Month: June 2021

Earnings per share

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Earnings per share

Bijal GANDHI

In this article, Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains the meaning and calculation of Earnings per Share.

This reading will help you understand the earnings per share in detail with relevant examples.

Introduction

The earnings per share (EPS) indicates the total amount of money that the company earns for each share of its total stock. A high EPS is a good indication as investors will be willing to pay more for each share owing to higher profits and vice versa. There are several methods to derive EPS.

Calculation of EPS

One direct way to calculate EPS is by simply dividing the net income by the number of common stocks that are outstanding for that period of the earnings. To understand the calculation for net income, refer to our blog on Income statement.

A refined way to calculate the EPS would be to adjust both the numerator and denominator. For the numerator, the net income should be adjusted for any dividends paid for preferred shares. For the denominator, a weighted average number of common shares should be taken since the number of outstanding shares tend to vary over time.

Bijal Gandhi

EPS example

Here, we again take the example of LVMH. The French multinational company LVMH Moët Hennessy Louis Vuitton was founded in 1987. The company headquartered in Paris specializes in luxury goods and stands at a valuation of $329 billion (market capitalization in June 2021). It is a consortium of 75 brands controlled under around 60 subsidies. Here, you can find a snapshot of LVMH Income statement for three years: 2018, 2019 and 2020. The last line highlights the basic and diluted EPS of the group for each of the three years.

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Net income for the group= 4702 millions
Average number of shares= 503,679,272
Basic EPS= 9.33 euros per year.

Basic EPS vs. Diluted EPS

Basic EPS eliminates the dilutive effect of warrants, stock options, convertible debentures, etc. These instruments will increase the total number of outstanding shares if exercised by the holders. For example, warrants when exercised will result in dilution of equity.

Diluted EPS considers all the potential sources of equity dilution and therefore it gives a clear picture of the actual earnings per share. In the above LVMH example, the diluted earnings are derived after adding the dilutive effect of stock option like described below,

Net income for the group= 4,702 millions
Average number of shares outstanding: 503,679,272
Dilutive effect of stock option and bonus share plans: 530,861
Average number of shares after dilution: 504,210,133
Diluted earnings per share: 9.32

How is EPS used?

EPS is one of the best indicators of a company’s profitability and performance. It is a helpful indicator to choose stocks as it is one of the sole metrics that isolates net income to find the earnings for shareholders. A growing or a consistent EPS means that the company creates value for the shareholders while a negative EPS might indicate losses, financial trouble or eroding investor value.

It also helps calculate the price to earnings (PE) ratio where the market price per share is divided by the EPS. This ratio helps understand how much the market is willing to pay for each euro of earnings.

Related posts on the SimTrade blog

   ▶ Bijal GANDHI Income statement

   ▶ Bijal GANDHI Revenue

   ▶ Bijal GANDHI Cost of goods sold

About the author

Article written in May 2021 by Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Income Statement

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Income Statement

Bijal GANDHI

In this article, Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains briefly the structure of an Income Statement.

This reading will help you understand the structure and the main components of the income statement.

Introduction

Income statement is a financial statement that reports the financial performance of an entity over a specified accounting period. The financial performance is measured by summarizing all income and expenses over a given period. Also known as ‘Profit and Loss’ Statement, the Income statement helps the company have a look at the profits for the year and helps it take financial decisions about costs and revenues. The Income statement is also the basis for the tax institution to compute the income tax that the company has to pay every year. The Income statement also allows shareholders to know the dividends that they can receive from the earnings.

Structure of an income statement

Bijal Gandhi

Main components of an income statement

The income statement may slightly vary sometimes depending upon the type of company and its expenses and income, but the general structure and lines may remain the same.

  • Revenue: Also known as top line, revenue or sales revenue refers to the value of the total quantity sold multiplied by the average price of goods or services sold.
  • Cost of goods sold: The cost of goods sold is the sum of all the direct costs associated with a product or service. For example, labor, materials, equipment, machinery, etc.
  • Gross Profit: Gross profit is derived after subtracting the cost of goods from sales/revenue.
  • Indirect Expenses: Indirect expenses include general, selling, and administrative expenses like marketing, advertisement, salary of employees, office, and stationery, rent, etc.
  • Operating Income: Gross profit less indirect expenses are equal to operating income. It is the firm’s profit before non-operating expenses and income, taxes and interest expenses are subtracted from revenues.
  •  Interest Expenses/Income: Interest expense/income is deducted/added from operating income to derive earnings before tax.
  • Tax: The taxes are deducted from pre-tax income to derive the net income. The taxes can be both current and future. The net income then flows to retained earnings on the balance sheet after deducting dividends.

Example: LVMH

The French multinational company LVMH Moët Hennessy Louis Vuitton was founded in 1987. The company headquartered in Paris specializes in luxury goods and stands at a valuation of $329 billion (market capitalization in June 2021). It is a consortium of 75 brands controlled under around 60. Here, you can find a snapshot of LVMH Income statement for three years: 2018, 2019 and 2020.

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Most important components of an income statement include:

  • Total Revenue= Sum of Operating and Non-Operating Revenues for the accounting period. ($ 44,651)
  • COGS: Cost of goods Sold is the total cost of sales of the products actually sold. ($15,871)
  • Gross Margin = Net Sales – Total COGS ($28780)
  • Total Expenses = Sum of Operating and Non-Operating Expenses (Marketing and Selling Expenses + General and administrative expenses + Loss from joint Venture = ($ 16,792 + $ 3641 + $ 42= $ 20475)
  • EBT: Earning before taxes = Net Financial Income (Income – Expenses before Taxes). ( – $ 608)
  • Net Income = (Total Revenues and Gains) – (Total Expenses and Loses) = $ 4702

Income statement and Statement of cash flow

It is important to know that Income Statement does not convey the cash inflow and outflow for the year; The Cash Flow Statement is used for this. For example, credit sale is not recorded in the cash flow statement while cash sale is. Credit sale refers to sale for which the customer will make payment in the future while for cash sales the customer makes the payment at the time of purchase.

Conclusion

Income statement is the source to obtain valuable insights about factors responsible for company’s profitability.

Related posts on the SimTrade blog

   ▶ Bijal GANDHI Earnings per share

   ▶ Bijal GANDHI Revenue

   ▶ Bijal GANDHI Cost of goods sold

About the author

Article written in May 2021 by Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Could the 2008 financial crisis been foreseen?

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Could the 2008 financial crisis been foreseen?

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

In September 2008, the bankruptcy of Lehman Brothers broke the news and disclosed to the public what would become the biggest financial crisis since 1929. This crisis, fuelled by the speculation around ill-rated and poorly packaged mortgage securities, has been explained by some by the “black swan” theory.

Developed by Nassim Nicholas Taleb (2007), the black swan theory states that, similarly to black swans which were unthinkable for Europeans before they conquered Australia, exceptional financial events have a very low probability of occurring and are unpredictable from a statistics point of view. Nonetheless, is it fair to consider the 2008 as an unpredictable “black swan”?

According to the dominant economic theory, 2008 was a surprise

From the 1980’ to 2007, the “great moderation” period has reinforced in the dominant economic school of thought (the new classical economy) the idea of a stable long-term growth, uninterrupted by economics shocks and crisis. Indeed, from the 1980’, especially in the United States, all the indicators are green. The GDP is growing steadily, unemployment is low (under 4% for three years in a row under the Clinton presidency) and credit is accessible.

The “great moderation” is characterized by the reduction in the volatility of business cycle fluctuations in developed nations compared with the decades before. The flattening of business cycle fluctuations had been on the public debate since the 1967 and the famous conference led by Social Science Research Council Committee On Economic Stability called “Is the business cycle obsolete”.
During this period, Central banks became more independent, and governments began to widely use counter-cyclical policies in order to maintain growth in the long term with a balanced budget.

In “La Grande Crise: comment en sortir autrement”, James K. Galbraith describes this thirty-year period as a “great mirage”: everything was going well, so economists believed that everything was going well in the economy, and that everything would go well in the economy. Ben Bernanke, Governor of the Federal Reserve between 2005 and 2014, explained in 2015 that between the 1980’ and 2007, developed economics had returned to a stable economic pattern, thus that a shock could inevitably come from outside the economy. This framework of thought shared by most economists, politicians and central bankers at that time can explain why the 2008 crisis was not even foreseeable, as it is impossible to foresee an external shock.

Nonetheless, the analysis of certain parameters foreshadowed an upcoming financial crisis

During the early 2000s, Dean Baker studied the evolution of bubbles across history in order to understand when the future crisis would occur. He specifically studied the price-to-earnings ratio (stock price / net income) of stocks on the stock market. He explained that a bubble appears when the gap between price and earnings widens in a non-proportional way (i.e., the stock prices increase more quickly than the net income or earnings does). During the course of his analysis, Dean Baker has even estimated the size of the mortgage bubble. He valued the bubble at $8,000 billion, which is strangely equivalent to the total amount of wealth destroyed during the 2008 financial crisis…

Minsky in 1986 stated that financial crises are a moment of the financial cycle. He explained that during a period of stability (here the “great moderation”), speculators get bored and begin to take more and more risks, until they reach a Ponzi phase, and the economy collapses. According to Minsky, the international wave of financial deregulation and the recombination of investment and commercial banks during the 1980s have allowed the speculative game to become even more dangerous. According to this theory, the 2008 crisis was thus bound to happen, the only uncertainty has been the exact date of the collapse of the economy.

Financial crisis are not black swans: they are rather common

Modern history is paved with financial crises. In 1637 the “tulip mania” in Holland led to a dramatic increase and then collapse in the price of the tulip bulb. At the height of the tulip craze, in February 1637, promises to sell a bulb were negotiated for ten times the annual salary of a skilled craftsman. Some historians have called this crisis the “first speculative bubble” in history, as the sudden drop in prices is similar to a crash and the financial instruments used (futures sales, “options” contracts – purchase/sale at a fixed price in advance) make it a real financial crisis.

Picture7
Anonymous, The Sale of Tulip Onions, 17th century. Oil on wood

During the XIXth century, the crises of the modern era appear. They are usually overproduction industrial crises which spread internationally. In 1857 occurred the “1st international crisis of the industrial era”. A series of bank failures in the US spread to the financial spheres in Europe, and then to the real economy, impacting industrial production and generating wage decreases. In May 1873, an intense speculation around real-estate led to a financial crash which spread to the rest of developed world. It was followed by a depression, a thirty-year period of depression and growth deceleration, characterized by persistent underemployment.

The 20th century also had its share of financial crises: 1929, the 1970s, etc.

Furthermore, economic research on financial crisis mainly focuses a western-centric event. If developed countries have enjoyed a high degree of stability, despite regular financial crises, it is not the case for economies of less-developed countries, which experience numerous repeated financial crises.

Useful resources

Baker D. (2008), The housing bubble and the financial crisis, Center for Economic and Policy Research (issue #46)

Bernanke B. (2015) The Federal Reserve and the Financial Crisis.

