Mos 1023 Final Exam Notes.docx

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Western University
Management and Organizational Studies
Management and Organizational Studies 1023A/B
Maria Ferraro

M OS F INAL E XAM N OTES Pg 134-150  Finance: study of how and under what terms savings (money) are allocated between lenders and borrows o Whenever funds transferred, a financial contract comes into existence: financial securities o Requires basic understanding of securities and corporate laws that facilitate funds  Canadian balance sheet o Difference between what is owned/owed: equity/net worth  Real assets: represent tangible things that compose personal and business assets o Finance is essentially management of entity’s balance sheet o Asset acquisitions: generally referred to as capital expenditure (capex) decisions o Liabilities: ways to finance expenditures aka. Corporate financing decisions  Financial assets: what individual lent to another; one’s assets/liabilities o NBSA: produced by stats Can  Basic idea: take financial data of major agents  Ex. Persons and unincorporated business grouped household sector account o 4 major ways of financing  Personal finance  Government finance  Corporate finance  International finance o Primary source of savings is household sector  2 major financial assetmarket value of investment in shares and market value of investment in insurance/pensions o Net providers of financing: older higher-income individual save/accumulate financial assets (positive financial asset position) o Net users for financing: younger and less wealthy individuals borrowing to buy houses and consumer durables (negative financial asset position)  Non resident sector usually net provider of funds  Basic financial flow o Financial intermediaries: entities that invest funds on behalf of others and change nature of transactions  Transform nature of securities they issue and invest in o Market intermediaries that simply make markets work better  Whole package of institutions is Canadian financial system  Intermediation: transfer of funds from lenders to borrowers  2 extremes in terms of transfer of money from lender to borrower o Borrower obtain funds directly from individuals o Obtain indirectly form individuals who first loaned (deposited) savings to financial institution  3 channels o Direct intermediation: non-market transaction; exchange negotiated between borrower and lender o Also direct: requires help to find suitable lenders; help from market intermediaries  Market intermediary: entity that facilitates working of markets and helps provide direct intermediation aka. Brokers  Responsibilities are to assist with transaction and bring borrowers and lenders together; do not change nature of transactions  Most important financial market in Canada is TSX; supports variety of market intermediaries o Financial institution/financial intermediary lends money to ultimate borrowers but raise money from borrowing form others  Ultimate lenders have indirect claim from ultimate borrower, direct claim from financial institution  Commonly refer marketing and financial intermediaries as “retail” (marketing) and “institutional” (financial) markets  Canadian bank’s core activity: acting as deposit takers and lenders o Banks and insurance companies are important financial intermediaries o Contractual savers: insurance companies; most cases, premiums paid on monthly basis so that insurers receive steady flow of cash o “Pure” insurance companies which do not have significant savings component are much smaller o Major financial assets of household sector: insurance/pension plans o Funds in pension plans held directly from pensioners  Contractual savers  3 most important financial institutions that change nature of financial contract o Chartered bank o Pension funds o Insurance company  Mutual funds act as pas through for individuals; convenient way to invest in equity/debt markets o Receive money through monthly savings plan  Mutual funds have 2 major functions o They pool small sums of money so they can make investments not possible for smaller investors o Offer professional expertise in management of those funds o Don’t transform nature of underlying financial security  Major borrowers o Government provides many services to Canadians which sometimes require borrowing o Crown corporations; provide goods and services needed by Canadians  Provinces and territories are net debtors except for Alberta, Yukon, and Northwest Territories o Federal government is net debtor and significant borrower o Government raise money for citizen through direct taxation/monopolizing/charging higher fees (taxes) o Government debt regarded as default free, only debt people can invest in and know they’ll get promised payments o Interest rates paid on different types of gov. debt serve as benchmark o Most important borrowing sector is business  Borrows finance growth in this capacity of making goods/services we consume o Assets need to be financed and reflected in firm’s capital expenditure and corporate financing decisions o On avg. non-profits corps have a lot less profit  Financial assets: formal legal does that set out rights and obligations of all parties involved  Debt instruments: legal obligations to repay borrowed funds at specific maturity date and provide interim interest payments o Ex. Bank loans, treasury bills, mortgage, bonds, loans  Equity instruments: ownership stake in company, most common form is common share; companies may also issue preferred shares: entitles owner fixed dividend payments  Financial markets are important and facilitate transfer of funds from lenders to borrowers o Primary markets: issue of new securities by borrower in return for cash form investors/lenders o Secondary markets: provide trading or market environment that permits investors to buy/sell existing securities  2 major markets  exchange/auctions  dealer over counter (OTC)  Exchanges been referred to as auction markets because involve bidding process that takes place in specific location  Investors presented at markets by brokers  OTC or dealer markets do not have physical location but consist of network of dealers who trade directly with one another  TSX: major stock exchange in Canada where most equity security transactions take place  TSX venture