The Top 5 Impact Investing Financial Firms

August 26, 2024July 28, 2021 by Anant JAIN

The Top 5 Impact Investing Financial Firms

In this article, Anant JAIN (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) talks about the top 5 Impact Investing financial firms on the basis of assets under management.

Introduction

Impact investing is defined as an investment decision made with the aim to generate positive social and environmental impact that can be measured, along with positive financial performance. It is essentially an investment strategy that may take the form of numerous asset classes and may result in many specific outcomes. The main point of impact investing is to utilize money and investment capital for positive social results.

Impact investing considers both the physical investments of firms (on the assets side of the balance sheet of the firm) and their impact on the environment and society, and the financial investments of investors, debt, or equity (on the liabilities side of the balance sheet of the firm) to finance the physical investments.

Impact investing is concerned with investing in firms that will create measurable societal benefits along with positive financial returns. Impact investing focuses on addressing a social or environmental issue, such as education, gender equality, renewable energy, to name a few.

Asset Under Management (AUM) is the cumulative market value of investments, that a person or entity manages on behalf of their respective clients.

As published by BlueOrchard Finance (on 08/01/2020), the top five impact investing firms based on assets under management are:

#1 Triodos Investment Management
#2 Vital Capital Fund
#3 BlueOrchard Finance
#4 The Reinvestment Fund
#5 Community Reinvestment Fund

#1 Triodos Investment Management

Impact Area: Renewable Energy
Location: Zeist, Netherlands
Year Founded: 1980

Triodos Investment Management, headquartered in the Netherlands, is a subsidiary of Triodos Bank (one of the world’s leading sustainable banks). Triodos has approximately $5 billion in assets under management. It is a globally acknowledged leader in impact investing. It offers investable solutions to solve today’s numerous significant sustainability challenges. Since 1995, Triodos has been actively involved in impact investing. Triodos is also one of the founding members of the Global Impact Investing Network (GIIN). Having more than 25 years of experience in impact investing, Triodos established its global expertise in Energy & Climate, Inclusive Finance, Sustainable Food & Agriculture, and Impact Equities & Bonds. The main areas where its investments are spread are Europe, South America, Africa, India, and Southeast Asia.

#2 Vital Capital Fund

Impact Area: Development
Location: Zurich, Switzerland
Year Founded: 2010

Vital Capital is a prominent impact investment, private equity fund. It primarily focuses on sub-Saharan Africa. Having more than 30 years of experience in Africa, its impact investing has delivered essential development growth to millions of individuals in low and middle-income communities. Vital Capital invests in businesses and projects designed to enhance the quality of life and offers substantial investment returns. With more than $350 million in assets under management, Vital Capital Funds primarily focuses on health care, agro-industrial projects, renewable energy, sustainable infrastructure, and education.

#3 BlueOrchard Finance S.A.

Impact Area: Microfinance
Location: Zurich, Switzerland
Year Founded: 2001

BlueOrchard Finance has invested more than $8 billion across more than 90 countries, including Asia, Latin America, Africa, and Eastern Europe. It has achieved an impact on more than 215 million people affected by poverty in emerging markets by providing them with access to financial and related services. BlueOrchard Finance was founded as part of a United Nations initiative in 2001 to mobilize market forces to alleviate poverty and empower them to create a better life. BlueOrchard Finance was the first commercial institution to microfinance investment globally. It provides both debt and equity funding to small businesses. It focuses on alleviating hunger and poverty, establishing food production and education programs, fostering entrepreneurship, and working on climate change issues.

#4 Reinvestment Fund

Impact Area: Community Development
Location: Philadelphia, Pennsylvania, USA
Year Founded: 1985

Reinvestment Fund is a national financial institution in the USA that generates opportunities for under-resourced people and areas via partnerships. Headquartered in Philadelphia, Pennsylvania, Reinvestment Fund has an estimated $2.5 billion in assets under management. The Reinvestment Fund finances housing projects, access to health care, educational programs, and job initiatives. Reinvestment Fund officially works with offices in Atlanta, Philadelphia, and Baltimore. It provides them with public policy advice and data analysis services to assist in developing community programs.

#5 Community Reinvestment Fund, USA

Impact Area: Community Development
Location: Minneapolis, Minnesota, USA
Year Founded: 1988

Community Reinvestment Fund (CRF) is a not-for-profit organization with a mission to empower people, improve their lives, and empower the communities through innovative financial solutions. Community Reinvestment Fund was founded in 1988, in Minneapolis, Minnesota. It is accredited as a community development financial institution. CRF develops products and services to increase the flow of capital to historically underinvested communities across the USA. With more than $3 billion in assets under management, CRF has utilized these funds to help increase job creation and economic development, provide affordable accommodations, and aid with communal amenities.

Useful resources

Triodos Investment Management

Vital Capital Fund

BlueOrchard Finance

The Reinvestment Fund

Community Reinvestment Fund

Global Impact Investing Network (GIIN)

About the author

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

MSCI ESG Ratings

August 26, 2024July 28, 2021 by Anant JAIN

MSCI ESG Ratings

In this article, Anant JAIN (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) talks about MSCI ESG Ratings.

Introduction

MSCI ESG Rating is a measure of a company’s commitment to environmental, social, and governance (ESG) criteria and socially responsible investments (SRI). The MSCI ESG rating focuses on a company’s exposure to financially relevant ESG risks. It applies a rule-based methodology to distinguish companies into industry leaders and laggards based on their exposure to ESG risks and their relative aptitude to manage those risks compared to their peers. The ESG Ratings are ranked from leader (AAA, AA) to average (A, BBB, BB) to laggard (B, CCC).