Galbraith J. (2015) La Grande Crise : Comment en Sortir Autrement.

Taleb N. (2007) The Black Swan: The Power of the Unpredictable.

About the author

Article written in June 2021 by Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2019-2022).

Stock split

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Stock split

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2018-2022) introduces the specificities of stock splits.

Stock split

What a stock split?

A stock split is a decision by a company’s board of directors to increase the total number of shares by issuing more shares to current shareholders. The effect is to divide the existing shares into multiple new shares.
Picture5

For instance, a company with 1 million shares launches a 2-for-1 stock split. Post-stock split, the Number of Outstanding Shares (NOSH) will be 2 million, thus, the company has to issue 1 million new shares. Each existing shareholder will receive an additional issued share for each share he/she already has.

During a stock split, the market capitalization of the company remains the same. In effect, the company has simply issued new shares to existing shareholders, it has not sold those shares (it would have been the case during a capital increase for instance). As the market cap remained the same and the Number of Outstanding Shares doubled during this stock split, the adjusting variable is the stock price. In this case it is divided by 2.

Before the operation, the per share price amounted to:

Screenshot 2021-06-21 at 19.32.33

After the stock split, the per share price amounts to:

Screenshot 2021-06-21 at 19.32.45

In other words, a stock split does not add any real value, because the issued shares are not bought.

Why do companies split their stock?

Stock splits are far from being uncommon. Apple has undergone two stock splits in the last 10 years: the first in 2014 (7-for-1 stock split) and the second in 2020 (4-for-1 stock split, where the share price decreases from $460 to $115). In 2020, Tesla has also decided to go with a 5-for-1 stock split, which reduced the share price from $1,875 to $375. But why do companies resort to stock-splits?

Two main reasons can explain why companies go through splitting their stock:

  • Decrease the stock price: when to stock price is too high, it can be quite expensive to acquire “lots” of shares (lot in the sense of bundle). Splitting the stock reduces the prices, thus allowing more investors to buy the company’s stock.
  • Increase the stock liquidity on the market: a higher number of shares outstanding can result into a higher liquidity for the stock, which makes the stock more attractive for buyers and sellers. Indeed, it allows more flexibility, and provide buying and selling movements from having too much of an impact on the company’s stock price.

Many companies exceed later the price level at which they had previously split their stock, causing them to go through another stock split. For instance, Walmart has split its stock 9 times between 1975 and 1999.

Stock exchanges publish regularly a Stock Splits Calendar, which notifies the market when to expect a split and at what ratio.

Stock split signaling

As we have seen in our example above, a stock-split is supposed to not influence the stock price (besides dividing its price by the stock-split ratio). In reality, a stock-split usually sends a positive signal to the market, as stock-splitting announces higher liquidity and decreased prices. Stock splits also allow companies such as Apple or Tesla to prevent their stock from breaking through the ceiling and make the stock unaffordable.

Reverse stock-split

What is a reverse stock-split

As for a traditional stock split, a reverse stock split is a decision made by a company’s board of directors. Nonetheless, like its name indicates, a reverse stock-split is the opposite of a traditional stock split. The goal is to decrease the total number of shares.

Before the reverse stock split After the reverse stock split

Picture6

In this example, the reverse stock split ratio is 1-for-2 (i.e., 1 new share for 2 existing shares). From the 1 million shares of the company, 0.5 million are destroyed. The Number of Outstanding Shares post-reverse stock-split is thus 0.5 million. As for a traditional stock split, no real value is created or destroyed, the market capitalization remains the same. The adjusting variable is the stock price. In this case, the stock price is multiplied by 2.

Why do companies go through reverse stock-split?

The reverse stock-split procedure is usually used by companies which have a low share price and would like to increase it. Indeed, companies can be delisted from stock exchanges if their stock falls below a certain price per share.

In addition, a reverse stock split can be used to eliminate shareholders that hold fewer than a certain number of shares. For instance, in 2011, Citigroup launched a reverse 1-for-10 split in order to reduce its share volatility and discourage speculator trading.

Useful resources

CNN Why it’s time for Amazon and other quadruple-digit stocks to split

Nasdaq Stock Splits Calendar

The Economic Times What is ‘Stock Split’

About the author

Article written in June 2021 by Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

How does the stock price of a firm change according to the shift of its capital structure?

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How does the stock price of a firm change according to the shift of its capital structure?

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2018-2022) analyses the effects of the shifts of capital structure on the stock price.

Capital structure and asymmetric information

The capital structure of a firm can be defined as the mix of the company’s debt and equity. Debt can be long-term or short-term. Equity can be common or preferred equity. The capital structure discloses the different sources of funding a firm uses in order to finance its operations and growth. It is usually measured through the gearing ratio: Debt / (Debt + Equity).

Picture2

The overall capital structure of a firm varies across the firm’s life and development through equity or debt issuances. Equity and debt issuance are seen on the balance sheet as an increase on the liabilities side.

Nonetheless, the balance sheet does not reveal the future decisions regarding the capital structure of the firm. Indeed, firms’ managers are suspected to hold information that outside investors and/or the market lack. These information discrepancies between the firm (managers) and the market (investors) are known as “asymmetric information”. Almost all economic transactions involve information asymmetries. These information failures influence the managers’ financial decision, and influence the market perception of the firm, through changes in stock price.

Announcement effects

The debt-equity choice conveys information for two reasons:

  • Managers will avoid increasing the firm’s leverage if the firm could have financial difficulties in the future.
  • Managers are reluctant to issue equity when the stock is thought to be undervalued.

Stock price reactions to capital structure changes are usually the following:

  • Common stock issuance: negative
  • Convertible debt issuance: negative
  • Straight debt: negative but insignificant
  • Bank debt (renewal): positive

Debt issuance

In 1958, Modigliani and Miller stated that in a world without taxes, bankruptcy costs, agency costs and asymmetric information, and in an efficient market, the value of a firm is unaffected by how it is financed. In other word, the choice of capital structure is irrelevant as it does not impact the value of the firm. As a result, debt issuance does not have any impact on the value of the firm according to their theory.

In 1963, Modigliani and Miller adapted their theory by integrating the notion of corporate taxation. In this framework, they show that the value of the levered firm is equal to the value of the unlevered firm plus the present value of the tax savings associated with the tax deductibility of the interests on the debt. In effect, debt conveys a taxable benefit called the “tax shield”.

In our non-Modigliani Miller perfect world, an increase in a firm’s debt ratio is often seen as a positive signal by the market as it shows that the firm managers believe in the firm capacity to generate taxable earnings in the future.

In order to come to this conclusion, Grinblatt and Titman (2002) have explained that firms choose their capital structure by comparing the tax benefit of debt financing and the cost of financial distress.
Picture3
Let us consider two firms, A (unlevered) and B (levered). Firm A has no debt, thus no interest expense, and Firm B has a debt of 100 with a 10% interest rate. A and B have the same EBIT. Through its debt, B has a yearly tax shield of 3 (the tax rate is 30%), meaning that B pays less tax than A which has no debt and then no tax shield.

Nonetheless, the effects of issuing straight debt (a debt which cannot be converted into something else) is negative but insignificant. But renewing bank debt translates into an increase in stock prices. Overall, the announcement of a debt issuance has on average little impact on the stock price, as it shows to the market that the firms:

  • Needs funding
  • Expects taxable income in the future
  • Will pay less tax as it will benefit from a higher tax shield
  • Is financially stable enough to convince banks or investors to lend it money.

Security sales

The table below (from Grinblatt and Titman (2002) summarizes a number of event studies that examine stock price reaction to the announcements of new security issues. It shows that raising capital is considered as a negative signal. For instance, when industrial firms issue common stock, their stock prices decline, on average about 13.1%.

Picture4
This is explained by the “adverse selection theory”, which states that firms are reluctant to issue common equity when the stock is undervalued. Thus, the market often assumes than common equity issuance and overvaluation go hand in hand. The issuing of common equity will thus have a negative effect on stock prices, as the market will think the stock is overvalued. As convertible bonds have a strong equity-like component, Grinblatt and Titman (2002) argue that the “adverse selection theory” can also explain why the market usually reacts negatively to the issuance of convertible bonds.

Pecking order theory

The market reacts favorably to leverage increase and unfavorably to leverage decrease. As a result, firms will use either internal financing (inside equity) or debt to finance their project over outside equity (equity issuance). This is called the “pecking order theory” of capital structure.

The theory of the financial pecking order states that, of the three possible forms of financing for a firm (internal cash flow, debt, equity), a firm will prefer to finance itself from internal cash flow, then debt, and finally, in the last case, by selling equity. This has a practical consequence on the way the company operates: once it has emptied its internal cash flow, it will issue debt. If it can no longer generate debt, it will issue equity.

Myers and Majluf (1984) highlight the consequences of information asymmetry between managers and investors. If the company finances itself with shares, it is because it believes that shares are overvalued and can therefore provide easy and abundant financing. If the company finances itself with debt, it is because it believes that shares are undervalued.

Nonetheless, firms can prefer to resort to equity rather than debt when they are experiencing financial difficulties. Indeed, in case of financial distress, the risk of having to suffer financial distress costs can be greater than the cost of issuing equity. Furthermore, firms can also decide to issue preferred equity in difficult times rather than common equity. In effect, preferred shareholders cannot force a firm into bankruptcy when it fails to meet its dividend obligations (while common shareholders can).

Useful resources

Grinblatt M. and S. Titman (2002) Financial Markets & Corporate Strategy, Second Edition – Chapter 19: The information conveyed by financial decisions.

Myers S.C. and N.S. Majluf (1984) Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics, 13(2) 187-221.

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   ▶ Shruti CHAND Balance sheet

   ▶ Louis DETALLE A quick review of the DCM (Debt Capital Market) analyst’s job…

   ▶ Louis DETALLE A quick review of the ECM (Equity Capital Market) analyst’s job…

About the author

Article written in June 2021 by Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2019-2022).

Dividend policy

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Dividend policy

Raphael Roero de Cortanze

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2018-2022) analyses the effects of dividend policy on the stock price.

What is a dividend?

Firms that generate earnings through their activities must choose between retaining these earnings (increase in reserves on the liabilities side of the balance sheet) or distributing these earnings to shareholders through paid dividends.

A dividend is a payment from a company to its shareholders. Dividends can take several forms:

Cash: the shareholders receive cash

  • Regular: the most common form of dividend, usually a quarterly cash distribution charged against retained earnings. These regular dividends are an engagement: the board of directors declares a dividend, of a certain amount and for a certain duration. Regular dividends are thus not very flexible: regular dividends are “sticky” as they represent a higher commitment (compared to special dividends or buybacks for instance).
  • Special: a special dividend is a payment made by a company to its shareholders, which the company declares to be separate from the typical recurring dividend cycle
  • Liquidating: a liquidating dividend is a distribution of cash or other assets to shareholders, with a view to shutting down the business. It is paid out after all creditor obligations have been settled

Stock dividend: the shareholders receive stock

A stock dividend is a dividend payment with shares rather than cash. It has the advantage to distribute to shareholders without decreasing the company’s cash balance. Nonetheless, it can dilute earnings per share

Dividend policy

Modigliani Miller: irrelevance of the dividend policy

The first theorem formulated by Modigliani and Miller in 1958 states that in a world without taxes, bankruptcy costs, agency costs and asymmetric information, and in an efficient market, the value of a firm is unaffected by how it is financed. In other word, the choice of capital structure is irrelevant as it does not impact the value of the firm. In the same way, the dividend policy (to pay or not to pay dividends to shareholders) does not affect the value of the firm. Dividend policy is thus irrelevant.

