation for that investment can be calculated.

Formula 17.5
Variance =

Where: P_n= probability of occurrence
R_n = return in n occurrence
E(R) = expected return

Formula 17.6
Standard Deviation =

Example: Variance and Standard Deviation of an Investment

Given the following data for Newco's stock, calculate the stock's variance and standard deviation. The expected return based on the data is 14%.

Figure: Expected return for Newco in various states

Scenario Probability Return Expected Return

Worst Case 10% 10% 0.01

Base Case 80% 14% 0.112

Best Case 10% 18% 0.018

Answer:
σ²= (0.10)(0.10 - 0.14)² + (0.80)(0.14 - 0.14)²+ (0.10)(0.18 - 0.14)²

= 0.0003

The variance for Newco's stock is 0.0003.

Given that the standard deviation of Newco's stock is simply the square root of the variance, the standard deviation is 0.0179 or 1.79%.

Covariance

The covariance is the measure of how two assets relate (move) together. If the covariance of the two assets is positive, the assets move in the same direction.

For example, if two assets have a covariance of 0.50, then the assets move in the same direction. If however the two assets have a negative covariance, the assets move in opposite directions. If the covariance of the two assets is zero, they have no relationship.

Formula 17.7
Covariance_a,b=

Example:

Calculate the covariance between two assets
Assume the mean return on Asset A is 10% and the mean return on Asset B is 15%. Given the following returns over the past 5 periods, calculate the covariance for

Asset A as it relates to Asset B.

Returns

N R_a R_b

1 10% 18%

2 15% 25%

3 5% 2%

4 13% 8%

5 8% 17%

Answer:

N R_a R_b R_a- Avg R_a R_b-Avg R_b R_a- Avg R_aR_b-Avg R_b

1 10 18 0 3 0

2 15 25 5 10 50

3 5 2 -5 -13 65

4 13 8 3 -7 -21

5 8 17 -2 2 -4

Sum 90.00

The covariance would equal 18 (90/5).

Correlation

The correlation coefficient is the relative measure of the relationship between two assets.
It is between +1 and -1, with a +1 indicating that the two assets move completely together and a -1 indicating that the two assets move in opposite directions from each other.

Formula 17.8

Example: Calculate the correlation of Asset A with Asset B.

Given our covariance of 18 in the example above, what is the correlation coefficient for Asset A relative to Asset B if Asset A has a standard deviation of 4 and Asset B has a standard deviation of 3.

Answer:
Correlation coefficient = 18/(8)(4) = 0.563

Components of the Portfolio Standard Deviation Formula
Remember that when calculating the expected return of a portfolio, it is simply the sum of the weighted returns of each asset in the portfolio. Unfortunately, determining the standard deviation of a portfolio, it is not that simple. Not only are the weights of the assets in the portfolio and the standard deviation for each asset in the portfolio needed, the correlation of the assets in the portfolio is also required to determine the portfolio standard deviation.

The equation for the standard deviation for a two asset portfolio is long, but should be memorized for the exam.

Formula 17.9

The Portfolio Management Process

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The portfolio management process is the process an investor takes to aid him in meeting his investment goals.

The procedure is as follows:

Create a Policy Statement -A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments.
Develop an Investment Strategy - This entails creating a strategy that combines the investor's goals and objectives with current financial market and economic conditions.
Implement the Plan Created -This entails putting the investment strategy to work, investing in a portfolio that meets the client's goals and constraint requirements.
Monitor and Update the Plan -Both markets and investors' needs change as time changes. As such, it is important to monitor for these changes as they occur and to update the plan to adjust for the changes that have occurred.

Policy Statement
A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments. This could be considered to be the most important of all the steps in the portfolio management process. The statement requires the investor to consider his true financial needs, both in the short run and the long run. It helps to guide the investment portfolio manager in meeting the investor's needs. When there is market uncertainty or the investor's needs change, the policy statement will help to guide the investor in making the necessary adjustments the portfolio in a disciplined manner.

Expressing Investment Objectives in Terms of Risk and Return
Return objectives are important to determine. They help to focus an investor on meeting his financial goals and objectives. However, risk must be considered as well. An investor may require a high rate of return. A high rate of return is typically accompanied by a higher risk. Despite the need for a high return, an investor may be uncomfortable with the risk that is attached to that higher return portfolio. As such, it is important to consider not only return, but the risk of the investor in a policy statement.

Factors Affecting Risk Tolerance
An investor's risk tolerance can be affected by many factors:

Age- an investor may have lower risk tolerance as they get older and financial constraints are more prevalent.
Family situation - an investor may have higher income needs if they are supporting a child in college or an elderly relative.
Wealth and income - an investor may have a greater ability to invest in a portfolio if he or she has existing wealth or high income.
Psychological - an investor may simply have a lower tolerance for risk based on his personality.

