FIN 301 (Just Chapter 14: Derivatives & Retirement)

Term
1 / 34
the trade-off between risk and return
Click the card to flip 👆
Terms in this set (34)
the trade-off between risk and return
-higher risk stocks should have higher returns
-lower risk bonds have lower returns

-many investors want to isolate or refine their risks
-can add or remove risk using derivatives
derivatives
an asset whose cash flows depend on the value of some other asset
-For Example:
-a derivative could pay $1 for every $1 the current price of Microsoft is over $120
-as the value of corn goes up $1, a derivative could increase its payout by $2
Derivatives are used to Hedge and Speculate, and change an investors expected risk and rewards
forward contract aspects
Today: agree on asset to deliver; agree on price to pay on delivery in future; this price is called the "forward price"; it is an enforceable contract

Later: deliver asset, pay the price
Agree today for a price later
forward contract
a contract between two parties specifying:
-a date for delivery of the underlying asset (delivery date)
-a specification of the underlying asset (asset)
-the price to be paid (forward price)
-delivery location & method
future contract
a forward contract between two parties specifying:
-a date for delivery of the underlying asset (delivery date)
-a specification of the underlying asset (asset)
-the price to be paid (future price)
-delivery location and method

Standardized agreement available on an exchange
--usually commodities, stocks, or bonds
futures vs. forwards
futures:
-standardized (same asset, delivery date for everybody)
-little counterparty risk*
-easily cancelled
-obligation to buy/sell
-creates leverage

forwards:
-customized (depends on provider)
-some counterparty risk*
-more difficult to cancel
-obligation to buy/sell
-creates leverage
producers (sellers) - futures and forwards
use future contracts to lock-in future selling price (reduce risk)
--gold miner expects they will be selling 10,000 ounces of gold in the future
--by entering into a future contract, can lock in the price today
users (buyers) - futures and forwards
use future contracts to lock-in future buying price (reduce risk)
--miller knows he will be buying 10,000 bushels of wheat in the future
--by entering into a future contract, he can lock in the price today
call option transaction
Today: agree on asset to deliver, agree on price today to pay IF there is a delivery in the future, buyer pays a premium today for agreement

Later: if current price is greater than agreed upon price:
-seller delivers asset
-buyer pays price

if current price is less than agreed on price, the buyer is better of buying at market price... don't use the option so NOTHING HAPPENS
option
gives the owner the right (but not the obligation) to buy or sell at a specific price at (or up to) a specific date
-the price of the transaction is the strike price
-the date of the transaction is the expiration date

-a call option gives you the right to buy at the strike
-a put option gives you the right to sell at the strike