In 1963, Modigliani and Miller adapted this theorem by integrating corporate taxation. In this framework, they show that the value of the levered firm is equal to the value the unlevered firm plus the present value of the tax savings associated with the tax deductibility of the interests on the debt in the income statement (tax shield). With corporate taxation, the capital structure matters as debt is more interesting than equity. But they show that the dividend policy still does not affect the value of the firm. Dividend policy is thus irrelevant.

Signaling

First of all, the stock price is expected to fall after the issuance of a dividend by the amount of the dividend itself. Dividend policy conveys information. Michaely, Thaler and Womack (1995) have demonstrated that the market reacts positively to dividend initiations (when the board of directors declares a dividend) and negatively to omissions (when the board of directors announces it won’t distribute a dividend).

As dividend policy conveys information, managers try to smooth out dividends. Dividends are thus less volatile than earnings: payout ratios (Dividend / Earnings per Share) increase in bad times and decrease in good times.

Example

As an example, General Motor’s dividend per share remained fairly stable between 1985 and 2008, even though its earnings were very volatile.

Picture1
Not all firms pay dividend. Dividend-paying firms are bigger and more profitable. DeAngelo, DeAngelo and Skinner (2004) have shown that dividends have become more concentrated. Indeed, in 1978 in the US, 67% of the total dividends were distributed by the Top 100 dividend-paying firms. In 2000, this proportion increased to 81% (of which 46% in the top 25 players).

Dividends during the COVID-19 crisis

During a financial crisis, it is logical to observe dividend cuts and omissions. Nonetheless, the crisis entailed by the COVID-19 pandemic is notable for the fact these dividend cuts and omissions were found among all firms from all sectors, whereas for instance the financial crisis of 2008 was primarily associated with a sharp drop of dividends across the financial sector (banks, insurance companies, brokers, market infrastructure firms such as stock exchanges, etc.).

In 2020, the pandemic caused a 12% global decline in dividends distribution compared to 2019. Between the second and fourth quarters of 2020, the dividend cuts reached 220 billion US dollars globally. Indeed, firm profitability and debt are determinants of dividend cuts and omissions, especially during crisis.

Nonetheless, part of the global decrease in dividends can be explained by the extraordinary measures taken by governments. In France, the government announced in April 2020 that large companies would be able to benefit from support measures if and only if they undertook not to pay dividends or buy back their shares. Similarly, the Federal Reserve in the US has imposed limits on dividend distribution for US banks and the European Central bank has forbidden to credit institutions (such as banks) to distribute dividends. As financial institutions present a systemic risk, these measures were a way to make sure banks focused on withstanding the economic depression, rather than compensating their shareholders. The Federal Reserve recently declared it would free most banks from the pandemic dividend limits as soon as the large US banks would have cleared the last round of stress tests. As a result, as dividend distribution limitations are lifted and economies return to their long-term trajectory, global dividend distribution is expected to gradually return to normalcy.

Key concepts

Earnings

A company’s earnings refer to its after-tax net income. Located at the bottom of the Income Statement, earnings are also referred as the “bottom line”.

Retained earnings

A company’s retained earnings is the amount of net income (or earnings) left after the company has paid out dividends to its shareholders. Retained earnings remains available for financing the firm business (day-to-day activity, investments, acquisitions of other companies).

Useful resources

Michaely R., R. Thaler and K. Womack (1995) Price Reactions to Dividend Initiations and Omissions: Overreaction or Drift? Journal of Finance, 50(2): 573-608.

DeAngelo H., L. DeAngelo and D. Skinner (2004) Are dividends disappearing? Dividend concentration and the consolidation of earnings, Journal of Financial Economics, 72(3): 425-456.

Krieger K., N. Mauck, S. Pruitt (2020) The impact of the COVID-19 pandemic on dividends, Finance Research Letters.

Holly Ellyatt (February 21, 2021) Pandemic caused $220 billion of global dividend cuts in 2020, research says CNBC.

Barrons

Bloomberg

Lex Europa

About the author

Article written in June 2021 by Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2019-2022).

Options

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Options

Akshit GUPTA

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) presents an introduction to Options.

Introduction

Options is a type of derivative which gives the buyer of the option contract the right, but not the obligation, to buy (for a call option) or sell (for a put option) an underlying asset at a price which is pre-determined, and a date set in the future.

Option contracts can be traded between two or more counterparties either over the counter or on an exchange, where the contracts are listed. Exchange based trading of option contracts was introduced to the larger public in April 1973, when Chicago Board Options Exchange (CBOE)) was introduced in the US. The options market has grown ever since with over 50 exchanges that trade option contracts worldwide.

Terminology used for an option contract

The different terms that are used in an option contract are:

Option Spot price

The option spot price is the price at which the option contract is trading at the time of entering the contract.

Underlying spot price

The underlying spot price is the price at which the underlying asset is trading at the time of entering the option contract.

Strike price

Strike price is essentially the price at which the option buyer can exercise his/her right to buy or sell the option contract at or before the expiration date. The strike price is pre-determined at the time of entering the contract.

Expiration date

The expiration date is the date at which the option contracts ends or after which it becomes void. The expiration date of an option contract can be set to be after weeks, months or year.

Lot size

A lot size is the quantity of the underlying asset contained in an option contract. The size is decided and amended by the exchanges from time to time. For example, an Option contract on an APPLE stock trading on an exchange in USA consists of 100 underlying APPLE stocks.

Option class

Option class is the type of option contracts that the trader is trading on. It can be a Call or a Put option.

Position

The position a trader can hold in an option contract can either be Long or Short depending on the strategy. A Long position essentially means Buying the option and a short position means Selling or writing the option contract.

Option Premium

Option premium is the price at which the option contracts trade in the market.

Benefits of using an option contract

Trading in option contracts gives the traders certain benefits which can be categorised as:

Hedging Benefits

Hedging is an essential benefit of the option contract. For an investor or a trader holding an underlying stock, an option contract provides them with the opportunity to offset their risk exposure by buying or selling an option contract as per their market outlook. If an trader holding stocks of APPLE is bearish about the market and expects the market to fall, he/she can buy a PUT option which essentially gives him/her the right to sell the security at a pre-determined price and date. Such a contract protects the trader from significant losses which he/she might incur if the stock price for APPLE goes down significantly.

Cost Benefits

While buying an option contract, the traders benefits from the leverage effect which exchanges across the world provides. Leverage helps the traders to multiply the size of their holdings with lesser capital investment. This also helps them to earn higher profits by taking limited risks.

Choice Benefits

In traditional trading, traders have a limited degree of flexibility as they can only buy or sell assets based on their outlook. Whereas, Option contracts provides a great choice to the traders as they can take different positions in call and put options (Long and short positions) and for different strikes and maturities.
They can also use different strategies and spreads to execute and manage their positions to earn profits.

Types of option contracts

The option contracts can be broadly classified into two categories: call options and put options.

Call options

A call option is a derivative contract which gives the holder of the option the right, but not an obligation, to buy an underlying asset at a pre-determined price on a certain date. An investor buys a call option when he believes that the price of the underlying asset will increase in value in the future. The price at which the options trade in an exchange is called an option premium and the date on which an option contract expires is called the expiration date or the maturity date.

For example, an investor buys a call option on Apple shares which expires in 1 month and the strike price is $90. The current apple share price is $100. If after 1 month,
The share price of Apple is $110, the investor exercises his rights and buys the Apple shares from the call option seller at $90.

But, if the share prices for Apple falls to $80, the investor doesn’t exercise his right and the option expires because the investor can buy the Apple shares from the open market at $80.

Put options

A put option is a derivative contract which gives the holder of the option the right, but not an obligation, to sell an underlying asset at a pre-determined price on a certain date. An investor buys a put option when he believes that the price of the underlying asset will decrease in value in the future.

For example, an investor buys a put option on Apple shares which expires in 1 month and the strike price is $110. The current apple share price is $100. If after 1 month,
The share price of Apple is $90, the investor exercises his rights and sell the Apple shares to the put option seller at $110.
But, if the share prices for Apple rises to $120, the investor doesn’t exercise his right and the option expires because the investor can sell the Apple shares in the open market at $120.

Different styles of option exercise

The option style doesn’t deal with the geographical location of where they are traded. However, the contracts differ in terms of their expiration time when they can be exercised. The option contracts can be categorized as per different styles they come in. Some of the most common styles of option contracts are:

American options

American style options give the option buyer the right to exercise his option any time prior or up to the expiration date of the contract. These options provide greater flexibility to the option buyer but also comes at a high price as compared to the European style options.

European options

European style options can only be exercised on the expiration or maturity date of the contract. Thus, they offer less flexibility to the option buyer in terms of his rights. However, the European options are cheaper as compared to the American options.

Bermuda options

Bermuda options are a mix of both American and European style options. These options can only be exercised on a specific pre-determined dates up to the expiration date. They are considered to be exotic option contracts and provide limited flexibility to the option buyer to exercise his claim.

Different underlying assets for an option contract

The different underlying assets for an option contract can be:

Individual assets: stocks, bonds

Option traders trading in individual assets can take positions in call or put options for equities and bonds based on the reports provided by the research teams. They can take long or short positions in the option contract. The positions depend on the market trends and individual asset analysis. The option contracts on individual assets are traded in different lot sizes.

Indexes: stock indexes, bond indexes

Options traders can also trade on contracts based on different indexes. These contracts can be traded over the counter or on an exchange. These traders generally follow the macroeconomic trends of different geographies and trade in the indices based on specific markets or sectors. For example, some of the most known exchange traded index options are options written on the CAC 40 index in France, the S&P 500 index and the Dow Jones Industrial Average Index in the US, etc.

Foreign currency options

Different banks and investment firms deal in currency hedges to mitigate the risk associated with cross border transactions. Options traders at these firms trade in foreign currency option contracts, which can be over the counter or exchange traded.

Option Positions

Option traders can take different positions depending on the type of option contract they trade. The positions can include:

Long Call

When a trader has a long position in a call option it essentially means that he has bought the call option which gives the trader the right to buy the underlying asset at a pre-determined price and date. The buyer of the call option pays a price to the option seller to buy the right and the price is called the Option Premium. The maximum loss to a call option buyer is restricted to the amount of the option premium he/she pays.

Long Call

With the following notations:
   CT = Call option value at maturity T
   ST = Price of the underlying at maturity T
   K = Strike price of the call option

The graph of the payoff of a long call is depicted below. It gives the value of the long position in a call option at maturity T as a function of the price of the underlying asset at time T.