exchange: stock exchange for trading securities of emerging companies not listed on TSX  TSX Group Inc. company that own TSX and TSX venture exchange  TSX markets: the group that performs trading operations for TSX and TSX venture exchange  Market capitalization: total market value of securities of an entity  Bourse de Montreal: exchange that acts as Canadian national derivatives market and carries on all trading in financial futures and options  Winnipeg Commodity exchange: exchange that handles futures trading in commodities  Market intermediaries now called “participating organizations” or “approved participants”  Ontario Securities Commission (OSC): an agency created by Ontario Government to protect investors in securities transactions  Canadian Trading and Quotation System (CNQ): an alternative market for small emerging companies o Requirements to trade on market less stringent than TSX venture exchange  Third market: trading of securities listed on organized exchanges in OTC market  Fourth market: trading of securities directly between investors without involvement of brokers/dealers Pg 152- 180notes  How new businesses get started o Started entrepreneur who discusses his ideas with people related to starting business o Leaves large companies to start businesses, using technology developed by firms  Initial funding of the firm o Bootstrapping: process which entrepreneurs raise “seed” money and obtain other resources to start business o Different ways of bootstrapping  Most of “seed” money usually comes from entrepreneur or other founders  Entrepreneurs often work regular full time jobs until business is on its feet  Venture Capital o Venture capitalists: individuals/firms that help new businesses get started and provide much of early-stage financing  Angels or angel investors: wealthy individuals who invest own money in emerging businesses at very early stages in small deals  Usually get money from various sources to invest in new business o Venture capital industry  Significant number of venture capital firms focus on high-technology investments o Why venture capital funding is different  High degree of risk involved: most new businesses fail and difficult to identify which firms will be successful  Types of productive assets  Most commercial loans made to firms have tangible assets such as machinery, equipment or physical inventory  Difficult to secure financing from traditional lending sources  Informational asymmetry problems  Entrepreneur knows more about their company’s prospects than lender does  Hard for investors to distinguish competent and incompetent businesses o The venture capital funding cycle  Bootstrap financing: entrepreneur supplies funds, prepares business plan and searches for initial outside funding  Seed-stage financing: venture capitalists provide funds to finish development of concept  Early-stage financing: venture capitalists provide financing to get business up and running  Latter-stage financing (mezzanine financing): includes one to five additional stages  Venture capitalists exit by selling to strategic buyer, selling to financial buyer or selling stock to public  How venture capitalists reduce risk  Staged funding: funding stage gives venture capitalist opportunity to reassess management team and firm’s financial performance o Typically go through 3-7 funding stages and each stage passed with vote of confidence for finance o Venture capitalists’ investments give equity interest in company o Usually preferred stock that is convertible into common stock at discretion of venture capitalists o Ensures venture capitalists have most senior claim among stockholders if business fails; conversion feature enables venture capitalists to share in gains if business is successful  Personal investment: Venture capitalists often require entrepreneur to make substantial personal investment in business  Syndication: occurs when originating venture capitalist sells percentage of deal of other venture capitalists o Increases diversification of originating venture capitalist’s investment portfolio  In-depth knowledge of industry and technology  The exit strategy  Provisions: timing, method of exit and what price is acceptable  Strategic buyer in private market o Looking to create value through synergies (the interaction of cooperation of 2+ organizations, substances, or agents to produce combined effect)  Financial buyer o Occurs when financial group- often a private equity firm- buys the new firm with intention of holding it for a period of time, usually 3-5 years, and selling for higher price o Different between strategic and financial buyout is financial buyer does not expect to gain from operating/marketing synergies o Financial buyout, firm operates independently and buyer focuses on creating value by improving operations as much as possible  Initial public offering o After IPO, venture capitalist will be able to sell shares they hold over time o Usually exit through strategic/financial sales rather than public sales (IPOs) o Venture capitalists provide more than financing  Provide advice to entrepreneurs  Extent of venture capitalists’ involvement in management of the firm depends on the experience and depth of management team  May want seat on board of directors  At minimum, want an agreement that gives them unrestricted access to information about firms’ operations and financial performance and right to attend/observe any board meeting  Insist on mechanism giving them authority to assume control of firm if firm’s performance is poor o Cost of venture capital funding  Bearing substantial amount of risk  Spend a considerable amount of time monitoring progress of businesses they fund and intervening when business’s management team needs help  Initial public offering o Company’s first sale of common stock in public market o First time stock issues given special name because marketing and pricing of issues distinctly different from those of seasoned offerings o Seasoned public offering: sales of securities (either stock or bonds) by firm that already has similar publicly traded securities outstanding o Public offerings means securities being sold are registered with Securities and Exchange Commission; thus can be sold to public at large o Advantages  Amount of equity capital can be raised in