Revenue Recognition and Accounting Entries

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Accounting Entries

The best way to identify the appropriate accounting entries is to consider an example:

Construction Company ABC, has just obtained a $50 million contract to build a five-building resort in the

Bahamas

for Meridian Vacations. Company ABC estimates that each building will take a full year to build. Meridian Vacations has agreed to pay Company ABC according to the following schedule: $5m in year 1, $10m in year 2, $10m in year 3, $10m in year 4 and $15m in year 5. Company ABC has estimated that the total cost of this contact will be $35m, and will occur over the five years in this way; $5m in year 1, $4m in year 2, $10m in year 3, $10m in year 4 and $6m in year 5. Equal monthly payments will be made to ABC, and Meridian will have a 30-day grace period except for the last payment in year 5.

Figure 6.6: Illustration of Construction Company ABC's expected figures

Total Revenue:	$50M
Total Cost:	$35M
Year 1	Year 2	Year 3	Year 4	Year 5	Total cost
	5,000,000	4,000,000	10,000,000	10,000,000	6,000,000	35,000,000
Payment Terms	5,000,000	10,000,000	15,000,000	8,000,000	12,000,000	50,000,000
Cash Received	4,583,333	9,583,333	14,583,333	8,583,333	12,666,667	50,000,000
Accounts Receivable	416,667	833,333	1,250,000	666,667	-

Percentage-of-Completed-Contract Method

We first need to estimate the revenues Company ABC will declare each year. Remember we are using the percentage-of-completion method based on estimated cost.

Figure 6.7: Construction Company ABC's Estimated Revenues

Year 1
Year 2
Year 3
Year 4
Year 5
Total

Cost
5,000,000
4,000,000
10,000,000
10,000,000
6,000,000
35,000,000

% of Completion
14.29%
11.43%
28.57%
28.57%
17.14%
100%

Cumulative
14.29%
25.71%
54.29%
82.86%
100%

Revenue
7,142,857
5,714,286
14,285,714
14,285,714
8,571,429
50,000,000

Step 1:
Revenues to be declared

We first need to extrapolate how much each annual cost represents as a percentage of the total cost. Armed with this information we multiply the percentage of completion with the total expected revenue for the project for each period.

Recall that one of the basic accounting principles is assurance of payment, and here is the formula used to determine amount of revenues to be recognized at any given point in time:

Formula 6.4

(Services Provided to Date/Total Expected Services) x Total Expected Inflow

This is basically the same formula used in the percentage-of-completion method.

Step 2:

Cost to be declared

Since this is the basic assumption of this accounting methodology, the expenses remain the same as the ones that were estimated.

Results:1. Annual Income Statement Entries

In each year, the revenues, expenses would be entered as seen on the following table.

Note: For simplicity, taxes were not considered.

Figure 6.8: Construction Company ABC's Income Statement (% of Completion Method)

2. Balance Sheet Statement Entries

Figure 6.9: Construction Company ABC's Balance Sheet (% of Completion Method)

Explanation of Balance Sheet Entries:

Cash:It is the total cash Company ABC has on hand at the end of the year, and is defined as the total cash inflow minus the total cash outflow. If the result of this equation were negative, the company would have to borrow from its line of credit additional funds to cover its total expenses.
Accounts Receivable:The total amount billed less the cash received by Meridian.
Net construction in progress (asset) and net advance billing(liability): These accounts offset each other and are composed of construction in progress less total billings.
- If the result of this equation were negative, the company would have billed its client for more than what has delivered. This would have constituted a liability for the construction company, and would have been reported as net advance billings.
- If this equation were positive, then the company would have built more than the client has paid for it, and the result of the equation would have constituted an asset and would be recorded as net construction in progress.
- In most cases, companies only report net construction in progress or net advance billing on their balance sheet.
Retained earnings -The cumulative shares of the total profit to date. This item is not shown on the balance sheet above. It normally appears after shareholders equity.

Formula 6.5

Construction in progress = the cumulative cost incurred since inception + (cumulative percentage of completion x total estimated net profit of the project)

Less
Total billings = cumulative amount billed to the client since inception

Remember, if the result of the above equation is:
Positive (asset) = net construction in progress
Negative (liability) = net advance billings

Figure 6.10: Other Items on Company ABC's Balance Sheet (% of Completion Method)

Completed-Contract Method

Under this accounting methodology, revenues and expenses are not recognized until the contract is completed and the title is transferred to the client.

Annual Income Statements

In this case, nothing would be reported on the annual income statements until Year 5.

Figure 6.11: Company ABC's Income Statement (Completed Contract Method)

Balance Sheet Statements
Under this method, the balance sheet entries are the same as the percentage-of -completion method, except for the Net Advance Billing account.

