BU 111 ReviewBU 111 Review

Qualitative ReviewQualitative Review

(no numbers – just theory)(no numbers – just theory)

Bull MarketBull Market

• Think the stock prices will increaseThink the stock prices will increase– Go long in stockGo long in stock– But on MarginBut on Margin– Buy call optionsBuy call options– Write put optionsWrite put options

Bear MarketBear Market

• Think the share prices will decreaseThink the share prices will decrease– Short the stockShort the stock– Buy Put optionsBuy Put options– Write Call optionsWrite Call options

Reasons for InvestingReasons for Investing

• Hedge against inflationHedge against inflation

• Extra retirement money – protect Extra retirement money – protect against living foreveragainst living forever

• Insure family against an early deathInsure family against an early death

• Savings for future purchasesSavings for future purchases

• Too lazy to work – like the free Too lazy to work – like the free moneymoney

Short SaleShort Sale

• Think the shares will decrease (bearish)Think the shares will decrease (bearish)

• You borrow shares from the brokerYou borrow shares from the broker

• Sell the shares in the marketSell the shares in the market

• Deposit the proceeds as well as a 50% Deposit the proceeds as well as a 50% deposit with the broker.deposit with the broker.

• If shares go up – you will receive a broker If shares go up – you will receive a broker call.call.

• Remember – you need to have 50% on Remember – you need to have 50% on deposit therefore the short call will be:deposit therefore the short call will be:

Short CallShort Call

• New deposit = Current market value New deposit = Current market value (# of shares * share price) * 50%(# of shares * share price) * 50%

• Short call = New Deposit – Old Short call = New Deposit – Old DepositDeposit

• To cover a short you must go into the To cover a short you must go into the market and buy the shares.market and buy the shares.

Short Calls and DividendsShort Calls and Dividends

• When you short a stock, you are selling the When you short a stock, you are selling the shares that are borrowed from the broker. shares that are borrowed from the broker. Therefore, you do not own the shares and do Therefore, you do not own the shares and do not have any of the rights associated with not have any of the rights associated with the shares.the shares.

• Therefore, when a dividend is declared you Therefore, when a dividend is declared you will not receive it. In fact, since you sold will not receive it. In fact, since you sold someone else’s shares without their someone else’s shares without their knowledge, you now owe them the dividend.knowledge, you now owe them the dividend.

Short Call RisksShort Call Risks

• Responsible for dividends if declaredResponsible for dividends if declared

• Unlimited loss – price can go up Unlimited loss – price can go up foreverforever

• Market conditions – bull vs. bearMarket conditions – bull vs. bear

• Forced to cover at an inopportune Forced to cover at an inopportune timetime

Margin BuyMargin Buy

• You think the stock price will increase You think the stock price will increase (bullish)(bullish)

• You borrow a set percentage from the You borrow a set percentage from the broker and purchase X number of broker and purchase X number of sharesshares

• Amount usable (50% margin, $5000 Amount usable (50% margin, $5000 to invest):to invest):– 50% * X = $500050% * X = $5000– X = $10,000X = $10,000

Margin CallMargin Call

• When the stock price declines you will When the stock price declines you will receive a margin call.receive a margin call.

• The amount loaned by the broker is a The amount loaned by the broker is a certain percentage of the market value of certain percentage of the market value of the stock.the stock.

• To determine the margin call:To determine the margin call:– Compute the current market valueCompute the current market value– Multiply the margin percentage to determine Multiply the margin percentage to determine

what the broker will loan as of todaywhat the broker will loan as of today

Margin CallMargin Call

• Margin call = Amount of old loan – Margin call = Amount of old loan – amount of new loan.amount of new loan.

• When margin call is paid, the loan is When margin call is paid, the loan is deducted by that amount, and you deducted by that amount, and you only pay interest on the new loan only pay interest on the new loan amount.amount.

Margins and DividendsMargins and Dividends

• When you buy a stock on margin you When you buy a stock on margin you own the stock (with all the rights) own the stock (with all the rights) and owe the broker the amount of and owe the broker the amount of the loan.the loan.

• If the stock declares a dividend, then, If the stock declares a dividend, then, since you own the stock you will since you own the stock you will receive the dividend in the entire receive the dividend in the entire amount.amount.

OptionsOptions

• Call Options – the Call Options – the right right to buy to buy shares (100 shares per contract) at a shares (100 shares per contract) at a stated price (exercise price)stated price (exercise price)

• Put Options – the Put Options – the rightright to sell shares to sell shares at a stated priceat a stated price

• Price of an option is a combination of Price of an option is a combination of the intrinsic value and time value.the intrinsic value and time value.

Factors affecting Option Factors affecting Option PricesPrices

• Strike PriceStrike Price

• Stock PriceStock Price

• Risk free interest rateRisk free interest rate

• Time to maturityTime to maturity

• VolatilityVolatility

• DividendsDividends

Intrinsic ValueIntrinsic Value

• Intrinsic Value Intrinsic Value – Call = Stock Price – Exercise PriceCall = Stock Price – Exercise Price– Put = Exercise Price – Stock PricePut = Exercise Price – Stock Price– Value of the option if exercised today, or Value of the option if exercised today, or

0.0.– The intrinsic value can never be The intrinsic value can never be

negativenegative

In the MoneyIn the Money

• A call option is in the money when the A call option is in the money when the price of the underlying shares has price of the underlying shares has increased above the exercise price.increased above the exercise price.