public equity markets is larger than amount raised through private sources  Additional equity capital can usually be raised through follow-on seasoned public offerings at low cost  Going public can enable entrepreneur to und growing business without giving up control  Active secondary market in which stock holders can buy and sell its shares  Enables entrepreneur and other managers to easily diversify personal portfolios or to sell shares to enjoy  Easier to attract top management talent and to better motivate current managers o Disadvantages  High cost of IPO itself  Partly due to fact stock is not seasoned; value is more uncertain  Costs of complying with ongoing SEC disclosure requirements  Transparency that results from compliance can be costly  Managers focus on short-term profits rather than long-term value maximization o Investment banking services o 3 basic services when bringing securities to market  Origination: give firm financial advice and getting issue ready to sell  Underwriting: risk-bearing part of investment banking  Distribution: reselling securities to public o Important task for firm because not all investment banks are equal o Top investment banking firms do not want to bring bad deals to market o Securing service o investment banking firm with reputation for quality and honesty will improve market’s receptivity and help ensure successful IPO  Origination o Investment banker helps firm determine whether it is ready for IPO o Once decision to sell stock is mad, firm’s management must obtain number of approvals  Firm’s board must approve all security sales  Stock holder approval required if number of shares of stock is to be increased o First step in process is to file registration statement with SEC  Preliminary prospectus: contains detailed information about type of business activities in which firm engaged in and financial condition, description of management team and experience, and competitive analysis of industry, range within which issuer expects initial offering price for stock ot fall, number of shares firm plans to sell, an explanation of how proceeds from IPO will be used, a detailed discussion of risks associated with investment opportunity  Information designed to allow investors to make good decisions about investing security issue and risks associated with it o Approval means only that firm has followed various rules and regulations  Underwriting o Can be underwritten in 2 ways: on firm commitment basis or on a best-effort basis o Firm-commitment underwriting  The investment banker guarantees the issuer a fixed amount of money from stock sale  Underwriter bears risk that resale price might be lower than price underwriter pays- price risk  Underwriter’s spread: investment banker’s compensation  Spread is difference between investment banker’s purchase price and offer price o Best-effort underwriting  Investment banking firm makes no guarantee to sell securities at particular price  Only to make best effort to sell as much of issue as possible at certain price  Investment banker does not bear price risk associated with underwriting the issue, and compensation is based on number of shares sold o Underwriting syndicates  Underwriters combine to form group  Each member responsible for proportional share of securities being issued  Participating entitles each underwriter to receive portion of underwriting fee and allocation of securities to sell to its own customers  May enlist other investment banking firms kwon as selling group, which assists in sales of securities o Determining offer price  Determine highest price at which bankers will be able to quickly sell all of shares being offered and result in stable secondary market for shares  One step to determine price is consider value of firm’s expected cash flows  Investment bankers will consider stock price implied by multiples of total firm value to EBITDA/stock price to earnings for similar firms already public  Investment will conduct road show in which management makes presentations about firm its prospects to potential investors  The road show is key marketing and information-gathering event for IPO  Generates interest in offering and helps investment banker determine number of shares that investors likely to purchase at different times o Due diligence meeting  Purpose of meeting to list, gather and authenticate matters  Have final opportunity to ask management questions about firm’s financial integrity, intended use of proceeds and other issues  To protect investment bankers reputations and to reduce risk of investor’s lawsuits in event and investment goes sour later on  Distribution o Underwriters and issuer determine final offer price in pricing call  Pricing call: takes place after market closed for the day  During call, lead underwriter (aka book runner) makes recommendation concerning appropriate price, and firm’s management decides whether price is acceptable o Accepting/rejecting, management ultimately makes pricing decision  If accepted, issuer files amendment to registration statement with SEC,  Once securities registered with SEC, can be sold to investor o The first day of trading  Syndicate’s primary concern is to sell securities as quickly as possible at offer price  Speed of sale reflects market conditions at end of previous day and conditions can change quickly  In successful offerings, most of securities will have been presold o The closing  Issuing firm delivers security certificates to underwriter and underwriter delivers payment for securities, net of underwriting fee to issuer  The Proceeds o What are total expected proceeds from common-stock sale? o How much money does the issuer expect to get from the offering? o What is the investment bank’s expected compensation from the offering? o First to work through allocations on per-share basis and compute total dollar amounts  Dividends: something of value that is distributed to firm’s stockholders on pro-rata basis (in proportion to percentage of firm’s shares that they own) o Distributions to stockholders reduce availability of capital for new investments and increase firm’s financial leverage o Dividend policy: firm’s overall policy regarding distributions of value to stock holders  Types of dividends o Most common form: regular cash dividend: cash dividend paid