1
Q
What is the definition of long-term financial management?
A
It involves planning, organizing, directing, and controlling an organization’s financial resources to achieve its strategic objectives over the long term. Long-term financial management determines how a company finances its long-term assets. “Long term” typically means more than one year.
2
Q
What is the long-term capital structure of a company, and what does it include?
A
It is the long-term and permanent sources of financing used by the company, which includes its long-term liabilities and its equity.
3
Q
What are the external sources of long-term financing for a company?
A
- Issuance of debt securities
- Issuance of equity securities (common or preferred)
- Long-term bank financing
- Leasing
4
Q
What is the primary difference between common stock and preferred stock?
A
- Common stock represents voting ownership and potential dividends.
- Preferred stock has characteristics of both bonds and common stock, offering fixed dividends but without voting rights.
5
Q
What is the optimal capital structure for a company?
A
The mixture of long-term debt and equity that minimizes the company’s overall cost of capital.
6
Q
What factors influence the determination of a company’s optimal capital structure?
A
- Future prospects of the company and its degree of business risk
- Performance of equity markets
- Risk tolerance of the company’s management
- The issuer’s reputation and interest rate it would need to pay to issue debt
- The cost of each source of capital
7
Q
What is the cost of capital?
A
The average rate of return that investors require to invest in a company’s debt and equity.
The required return from the investor’s perspective is equal to the cost of capital from the company’s standpoint.
8
Q
How is the overall cost of capital calculated?
A
The overall cost of capital is a weighted average of the costs of all outstanding capital, weighted according to the percentages of the total market value of all the capital represented by each form of capital.
A company’s current cost of capital is calculated using the current market values of its outstanding debt and equity, not their book values.
9
Q
Fill in the Blank:
When a company makes a long-term investment, management’s required rate of return for the investment is also called its ___________ rate.
A
hurdle
“Hurdle rate” is another name for the required rate of return on an investment.
10
Q
What is a bond in the context of debt financing?
A
A debt security representing a loan by bondholders to the issuing company. It promises periodic interest payments and repayment of the face amount at maturity.
11
Q
What is the risk-free rate?
A
A theoretical rate representing the time value of money when it is invested in a perfectly safe investment, often represented by short- to intermediate-term U.S. Treasury securities.
12
Q
What is the best proxy for a risk-free rate?
A
The short- to intermediate-term U.S. Treasury securities rate.
The likelihood of the U.S. government defaulting is extremely low, making these securities a suitable proxy for a risk-free rate.
13
Q
What is liquidity in the context of investing, and how does liquidity affect the interest rate required by investors in a bond issue?
A
It is the quality of being readily convertible into cash. A bond that is liquid is one that is actively traded on secondary markets and thus can easily be sold.
More liquid bonds can pay a lower interest rate; less liquid bonds require the issuer to pay a higher interest rate.
Liquidity reduces the risk to investors, as they can sell the bonds more easily if needed.
14
Q
What type of bonds can be issued as federally tax-exempt?
A
Bonds issued by state and local governments.
Interest on bonds issued by private-sector corporations is always taxable.
15
Q
What is the par value of a bond?
A
The stated amount (face value) of the bond that is used to calculate interest payments and that is repaid to the bondholders at maturity.
16
Q
What is the stated interest rate on a bond also known as?
A
Coupon rate or nominal rate
17
Q
What information is typically found on the face of a bond?
A
- Par value
- Stated interest rate
- Issue date
- Maturity date
- Information about how often and on what dates the bond pays interest
18
Q
How is the annual interest paid by a bond calculated?
A
By multiplying the par value of the bond by its stated annual rate of interest.
19
Q
When does a bond sell at a discount?
A
When the market rate of interest for bonds with similar characteristics is higher than the stated rate on the bond.
20
Q
When does a bond sell at a premium?
A
When the market rate of interest for bonds with similar characteristics is lower than the stated rate on the bond.
21
Q
What are debt issuance costs?