Payoff of a long position in a call option
Long call

Short Call

When a trader has a short position in a call option it essentially means that he has sold the call option which gives the buyer of the option the right to buy the underlying asset from the seller at a pre-determined price and date. The seller of the call option is also called the option writer and he/she receive a price from the option buyer called the Option Premium. The maximum gain to a call option seller is restricted to the amount of the option premium he/she receives.

Short call

With the following notations:
   CT = Call option value at maturity T
   ST = Price of the underlying at maturity T
   K = Strike price of the call option

The graph of the payoff of a short call is depicted below. It gives the value of the short position in a call option at maturity T as a function of the price of the underlying asset at time T.

Payoff of a short position in a call option
Short call

Long Put

When a trader has a long position in a put option it essentially means that he/she has bought the put option which gives the trader the right to sell the underlying asset at a pre-determined price and date. The buyer of the put option pays a price to the option seller to buy the right and the price is called the Option Premium. The maximum loss to a put option buyer is restricted to the amount of the option premium he/she pays.

Long Put

With the following notations:
   PT = Put option value at maturity T
   ST = Price of the underlying at maturity T
   K = Strike price of the put option

The graph of the payoff of a long put is depicted below. It gives the value of the long position in a put option at maturity T as a function of the price of the underlying asset at time T.

Payoff of a long position in a put option
Long put

Short Put

When a trader has a short position in a put option it essentially means that he has sold the call option which gives the buyer of the option the right to sell the underlying asset from the seller at a pre-determined price and date. The seller of the put option is also called the option writer and he/she receive a price from the option buyer called the Option Premium. The maximum gain to a put option seller is restricted to the amount of the option premium he/she receives.

Short Put

With the following notations:
   PT = Put option value at maturity T
   ST = Price of the underlying at maturity T
   K = Strike price of the put option

The graph of the payoff of a short put is depicted below. It gives the value of the short position in a put option at maturity T as a function of the price of the underlying asset at time T.

Payoff of a short position in a put option
Short put

Related posts on the SimTrade blog

   ▶ All posts about Options

   ▶ Jayati WALIA Black-Scholes-Merton option pricing model

   ▶ Akshit GUPTA Analysis of the Rogue Trader movie

   ▶ Akshit GUPTA History of Options markets

   ▶ Akshit GUPTA Option Trader – Job description

Useful Resources

Academic research

Hull J.C. (2015) Options, Futures, and Other Derivatives, Ninth Edition, Chapter 10 – Mechanics of options markets, 235-240.

Business analysis

CNBC Live option trading for APPLE stocks

About the author

Article written in June 2021 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Forward Contracts

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Forward Contracts

Akshit Gupta

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) introduces Forward contracts.

Introduction

Forward contracts form an essential part of the derivatives world and can be a useful tool in hedging against price fluctuations. A forward contract (or simply a ‘forward’) is an agreement between two parties to buy or sell an underlying asset at a specified price on a given future date (or the expiration date). The party that will buy the underlying is said to be taking a long position while the party that will sell the asset takes a short position.

The underlying assets for forwards can range from commodities and currencies to various stocks.

Forwards are customized contracts i.e., they can be tailored according to the underlying asset, the quantity and the expiry date of the contract. Forwards are traded over-the-counter (OTC) unlike futures which are traded on centralized exchanges. The contracts are settled on the expiration date with the buyer paying the delivery price (the price agreed upon in the forward contract for the transaction by the parties involved) and the seller delivering the agreed upon quantity of underlying assets in the contract. Unlike option contracts, the parties in forwards are obligated to buy or sell the underlying asset upon the maturity date depending on the position they hold. Generally, there is no upfront cost or premium to be paid when a party enters a forward contract as the payoff is symmetric between the buyer and the seller.

Terminology used for forward contracts

A forward contract includes the following terms:

Underlying asset

A forward contract is a type of a derivative contract. It includes an underlying asset which can be an equity, index, commodity or a foreign currency.

Spot price

A spot price is the market price of the asset when the contract is entered into.

Forward price

A forward price is the agreed upon forward price of the underlying asset when the contract matures.

Maturity date

The maturity date is the date on which the counterparties settle the terms of the contract and the contract essentially expires.

Forward Price vs Spot Price

Forward and spot prices are two essential jargons in the forward market. While the strict definitions of both terms differ in different markets, the basic reference is the same: the spot price (or rate according to the underlying) is the current price of any financial instrument being traded immediately or ‘on the spot’ while the forward price is the price of the instrument at some time in the future, essentially the settlement price if it is traded at a predetermined date in the future. For example, in currency markets, the spot rate would refer to the immediate exchange rate for any currency pair while the forward rate would refer to a future exchange rate agreed upon in forward contracts.

Payoff of a forward contract

The payoff of a forward contract depends on the forward price (F0) and the spot price (ST) at the time of maturity.

Pay-off for a long position

Long Position

Pay-off for a short position

Short Position

With the following notations:
N: Quantity of the underlying assets
ST = Price of the underlying asset at time T
F0 = Forward price at time 0

For example, an investor can enter a forward contract to buy an Apple stock at a forward price of $110 with a maturity date in one month.

If at the maturity date, the spot price of Apple stock is $120, the investor with a long position will gain $10 from the forward contract by buying Apple stock for $110 with a market price of $120. The investor with a short position will lose $10 from the forward contract by selling the apple stock at $110 while the market price of $120.

Figure 1. Payoff for a long position in a forward contract
long forward

Payoff for a short position in a forward contract
Short forward

Use of forward contracts

Forward contracts can be used as a means of hedging or speculation.

Hedging

Traders can be certain of the price at which they will buy or sell the asset. This locked price can prove to be significant especially in industries that frequently experience volatility in prices. Forwards are very commonly used to hedge against exchange rates risk with most banks employing both spot and forward foreign exchange-traders. In a forward currency contract, the buyer hopes the currency to appreciate, while the seller expects the currency to depreciate in the future.

Speculation

Forward contracts can also be used for speculative purposes though it is less common than as forwards are created by two parties and not available for trading on centralized exchanges. If a speculator believes that the future spot price of an asset will be greater than the forward price today, she/he may enter into a long forward position and thus if the viewpoint is correct and the future spot price is greater than the agreed-upon contract price, she/he will gain profits.

Risks Involved

Liquidity Risk

A forward contract cannot be cancelled without the agreement of both counterparties nor can it be transferred to a third party. Thus, the forward contract is neither very liquid nor very marketable.

Counterparty risk

Since forward contracts are not traded on exchanges, they involve high counterparty risk. In these contracts, either of the counterparties can fail to meet their obligation resulting in a default.

Regulatory risk

A forward contract is traded over the counter due to which they are not regulated by any authority. This leads to high regulatory risk since it is entered with mutual consent between two or more counterparties.

Related posts in the SimTrade blog

   ▶ Akshit GUPTA Futures contract

Useful Resources

Hull J.C. (2015) Options, Futures, and Other Derivatives, Ninth Edition, Chapter 1 – Introduction, 23-43.

Hull J.C. (2015) Options, Futures, and Other Derivatives, Ninth Edition, Chapter 5 – Determination of forward and futures prices, 126-152.

About the author

Article written in June 2021 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Futures Contract

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Futures

Akshit Gupta

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) introduces Futures contracts.

Introduction

The last few decades have witnessed an incredible increase in international trade volume and business due to the globalization wave that has spread across the world causing unforeseeable and rapid fluctuations in financial assets’ prices, interest and exchange rates, and has made the corporate world vulnerable to rampant financial risk more than ever before. Thus, risk management is extremely essential for investors and firms to hedge against uncertainties in financial markets. Derivatives are efficient risk management tools and future contracts are one such derivative that have become an integral part of the modern financial system.

A futures contract is an agreement between a buyer and a seller wherein the seller agrees to deliver a specified quantity of any particular financial asset or commodity at a predetermined time in future, at a mutually agreed upon price. The parties involved in the contract are obligated to fulfil their respective terms specified in the contract. Future contracts are standardized by an exchange i.e., they can be only traded through designated markets under stringent financial safeguards. This provides them transparency, liquidity and also eliminates potential counterparty risks due to the guarantee provided by the clearing houses. In general, the underlying asset of futures can either be commodities like food grains, metals, vegetables, etc. or financial instruments like equity shares, market indices, bonds, etc.

Another essential feature of futures is that they are settled daily and not just at the maturity of the contract. That is, traders have an option to either close or extend their open positions without holding the contract to expiration. One of the defining features of the futures markets is daily. The final daily settlement price for futures is the same for everyone which is the mark-to-market (MTM) prices on all contracts established by the exchange. While different contracts may have different closing and daily settlement calculations, the methodology is entirely disclosed in the contract specifications and the exchange rulebook, hence the transparency.

Terminology used for a futures contract

Underlying asset

A futures contract is a type of a derivative contract. It includes an underlying asset which can be an equity, index, commodity or bond.

Spot price

A spot price is the current market price of the underlying asset when the contract is entered into.

Future price

A future price is the agreed upon future price of the underlying asset at the time of entering the agreement.

Maturity/Expiration date

The maturity date is the date on which the counterparties can settle the terms of the contract and the contract essentially expires.

Payoff

Formally the payoff function for a long position in a futures contract is given by:

Long Position

And, the payoff function for a short position in a futures contract is given by:

Short Position

With the following notations:
N: Quantity of the underlying assets
FT = Futures price at maturity T
F0 = Futures price at time 0

Note: the futures price at maturity T is equal or close to the price of the underlying asset (if there is no arbitrage).

Payoff of a long position in a futures contract
Long futures

Payoff of a short position in a futures contract
Short futures

Example

Consider a future contract on an Apple stock with a futures price of $50 and a maturity of one month.

If at the maturity date, the price of Apple stock is $60, the investor with a long position will gain $10 from the futures contract by buying Apple stock for $50 with a market price of $60. The investor with a short position will lose $10 from the forward contract by selling the apple stock at $50 while the market price of $60.

Underlying of futures contracts

There are different types of futures contracts based on the type of the underlying asset, a few main ones explored more below:

Commodity futures

They enable hedging against price fluctuations in various commodities including agricultural products, gold, silver, copper, crude and natural oil, petroleum etc. Speculators may also use them to bet on price movements. Commodity markets are highly volatile, and participants are generally large institutional firms, including private companies and governments. The initial margins are low in commodities and the upside potential is enormous, but the risks tend to be high as well.

Interest rate futures

These are futures based on interest rates i.e., the underlying assets are interest paying bonds like the US treasuries or T-bills (generally government bonds) and these contracts enable investors to hedge against changes in interest rates. Purchasing an interest rate futures contract thus allows the buyer to lock in the price of a debt security bearing an interest rate. The buyer can speculate or hedge against interest rate.

Currency futures

Also known as exchange rate or FX futures, these enable hedging against fluctuations in exchange rates of various currency pairs and thus limit risk exposure. The underlying asset is essentially currencies that can be traded at a predetermined exchange rate at a specific time in future.