-the cost to own an option today is called the premium or sometimes just the price
producers (sellers) - optionsuse options contracts to create minimum future selling price --gold miners thinks they will be selling 10,000 oz of gold in the future --by entering into a put option, sets a minimum price to receive (the strike)users (buyers) - optionsuse options contract to create maximum future buying price --miller thinks they will be buying 10,000 bushels of wheat in the future --by entering into a call option, sets maximum price to pay (the strike)vanilla swap transactionToday: agree on fixed amount to receive/pay, agree on index to determine amount to pay/receive, one price is fixed,, the other varies with the index Later: fixed price is paid, variable price is paid net money exchange depends on underlying indexswapsa contract between two parties -company B agrees to pay company A cash flows depending on an underlying index/rate/asset -company A agrees to pay company B some fixed amount -effectively, company A has given up a known cash flow to receive an unknown cash flow -company B gives up a variable cash flow to receive a fixed -mainly used for interest rates -mostly used by companies to convert variable rate debt into floating rate or vice versa -also used by banks to reduce interest rate exposurehedging vs. speculation with derivativesa hedger uses derivatives to reduce risk exposure Example 1: -BMW regularly buys engines built in Great Britain -BMW can enter into forward agreements that guarantee the future exchange ratehedging vs. speculation with derivativesa speculator uses derivatives to increase risk exposure Example 1: -an investor believes that SAM is currently undervalued and expects the price to go up to $195 per share in the next six months. The stock is currently $186speculating with stocks: an investor believes that SAM is currently undervalued and expects the price to go up to $195 per share in the next six months. The stock is currently $186Today: -the investor can buy 100 shares of SAM at $186 today -total investment = $18,600 In six months: -if shares are worth $195 ---investment is worth $19,500 -trader clears $900 (19,500 - 18,600) -return of 4.84% ($900/$18,600)speculating with options: An investor expects the price of Boston Beer Company (SAM) to go up to $195 per share in the next six monthsToday: -the investor can buy an option giving them the right to buy 100 shares of SAM at $185 in six months -the option costs $700 ($7/share) -total investment = $700 In six months -if shares are worth $195: --exercise option to buy 100 shares at $185/share --sell immediately at $195/share on the exchange --investor clears $1000 (19,500 - 18,500) --return of 42.9% (($1000 - $700)/$700) what if shares are $180? -DO NOT exercise option -loses everything (($0 - $700/$700) = -100%)ways individuals invest-stocks, treasury bonds, municipal bonds, corporate bonds, options, futures -most transaction go through some type of intermediary (online brokerage, in-person brokerage, mutual funds )electronic brokerages-TD ameritrade, Robinhood -provide access to markets electronically -no person directly involved; investor makes all the choices -provides access to a wide range of asset classes PROS: low cost trading, some info resources, lots of choices CONS: no advice, little info on common practices, doesn't guarantee diversificationpersonal broker/wealth manager-Edward Jones, J.P morgan -provide access to markets -advisory role -lots of terms for the people in this category: investment advisor, financial advisor, broker, wealth manager PROS: provide guidance, informed on practices, may offer additional products (estate planning, insurance) CONS: higher cost, potential conflict of interestbroker (or broker dealer)•Provides access to markets and sometimes investment advice •Registered with FINRA •Advice meets the "suitability standard", meaning they make recommendations that match your risk tolerance and disclose any conflicts of interest •Usually commission-based: make money on each transactioninvestment advisor (or RIA)•Provides access to markets and investment advice •Registered with the SEC •Advice meets the "fiduciary standard", meaning they make recommendations with your best interests in mind and without conflict of interest •Usually fee-based: flat fee or potentially a percentage of assetsmutual fund-Mutual fund: A portfolio run by a financial professional that investors can buy and sell directly •Example: Fidelity, Vanguard, American Funds - -Anyone can go to any mutual fund company and invest in any of their mutual funds (with a few exceptions) •The large fund companies offer many funds representing different asset classes •You can choose these yourself, or go to a broker or an adviser to help you pick among them - -Pros: Choices made by a professional, can buy/sell for free, diversified Cons: Modest guidance, not geared towards stock picking, annual feesnon-retirement investment1.Pay income taxes on dividends and interest, capital gains taxes on price appreciation 2.Watch costs carefully. If it costs 1% to buy and 1% to sell, have to earn 2% to break even 3.Research can help - ValueLine, Morningstar are two sources 4.Match goal timeframe to risk -Long timeframe implies more risky investments -Short timeframe implies less risky investmentssaving for retirement (part 1)Through work: -"Defined benefit" = pensions -"Defined contribution" = 401-k • On your own: -"Individual Retirement Account" •Traditional IRA (or sometimes just "IRA") •Roth IRAsaving for retirement (part 2)401-k is a benefit of many jobs -You can contribute up to $19,500 (in 2021, $26,000 if over 50) -Employer usually contributes alongside you •Called the "Employer Match" - It's a big deal! -Employee decides how money is invested among options provided - Key benefits: -Tax deferred •Tax-free up front! •Reduces your income tax bill, but you pay when you withdraw money in the future -Employer match multiplies your own contribution -Access to many options, usually with a support systemsaving for retirement (part 3)Another issue for 401-k is picking active or passive investment •"active vs passive" mutual funds -Active mutual funds has a professional trying to choose investments that will perform better than the market -Passive mutual funds buy and hold the "whole" market •Key differences: -Passive is cheaper than active (usually a lot cheaper) -Active is less diversified -Active could outperform, but historically has not •Most 401-k plans now offer both index funds and active fundssaving for retirement (part 4)To address these two issues (Complexity and Active vs Passive), many employers encourage employees to consider a target date mutual fund -A mutual fund that matches investments to your "target" retirement date -Decreases risk as you approach the target date Pros: -Diversified portfolio across multiple types of investments -Decreases risks as time goes by -No decisions required by investor other than how much to invest Cons: -Hard to evaluate -Potentially higher fees Surprisingly not interchangeable, not even with similar target datesinvesting for retirement on your ownIndividual Retirement Accounts (IRA) are accounts you can set up on your own to save for retirement •Why IRAs? -Employer doesn't have a 401-k -You want more control over your retirement investments -You want to invest more than the 401-k limits •Most any tradeable financial asset can be put in an IRA account -Most mutual fund companies let you set up an IRA with their funds -Most brokerages and financial advisers will offer IRA accountsinvesting for retirement on your own (part 2)Two types of IRAs: -Traditional IRA: •Reduce taxes now, taxed when withdrawn •Must start withdrawing at a certain age • -Roth IRA: •Pay taxes now, not taxed when withdrawn •No requirement to withdraw • •You can contribute up to $6000 in 2020 ($7000 if over 50)how to invest to retirement•Easiest option: Target date funds through your employer's 401-k -It adjusts risks automatically through time -Employer has some obligation to make sure it isn't terrible - •More involved option: Choose among the options in your employer's 401-k... but how?retirement savings cycleWhen young, choose higher risk assets (but with diversification): -At least 70% of assets in equity mutual funds, including international -Remaining assets in bonds and (maybe) real estate funds - As you get older, have more invested in lower risk assets: -Rebalance your portfolio through time to have less equity and more bonds -Approaching retirement, you should be closer to 50-60% equity - In retirement: -Withdraw modest amounts, invest in both equity and bondsthe value of investing earlySuppose you expect to average 8% return per year in your 401-k and plan to retire at age 65: -How much would you expect $5000 invested at age 22 to be worth? -What if you waited until age 30 to invest that $5000? Age 40? 50? 60?