A
- Underwriting fees
- Accounting fees
- Legal fees
- Promotion costs
22
Q
What is the relationship between a bond’s selling price and its face value when the market rate equals the stated rate?
A
The selling price is equal to the face value.
23
Q
What is the effect of a bond’s special features on the bond’s investors’ required rate of return?
A
If a special feature or provision is harmful to the investors, they will require a higher rate of return.
If the special feature or provision is beneficial to the investors, they may accept a lower rate of return.
24
Q
What is a bond indenture?
A
A bond represents a contract between the issuer (the borrower) and the bondholders (the lenders). The legal contract is called the indenture and it contains all the terms and conditions of that bond issuance, including features such as the maturity date, the interest rate, and the timing of interest payments.
25
What is the effect of **restrictive covenants** on bond interest rates?
They can make a bond issue more attractive to investors, potentially allowing the issuer to borrow funds at a slightly lower interest rate.
## Footnote
Restrictive covenants protect bondholders by limiting company actions that could be detrimental to them, such as a requirement to maintain certain financial ratios or limiting dividend payments on equity.
26
What is a **call provision** in a bond?
It gives the issuer the option to retire (pay off) the bond before its maturity at a given price.
## Footnote
This provision is advantageous for the issuer if market interest rates fall, because it allows them to refinance at a lower rate. However, it is disadvantageous for investors who may not be able to reinvest at the same high rate.
27
How does a **put provision** benefit bond investors?
It allows investors to redeem the bond if certain events occur or covenants are violated. The benefit to an investor is that the investor can require the issuer to pay off the debt by repurchasing the bonds from the investor. The price for repurchasing the bonds is either specified in the indenture or calculated according to its terms.
## Footnote
A put provision is beneficial to the investor, so it may enable the issuer to issue the bonds at a lower coupon rate.
28
What is the **conversion ratio** for a convertible bond?
The par value of the convertible bond divided by the conversion price of the stock. It represents the number of shares of stock that each bond can be converted into.
29
What are the advantages of convertible bonds for **issuers**?
Convertible bonds can become equity financing if converted, relieving the issuer of paying interest or repaying the principal at maturity.
30
What are the advantages of convertible bonds for **investors**?
If the market price of the bond declines due to rising interest rates or some other reason, investors have another option in addition to holding the bond or selling the bond at the market price: they could convert it to common stock.
## Footnote
A convertibility clause is beneficial to the investor and would therefore decrease the investors' required rate of return.
31
What is a bondholder's primary risk associated with debenture bonds?
Debenture bonds are unsecured and rely solely on the creditworthiness of the issuer, posing greater risk to bondholders.
## Footnote
Only companies with high credit ratings can typically issue debenture bonds due to the lack of collateral.
32
What distinguishes Eurobonds from foreign bonds?
Eurobonds are denominated in a currency different from the country where they are sold, while foreign bonds are issued in a foreign country and denominated in that country's currency.
## Footnote
Eurobonds allow issuers to choose markets with favorable interest rates and may have fewer regulatory compliance costs.
33
What is the relationship between **interest rates** and **inflation**?
There is an **inverse relationship** between market interest rates and inflation. Low interest rates encourage increased economic activity which can lead to inflation, while high interest rates can decrease activity and reduce inflation.
## Footnote
Central banks use interest rate adjustments as a primary tool to control inflation.
34
How do interest rates affect the market prices of financial instruments?
There is an inverse relationship between interest rates and market prices of financial instruments.
When interest rates increase, the market prices of stocks and fixed income bonds typically decrease.
The opposite happens when market rates of interest decrease. Market prices of both stocks and fixed income bonds increase.
35
Why do market prices of bonds decrease when interest rates increase?
The amount investors are willing to pay for fixed income bonds decreases because investors want to receive the higher market rate of interest on their fixed income invest-ments, so the price they are willing to pay for existing, lower rate bonds decreases.
36
How does the tax deductibility of interest impact a company's financing decisions?
Interest paid on debt is tax deductible, which reduces the actual cost of interest and makes bonds a less expensive source of financing than equity.