on regular basis; usually quarterly and common means by which firms return some profit to shareholders o Size of firm’s regular cash dividend is typically set at a level that management expects the company to be able to maintain in the long run  Barring some major change in fortunes of company, management don’t want to reduce dividend o Extra dividend: if earnings higher than expected  Often paid at same time as regular cash dividends and some companies use to ensure minimum portion of earnings distributed to stockholders each year o Special dividend: one-time payment to stockholders; tend to be considerably larger than extra dividends; usually used to distribute large amounts of cash  Might be used to distribute proceeds from sale of major asset/business or as means of altering company’s capital structure o Liquidating dividend: paid to stockholders when firm is liquidated (when assets are sold, proceeds from sale of assets distributed to creditors, stockholders and others who have claim on firm’s assets and firm ceases to exist  First claim: creditors-> second claim: private shares-> third claim: common shares  Distributions of value can also take form as discounts on company’s products/free sample  Often not thought of as dividend because value received is not in form of cash and because value received does not reflect proportional ownership in firm o Dividend payment process  More easily defined for companies with publicly traded stock than private companies  Board Vote  Vote by company’s board of directors to pay dividend  Board must approve any distribution of value to stockholders  The public announcement  Declaration date: announcement date of dividend  Usually includes amount of value stockholders will receive per share, as well another dates associated with dividend payment process  Sends signal to market about what management thinks the future performance be o If signal differs from investors’ thoughts, will adjust prices at which they are willing to buy or sell company’s stock accordingly  Decision to cut/eliminate dividend can single management is pessimistic and can cause stock price to go down; vice versa  The ex-dividend date: first date on which stock will trade without rights to dividend  Those who buy before the date will receive dividend  Before date, stock is said to be trading “cum dividend”; after date “ex dividend”  Important because can have significant implications for taxes/transaction costs they pay o Purchasing before date will result in receiving dividend on which taxes will have to be paid (unless they’re tax-exempt organization)  Dividend can create difficulties for stockholder who wants specific amount of money invested in firm o Returning value to stockholder, firm pays dividend may reduce stockholder’s investment below level preferred; making it necessary to purchase additional shares and incur associated brokerage fees  Firm’s shares changes on the date; drop signifies difference in value of cash flows that stockholders are entitled to before and after ex-dividend date  Record date: date on which investor must be “stockholder of record” (officially listed as stockholder) in order to receive dividend  Typically follows ex-dividend date by 2 days  Board specifies record date when it votes to make dividend payment  Ex-dividend day precedes record date because it takes time to update stockholder lst when someone purchases shares  Payable date  When stockholders of record actually receive dividend  Typically couple weeks after record date  Dividend process at private companies  Private companies shares are bought and sold less frequently, fewer stockholders and no stock exchange involved in dividend payment process  Board members know identities of stockholders when they vote to authorize dividend; makes it easy to form all stockholders of decision and easy to actually pay it  No public announcement, no need for ex-dividend date  Record date and payable date can be any day on/after day that board approves dividend o Stock Repurchase: company buys some shares from stockholders  How stock repurchases differ from dividends  Do not represent a pro-rate distribution of value to stockholders, because not all stockholders participate o Can decide whether or not they want to participate vs. dividends, all stockholders receive dividend whether they want it or not  When company repurchases own shares, removes them from circulation o Removing shares from circulation can change ownership of firm= increasing/decreasing fraction of shares owned by major stockholders and diminish ability to control company o Less liquidity for remaining shares if public company with small number of shares distributes lots of cash to investors through stock repurchase o Since dividend does not affect who owns shares, does not effect liquidity/ownership  Taxed differently than dividends o Total value of dividends normally taxed vs stockholder taxed only on profit of sale o Since stockholders choose whether to participate in repurchase plan, can choose when they pay taxes on profits from selling stock  Dividends and stock repurchases accounted for differently on balance sheet o Cash dividend=cash amount on assets side of balance sheet and retained earnings account on liabilities and stockholder’s equity side of balance sheet are reduced o Stock repurchase: cash account on assets side of balance sheet reduced and treasury stock account on liabilities and stockholders’ equity side increased (becomes more negative)  How stock is repurchased  Simply purchase shares in market o Known as open-market repurchases and convenient way of repurchasing share on ongoing basis o When company has large amount of cash to distribute, may be difficult because government limits number of shares company can repurchase per day  Restricts companies from being able to influence stock price; could take months to distribute large amount of cash  Tender offer: open offer by company to purchase shares o Used when company does not want to use special dividend and when they want to give out large amount of cash at one time o Two types  Fixed price: management announces price that will be paid for shares and maximum number of shares that will be repurchased  If number of shareholders exceed how much shares firm wants to buy back, they’ll buy a