Futures Derivatives

• Futures contracts are traded on an organize exchange, and the contract terms are standardized by that exchange
• The vast majority of futures contracts do not lead to delivery because most traders choose to close out their positions prior to the delivery period specified in the contract.
• Closing out a position means entering into the opposite trade to the original one
• For most contracts, daily price movement limits are specified by the exchange. Normally, trading ceases for the day once the contract is limit up or limit down
• If in a day the price moves down from the previous day's close by an amount equal to the daily price limit, the contract is said to be limit down
• If it moves up by the limit, it is said to be limit up
• A limit move is a move in either direction equal to the daily price limit
• As the delivery period for a futures contract is approaching, the futures prices converges to the spot price of the underlying asset. When the delivery period is reached, the futures price equals - or is very close to - the spot price
• This is because of arbitrage opportunity: Sell a futures contract, Buy the asset, Make delivery
• The amount that must be deposited at the time the contract is entered into is known as the initial margin
• To ensure that the balance in the margin account never becomes negative, a maintenance margin, which is somewhat lower than the initial margin, is set. It is usually about 75% of the initial margin
• If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level the nest day
• The extra funds deposited are known as variation margin
• In an attempt to reduce credit risk, the over-the-counter market is now imitating the margining system adopted by exchanges with a procedure known as collateralization
• Open Interest is the total number of contracts that is outstanding
• Types of trades and orders:

1. limit order
2. stop-loss order
3. stop-limit order
4. market-if-touched order
5. market-not-held order

Asset-based Valuation Models

• Asset-based models assign a value to the firm by aggregating the current market value of its individual component assets and liabilities
• When market price exceeds book value, a reason able explanation is that the value of the firm exceeds the sum of ts parts
• When profitability is below normal, (adjusted) book value may exceed market price

Book Value

• Historical cost-based book value reflects the minimum value of the firm. Thus, book value is viewed as a conservative estimate of the firm's value
• The relationship between price and book value depends to a great extent on the nature of the firm's assets, its reporting methods, its profitability, and the overall economy

Tobin's Q Ratio

• It is defined as the market value of the firm divided by its book value on a replacement cost basis
• Q values below 1 imply that the firm earns less than the required rate of return
• Firms with low Q ratios are often seen as prime takeover or merger targets

Stability and Growth of Book Value

• For most firms, retained earnings provide most of the growth in book value. The increase in book value:

B(1) - B(0) = Income - Dividends

= (ROE x B(1)) - (k x ROE x B(0))

= (1 - k) x ROE x B(0)

Derivative Accounting

Foreign Exchange Forwards

• The difference between the forward rate and the exchange rate at the date of the transaction should be recognized as income or expense over the life of contract
• The profit or loss arising on cancellation or renewal of a forward exchange contract should be recognized as income or expense for the period

Index Futures

• Fair value requires that underlying securities and associated derivative instruments be valued at market values at the financial year end
• At the point of buying or selling index futures, the payment made by the client towards Initial Margin would be reflected as an Asset in the balance sheet
• A profit or loss would arise at the point of squaring up. It would be recognized in the P&L account of the period in which the squaring up takes place

Leases

Operating Lease: Lessee

• An operating lease is economically similar to renting an asset
• A company that enters into an operating lease as the lessee records a lease expense on its income statement during the period it uses the asset
• No asset and liability is recorded on the balance sheet
• On the statement of cash flow, the full lease payment is shown as an operating cash outflow

Capital Lease: Lessee

• A capital lease is economically similar to borrowing money and buying an asset
• A company that enters into a finance lease as the lessee reports an asset (leased asset) and related debt (lease payable) on the balance sheet
• The initial value of both the leased asset and lease payable is the present value of future lease payments
• On the income statement, the company reports interest expense on the debt, and if the asset acquired is depreciable, the company reports depreciation expense
• Reported debt is higher and expenses are generally higher in the early years

Operating Lease: Lessor

• The lessor records any lease revenue when earned
• The lessor continues to report the leased asset on the balance sheet and the asset's associated depreciation expense on the income statement

Capital Lease: Lessor

• The lessor reports a lease receivable based on the present value of future lease payments and reduces its assets by the carrying value of the asset leased
• Two types of capital lease:

1. Direct financing lease - It results when the present value of lease payment (and thus the amount recorded as a lease receivables) equals the carrying value of the leased asset.
2. Sales-type lease - If results when the present value of lease payments (and thus the amount recorded as a lease receivable) exceeds the carrying value of the leased asset. A lessor reports revenue from the sale, cost of goods sold, profit on the sale, and interest revenue earned from financing the sale