## Footnote
This advantage is limited by the company's debt level, which can increase the cost of capital if debt becomes too high in proportion to equity in the company's capital structure.
37
What happens if a company's debt level becomes too high?
* Debt holders and equity investors perceive increased risk.
* They require higher returns, increasing the company's cost of capital, including both debt and equity capital.
38
How is the cost of debt calculated from an **accounting** perspective?
It is the effective annual interest rate or yield to maturity on the company's outstanding bonds when originally issued.
## Footnote
For accounting purposes, the interest expense on a company’s outstanding debt is recognized in the accounting system at its pretax amount, although if it is to be used in decision making, it is usually considered at its after-tax equivalent.
39
How is the cost of debt calculated from a **cost of capital** perspective?
It is the investors' required rate of return for debt of similar term and risk characteristics at any given moment. The cost of debt from a cost of capital perspective is expressed at its after-tax equivalent rate because interest is tax deductible and the rate is used for analysis and decision making.
40
What is the formula for calculating the **after-tax cost of debt**?
After-tax cost of debt = Pretax annual interest rate × (1 − tax rate)
41
What does the term structure of interest rates describe?
The relationship between interest rates on bonds and the term to maturity of bonds with the same risk characteristics other than their term as of a moment in time.
42
What does an **upsloping yield curve** indicate?
An upsloping yield curve occurs when longer-term interest rates are higher than shorter-term rates, indicating that investors require a higher return for longer-term investments due to increased risk. If it is steeper than usual, it can reveal market participants’ expectations that inflation and interest rates will increase in the future.
43
What does a **downsloping yield curve** indicate?
Market participants expect interest rates to decrease. Borrowers prefer to borrow short term so they can refinance at a lower interest rate later, while investors prefer to invest long-term to lock in the current higher rate of return.
This leads to low supply and high demand for short-term funds, leading to increaed short-term rates; and high supply and low demand for long-term funds, leading to decreased long-term rates. .
44
What is **bond duration**?
The duration of a fixed income security is a weighted average of the times until the receipt of interest and principal cash flows, weighted according to the proportion of the total present value of the security represented by each cash flow to be received.
## Footnote
A security’s duration is a measure of how sensitive its market value is to interest rate changes, that is, how much the market value of the security changes when interest rates change.
45
What is the best measure of interest rate risk for a fixed income security?
Duration
## Footnote
Duration measures how sensitive a security's market value is to interest rate changes.
46
How does the maturity of a fixed income security affect its duration?
The longer the time until maturity, the higher the duration and the greater the security's sensitivity to interest rate changes.
## Footnote
As maturity approaches, duration decreases, making the security less sensitive to interest rate changes.
47
What is duration hedging in a fixed income portfolio?
Diversifying the duration of holdings in the portfolio, with some short-term holdings, some intermediate-term holdings, and some long-term holdings.
## Footnote
Diversifying a fixed income portfolio in this way can make the portfolio less sensitive to interest rate moves than it would be if it consisted of all long-term debt securities.
48
What are the two general types of equity securities?
* Common stock
* Preferred stock
49
What **rights** do common shareholders typically have?
* The right to vote
* The right to receive dividends if declared
* The right to buy shares of a new issue if preemptive rights exist
* The right to share in the distribution of residual assets if the company is liquidated.
50
What is the **par value** of common stock?
A small amount representing the company's legal capital.
## Footnote
It is the maximum personal liability of a shareholder in case of liquidation.
51
How is preferred stock similar to bonds?
* Usually holders of preferred stock do not vote on issues.
* Preferred stock usually pays, or earns, a fixed annual payment in the form of a dividend.
* Preferred shareholders have preference over common shareholders in asset distribution, though they have a lower priority than bondholders.
* Preferred shareholders usually receive dividends before common stockholders.
* Preferred stocks are often issued with bond-like features.
52
What is a characteristic of cumulative preferred shares?
They earn their dividend every year, even if it is not declared and paid.