portion from everyone  Dutch auction: firm announces number of shares they will repurchase and asks stockholders how many shares they will sell at series of prices, ranging from just above price to higher price  Once offers been collected, they determine price that would allow them to repurchase number of shares they want  Targeted stock repurchases: used to buy blocks of shares from large stockholders o Can benefit stockholders who are not selling because managers may be able to negotiate per-share price that is below current market price o Commonly used to refer to any open offer to purchase any shares, not just shares of firm making announcement o If company repurchases block of shares, less chance shares will fall into unfriendly investor o Stock dividends and stock splits  Stock dividends: distributes new shares of stock on pro-rata basis to existing stockholders  Number of companies pay regularly scheduled stock dividends  No value distributed when stock dividend is paid o No assets going out of company o Value of total assets in company do not change and value per share decreases  Number of shares owned increases while value per share decreases  Stock splits: involves distribution of larger multiple of outstanding shares  Stock dividends are regularly scheduled events vs stock splits tend to occur infrequently during life of company  Same as stock dividends: no value distributed  Reasons for stock dividends & stock splits  Trading range: successful company use stock dividends/stock splits to make it appear more attractive to investors o Historically, more expensive to purchase odd lots of less than 100 shares vs. round lots of 100 shares o Odd lots are less liquid because investors want to buy round lots of 100 shares o Costs more for companies to service odd-lot owners o If buying rounds of lots becomes too expensive; investors wont buy at all therefore stock splits/stock dividends bring down price of shares  Benefit of stock splits: can send positive single to investors about management’s outlook for future resulting in higher stock price  May reverse stock splits; may be undertaken to satisfy exchange requirements o Setting dividend policy  What the managers say  Survey of dividend policy published in 1956 by John Lintner o Firms tend to have long-term target payout ratios o Dividend changes follow shifts in long-term sustainable earnings o Managers focus more on dividend changes than on the dollar amount of dividend o Managers are reluctant to make dividend changes that might have to be reversd  More recent study found managers continue to be concerned about surprising investors with bad news  Maintaining lvl dividend payments is as important to execs as investment decision they make  Expected stability of future earnings affects dividend decisions  Managers end to repurchase shares using cash that is left over after investment spending  Managers prefer repurchases because repurchase programs more flexible than dividend programs and because they can be used to time market when management considers company stock price too low  Believe institutional investors do not prefer dividends over repurchases or vice versa; choice between 2 methods of distributing value has little effect on who own company stock 180-206  Derivatives are contracts between buyer and seller that have price and that trade in specific markets o Importance of derivative securities lies on flexibility they provide investors in managing investment risk o Derivative is a financial position based on an underlying asset o They’re fleeting and have short life spans o Powerful because they bulge with leverage- small change in underlying asset’s price usually means bigger change in derivatives’ value o Most common derivatives are swaps: two investors agree to trade return on different assets  Banks often use interest rate swaps to protect them selves; makes sure has cash to make payments  Options o Investors can purchase an option: securities representing a claim on particular stock/groups of stock  Gives holder right to receive/deliver shares of stock under specified conditions  Doesn’t have to be exercised  Instead investor can buy and sell equity-derivative securities that derive value from equity prices of same corporation o Gain/losses depend on difference between purchase price and sales price o Option basics  Options typically represent claims on underlying common stock and are created by investors and sold to other investors  Corporation whose common stock underlies has no direct interest in transaction o Therefore not responsible for creating, terminating or executing put and call contracts  Call option: gives holder right but not obligation to buy a specified number of shares of particular common stock at specified price any time prior to specified expiration date o Purchased if they expect stock price to rise because price of call and common stock move together o Allows investors to speculate on a rise in price of underlying common stock without buying stock itself  Put option: gives buyer right but not obligation to sell a specified number of shares of a particular common stock at specified price prior to specified expiration date o Shares sold by owner of put contract to writer of contract who has been designated to take delivery of shares and pay specified price o Purchase puts if they expect stock price to fall, value of put will rise as stock price declines o Why options markets  Puts and calls expand opportunity set available to investors, making available risk-return combinations that otherwise would be impossible  Or improve risk-return characteristics of portfolio  Investor can control a claim on underlying common stock for much smaller investment than required to buy stock itself (calls)  In case of puts, investor can duplicate shore sale without margin account and at modest cost in relation to value of stock o Option buyer’s maximum loss is known in advance o If option expires worthless, most buyer can lose is price of option  Provides leverage (advantage) by magnifying percentage gains in relation to buying/short selling underlying stock  Using options on S&P/TSX 60 index, investor can participate in market movements with single trading decisions o Options terminology  Exercise (strike) price: the per-share price at which