• A put option is in the money when the A put option is in the money when the price of the underlying shares has price of the underlying shares has decreased below the exercised price.decreased below the exercised price.

• Options are at the money when the price Options are at the money when the price of the underlying shares are equal to the of the underlying shares are equal to the exercise price of the option.exercise price of the option.

BondsBonds

• Bonds are a fixed income investmentBonds are a fixed income investment

• Debenture – an unsecured bond (not Debenture – an unsecured bond (not guaranteed by mortgage)guaranteed by mortgage)

• Price of the bond is the present value Price of the bond is the present value of all future interest payments and of all future interest payments and the average capital gain/loss of the the average capital gain/loss of the principle.principle.

Bond FeaturesBond Features

• Conversion – bond can be converted into a Conversion – bond can be converted into a specific number of shares – option of the specific number of shares – option of the owner of the bondowner of the bond

• Redemption – Company can redeem the Redemption – Company can redeem the bonds at their discretionbonds at their discretion

• Retractable – bondholder has the option to Retractable – bondholder has the option to redeem the bond before maturityredeem the bond before maturity

• Extendable – bondholder has the option to Extendable – bondholder has the option to extend the maturity of the bondextend the maturity of the bond

• Callable – firm recalls the bonds before Callable – firm recalls the bonds before maturitymaturity

Bond Prices and Interest Bond Prices and Interest RatesRates• Discount – bond price is below $1,000Discount – bond price is below $1,000

– Interest rates have risen in the economyInterest rates have risen in the economy

• Premium – bond price is above $1,000Premium – bond price is above $1,000– Interest rates have dropped in the economyInterest rates have dropped in the economy

• Par – bond price is equal to $1000Par – bond price is equal to $1000– Interest rates have not movedInterest rates have not moved

Bond Prices vary inversely with Bond Prices vary inversely with Interest ratesInterest rates

• Because the price is made up of both Because the price is made up of both a capital gain/loss and interest a capital gain/loss and interest payments the bond prices will move payments the bond prices will move with the prevailing interest rate.with the prevailing interest rate.

• Since the interest rate is fixed, only Since the interest rate is fixed, only the capital gain can move and the capital gain can move and therefore the price of the bond must therefore the price of the bond must change with the interest rates.change with the interest rates.

Bond Prices and Interest Bond Prices and Interest RatesRates• If the interest rates in the market go If the interest rates in the market go

up, then the old bonds at the lower rate up, then the old bonds at the lower rate are less attractive and therefore need a are less attractive and therefore need a discount in price in order to sell. discount in price in order to sell.

• The capital gain achieved from this The capital gain achieved from this discount, helps to bring the yield of the discount, helps to bring the yield of the bond to that of the going market rate.bond to that of the going market rate.

StocksStocks

• Common stockCommon stock– Usually have full voting rightsUsually have full voting rights– Not guaranteed dividend paymentsNot guaranteed dividend payments

• Preferred StockPreferred Stock– Usually have no voting rightsUsually have no voting rights– Usually guaranteed dividendsUsually guaranteed dividends

• Dividends can accumulate (arrears)Dividends can accumulate (arrears)

• Participative – get extra dividends when more money Participative – get extra dividends when more money is declared and a certain level of common dividends is declared and a certain level of common dividends are done.are done.

Value of StocksValue of Stocks

• Overvalued – the stock is trading at a Overvalued – the stock is trading at a price that is greater then that of price that is greater then that of stocks of comparable risk.stocks of comparable risk.

• Undervalued – the stock is trading at Undervalued – the stock is trading at a price that is less then that of stocks a price that is less then that of stocks of similar risk.of similar risk.

Investor PreferencesInvestor Preferences

• Different investors will require Different investors will require different mechanisms to invest:different mechanisms to invest:– Older people are generally on a fixed Older people are generally on a fixed

income and therefore cannot absorb a income and therefore cannot absorb a loss as readily as younger investors. loss as readily as younger investors. Therefore, they would be more Therefore, they would be more interested in fixed income securities interested in fixed income securities such as bonds/GIC’s/preferred shares such as bonds/GIC’s/preferred shares that have limited risk.that have limited risk.

Investment Preferences Investment Preferences cont…cont…• Younger people on the other hand are Younger people on the other hand are

still working and therefore can make still working and therefore can make back potential losses and are willing back potential losses and are willing to take more risk. They would then be to take more risk. They would then be more interested in high growth stocks more interested in high growth stocks and speculation. and speculation.

• Remember it is best to have a well Remember it is best to have a well diversified portfolio no matter the age.diversified portfolio no matter the age.

Critical Success FactorsCritical Success Factors

• Financial PerformanceFinancial Performance

• Satisfied customersSatisfied customers

• Quality product and serviceQuality product and service

• Innovation and CreativityInnovation and Creativity

• Knowledgeable and dedicated staffKnowledgeable and dedicated staff

Relationship among CSF’sRelationship among CSF’s

• You will achieve financial performance You will achieve financial performance when you have satisfied customers.when you have satisfied customers.

• You will have satisfied customers when You will have satisfied customers when you have quality products/services.you have quality products/services.

• You will have quality products/services You will have quality products/services when you have innovation and when you have innovation and creativity.creativity.

• You will have innovation and creativity You will have innovation and creativity when you have a knowledgeable and when you have a knowledgeable and dedicated staff.dedicated staff.