## Footnote
If an earned cumulative dividend is not declared in a particular year, that dividend accumulates, and it must be declared and paid in the future before any future common dividends may be paid.
53
What happens to noncumulative preferred dividends if not declared in a specific year?
They are lost and not collectible in future periods.
54
# True or False:
Preferred dividends are tax-deductible for the company.
False
## Footnote
Preferred dividends are paid after interest and taxes and are not tax-deductible for the company.
55
# Fill in the blanks:
The policy a company uses to determine the amount of dividends paid to common stockholders is called its \_\_\_\_\_\_\_ \_\_\_\_\_\_\_.
dividend policy
56
What are the major factors affecting a corporation's dividend policy?
* The amount and stability of the company’s earnings
* The company’s policy with respect to financing
* The amount of cash not needed for operations
* Available investment projects
* The company’s debt service obligations
* The corporation’s ability to borrow
* The past dividend rate
* The company’s need for cash to fund growth
* Corporate income tax rates
* The tax position of the shareholders and the dividend income tax rate they will pay
57
What is a **residual dividend policy**?
A dividend is paid only if the funds are not needed for investment by the company in operations of their own that would provide a higher return than the shareholders would be able to receive.
58
What determines who will receive a dividend that has been declared?
The ex-dividend date.
* Anyone who buys the stock on or after the ex-dividend date **will not** receive the dividend.
* Anyone who sells the stock on or after the ex-dividend date **will** receive the dividend.
59
How is a stock split different from a stock dividend with respect to the par value per share of stock?
In a stock split the par value of each share is adjusted, but in a stock dividend, there is no adjustment to the par value of each share.
60
What is a reverse stock split?
It reduces the number of shares outstanding, which causes the market value of each share to increase.
The total market value of the outstanding shares will be unchanged.
## Footnote
In a 1-for-2 reverse split, the holder of 200 shares at a market price of $10 each (and a total market value of $2,000) before the reverse split will have 100 shares at a market price of $20 each (and a total market value of $2,000) after the reverse split.
61
What is treasury stock?
Shares of a company that have been sold to other parties and then repurchased by the company.
## Footnote
Treasury stock is a reduction of the company’s equity.
62
Are treasury shares outstanding stock?
No
## Footnote
Treasury shares are shares that are issued but are not outstanding.
63
What is a stock right?
The right to buy stock from the issuing company at a given price before a certain date.
64
What is a method by which a foreign company can participate in the U.S. markets without needing to go through the formal SEC share registration process to sell its shares publicly in the U.S.?
American Depository Receipts
| (ADRs)
65
What is the intrinsic value of a share of stock?
What its market price **should** be if it is properly priced, based on all the factors that bear on valuation—assets, earnings, future prospects, management, and so on.
## Footnote
If markets are reasonably efficient and market participants are reasonably informed, the current market price of a security should fluctuate closely around its intrinsic value.
66
What is a stock's intrinsic value based on?
Its cash-generating ability: the present value of all anticipated future cash flows to be provided to the investor, discounted at the investors' required rate of return appropriate for the risk involved.
## Footnote
In calculating the intrinsic value of a share of stock, valuation models use the average rate of return required for a particular investment by all market participants.
67
What is the Zero Growth Dividend Model used for?
To calculate the intrinsic value of preferred stock and of common stock when it pays a dividend that is not expected to grow.
68
What is the formula for the Zero Growth Dividend Model used for valuing stock?
P0 = Annual Dividend / Investors' Required Rate of Return
69
What is the Dividend Growth Model used for?
To calculate the intrinsic value of common stock when the dividend is expected to grow indefinitely at a constant rate.
70
What is the formula for the Dividend Growth Model that is used for valuing stock when the dividend is expected to grow at a constant rate indefinitely?
P0 = Next Annual Dividend / (Investors' Required Rate of Return − Annual Future Growth Rate of Dividend)
71
How is the intrinsic value of a stock calculated when the company's dividend is expected to grow rapidly for a few years and then slow down to a more normal growth rate?