common stock may be purchased from or sold to a writer  Most options available at several different exercise prices, as stock price changes options with new exercise prices are added  Expiration date: date on which option expires  Equity options expiring on Saturday following 3 Friday of the month  Forces clients to make decision on Friday  Option premium: price paid by option buyer to seller of option  Option exchanges introduced combinations of standardized expiration dates (trading cycles) and standardized exercise prices  Equity option cycles  Issued by CDCC (Canadian Derivatives Clearing Corporation) and listed on Montreal Exchange have expiry cycles  Used to establish length o time that option will be listed and quoted by equity option market makers  Cycles vary in relation to dividend that is being paid out by listed underlying company and comprised of 4 maturities: Two near months and two quarterly months o Exception: iShares and index options, have 5 maturities  Montreal exchange also has long-term equity options expiring in one-, two-, three- year intervals o Only have 1 expiry month o Eventually get included as regular expiries when cycle approaches nine months to expiry  Long-term options or LEAPs (long-term equity anticipation securities)  Options with maturities greater than one year and ranging to two years and beyond  Available on several stocks with more being traded all the time o How options work  Sellers are investors, either individuals or institutions, who seek to profit from their beliefs about underlying stock’s likely price performance just as buyer does  They probably have opposite opinions which result in option o Call writer expects price of stock to remain roughly steady or perhaps move down o Call buyer expects price of stock to move upward and relatively soon o Put writer expects price of stock to remain roughly steady or perhaps move up o Put buyer expects price of stock to move down and relatively soon o Mechanics of trading  Options exchanges  Mostly are American style which can be exercised at any time up to and including expiration date  Index options and over-the-count (OTC) options typically European, meaning it can only be exercised on expiration date  Can be bought or sold through exchange facility or privately arranged  Option markets provide liquidity to investors  Liquidity problems usually overcome by o Offering standardized option contracts o Having all transactions guaranteed by clearing corporation which effectively becomes buyer and seller of each option contract  Puts and calls have transactions handled as bookkeeping entries  Option trades settle on next business day after trade o Exercise of an equity option settles in 3 business days, same with stock transactions  Canadian options markets has traditionally been thin trading o Many investors have often taken option trades to us markets  Stock index options are “cash-settled” based on 100 times the value of index at expiration date  Clearing corporation  In Canada, all equity, bond and stock index positions are issued and guaranteed by single clearing corporation, CDCC, owned by ME  In US all listed options cleared through Options Clearing Corporation o Exercise on options trading on exchanges accomplished by submitting exercise notice to clearing corporation o Clearing corporation then assigns exercise notice to member firm which assigns to one of its account  Function as intermediaries between brokers representing the buyers and writers o Once brokers representing buyer and seller negotiate price, they no longer deal with each other but with CDCC or OCC o Call writers contract with CDCC itself to deliver shares of particular stock and buyers of calls receive right to purchase form CDCC  Becomes buyer for every seller and seller for every buyer, guaranteeing that all contract obligations will be met o Prevents risk and problems that could occur as buyers attempted to force writers to honour obligations  Net position is zero because number of contracts purchased must equal number sold  Writer cannot execute offsetting transaction to eliminate obligation  Transactors in market can easily cancel out obligations of both call and put writers wishing to terminate their position  Options cannot be purchased on margin and buyer must pay 100% of purchase price o Puts and calls, margin refers to collateral that option writers provide brokers to ensure fulfillment of contract o Collateral required by CDC of its member firms whose clients have written options, in order to protect CDCC against default by option writers o Member firms require customers who have written options to provide collateral; can be cash or marketable securities o Some basic option characteristics  if S> E, a call is in the money and a put is out of the money  if S< E a call is out of money and put is in the money  if S=E, an option is at the money o S:price of common stock; E= exercise price of a call  Futures o Futures allow investors to manage investment risk and to speculate in the equity, fixed-income and currency markets o Why future markets  Physical commodities and financial instruments typically traded in cash markets  Cash contract calls for immediate delivery and used by those who need commodity now  Cannot be cancelled unless both parties agree  2 types of cash markets  Spot markets for immediate delivery o Refers to current market price of an item available for immediate delivery  Forward market for deferred delivery o Forward price is price of item that is to be delivered at specified time in future  Forward contract: simply a commitment today to transact in future  Other party willing to deliver product in the future for price negotiated today  Both parties agreed to a deferred delivery at sales price that is currently determined  No funds been exchanged but reduces risk  Forward and futures markets developed to allow individuals to deal with risks they face  Future markets are organized and standardized forward markets  Organized futures exchange standardizes non-standard forward contracts, establishing many features and only leaving price and number of contracts for future traders to negotiate  Individuals can trade without personal contact with each other because of centralized marketplace  Performance guaranteed by clearing house  