Mutual Funds

• Open-end fund - An investment company that stands ready to buy and sell shares at any time
• Closed-end fund - An investment company with a fixed number of shares that are bought and sold only in the open stock market
• Net Asset Value (NAV) - The value of assets less liabilities held by a mutual fund, divided by the number of shares outstanding

To quantify as a regulated investment company, the fund must follow three basic rules:

1. It must in fact be an investment company holding almost all of its assets as investments in stocks, bonds, and other securities
2. Limits the funds to using no more than 5% of its assets when acquiring a particular security
3. The fund must pass through all realized investment income to fund shareholders

Types of Expenses and Fees

• Frond end load - A sales charge levied on purchases of shares in some mutual funds
• No-Load funds
• Offering Price = NAV + load
• Back-end load - Charges levied on redemptions

Money Market Mutual Fund - A mutual fund specialized in money market instruments. Their NAVs are always $1 per share. A money market fund simply sets the number of shares equal to the fund's assets. As the fund earns interest on its investments, the fund owners are simply given more shares.

Money Market Deposit Account - Banks offering MMMF and FDIC protection

Measuring Cash Flows

• Free cash flow to equity = Net income - (Capital expenditures - Depreciation) - Change in noncash working capital + (New debt raised - Debt repayment)

• Free cash flow to firm = Operating income (1 - Tax rate) - (Capital expenditures - Depreciation) - Change in noncash working capital

The expenses incurred by a firm can be categorized into three groups:

• Operating expenses - like labor and material, which are expected to generate benefits only in the current period
• Capital expenses - like land, building, and equipment, which are expected to generate benefits over multiple periods
• Financial expenses - such as interest expenses, which are associated with the use of nonequity financing

Misleading accounting measures of earnings:

1. The inclusion of capital expenses such as R&D in the operating expenses
2. Financial expenses such as operating leases expenses that are treated as operating expenses

Capitalized R&D Expenses:

• To capitalize and value research assets, we make an assumption about how long it takes for R&D to be converted, on average, into commercial products. This is called the amortizable life of these assets
• Once the amortizable life of R&D expenses has been estimated, the next step is to collect data on R&D expenses over past years ranging back to the amortizable life of the research asset

Value of the research asset =

=> Adjusted book value of equity = Book value of equity + Value of the research asset

=> Adjusted operating income = Operating income + R&D expenses - Amortization of research asset

=> Adjusted net income = Net income + R&D expenses - Amortization of research asset

Techniques for Managing Earnings

• Planning Ahead
• Revenue recognition
• Book revenues early
• Capitalize operating expenses
• Write-offs
• Use reserves
• Income from investments

Adjustments to Income

• One-time expenses or income that is truly one-time
• Expenses and income that do not occur every year but seem to recur at regular intervals
• Expenses and income that recur every year but with considerable volatility
• Items that recur every year that change signs - positive in some years and negative in others

Reinvestment Needs

• Two components go into estimating reinvestment:

1. Net capital expenditure
2. Investment in working capital

Net Capital Expenditure :-

• In estimating net capital expenditure, we generally deduct depreciation from capital expenditure
• The positive cash flows from depreciation pay for at least a portion of capital expenditures and it is only the excess that represents a drain on the firm's cash flow
• When estimating the capital expenditures to use for forecasting future cash flows, we should normalize capital expenditures

Method I: by averaging capital expenditures over a number of years

• Estimate the average capital expenditures over the last four or five years for a manufacturing firm and use that number rather than the capital expenditures from the most recent year
• 
  

Equity Multiples

Measuring the Market Value of Equity:

• The market capitalization is usually computed using the number of shares outstanding today (primary shares)
• The earnings per shares and book value per share are often computed using the potential number that can be outstanding if management options, convertibles, and warrants are exercised (diluted shares)

The Book Value of equity is the difference between the book value of assets and the book value of liabilities. There are firms with negative book values of equity - the result of continuously losing money - where price-to-book ratios cannot be computed.