By means of the Two-Stage Discount Dividend Model.
72
How is the Two-Stage Dividend Discount Model used to calculate the intrinsic value of a stock whose dividend is growing rapidly, but after a few years it is expected to slow down to a more normal growth rate?
The Dividend Growth Model is adjusted by dividing the projected dividend cash flow stream into two parts:
1. the initial fast growth period, and
2. the next period, when normal and sustainable but lower growth is expected.
The present values of the two dividend streams are calculated and then summed to determine the value of the share.
73
What is the earnings multiple method of determining the intrinsic value of a share of stock?
A company's earnings multiple is its P/E ratio.
The earnings multiple method is a method of valuing a common stock using the P/E ratios of comparable publicly owned companies in the same industry.
P0 = Risk-Adjusted P/E Ratio × EPS
74
How is the cost of existing preferred stock calculated for purposes of determining the cost of capital?
Cost of Existing Preferred Stock = Annual Cash Flow Per Share in the Form of Dividends / Current Market Price of Preferred Stock
## Footnote
The numerator remains constant over time, but the denominator changes with the market price of the preferred stock.
75
What is the formula for the intrinsic cost of newly issued preferred stock?
Cnp = D / Pn
## Footnote
Where:
D = Annual dividend per share
Pn = Net proceeds per share
The net proceeds per share is the selling price per share minus flotation costs per share.
76
What are the two main ways a company can raise common equity capital?
* Retained earnings - profits reinvested in the business
* New common equity issued
77
In calculating the cost of equity capital, what is the cost of retained earnings based on?
The opportunity cost of the next best investment not made by the company on behalf of the shareholders.
## Footnote
Shareholders expect a return on reinvested earnings that matches or exceeds alternative investment opportunities.
78
What model is used to calculate the cost of retained earnings when dividends are paid and are expected to grow at a constant rate in the future?
The Dividend Growth Model
| (restated)
## Footnote
This model uses dividends per share, the expected growth rate of dividends, and the market price of the share.
79
In calculating the cost of capital, what is the formula for the restated Dividend Growth Model that is used to calculate the cost of retained earnings?
Cre = (D1 / P0) + G
## Footnote
Where:
Cre = Cost of retained earnings
D1 = The next annual dividend per share
P0 = Common stock share price currently
G = Annual expected growth rate in dividends
80
When should the Capital Asset Pricing Model (CAPM) be used to estimate the cost of equity for cost of capital calculations?
When the company pays no dividend.
## Footnote
The CAPM is used to estimate the cost of equity for both retained earnings and new equity when dividends are not paid.
81
What is the formula for the Capital Asset Pricing Model (CAPM)?
R = RF + β (RM − RF)
## Footnote
Where:
R = Investors' required rate of return
RF = Risk-free rate
β = Beta coefficient
RM = Expected rate of return for the market portfolio
This formula calculates the investors' required rate of return based on the risk-free rate, beta, and expected market return.
82
How does the cost of new common equity compare to the cost of existing common equity (retained earnings)?
The cost of new common equity is higher than the cost of existing common equity (retained earnings) due to flotation costs.
## Footnote
Flotation costs are incurred when issuing new shares, making new equity more expensive than retained earnings.
83
What is the formula for calculating the cost of newly issued common stock for cost of capital calculations?
Cns = (D1 / Pn) + G
## Footnote
Where:
Cns = Cost of the new issuance of common stock
D1 = The next dividend to be paid per share
Pn = Net proceeds per share
G = The annual expected % growth rate in dividends
84
What is the cost of capital?
The company's overall cost for its long-term debt and equity financing expressed as an annual rate.
## Footnote
It represents the investors' required rate of return based on the current market value of the company's capital.
85
Why is the cost of capital important for management to know?
It is used in making capital investment decisions to ensure the project's anticipated rate of return exceeds the cost of capital.
## Footnote
The cost of capital is the minimum required rate of return for a project necessary to avoid diluting shareholders' interests.