Physical settlement and cash settlement

Physically settled futures contracts are known as ‘physical delivery’. Physical settlement means that at the expiration of the futures contract, the actual underlying asset will be exchanged between the counterparties at the pre-determined futures price. So, at the expiry of the futures contract, the short position holder will deliver the underlying asset to the long position holder. Most commodity futures, including commodity Futures, are physically settled while most non-physical asset futures such as index futures are cash settled.

Cash settlement means that at the end of a futures contract’s life, only the profit and loss are settled in cash between the long and the short with no exchange of the physical asset. In case of cash settlement (in case the contract has expired), there is no need for physical delivery of the contract. Instead, the contract can be cash-settled. When the contract expires, the trader’s margin account will be marked-to market for P&L on the final day of the contract. Cash settlement is a preferred option for most traders because of the savings in transaction costs.

Use of futures contracts

Futures contracts can be used as a means of hedging or speculation.

Hedging

Futures are very commonly used for hedging in equities, commodities and foreign exchange. In a futures currency contract, the buyer hopes the asset to appreciate, while the seller expects the asset to depreciate in the future. The futures are an efficient instrument to protect the buyer/seller of the contract from the risk involved in the severe price movement of the underlying asset.

Speculation

Futures contracts can also be used for speculative purposes. It is more common than a forward contract as the futures contracts are available for trading on centralized exchanges. If a speculator believes that the future spot price of an asset will be greater than the futures price today, she/he may enter into a long futures position and thus if the viewpoint is correct and the future spot price is greater than the agreed-upon contract price, she/he will gain profits.

Clearing houses

A clearing house is an agency or a separate corporation of a futures exchange that is responsible for settling trading accounts, clearing trades, collecting and maintaining margin amounts, regulating delivery and reporting trading data. Clearing houses act as third parties to futures contracts and its purpose is to reduce the settlement risks like counterparty default risk by collecting collateral deposits (also called “margin deposits”) that can be used to cover losses, providing valuation of trades and collateral, monitoring the credit worthiness of the contract and ensuring that delivery of the underlying asset is consistent in terms of quality, quantity, size etc. thus providing a robust risk management framework for future contracts. The New York Stock Exchange (NYSE) and the NASDAQ are two renowned clearing houses in the United States. Options Clearing Corporation (OCC) is another specializing in equity derivatives clearing.

Mark-to-market

Mark to market mechanism is used to mark the value of an asset to its current market price. This essentially means that the price fluctuations in a forward contract are settled to record the absolute gains or losses happening at the end of every period which is pre-decided.
This is done to ensure that adequate margin is maintained by each counterparty on a rolling basis. This also reduces the probability of credit defaults by each counterparty.

Useful resources

Hull J.C. (2015) Options, Futures, and Other Derivatives, Ninth Edition, Chapter 1 – Introduction, 23-43.

Hull J.C. (2015) Options, Futures, and Other Derivatives, Ninth Edition, Chapter 5 – Determination of forwards and futures prices, 126-152.

Corporate Finance Institute: Futures contracts

Related posts

   ▶ Gupta A. Forwards contracts

About the author

Article written in June 2021 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Option Trader – Job Description

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Option Trader – Job description

Akshit GUPTA

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) presents the job description of an Option Trader.

Introduction

Options are a type of derivative contracts which give the buyer the right, but not the obligation, to buy (for a call option) or sell (for a put option) an underlying asset at a predetermined price and at a given date.

Option traders are generally hired by investment banks, investment firms, brokerage firms and commercial banks (for the trading of currencies on the foreign exchange).

Work of an option trader

An option trader is responsible to maximize trading revenue and use different hedging strategies to minimize the portfolio risk and prevent capital loss. He/she trades in two types of option contracts namely, call and put options by taking long or short positions (most of the time selling options to clients).

Trading in options is a highly complex work as the option pricing and risk exposure depend on a number of factors which includes the changes in prices of the underlying, volatility, interest rates, time value, etc. To manage his/her option book, an option trader also uses option Greeks, which are financial tools that measure the price sensitivity of option contracts.

These tools help the option traders to understand the market in a better sense and determine which options to trade and when. Option traders also use different quantitative models (such as the Black-Scholes-Merton model in continuous time and the binomial model in discrete time) to price different option contracts and manage their positions.

With whom does an option trader work?

Option traders work in coordination with several teams. These teams are responsible for providing the option traders with underlying data and market inputs. Some of the most common teams that an option trader works with are:

Sales

A sales analyst works with the retail or institutional clients of the firm to implement profit generating strategies on the client’s investments. An option trader also works with the sales team of the firm to execute trades based on the clients’ needs.

Portfolio managers

An option trader also works with the portfolio managers of the firm to manage portfolios of the firm’s clients by implementing hedging strategies based on option contracts.

Quants

An option trader also works with the quantitative analysts of the firm to utilise different quantitative models to price option contracts and implement hedging strategies.

Economists and Sector specialists

An option trader trading in indices, equities or currencies, works in tandem with the Economists or sector specialists to predict the macroeconomic trends and gather information about specific sectors and economies

Equity researchers

An option trader trading in equities work with the equity researchers of the firm to obtain financial and non-financial data about different equity underlying.

How much does an option trader earn?

The remuneration of an option trader depends on the type of role and organization he/she is working in. As of the writing of this article (2021), an entry level option trader working in a financial institution can earn an average salary of €65,000/year. The option traders also earn high bonuses and commissions which are based on a percentage of the total profits they have generated over the period.

What training to become an option trader?

In France, an individual who wants to work as an option trader is highly recommended to have a Grand Ecole diploma with a specialization in market finance. He/she should possess strong knowledge of financial markets, mathematics, and economics. He/she must understand financial and economic trends and have strong research skills and interpersonal skills.

The knowledge of coding languages like Python and VBA is also a very desirable skill to become an option trader. To work as an option trader, it is advised to start your career as an intern or an apprentice at a French financial institution while pursuing your diploma.

The Financial risk management (FRM) or Chartered Financial Analyst (CFA) certification provides a candidate with an edge over the other applicants while hunting for a job as an option trader.

Relevance to the SimTrade course

The concepts about option trading can be learnt in the SimTrade Certificate:

About theory

  • By taking the Exchange orders course, you will know more about the different type of orders that you can use to buy and sell assets in financial markets.

  • By taking the Market information course, you will understand how information is incorporated into market prices and the associated concept of market efficiency.

Take SimTrade courses

About practice

  • By launching the Sending an Order simulation, you will practice how financial markets really work and how to act in the market by sending orders.

  • By launching the Efficient market simulation, you will practice how information is incorporated into market prices through the trading of market participants and grasp the concept of market efficiency.

Take SimTrade courses

Useful resources

Hull J.C. (2018) Options, Futures, and Other Derivatives, Tenth Edition, Chapter 10 – Trading strategies involving options, 276-294.

Hull J.C. (2018) Options, Futures, and Other Derivatives, Tenth Edition, Chapter 8 – Mechanics of options markets, 235-240.

Related posts

   ▶ Akshit GUPTA Market maker – Job description

   ▶ Akshit GUPTA Trader – Job description

   ▶ Akshit GUPTA Risk manager – Job description

About the author

Article written in June 2021 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

History of Options Markets

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History of the options markets

Akshit Gupta

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) presents an introduction to the History of the Options markets.

Introduction

Options are a type of derivative contracts which give the buyer the right, but not the obligation, to buy or sell an underlying security at a pre-determined price and date. These contracts can either be traded over-the-counter (OTC) through dealer or broker network or can be traded over an exchange in a standardized form.

A brief history

The history of the use of options can be dated back to ancient times. In early 4th century BC, a philosopher, and an astronomer, named Thales of Miletus calculated a surplus olive harvest in his region during the period. He predicted an increase in demand for the olive presses due to an increase in the harvest. To benefit from his prediction, he bought the rights to use the olive presses in his region by paying a certain sum. The olive harvest saw a significant surplus that year and the demand for olive presses rose, as predicted by him. He then exercised his option and sold the rights to use the olive presses at a much higher prices than what he actually paid, making a good profit. This is the first documented account of the use of option contracts dating back to 4th century BC.

The use of option contracts was also seen during the Tulip mania of 1636. The tulip producers used to sell call options to the investors when the tulip bulbs were planted. The investors had the right to buy the tulips, when they were ready for harvest, at a price pre-determined while buying the call option. However, since the markets were highly unstandardized, the producers could default on their obligations.
But the event laid a strong foundation for the use of option contracts in the future.

Until 1970s, option contracts were traded over-the-counter (OTC) between investors. However, these contracts were highly unstandardized leading to investor distrust and illiquidity in the market.

In 1973, the Chicago Board Options Exchange (CBOE)) was formed in USA, laying the first standardized foundation in options trading. In 1975, the Options clearing corporation (OCC) was formed to act as a central clearing house for all the option contracts that were traded on the exchange. With the introduction of these 2 important bodies, the option trading became highly standardized and general public gained access to it. However, the Put options were introduced only in 1977 by CBOE. Prior to that, only Call options were traded on the exchange.

With the advent of time, options market grew significantly with more exchanges opening up across the world. The option pricing models, and risk management strategies also became more sophisticated and complex.

Market participants

The participants in the options markets can be broadly classified into following groups:

  • Market makers: A market maker is a market participant in the financial markets that simultaneously buys and sells quantities of any option contract by posting limit orders. The market maker posts limit orders in the market and profits from the bid-ask spread, which is the difference by which the ask price exceeds the bid price. They play a significant role in the market by providing liquidity.
  • Margin traders: Margin traders are market participants who make use of the leverage factor to invest in the options markets and increase their position size to earn significant profits. But this trading style is highly speculative and can also lead to high losses due to the leverage effect.
  • Hedgers: Investors who try to reduce their exposure in the financial markets by using hedging strategies are called hedgers. Hedgers often trades in derivative products to offset their risk exposure in the underlying assets. For example, a hedger who is bearish about the market and has shares of Apple, will buy a Put option on the shares of Apple. Thus, he has the right to sell the shares at a high price if the market price for apple shares goes down.
  • Speculators: Speculative investors are involved in option trading to take advantage of market movements. They usually speculative on the price of an underlying asset and account for a significant share in option trading.

Types of option contracts

The option contracts can be broadly classified into two main categories, namely:

Call options

A call option is a derivative contract which gives the holder of the option the right, but not an obligation, to buy an underlying asset at a pre-determined price on a certain date. An investor buys a call option when he believes that the price of the underlying asset will increase in value in the future. The price at which the options trade in an exchange is called an option premium and the date on which an option contract expires is called the expiration date or the maturity date.

For example, an investor buys a call option on Apple shares which expires in 1 month and the strike price is $90. The current apple share price is $100. If after 1 month,
The share price of Apple is $110, the investor exercises his rights and buys the Apple shares from the call option seller at $90.

But, if the share prices for Apple falls to $80, the investor doesn’t exercise his right and the option expires because the investor can buy the Apple shares from the open market at $80.