Hedgers: people who prevent complete loss  Shift price risk to speculators o Current future markets  Futures contracts current traded on future exchanges divided  Commodities- agricultural, metals and energy-related  Financials- foreign currencies as well as debt and equity measurements  Each type of contract, different delivery dates available  Each contract specify trading unit involved and deliverable grade necessary to satisfy contract  Investors can also purchase options on future contracts  Proliferation of foreign-based futures contracts on US futures exchanges  Proliferation: growth of production of a rapid and often excessive spread/increase  True for interest rate futures and stock-index futures and good evidence of move toward globalization  Only commodity exchange in Canada: ICE Futures Canada, where trading taken place for several years  Futures on canola most active commodity futures traded in Canada  Financial futures contracts presently traded in Canada on ME  ME trades contracts on 3-month bankers’ acceptances as well as two-year and 10-year Government of Canada bonds  Also offer 30-day overnight Repo Rates  Centre of commodity futures is Chicago Board of Trade and Chicago Mercantile Exchange  Future markets in Canada are very small and less developed both in terms of variety of products and trading volume o International futures markets  European futures exchanges are quite competitive; most systems now fully automated order- matching systems  New NYSE Euronext provides marketplace of trading cash and derivative securities  Japan has 7 commodity futures exchanges, each which trades specific contracts; commodity futures markets account for most futures trading o Futures contracts  Futures price at which exchange will occur at contract maturity determined today  “Buying” and selling does not have same meaning in futures transactions as it does in stock and bond transactions  Legal contracts and are binding  Buyer & seller can eliminate commitment simply by taking opposite position in same commodity/financial instrument for same futures month  Trading on ME regulated by provincial securities admins  Trading on ICE Futures Canada regulated by Canadian Grain Commission  Futures trading in US regulated by Commodity Futures Trading Commission  In Canada, investment advisors must pass Derivatives Fundamental Course and Futures Licensing Course before dealing in futures or options on futures  Structure of futures markets o Futures exchanges  Trades futures contracts  Voluntary, non-profit and typically unincorporated  Provides an organized marketplace where established rules govern conduct of the members  Financed by membership dues and fees charged for services rendered  Can trade for their own accounts or as agents for others  Futures commission merchants act as agents for general public for which they receive commission o Clearing corporations  Used to reduce risk; ensure participants maintain margin deposits or earnest money to ensure fulfillment of contract  Canadian Derivatives Clearing Corporation in charge of future options contracts traded on ME  ICE Clear Canada in charge of ICE Futures Canada  Stands ready to fulfill contract if either buyer or seller defaults, thereby helping to facilitate orderly market in futures  Makes futures market impersonal; allows participants to easily reverse position before maturity because it keeps track of participant’s obligations o Basic procedures  Short position (seller), which commits a trader to deliver an item at contract maturity  Long position (buyer) which commits a trader to purchase an item at contract maturity  Selling short in futures trading means only that contract not previously purchased is sold  Someone sells in short and someone holds in long in every futures contract  Zero-sum game, sum gained by one party is sum lost in other party  Option contract involves right to make or take delivery; future s contract involves obligation to take or make delivery  However can be settled by delivery or by offset (liquidation of a futures position by an offsetting transaction- buyers sell their positions and sellers buy their positions prior to settlement of the contract (delivery))  Delivery occurs in less than 1% of all transactions  Futures positions must be closed out within specified time, either by delivery or offset  Trading follows procedure of every bid and offer competes without priority as to time or size  Open outcry: any offer to buy or sell communicated verbally and/or through use of hand signals and must be made to all traders in pit o Margin  Futures margin: the good faith deposit made by buyer or seller to ensure completion of a contract  Performance bond  Each clearing house has its own initial margin requirements identical for both buyer and seller of futures contract  Brokerage firms can require higher margin  Margin represents equity of transactor (Either buyer or seller)  Equity small=risk magnified  Each contract requires maintenance margin below which investor’s net equity cannot drop: usually 75% of initial margin requirements  Net equity defined as value of deposited funds plus open profit or minus open loss  If market price of futures contract moves adversely to owner’s position, equity declines  Margin calls occur when price goes against investor causing investor’s equity to fall below maintenance margin level, requiring transactor to deposit additional cash or to close out account  Withdrawal of funds can only occur if net equity rises above initial margin requirement  All futures contracts are marked to market daily: all profits and losses on contract credited and debited to each investor’s account every trading day  Can withdraw gains whereas those with loss will receive margin call when equity falls below specified variation margin: process referred to as daily resettlement and price used is contract’s settlement price  Clearing house establishes settlement price at close of trading  Amount credited to buyer because the price moved in direction the buyer expected  Same amount being debited to seller, who is now on wrong side of price movement o Using future contracts  Hedgers  Parties at risk with commodity or an asset which means they are exposed to price changes  Buy or sell futures contracts in order to offset their risk; form