86
What is the weighted average cost of capital?
| (WACC)
A weighted average of the costs of debt, preferred equity, and common equity, weighted according to their current market values.
## Footnote
WACC is expressed as an annual rate and is used to evaluate investment opportunities.
87
How is a company's weighted average cost of capital (WACC) calculated?
* Calculate the annual after-tax cost of each individual component of capital.
* Determine the appropriate weighting for each component using market values.
* Sum the products of the weights and the after-tax costs for each component.
88
What is the effect of taxes on the cost of debt when calculating the cost of capital?
The cost of debt is reduced for the effect of taxes because interest is a tax-deductible expense.
## Footnote
This makes the after-tax cost of debt lower than the pre-tax cost of debt.
89
What is the **marginal cost of capital**?
The incremental cost of the next amount of capital to be raised.
## Footnote
It is important for optimizing the capital structure and is a weighted average if multiple types of new capital are raised.
90
When should the weighted marginal cost of capital (WMCC) be used instead of WACC?
In a decision situation, the weighted marginal cost of capital should be used instead of the WACC as the financing cost for any future investment because the WMCC represents the cost of obtaining the financing for a new investment.
91
What are derivatives used for?
Risk management
## Footnote
Because changes in the fair values or cash flows of a derivative can be used to offset the changes in fair values or cash flows of an asset that is at risk. Thus, derivatives can be used as hedges.
92
What is an "**underlying**" in the context of derivatives?
A specified interest rate, security price, commodity price, foreign exchange rate, index, or some other value from which a derivative derives its value.
93
What is a "**notional amount**" in the context of derivatives?
A monetary amount, a number of shares, a number of bushels, or a number of other units as specified in the derivative contract.
## Footnote
The notional value of a derivative contract is the notional amount multiplied by the current price of the underlying asset.
94
What does a payment provision in a derivative specify?
A fixed or determinable settlement to be made if the underlying price or rate behaves in a specified manner.
95
How is the settlement amount of a derivative determined?
By the interaction of the notional amount with the underlying price or rate of the asset, liability, or other indicator on which the value of the derivative is based.
## Footnote
The interaction may involve simple multiplication or a formula with leverage factors or other constants.
96
What is the purpose of **hedging**?
To reduce or eliminate risk by using an offsetting transaction, structured so that if the original transaction causes an adverse outcome, the hedge will create a positive outcome to cancel out at least partially the adverse outcome from the original transaction.
## Footnote
If the original transaction causes a positive outcome, the hedge will create a negative outcome that will at least partially cancel out the positive outcome.
The purpose of a hedge is not to guarantee a positive outcome but to reduce or eliminate risk.
97
What are the three classifications of hedges?
* Fair value hedge
* Cash flow hedge
* Hedge of a net investment in foreign operations
98
What is a **fair value hedge** used for?
To hedge or offset exposure to changes in the fair value of a recognized asset or liability or of a recognized or unrecognized firm commitment.
99
What is a **cash flow hedge** used for?
To hedge exposures to cash flow risk in an upcoming, forecasted transaction such as a planned purchase or sale or a planned debt issuance, and currency exchange risk associated with a forecasted transaction.
100
What is a hedge of a net investment in foreign operations used for?
To hedge the currency risk associated with the translation of the net assets of a foreign operation into the entity’s currency for the preparation of consolidated financial statements.
101
What are the four types of derivatives typically used to create hedges?
* Forward contracts
* Futures contracts
* Swaps
* Options
102
What is a forward contract?
An agreement between two parties to buy or sell an asset on a specified date in the future for a specified price.
## Footnote
Forward contracts can be for the purchase or sale of a commodity such as coffee beans or for the purchase or sale of foreign currency.
By executing a forward contract, the parties know the future price they will pay or receive and thus they eliminate the uncertainty.
103
How is a forward contract negotiated?
Forward contracts are not traded on exchanges.
Brokers may be used to bring together the buyer and the seller, who then negotiate the terms of the contract; but two parties may simply negotiate forward contracts between themselves.