Put options

A put option is a derivative contract which gives the holder of the option the right, but not an obligation, to sell an underlying asset at a pre-determined price on a certain date. An investor buys a put option when he believes that the price of the underlying asset will decrease in value in the future.

For example, an investor buys a put option on Apple shares which expires in 1 month and the strike price is $110. The current apple share price is $100. If after 1 month,

The share price of Apple is $90, the investor exercises his rights and sell the Apple shares to the put option seller at $110.

But, if the share prices for Apple rises to $120, the investor doesn’t exercise his right and the option expires because the investor can sell the Apple shares in the open market at $120.

Different style of options

The option style doesn’t deal with the geographical location of where they are traded. However, the contracts differ in terms of their expiration time when they can be exercised. The option contracts can be categorized as per different styles they come in. Some of the most common styles of option contracts are:

American options

American style options give the option buyer the right to exercise his option any time prior or up to the expiration date of the contract. These options provide greater flexibility to the option buyer but also comes at a high price as compared to the European style options.

European options

European style options can only be exercised on the expiration or maturity date of the contract. Thus, they offer less flexibility to the option buyer in terms of his rights. However, the European options are cheaper as compared to the American options.

Bermuda options

Bermuda options are a mix of both American and European style options. These options can only be exercised on a specific pre-determined dates up to the expiration date. They are considered to be exotic option contracts and provide limited flexibility to the option buyer to exercise his claim.

Related posts on the SimTrade blog

   ▶ All posts about options

   ▶ Akshit GUPTA Analysis of the Rogue Trader movie

   ▶ Akshit GUPTA Market maker – Job description

   ▶ Akshit GUPTA Tulip mania of 1636

Useful Resources

Chapter 10 – Mechanics of options markets, pg. 235-240, Options, Futures, and Other Derivatives by John C. Hull, Ninth Edition

Wikipedia Options (Finance)

The Street A Brief History of Stock Options

About the author

Article written in June 2021 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

My internship experience at Deloitte

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My Internship Experience at Deloitte

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) shares his experience as a strategist intern with Deloitte, and talks about the functioning of Deloitte and Robotics Process Automation (RPA).

About Deloitte

Founded in 1845, Deloitte is one of the biggest professional service providers in the world. Being one of the “Big Four” accounting firm, it provides services in audit & assurance, consulting, financial advisory, risk advisory, tax and legal advisory. A key aspect about Deloitte is that it does not sell any products but rather services. Hence, it’s crucial for Deloitte to find the right mix of people to be hired for the job as explained below. Moreover, Deloitte likes to focus on automation of its processes because it increases the human productivity by removing repetitive tasks and allows its employees to focus more on crucial and important tasks. It doesn’t decrease the human input but in fact, increases the human output.

The working process

The working process for a new mission for a client is decomposed in three steps.

Step 1: The engagement letter

When is a new client comes onboard, the first step is to sign the engagement letter which defines the scope of the project, the estimated input and billable hours for the project and its breakup, and finally the price quotation to the client. This is always followed by a negotiation between the client and Deloitte and upon mutual agreement, the engagement letter gets signed.

Step 2: On-boarding

When the client gets “onboarded” with Deloitte then Deloitte’s employees who will be working with that particular client also get onboarded with the client’s firm. For example, if Coca-Cola is a client at Deloitte, then the employees at Deloitte working with Coca-Cola will also have to get onboarded with Coca-Cola’s employee platform .

Step 3: The plan and delegation

The next step is to do a thorough analysis of the project and the problems, the target areas, the areas requiring more efficiency, etc. This is usually followed by a thorough plan formulated by a Director or Senior Manager of Deloitte. The plan is then passed on to the Associates and Analysts with their designated tasks for the project with deliverables to be achieved and deadlines to be met.

The Organizational Hierarchy at Deloitte

The hierarchy of Deloitte is quite simple with titles and levels. In an ascending order, it is given by:

  • Analyst (I-III)
  • Analyst IV / Associate Consultant
  • Consultant (I-II)
  • Consultant (III-IV) / Assistant Manager
  • Manager (I-II)
  • Senior Manager (I-II)
  • Director
  • Partner

To reach a position as a Manager or above, it is important to show your business potential to get clients for the firm. Therefore, it important for a person, aiming to reach that level, to have a good network and communications skills.

Work Ethics & Environment

As a Deloitte employee, you have to restructure your schedule according to your client’s requirement especially if the client works at a different time zone (although it is extremely rare to be assigned a client with a huge time-zone difference). It is also important to realize that an employee essentially works at two firms, one being his/her employer, Deloitte, and the second being the Client’s firm. Hence, it is important for an employee to not only work with the Client but constantly update his/her progress at Deloitte. The work has to be extremely presentable to the client because the data and numbers can become very complex and difficult for a client to understand during a presentation. Therefore, it becomes important to make sure that your work is presentable and readable. The work has to be very categorical and detailed.

The working environment is quite pleasant. There are multiple team-building events and activities with various offsites, conducted throughout the year to integrate the employees more. At the same time, your supervisors and co-workers are really helpful. Even though initially one can find the environment quite fast paced and overwhelming, one can get a hang after a short period of time.

Despite the tough schedule and huge amount of workload, it is actually quite rewarding because understanding different clients’ businesses and operations make you more equipped and knowledgeable and thus adds value to your profile.

What is Robotics Process Automation (RPA)?

Robotics Process Automation (RPA) is the utilization of artificial intelligence (AI) to transform and digitize business processes. In this new era of AI, more and more organizations are on the process of completely digitizing and automating every department in their organization and RPA serves as a base for it essentially. RPA is a software which uses robots that can emulate the digital desktop work that people do. RPA is governed by business logic and structure inputs. But it does not mean that they are physical robots, they are just a digital software used to carry out functions which are monotonous, repetitive and one tone in nature. RPA can be utilized in a wide range of daily cases such as the “copy paste” activities, which can be automated using RPA for actions such as copying items from a mail to an Excel sheet, filling out forms, etc. It uses computer software robots called ‘bots’ to carry out these tasks. RPA eliminates more and more mundane admin work and handles it well and in full in compliance. This enables an organization to achieve greater efficiency by streamlining processes and improving accuracy. It also enables humans/employees to focus more on work that requires judgement, creativity, and interpersonal skills.

Robotic process automation uses a logit/probit regression as one of its bases to achieve its function of handling mundane and repetitive tasks. Logit/probit regression is a binary regression model in which the dependent variable (DV) takes the value of 0 or 1. In practice, it is used for answering tasks that have only two outputs: “yes” (1 in the model) or “no” (0). The diagram below explains how RPA functions and how it uses logit/probit in the process. The diagram shows how RPA assesses a mail and enters any relevant information in an Excel sheet and sends it to the employee related to it. The bot (robots called in RPA processes as already mentioned) reads an email sent to the employee, opens the Excel file attached to the email, and enters data from the Excel file into an Enterprise Resource Planning (ERP) platform. When this happens, the bot enters the information in the Excel file, then looks for any possibility of the matter being escalated or not (to be defined). If escalation is required, then the bot sends a notification to the employee for analysis which eventually ends the task. If escalation is not required, then the bot automatically ends the task.

Figure 1. RPA Working Process
RPA Working Process
Source: Krify

My Experience at Deloitte

As a student pursuing his graduation in Economics, landing an internship at Deloitte was really surreal. I was always inclined towards consultancy and getting a first-hand experience really helped me be more certain about my hunch. I worked as a trainee in the Strategy & Operations Department in New Delhi. During my short six-week internship, I was primarily required to execute individual analysis of RPA and its applicability in Accounts Payable Processes. It was quite an interesting individual project to understand how the digitization of organizations are executed and the capacity to which processes and tasks can be automated using AI. The internship was an eye opener about the effort and handwork required to make as a consultant in one of the “Big Four” companies.

What I learnt during my internship

The three main things I learnt during my internship at Deloitte are as follows:

  • I gained information about the structure and working environment at Deloitte.
  • I learnt about digital transformation, particularly Robotics Process Automation.
  • I acquired an insight about the soft and hard skills required to make as an intern at Deloitte.

Related posts in the SimTrade blog

Looking for an internship? Looking for a job? You may find useful information by reading other posts where students share their professional experience:

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▶ Raphaël ROERO DE CORTANZE
In the shoes of a Corporate M&A Analyst

▶ Youssef LOURAOUI My experience as a portfolio manager in a central bank

▶ Alexandre VERLET Classic brain teasers from real-life interviews

About the author

The article was written in June 2021 by Anant JAIN (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Government debt

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Government debt

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023) introduces you to government debt.

A government debt is a debt issued and guaranteed by a government. It is then owed in the form of bonds bought by investors (institutional investors, individual investors, other governments, etc.).

According to the OECD: “Debt is calculated as the sum of the following liability categories (as applicable): currency and deposits; debt securities, loans; insurance, pensions and standardized guarantee schemes, and other accounts payable.”

Before the Covid-19 crisis, the government debt of all countries in the world was estimated at $53 trillion. According to the IMF, it is expected to rise from 83% to 96% of world GDP as a result of the crisis.

In order to better understand debt, it is necessary to go back to several points. How does a government issue debt? Who holds government debt? How is government debt measured?

How does a government issue debt?

There are two principal ways to issue bonds: syndication and auction.

Syndication

Syndication is the most common way to issue debt. It is when several financial institutions join together to ensure the placement of a bond with investors in order to reduce their risk exposure. However, since the 1980’s, governments tend to use the auction method.

Auction

The auction can be “open”, i.e. all direct participants in public securities auctions (credit institutions, management and intermediation companies, etc.) have the possibility of acquiring part of the security put up for auction. It can also be “targeted”, i.e. the issue is reserved only for the primary dealers – banks or other financial institutions that has been approved to trade securities – of the issuing State.

A few days before the planned date of an auction, the State makes an announcement, confirming, postponing or cancelling the operation. It also gives the characteristics of the securities to be issued, i.e. the type of securities, the maturity and the amount it wishes to raise. Buyers can then submit several bids, each specifying the desired quantity and price. The issue lines are then auctioned to the highest bidders. The higher the demand is, the lower the issue rate is.

Auction is used because it provides investors, among other things, with transparency and free competition on an investment product with an attractive benefit in relation to a low risk level.

Each country that issues bonds uses different terms for them. UK government bonds, for example, are referred to as gilts. In the US, they are referred to as treasuries: T-bills (that expire in less than one year), T-notes (that expire in one to ten years) and T-bonds (that expire in more than ten years). In France, the government issues short-term liabilities (“Bons du Trésor”) and long-term liabilities (“OAT for “Obligations Assimilables du Trésor”) with maturity between 2 and 50 years.

Who holds government debt?

Government debt can be broken down into domestic and external debt depending on whether the creditors are residents or non-residents.