Figure 6.12: Company ABC's Balance Sheet (Completed Contract Method)

Balance Sheet Entries

Cash and accounts receivablesstay the same under both the percentage of completion and completed contract methods.
- This is normal because, no matter which method you use, you always know how mush cash you have in the bank, and you how much credit you have extended to your client.
Net construction in progress (asset) / net advance billing - The basic concepts are the same, except that under this methodology, construction in progress does not include the cumulative effect of gross profits in the formula (i.e. excludes cumulative percentage of completion x total estimated net profit of the project).

What is a Derivative?

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A Derivative derives its value from the value of some other financial asset or variable. For example, a stock option is a derivative that derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from an interest rate index. The asset from which a derivative derives its value is referred to as the underlying asset. The price of a derivative rises and falls in accordance with the value of the underlying asset. Derivatives are designed to offer a return that mirrors the payoff offered by the instruments on which they are based.

By way of example, a few standard derivatives are listed below. The most commonly-traded derivatives - forwards, futures, options and swaps .

Asian Option - Also called an average option, this is an option with a payoff that is linked to the average value of an underlying asset on a specific set of dates during the life of the option.

Basket Option - An option with a payoff that is linked to a portfolio or "basket" of assets such as the Fortune 500.

An interest-rate cap is an option that protects the holder from rises in short-term interest rates by making a payment to the holder when an underlying interest rate index exceeds a specified strike or cap rate.

A credit derivative is an OTC derivative designed to transfer credit risk from one party to another. By synthetically creating or eliminating credit risk from one party to another. swaption is an OTC option on a swap. . Usually, the underlying swap is a vanilla interest rate swap. Unless stated otherwise, that is how we will use the term in this article. However, the term "swaption" might be used to refer to an option on any type of swap.

There is also a somewhat arbitrary distinction between vanilla and exotic derivatives. The former tend to be simple and more common, the latter more complicated and specialized. There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom.

Derivatives are further distinguished from cash instruments in that they are contracts between two or more parties. These contracts are promises to convey ownership of an asset rather than the asset itself. Like other contracts, derivatives represent an agreement between two parties; the terms of the agreement are highly flexible and the contract has a fixed beginning and ending date.

Derivatives are generally used to hedge risk, but can also be used for speculative purposes. For example, an Asian investor who uses U.S. dollars to buy shares in a U.S. company (traded on a

U.S.

exchange) would be exposed to exchange-rate risk when she sells the shares and converts dollars back to her home currency. To hedge this risk, the investor could purchase derivatives - currency futures - to lock in a favorable exchange rate.

Despite the risks, derivatives are also attractive to investors because they trade for a fraction of the price of the underlying asset, enabling investors to control more of an asset for less money.

Because derivatives are contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Options are the most commonly traded type of derivative. An options contract gives the owner the right to buy or sell an asset at a set price on or before a given date. Other products include futures contracts, forward contracts, warrants and swap contracts. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

Key points to remember:

Derivatives are contracts between buyers and sellers.
They are referred to as "wasting" assets because they have a defined and limited life with a set initiation and expiration date. The value of a derivative decreases as it gets closer to the expiration date.
Generally, payoff is determined or made at the expiration date, although this is not true in all cases.
Sometimes no money is exchanged at the beginning of the contract.
Cash or spot price is the price an investor would have to pay for immediate purchase.

Exchange-traded vs. over-the-counter derivatives

Like their underlying cash instruments, some derivatives are traded on established exchanges (the New York Stock Exchange, the French CAC or the Chicago Board of Trade). These are referred to as exchange-traded derivatives and, generally, they have highly standardized terms and features.

The advantage of exchange-traded derivatives is that regulated exchanges provide clearing and regulatory safeguards to investors.

Many other derivative instruments, including forwards, swaps and exotic derivatives, are traded outside of the formal, established exchanges. These are over-the-counter or OTC-traded derivatives. They can be created by any two counterparties with highly flexible terms and a nearly infinite number of underlying assets or asset combinations. In the OTC derivatives market, large financial institutions serve as derivatives dealers, customizing derivatives for the specific needs of clients.

Scenario	Probability	Expected Return
Worst Case	10%	10%
Base Case	80%	14%
Best Case	10%	18%

N	R_a	R_b
1	10%	18%
2	15%	25%
3	5%	2%
4	13%	8%
5	8%	17%

N	R_a	R_b	R_a- Avg R_a	R_b-Avg R_b	R_a- Avg R_aR_b-Avg R_b
1	10	18	0	3	0
2	15	25	5	10	50
3	5	2	-5	-13	65
4	13	8	3	-7	-21
5	8	17	-2	2	-4
Sum					90.00