104
What are the **risks** of forward contracts?
* **Credit** risk - fulfillment of a forward contract is dependent on the creditworthiness of both parties.
* Risk of **default** by one of the counterparties to the contract - because the counterparty could do better in the spot market and simply chooses to default.
105
What is a futures contract?
An agreement to buy or sell an asset on a specified future date for a specified price.
106
What are the differences between forward contracts and futures contracts?
* Futures contracts - traded on exchanges, traders have no risk of default by the counterparty. Forward contracts - not traded on exchanges and carry risk of default by the counterparty.
* Futures contracts - for standardized quantities of the specified asset at standardized prices. Forward contracts - individualized and the quantity and price negotiated by the contracting parties.
* Futures contracts - valued daily at their closing prices, marked to market each day, and usually closed out by taking an offsetting position. Forward contracts - settled on their expiration dates by physical delivery of the asset to the buyer.
107
What are the two basic types of futures contracts?
* **Commodity** futures - raw materials
* **Financial** futures - interest rate futures
108
# Fill in the Blank:
The party to a forward or futures contract that has contracted to **purchase** the underlying asset at the contract price on the contract's expiration date is called the \_\_\_\_\_\_\_ party.
long
## Footnote
The long party in a forward or futures contract is the party that has contracted to **purchase** the underlying asset.
109
# Fill in the blank:
The party to a forward or futures contract that has contracted to **sell** the underlying asset at the contract price on the contract's expiration date is called the \_\_\_\_\_\_\_ party.
short
## Footnote
The short party in a forward or futures contract is the party that has contracted to **sell** the underlying asset.
110
# True or False:
The terms "long" and "short" for the parties to forward contracts and futures contracts have standardized meanings that apply across all types of investments.
False
## Footnote
The designations of long and short parties to forward or futures contracts do not correspond to the use of the terms for other types of investments, such as long and short parties to options or “selling short” a stock. The terms have specific meanings for specific types of investments, and they do not mean the same thing across all types of investments.
111
What is a plain vanilla interest rate swap?
An interest rate swap is a forward contract between two parties to exchange future interest payments on debt based on a specified principal amount for a specified period of time.
A **plain vanilla** interest rate swap involves one borrower’s interest payment at a fixed rate and the other borrower’s interest payment at a floating (or variable) rate.
112
What is the difference between a foreign currency swap and an interest rate swap?
In an interest rate swap, the two currencies swapped are the same and only the interest payments are swapped, whereas in a foreign currency swap, the currencies swapped are different, and both interest and principal payments may be swapped.
113
# True or False:
A put option on a stock gives the buyer of the option the right (but not the obligation) to exercise the option and buy the underlying security at the strike price.
False
## Footnote
A put option on a stock gives the buyer of the option the right (but not the obligation) to exercise the option and **sell** the underlying security at the strike price.
114
# Fill in the blank:
An investor who has purchased an option to buy or sell a stock (the party who decides to exercise the option, or not) is called the \_\_\_\_\_\_\_\_ party.
long
## Footnote
The long party to a call or put option is the investor who has purchased the option to buy or sell the underlying asset (the party who decides to exercise the option, or not).
115
What is the difference between a **covered call** option and a **naked call** option?
* A covered call option is a call option for a stock that the option writer (the option seller) holds in their portfolio.
* A naked call option is a call option for a stock the option writer does not hold in their portfolio.
## Footnote
A covered call carries much less risk for the writer than a naked call, because the writer already owns the underlying stock and will not need to go out into the market and buy it if the call option is exercised.
116
When an investor holds a call option to purchase a stock for $10 per share and the market price of the stock is $12 per share, is the option in-the-money or out-of-the-money for the holder of the option?
The call option is **in-the-money** for the holder because the market price of the stock is higher than the exercise price of the option, so the holder can exercise the option and buy the stock at a price lower than the market price.
## Footnote
A call option gives the holder of the option the right to buy the underlying stock at a set price (the exercise, or strike, price) until the option's expiration date.