Domestic debt

Domestic debt refers to all claims held by economic agents (households, companies, financial institutions) resident in a sovereign state on that state. It is mostly denominated in the national currency. A government can call for savings, but savings used to finance the deficit can no longer be used to finance private activity and in particular productive investment. This is known as the crowding-out effect. A government must therefore deal with this limit.

External debt

External debt refers to all debts owed to foreign lenders. A distinction must be made between gross external debt (what a country borrows from abroad) and net external debt (the difference between what a country borrows from abroad and what it lends abroad). A level of debt that is too high can be dangerous for a country. In the event of fluctuations in the national currency, the interest and principal amounts of the external debt, if denominated in foreign currency, can quickly become a burden leading to default.

The case of France

In France, non-residents are the main holders of French public debt. They hold 64% of the bonds issued by the government. They are institutional investors, but also sovereign investment funds, banks and even hedge funds. In addition, as regards domestic debt, French insurance companies hold nearly 20% of French securities. They are used for life insurance investments. Finally, French banks and French mutual funds hold 10% and 2% respectively.

How to measure government debt?

While the French debt has risen from 2000 billion euros in 2014 to 2700 billion in 2021, the debt burden has fallen from 40 billion to 30 billion. What do these two ways of looking at a country’s debt mean?

In the European Union, the current measure of public debt is the one adopted by the Maastricht Treaty. It takes into account the nominal amount borrowed. This is a relevant criterion for measuring the government’s budgetary misalignments, i.e. its financing needs. It also makes it possible to introduce debt rules: the debt must be less than 60% of GDP.

Another way of measuring debt is to take into account the interest charges on public debt. This criterion makes it possible to account for the cost of the debt and not its amount. It is this criterion that must be considered in order to anticipate future financing needs, to plan taxes and interest charges in the government budget.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

Related posts on the SimTrade blog

   ▶ Rodolphe CHOLLAT-NAMY Why do governments issue debt?

   ▶ Rodolphe CHOLLAT-NAMY Bond valuation

   ▶ Rodolphe CHOLLAT-NAMY Bond markets

   ▶ Bijal GANDHI Credit Rating

   ▶ Jayati WALIA Credit risk

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023).

Examples of companies issuing bonds

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Examples of companies issuing bonds

Rodolphe CHOLLAT-NAMY

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) provides you with examples of companies issuing bonds.

In order to better understand corporate bonds, it is appropriate to look at recent issues to see their different characteristics: Veolia, Essilorluxottica and LVMH.

Véolia: EUR 700 million 6-year bond issuance with negative interest rate

The company

Veolia is a French multinational utility company. It markets water, waste and energy management services for local authorities and companies.

It employs more than 163,000 employees and had revenues of €27 billion in 2019.

The company recently made headlines in the financial news with its takeover bid for Suez. After months of financial, political and media battle, the French giants finally agreed on a merger. The new group is expected to have a 5% share of the world market with 230,000 employees.

The bond issuance

On Monday, January 11, 2021, Veolia issued €700 million of bonds maturing in January 2027 at a negative rate of -0.021%.

This is the first time that a BBB-rated issuer has obtained a negative rate for this maturity. This was due to strong demand from investors who welcomed the transaction. As a result, the order book reached up to 2 billion euros, which allowed for a negative yield. This reflects the very positive perception of Veolia, as well as the credibility of its proposed merger with Suez.

This example is quite symptomatic of the low-rate period we are currently in. Indeed, we see here that a company can take on debt at negative rates.

Essilorluxottica: €3 billion bond issuance

The company

EssilorLuxottica is a Franco-Italian multinational company, resulting from the 2018 merger of the French company Essilor and the Italian company Luxottica. It is one of the leading groups in the design, production and marketing of ophthalmic lenses, optical equipment, prescription glasses and sunglasses.

The group employs more than 153,000 people and had sales of EUR 14 billion in 2002.

The bond issuance

On Thursday, May 28, 2020, EssilorLuxottica issued €3 billion of bonds. The bonds have maturities of 3.6 years, 5.6 years and 8 years, with rates of 0.25%, 0.375% and 0.5% respectively.

Demand was very high as the order book reached almost 11 billion euros, reflecting investors’ confidence in EssilorLuxottica’s model.

This example allows us to notice that during an issue, bonds of different maturities can be issued at the same time. This allows us to respond adequately to financing needs by allowing us to play on the maturity and therefore on the rates. Here, the rates increase with time. In fact, outside of recessionary periods, this correlation is observed because the risks for investors increase with time. In the same way, their money is immobilized for a longer period of time and therefore must be remunerated for that.

LVMH: 9.3-billion-euro bond issuance

The company

LVMH is a French group of companies, today a world leader in the luxury goods industry. The firm has a portfolio of seventy brands including Moët, Hennessy, Louis Vuitton, Dior, Céline, …

The group employs more than 163,000 employees and had a turnover of 53 billion euros in 2019.

Announced in November 2019, then canceled because of Covid-19, the takeover of Tiffany finally took place in January 2021 for a total amount of $ 15.8 billion.

The bond issuance

On February 6, 2020, LVMH issued €9.3 billion in bonds, denominated in euros and pounds sterling. This was the largest bond issue in Europe since AB inBev in 2016. The maturities of the bonds issued range up to 11 years with a yield of 0.45%. Some tranches, including the four-year euro tranche, have a negative yield. The overall cost of this financing is estimated at 0.05%.

The purpose of this issue was to refinance the acquisition of Tiffany. It received strong interest from investors with an order book of nearly 23 billion euros. In addition, LVMH benefited from very favorable market conditions. Indeed, January had been rather weak in terms of the volume of issues by companies in the investment grade category and had been dominated by those in the high yield category. Thus, investors had a lot of liquidity to invest in more secure investments. Finally, LVMH issues few bonds even though the group is highly rated. Investors were therefore looking to acquire its debt.

This example allows us to understand the conditions of a record issue. Moreover, it also allows us to underline that it is possible to resort to borrowing to finance new projects, current expenses or, in this case, an acquisition.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

Related posts

   ▶ Rodolphe CHOLLAT-NAMY Bond valuation

   ▶ Rodolphe CHOLLAT-NAMY Bond risks

   ▶ Rodolphe CHOLLAT-NAMY Bond markets

   ▶ Bijal GANDHI Credit Rating

   ▶ Jayati WALIA Credit risk

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

The rise in corporate debt

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The rise in corporate debt

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) analyzes the rise in corporate debt.

Since the financial crisis of 2007-2008, the level of debt in the world has increased significantly. Global debt, which includes the debt of (non-financial) corporations, financial institutions, governments and households, has risen from 292% of global GDP in 2008 to 318% in 2018. This increase in global debt is primarily driven by the growth of non-financial corporate debt after the subprime crisis. Indeed, the debt of non-financial companies rose from 78% to 92% of GDP between 2008 and 2018. What are the reasons for this increase? How did the coronavirus crisis impact debt levels? What are the consequences of rising debt levels?

Growth in corporate debt through the bond markets, mainly driven by emerging countries

An increase linked to an increase in bond issues

Until the 2008 crisis, the banking sector was the fastest growing corporate financing tool, notably through international banks. Since the 2008 crisis, there has been a shift. Companies then began to take on more debt on the financial markets (bonds) than from banks (credit). Thus, the increase in corporate debt since the 2008 crisis has been mainly through the bond markets. The main driver of this increase is the accommodating monetary policies pursued by the developed economies.

An increase driven by developing countries

Moreover, the rise in non-financial corporate debt has not been uniform across the world. It has actually been concentrated in emerging economies. Between 2008 and 2018, this type of debt in emerging economies grew from $9 trillion to $28 trillion. This growth is much faster than the growth of the GDP of these countries. Indeed, over the same period, the debt of non-financial companies has increased from 56% to 96% of GDP. At the same time, the debt of non-financial corporations has grown at the same rate as GDP since 2008 in the developed economies (with the exception of China).

The growing share of bond markets, in the case of emerging economies, is noteworthy. Indeed, between 2008 and 2018, the share of bonds in the total debt of non-financial companies in emerging economies rose from 19% to 32%, effectively increasing by 13 percentage points.

A rise in non-financial private sector debt with the Covid-19 pandemic

The exceptional measures taken by governments around the world eased financial conditions to support the economy of their own country. This response to the pandemic helped maintain the flow of credit to households and businesses, facilitated the recovery and contained financial risks. Nevertheless, this support has increased private non-financial sector indebtedness in both advanced and emerging economies.

While we saw above that the debt-to-GDP ratio of firms in developed countries was constant between 2008 and 2018, it worsened with the Covid-19 pandemic. The debt of private non-financial firms in developed countries rose from 149% of GDP in Q3 2019 for the US to 160% in Q3 2020. Similarly, debt of private non-financial firm in the Eurozone rose from 120% to 129% over the same period. Debt levels are not uniformly high as it depends on the size of the company and its sector of activity.

Companies have had massive recourse to borrowing first of all to cope with their cash flow difficulties, between a fall in activity and marked tensions in terms of payment. In addition to this, there is also a precautionary attitude which is pushing companies to use their borrowing capacity to the maximum in order to build up an extra cash cushion. Finally, large companies will also take advantage of borrowing facilities for other purposes. In particular, they will use debt to conduct share buyback programs and pay dividends.

What are the consequences of increased debt?

The growth in debt financing can have a number of positive aspects. It may indicate that firms are less constrained in their financing, allowing them to raise more funds to pursue profitable investment projects and expand. Similarly, it may mean that firms are obtaining new financing outside the traditional banking system, which helps them grow by diversifying their sources of funding.

However, it also poses a number of risks. In the aftermath of the Covid-19 crisis, corporate debt reached a worrying level. The question is: how will companies manage the repayment of their debt?

The accumulation of high levels of debt in a period of weak economic growth and declining corporate profits has been accompanied by increased default risks.

In addition, refinancing risks may have increased, as the fastest growth in corporate debt has been through bond financing, which is more difficult to refinance.

Finally, the post-covid recovery is likely to be asynchronous and divergent across countries. Financial conditions are likely to tighten in developed country markets, making it more difficult to finance companies in emerging economies.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

Related posts on the SimTrade blog

   ▶ Rodolphe CHOLLAT-NAMY Why do companies issue debt?

   ▶ Rodolphe CHOLLAT-NAMY Corporate debt

   ▶ Bijal GANDHI Credit Rating

   ▶ Jayati WALIA Credit risk

   ▶ Louis DETALLE A quick review of the DCM (Debt Capital Market) analyst’s job…

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Credit analyst

by

Credit analyst

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to the job of credit analyst.

Within an investment bank, several jobs are directly linked to bonds. Among them is that of credit analyst. What does a credit analyst do? What are the qualities required to be a credit analyst?

The missions of a credit analyst

Within a bank, the role of the credit analyst is to study in depth the financial situation of companies (risk assessment, analysis of strengths and weaknesses, analysis of financial accounts, etc.) in order to determine their solvency.

More concretely, analysts have three main tasks:

Firstly, as mentioned above, analysts conduct in-depth analyses of the financial statements and credit applications of the companies under their responsibility. They keep abreast of their current situation and closely monitor any developments that may affect their debt capacity.