• The value of growth lies in the future, and as interest rates rise, the value of expected growth decreases. Consequently, surprises about expected growth have a bigger impact when interest rates are low than when they are high
• The P/E ratio is much more sensitive to changes in expected growth rates when interest rates are low than when they are high
• If the firm is able to sustain high growth for longer period, all of the equity multiples will register higher values
• Holding other variables constant, increasing the risk of equity (beta) will decrease all equity multiples
• Not all growth is created equal, and companies that generate growth more efficiently (with less investment) should trade at higher equity values than firms that generate the same growth less effectively

Earnings growth rate = Retention ratio x Return on equity

• As the return on equity increases, the equity multiples all go up. At very low returns on equity, the firm will have to issue substantial new equity to sustain its high earnings growth, and the equity value per share decreases to reflect the potential dilution
• When the excess returns (difference between the return on equity and the cost of equity) are negative, the stock trades at below book equity

Relative Valuation

Three essential steps in relative valuation:

1. finding comparable assets that are priced by the market
2. scaling the market prices to a common variable to generate standardized prices that are comparable
3. adjusting for differences across assets when comparing their standardized values

Multiples:

• Earnings Multiple: Price/Earnings ratio, alternatively, EBIT and EBITDA can also be used to replace Earnings.

  Variations in Price - current price; average price over the last six months or a year

  Variations in Earnings - EPS from the most recent financial year (current P/E); the last four quarters of earnings (trailing P/E); expected EPS in the next financial year (forward P/E). EPS can be computed based on primary shares outstanding or fully diluted shares or include or exclude extraordinary items.

  One of the problems with using the current P/E to compare firms in a group is that different firms can have different fiscal year ends.

• Book Value: Stock Price/Book Value of equity (net worth)
• The ratio of the market value of the firm to replacement cost is called Tobin's Q
• Revenue Multiples: price/sales ratio
• Enterprise value-to-sales ratio: The numerator becomes the market value of the operating assets of the firm.

Enterprise Value is the sum of the market values of debt and equity, net of cash.

• Companies that use aggressive assumptions in measuring earnings will look cheaper on earning multiples than firms that adopt conservative accounting practices
• Every multiple is a function of three variables - risk, growth, and cash-flow-generating potential
• The PEG ratio, which is the ratio of the P/E to the expected growth rate in earnings of a a firm, is widely used to analyze high-growth firms.

Steps to use Multiples...

• ...to ensure that the multiple is defined consistently and that it is measured uniformly across the firms being compared
• ...to be aware of the cross-sectional distribution of the multiple, not only across firms in the sector being analyzed but also across the entire market
• ...to analyze the multiple and understand not only what fundamentals determine the multiple but also how changes in these fundamentals translate into changes in the multiple
• ...to find the right firms to use for comparison and controlling for differences that may persist across these firms

Fundamentals determining Equity Multiples:

P/E - Expected growth, Payout ratio, Equity risk

PEG - Expected growth, Payout ratio, Equity risk

Price/FCFE - Expected growth, risk

Price/BV of equity - Expected growth, Payout ratio, Equity risk, Return on equity

Price/sales - Expected growth, Payout ratio, Equity risk, net margin

(companion variable for each multiple is italicized)

Discounted Cash Flow Models

• For Cash Flow to Equity computation use Cost of Equity as a discount rate
• Use Equity Valuation for firms which have stable leverage
• For Cash Flow to Firm computation use Cost of Capital as a discount rate
• Use Firm Valuation for firms which have high leverage and expect to lower the leverage over time

Direct

It doesn’t interest me what you do for a living. I want to know what you ache for, and if you dare to dream of meeting your heart’s longing.

It doesn’t interest me how old you are. I want to know if you will risk looking like a fool for love, for your dream, for the adventure of being alive.

It doesn’t interest me what planets are squaring your moon. I want to know if you have touched the center of your own sorrow, if you have been opened by life’s betrayals or have become shriveled and closed from fear of further pain! I want to know if you can sit with pain, mine or your own, without moving to hide it or fade it, or fix it. I want to know if you can be with joy, mine or your own, if you can dance with wildness and let the ecstasy fill you to the tips of your fingers and toes without cautioning us to be careful, to be realistic, to remember the limitations of being human.

It doesn’t interest me if the story you are telling me is true. I want to know if you can disappoint another to be true to yourself; if you can bear the accusation of betrayal and not betray your own soul; if you can be faithless and therefore trustworthy. I want to know if you can see beauty even when it’s not pretty, every day, and if you can source your own life from its presence. I want to know if you can live with failure, yours and mine, and still stand on the edge of the lake and shout to the silver of the full moon, “Yes!”

It doesn’t interest me to know where you live or how much money you have. I want to know if you can get up, after the night of grief and despair, weary and bruised to the bone, and do what needs to be done to feed the children.

It doesn’t interest me who you know or how you came to be here. I want to know if you will stand in the center of the fire with me and not shrink back. It doesn’t interest me where or what or with whom you have studied. I want to know what sustains you, from the inside, when all else falls away. I want to know if you can be alone with yourself and if you truly like the company you keep in the empty moments."