117
# True or False:
The intrinsic value of a call option is the excess of the market price of the underlying stock over the exercise (or strike) price of the option.
True
## Footnote
The amount by which the market price of the underlying stock is greater than the exercise (strike) price of a call option is the **intrinsic value** of a call option.
118
When an investor holds a put option to sell a stock for $10 per share and the market price of the stock is $12 per share, is the option in-the-money or out-of-the-money for the holder of the option?
The put option is **out-of-the-money** for the holder because the market price of the stock is higher than the exercise price of the option, so the holder would not exercise the option because they can sell the stock at the higher market price instead.
## Footnote
A put option gives the holder of the option the right to sell the underlying stock at a set price (the exercise, or strike, price) until the option's expiration date.
119
# Fill in the blank:
The amount by which the strike price of a put option is higher than the market price of the underlying stock is the option's \_\_\_\_\_\_\_\_\_ value.
intrinsic
## Footnote
The intrinsic value of a put option is the amount by which the strike price of the option is higher than the market price of the underlying stock.
120
An investor bought a put option on 100 shares of XYZ stock at a strike price of $40 and paid a premium of $2 per share for the option. During the period between purchase of the option and the expiration date of the option, the market price of the stock varied between a low of $42 and a high of $50.
How much did the investor gain or lose, or did the option buyer break even?
The option buyer lost $2 per share, or $200.
## Footnote
Because the market price of the stock remained above the strike price of the option for the option buyer's holding period, the option buyer let the option expire without exercising it because they could sell the stock at the market price for more.
The investor's loss is the premium paid for the option.
121
What is the extrinsic value of an option?
It's the option's time value.
## Footnote
Time to expiration adds value to an option because there is time for a price fluctuation to take place in the underlying security that will be favorable to the buyer. As long as some time remains before the option expires, the option will have time value.
122
# True or False:
The market value of an option is its intrinsic value minus its extrinsic value.
False
## Footnote
The market value of an option is its intrinsic value **plus** its extrinsic value.
123
An investor purchases 100 shares of stock X at $52. The investor also buys one option contract for 100 Stock X December $50 puts at $2 per share. The put option is exercisable until its maturity date in December and gives the investor the right to sell 100 shares of Stock X for $50 per share.
What is the investor’s **cost basis per share** for Stock X?
$54 per share.
## Footnote
$52 per share for the stock plus $2 per share for the put option.
124
An investor purchases 100 shares of stock X at $52. The investor also buys one option contract for 100 Stock X December $50 puts at $2 per share. The put option is exercisable until its maturity date in December and gives the investor the right to sell 100 shares of Stock X for $50 per share.
What is the investor’s **maximum total loss** on the stock if the stock’s market value falls?
$400
## Footnote
The investor’s cost per share for the stock and the put option is $52 + $2 = $54. The investor can exercise the put and sell the stock for $50 per share.
The investor’s maximum loss is $4 per share and for 100 shares of Stock X, the investor’s maximum total loss is $400.
CMA® Part 2
flashcards
Decks in class (19)
# Cards
-
A.1. Comparative Financial Statement Analysis11
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A.2. Financial Ratio Analysis150
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A.3. Profitability Analysis37
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A.4. Advanced Financial Topics60
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B.1. Risk and Return Fundamentals57
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B.2. Long-Term Financial Management124
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B.3. Raising Capital and Financial Markets38
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B.4. Working Capital Management105
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B.5. Corporate Restructuring and Valuation39
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B.6. International Finance68
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C.1. Cost-Volume-Profit (CVP) Analysis52
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C.2. Marginal Analysis and Decision Making57
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C.3. Pricing Decisions86
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D.1. Enterprise Risk Management (ERM)80
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E.1. Capital Investment Analysis and Cash Flows34
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E.2. Capital Investment Methods and Risk97
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F.1. Business Ethics and Fraud30
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F.2. IMA Code of Ethics and Fraud Triangle14
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F.3. Organizational Ethics and Culture64