Secondly, analysts provide recommendations related to the analysis and evaluation of the credit risk. If they think that the company is solid, they can for example propose to buy bonds of this company, which would thus constitute a safe investment. On the other hand, if they believe that the risk of default is increasing, they will propose to sell.

Finally, a significant part of analysts’ job is to present their results. This may take the form of a daily summary publication, or a more in-depth quarterly or annual publication. In addition, analysts may have to meet with the bank’s clients, mainly investors, to present their recommendations.

In addition, there may be ancillary tasks. For example, analysts may seek to develop new mathematical and statistical models to improve their understanding of bond risks.

What is the day-to-day life of a credit analyst like?

Analysts’ day starts early, before the financial markets open, so that he has time to brief investors on the latest bond news in the sectors they follow.

After that, their day depends very much on the calendar of the companies he or she follow. During the quarterly publications of these companies, they will spend time reading them and collecting the information contained in them. Similarly, they will attend the various conferences organized by these companies to explain the published results. The rest of the time, they will analyze this information, update their projection models and update their recommendations.

As the end of the semester or the year approaches, credit analysts’ days can become longer because they have to produce a semiannual or annual publication in which their recall the economic context and their recommendations. Following the publication of this, they will often make a tour of their clients to present it. This is known as a roadshow.

The qualities required to be a good credit analyst

Several qualities are necessary to be a good credit analyst.

First of all, credit analysts have strong corporate finance skills. In particular, they have a good understanding of corporate debt and liquidity ratios. The main ratios are: the debt-to-equity ratio which informs on the financial structure of the company, the interest coverage ratio which measures the capacity of a company to pay its interests and the debt-to-EBITDA ratio which measures the capacity of the company to repay its debt with the money generated by its activity.

Secondly, it is imperative to be very rigorous. Indeed, the quality of the analyses depends on the data collected. Analysts cannot afford to make mistakes in the figures they report. To this end, they have recourse to several sources of information: companies’ annual reports, press releases, financial statements, as well as market analyses produced by other players. It is important to note that all this information is public. Indeed, for legal reasons, to avoid insider trading, analysts have limited access to the information.

In addition, analysts must have strong synthesis skills. It is their analysis that investors will buy. It must therefore be as relevant as possible in order to present the best possible guidance. Moreover, the format of these analyses must also be carefully designed. They must be easily understandable by its readers. Analysts must therefore have presentation skills in order to sell them. It is important to take care of the content and the form.

Finally, analysts improve over time. They usually cover a particular sector. For example, he or she will be a specialist in the automotive sector. The better their knowledge of the sector, the more relevant their analysis. To do this, they must be familiar with the general environment of the sector they are following in order to identify future trends. Secondly, they must build up a database of the companies they follow.  The more accurate and long-standing the database, the better they will be able to put the new information they collect into perspective.

Related posts on the SimTrade blog

All posts about jobs in finance

   ▶ Jayati WALIA My experience as a credit analyst at Amundi Asset Management

   ▶ Aamey MEHTA My experience as a credit analyst at Wells Fargo

   ▶ Louis DETALLE My professional experience as a Credit Analyst at Societe Generale

   ▶ Jayati WALIA Credit risk

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Why do companies issue debt?

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Why do companies issue debt?

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) provides insights into why companies issue bonds.

A company can finance its activities in different ways: by internal financing (self-financing) and by external financing comprising debt and equity. Often, internal funds are not sufficient. The company must therefore make a choice between raising debt and raising equity. So, it is necessary to ask what might lead a company to prefer one over the other.

The advantages of debt over equity for a company

Debt is often preferred to equity because it is structurally less costly for the following reasons:

– The interest on the debt is tax deductible. The debt therefore costs the interest minus the tax savings (assuming that the company makes profit and pays taxes…).

– Investing in stocks is riskier than investing in bonds because of a number of factors. For instance, the stock market has a higher volatility of returns than the bond market, capital gains are not a guarantee, dividends are discretionary, stockholders have a lower claim on company assets in case of company default. Therefore, investor expect higher returns to compensate it for the additional risk.  Thus, for the company, financing itself through debt will be less expensive than through equity.

– The remuneration of the debt is not strictly proportional to the increase of the risk taken by the company, because there are multiple ways for lenders to take guarantees: leasing, mortgage….

Debt has other advantages over equity:

Debt can be used to gain leverage. It provides a leverage effect for shareholders who contribute only part of the sums mobilized in the investment. This effect is all the more important when the interest rate at which the debt is subscribed is low and the economic profitability of the investment is high.

Raising equity dilutes ownership of existing stockholders. When a company sells equity, it gives up ownership of its business. This has both financial and day-to-day operational implications for the business. Debt does not imply such a dilution effect.

There is a practical benefit for using debt. Issuing debt is easier than issuing equity in practice.

Finally, the terms of repayment of principal and interest payments are known in advance. This allows companies to anticipate future expenses.

The disadvantages of debt over equity

First, unlike equity, debt must be repaid at some point. This is because equity financing is like taking a share in the company in exchange for cash. Thus, where cash outflows are required to pay interest on debt and repay principal, this is not useful for equity.

Moreover, in equity financing, the risk is carried by the stockholders. If the company fails, they will lose their stake in the company. In contrast, in debt financing, creditors often require assets to be secured. Thus, if the company goes bankrupt, they can take the collateral.

Finally, the debt capacity of a company is limited. Indeed, the more debt a company takes on, the higher the risk of default. Thus, creditors will ask an already highly leveraged company for higher interest rates to compensate for the risk they are taking. Conversely, equity financing allows companies to improve their capital structure, and thus present better debt ratios to investors.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

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About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Expeditionary experience in a Chinese investment banking boutique

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Expeditionary experience in a Chinese investment banking boutique

Anna Barbero

In this article, Suyue MA (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) shares his experience as an intern at InvesTarget, an investment banking boutique in China focusing on capital raising and M&A.

About myself

I have been interested in finance ever since I started my study at ESSEC Business School in 2017. By acknowledging more about finance, during my 2nd year of study, I decided to build up my career in corporate finance, focusing on the primary market. By sending around 400 resumes to different companies and banks, I finally received my first internship offer in a top 10 securities company doing Real Estate Investment Trusts (REITs) and Commercial Mortgage-Backed Securities (CMBS) projects in China. Until now, I have finished 4 internships in the field of corporate finance, private equity, capital-raising advisory, and Mergers and acquisitions (M&A).

In this article, I would like to share with you about my internship in a capital-raising advisory team of a Chinese new-type investment banking boutique. This company mainly focuses on M&A and fundraising advisory; some of those companies will also play a role as venture capital if they have their own money to invest or they find some profitable projects.

My mission

In this internship, my primary exposure covered in Technology & Industrial sector, including Industrial Drone, Intelligence Vehicle, and Advanced Materials.

Main tasks

As an intern, my main tasks were mainly as followed:

  • Perform pro forma financing consequences, capitalization table, Discounted Cash Flows (DCF) analysis, and accretion/dilution analysis
  • Perform in-depth financial, accounting, and operation due diligence, which includes financial analysis, team’s background, and technology support on client companies
  • Prepare materials for internal business plan, business proposal, and financial advisory presentation
  • Conduct reports of industry research and company analysis on Telecom Media and Technology (TMT) specific sectors.

Details of a deal

Since a round of fundraising process is normally around six months, I had a chance to close two live deals. Let me take one of the deals as an example: we had a client company that is a top intelligent driving-technology startup with valuation around US$250m. The company was looking for US$30m Series B round funding (round of growth stage financing). Our role as a fundraising advisor was to screen potential investors (normally they are Venture Capitals (VCs), since B round is still in growth stage) who are interested in such field at first. We also helped and guided the client company to prepare the material needed for the fundraising, such as business plan, business contract, and company’s financial analysis. Subsequently, if VCs are interested, we will assist VCs to do the due diligence on the client company. It usually includes financial, accounting, law, and compliance documents. After the valuation of VCs, if they agree to invest in company’s shares, both VCs and client company will sign a Term Sheet and finish the transaction within a period mentioned by the contract.

Preparatory work

We also need to do industry and company research report in Technology and Industrial sector, in which industry research report should include the industry’s definition, category, history, political trends, market analysis, competition status, core technology, industry development trend, capital market research, etc. For the company research report, we should present the company’s background information, capitalization table, business category and products, team, financing history, cooperation relationship, etc.

Takeaway from my internship

Thus, by doing such work, as an intern, I could have a deep understanding regarding specific sectors and build up relationship with some top VCs and Private Equity (PE) firms. This is quite important for the students who want to work in the investment field of primary market.

Financial concepts

Venture Capital

Venture capital (VC) is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks, and any other financial institutions. However, it does not always take a monetary form; it can also be provided in the form of technical or managerial expertise. Venture capital is typically allocated to small companies with exceptional growth potential, or to companies that have grown quickly and appear poised to continue to expand.

Though it can be risky for investors who put up funds, the potential for above-average returns is an attractive payoff. For new companies or ventures that have a limited operating history (under two years), venture capital funding is increasingly becoming a popular – even essential – source for raising capital, especially if they lack access to capital markets, bank loans, or other debt instruments. The main downside is that the investors usually get equity in the company, and, thus, a say in company decisions.

Capital funding

Capital funding is the money that debt and equity holders provide to a business for daily and long-term needs. A company’s capital funding consists of both debt (bonds and loans) and equity (stock). The business uses this money for both capital expenditures (Capex) and operating expenditures (Opex). The debt and equity holders expect to earn a return on their investment. The form of returns is interests for debt holders, and dividends and capital gains for equity holders. However, in my internship, since the company is still a startup at growth stage, so it only includes equity financing, which means that the investors will directly own the company’s share rights by investment money.

Discounted Cash Flow (DCF)

The discounted cash flow (DCF) method is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today (present value) based on projections of how much money it will generate in the future. This applies to investment decisions of investors in companies, such as acquiring a company, investing in a technology startup, or buying stocks in the secondary market. For business, owners and managers are looking to make capital budgeting or operating expenditures decisions such as opening a new factory, purchasing or leasing new equipment.

The DCF formula is shown below:

Present value of a series of cash flows

where PV is the present value of the investment, CF the series of cash flows generated by the investment (CF1 is for year 1, CF2 is for year 2, …, CFT is for the last year T) and r the discount rate.

Relevance to the SimTrade certificate

The experience shared above is strongly related to the SimTrade Certificate. The primary market is where securities are created, while the secondary market is where those securities are traded by investors. The boundary between primary and secondary market is the IPO. Once stocks are traded in public, it comes to secondary market. From my perspective, most parts of the investment analysis and logic are the same, such as fundamental analysis, DCF, P/E ratio, etc. so we can benefit from SimTrade by learning how business factors will affect the company’s stock performance and why and when should we make the right investment.

Related posts

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Useful resources

InvesTarget

Investopedia Venture Capital

Investopedia Private Equity

About the author

Article written in June 2021 by Suyue MA (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).