of insurance  Actual deal in commodity or financial instrument specified in futures contract  Futures; risk reduced by having gain in futures position offset loss on cash position and vice versa  Willing to forego some profit potential in exchange for having someone else assume part of risk  Smaller chance of low return but smaller chance of high return  Reduces risk of loss, also reduces return possibilities relative to unhedged position o Used by investors who are uncertain of future price movements and who are willing to protect selves against adverse price movements at expense of possible gains  Speculators  Buy or sell futures contracts in an attempt to earn a return  Willing to assume risk of price fluctuations, hoping to profit them  Typically do not transact in physical commodity or financial instrument underlying futures contract o Have no prior market position  Absorb excess demand or supply generated by hedgers and assume risk of price fluctuations that hedgers wish to avoid  Contribute to liquidity of market and reduce variability in prices over time  Advantages of speculating in futures markets o Leverage: magnification of gains and losses can easily be 10 to 1 o Ease of transacting: investor who thinks interest rates will rise will have difficulty selling bonds short, but easy to take short position in bond futures contract o Transaction costs: significantly smaller in futures markets Pg 209-237  Types of Takeovers o Takeovers: transfer of control from one ownership group to another o Acquisition: occurs when one firm (acquiring firm or bidder) completely absorbs another firm (the target firm)  Acquiring firm retains its identity while acquired firm ceases to exist  Shares of acquired firm were delisted from TSX  Disappearance of purchased firm as all senior management functions reside with acquirer o Merger: combination of two firms into new legal entity  New company’s name was hybrid and neither dominant o Acquisitions made through cash transactions where shareholders in target company receive cash for shares  When one company acquires another, approval of target company’s shareholders required since they have to agree to sell their shares  Shareholders of acquiring company do not have to give approval unless theres specific provision in company’s charter do the shareholders of acquiring firm get to vote on whether or not company should make acquisition o Alternative to cash transaction is share transaction: acquiring company offers shares or some combination of cash and shares to target company’s shareholders  Often requires approval of acquiring firm’s shareholders  Whether it does or does not depend on whether firm has limit on authorized share capital o Merger, both sets of shareholders have to agree to exchange existing shares for shares of new company  Amalgamation: genuine merger in which both sets of shareholders must approve transactions  Two companies approve on amalgamation agreement and special meeting of shareholders called to vote on agreement  2/3 of shareholders of both amalgamating firms have to approve  21 days’ notice given for special meeting o Amalgamation also used when acquirer has purchased all shares in target o Going private transaction or issuer bid: special form of acquisition where purchaser already owns a majority stake in target company o Free Trade Agreement between Canada and US  Economies became more integrated  U.S multinationals wanted to become more integrated and buying out Canadian minority shareholder o When controlling shareholders seeks approval for amalgamation, special rules come into place  Presumption that controlling shareholders knows much more accurately what the true value of the shares really is and will abuse position unless safeguards are in place  Critical safeguard: “majority of the minority” shareholders has to approve special resolution to amalgamate two companies and that there be a fairness opinion  Fairness opinion: an opinion by independent expert about the value of firm’s shares, based on external valuation  Securities Legislation o Provincial responsibility and slight differences across provinces o Several critical shareholder percentages investors have to be aware of  10% early warning (5% in US)  Level of shareholding by any one owner that requires report to be sent to OSC  Allows company to know who owns its shares and whether significant block has been bought by potential acquirer  20% takeover bid  Cannot buy any more shares in open market unless they make takeover bid  50.1% control  Gives a company control so that it can call a special meeting of shareholders (5% shareholding needed for this) and can change membership of board of directors  In US, members of BOD can be removed without cause, so majority shareholder can change management and take control of firm’s affairs  66.7% amalgamation  Can be disputed by majority of minority shareholders  90% minority squeeze-out  Can force minority of shareholders to sell shares at takeover price  Prevents small minority from frustrating a bid that is fair since it has been accepted by majority of shareholders  Few dissidents can wreak havoc by refusing to sell a small number of shares o Opening toehold: most firms will acquire under 10% and possibly up to 20% level of target shares in open market  Do this to acquire shares at market price without paying premium  Buying anymore shares after 20% require takeover bid, which is an offer to purchase outstanding voting shares of a class of securities to any person or company who is in Ontario where together offeror’s securities constitute in aggregate 20% of more of outstanding securities  Applies to individuals alone or “working in concert with others”  Otherwise company can buy 20% itself and then get friendly parties to buy two more blocks of 20% and thereby effect a takeover without making takeover bid o Takeover circular, describing bid, financing and all relevant information, similar to prospectus must be sent to all shareholders for review  Target has 15 days to circulate a letter indicating acceptance or rejection and bid has to be open for 35 days from its announcement in newspaper  Shareholders then tender (to sign an authorization accepting a takeover bid made to target company
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