Rating companies on the basis of ESG dimensions enables socially conscious investors to screen potential investments according to their personal investment goals and values.

Environmental, social, and governance (ESG) criteria

ESG criteria constitute a framework that helps socially conscious investors screen potential investments that incorporate their personal values/agendas. The ESG criteria screen companies based on sound environmental practices, healthy social responsibilities and moral governance initiatives into their corporate policies and daily operations.

Socially responsible investing (SRI)

SRI is a type of investment that is categorized to be socially responsible due to the nature of the operation the company conducts. SRI is an investment that considers two aspects:1) social/environmental changes; 2) financial performance. In other words, socially responsible investors promote practices that they believe will lead to environmental benefits, consumer protection, racial/gender diversity, etc. Some socially responsible investors also do the opposite of investing by avoiding companies that negatively impact society, such as alcohol, tobacco, deforestation, pollution, etc.

How Do MSCI ESG Ratings Work?

Over the past decade, ESG investing has become more popular. In 2020, the US SIF: The Forum for Sustainable and Responsible Investment published that more than $17 trillion of professionally managed assets were held in sustainable assets (about one-third of all assets under management).

Data providers have created various scoring criteria to rank and access potential ESG investments. Besides MSCI, other financial firms have curated their own proprietary ESG scoring models, including Standard & Poors (S&P), Blackrock, and Russell Investments. As a result, socially responsible investors can make more informed decisions when screening companies, ETFs, or mutual funds to include in their portfolios.

Division of ESG into pillars

MSCI’s ratings segregate ESG into its three pillars: environment, social, and governance. Figure 1 below shows the main components of each pillar and the key issues of each component.

MSCI evaluate thousands of data points across 35 ESG Key Issues that focus on the junction between a company’s core business and the industry-specific issues that may create significant risks and opportunities for the company. All companies are automatically evaluated for Corporate Governance and Corporate Behavior.

Figure 1. MSCI ESG classification.

Source: MSCI.

For example, in Figure 1, we take the example of a soft drink sub-industry (say Coca-Cola). In this scenario, the key issues for the environment and social pillar are highlighted. All the key issues mentioned for the governance pillar will be automatically considered for this industry (or any other industry).

Calculation of MSCI scores

When calculating the ESG scores for a company, MSCI rates each key issue from zero to ten. Zero indicates virtually no exposure, and ten represents very exposure to a particular ESG risk or opportunity.

MSCI also evaluates a company for its possible exposure to dubious business activities (e.g., gambling, weapons, tobacco, etc.). The data informing these scores are received from corporate filings, financial reports, and press releases. In addition to this, almost half of all data comes from hundreds of third-party media, academic institutions, non-government organizations (NGO), regulatory, and government sources.

Scores based on a company’s individual metrics are aggregated, weighted, and scaled to the relevant industry sector. Finally, an intuitive letter-based grade gets assigned to the company.

Assessment of MSCI scores

MSCI distinguishes its grades into three categories, mentioned below in descending order:

1. Leader (grade AAA & AA) – this grade indicates that a company is leading its relative industry. The company is managing the most significant ESG risks and opportunities.
2. Average (grade A, BBB & BB) – this grade indicates a company has an unexceptional or mixed track record of alleviating ESG risks and opportunities.
3. Laggard (grade B or CCC) – this grade indicates that a company is lagging in its industry because of the high exposure to ESG risks and failure to mitigate them.

Figure 2. MSCI ESG Score board.

Source: MSCI.

Example of MSCI ESG rating

The following case below is a real-life example of the MSCI ESG rating of Tesla, an electric vehicle producer. The company attained an overall grade of “A”, achieving the higher end of the “average” category.

When we look at the breakdown of this rating:

Tesla exceeds corporate governance and environmental risks, maintains a comparatively small carbon footprint, and utilizes green technologies.
The company scores an average grade for product quality and safety due to its past experiences of exploding batteries, undesirable crash test ratings, and accidents involving the car’s “autopilot” feature.
Tesla’s score is below-average for labor management practices. Tesla has been found to violate labor laws by blocking unionization. It has also repeatedly violated the National Labor Relations Act.

It is fascinating to note that the French auto parts maker, Valeo SA is the only company in the auto industry that earns a “leader” category grade from the MSCI ESG Ratings.

Useful resources

MSCI

MSCI Ratings Methodology

Tesla’s MSCI Rating

US SIF

About the author

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

Environmental, Social & Governance (ESG) Criteria

August 26, 2024July 28, 2021 by Anant JAIN

Environmental, Social & Governance (ESG) Criteria

In this article, Anant JAIN (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) talks about Environmental, Social & Governance (ESG) criteria and its individual components.

Introduction

Environmental, social, and governance (ESG) criteria constitute a framework that helps socially conscious investors to screen potential investments which incorporate their personal values/agendas. The ESG criteria screen companies based on sound environmental practices, healthy social responsibilities and moral governance initiatives into their corporate policies and daily operations.

Environmental criteria analyze how an organization performs as an agent of nature. Social criteria examine how it manages relations with employees, suppliers, customers, and the communities where it operates. Governance criteria deal with a companies’ audits, taxation, and firm management (composition of boards, shareholder rights, etc.).

There has been a rise in social investing, particularly by the younger section of the potential investors such as millennials and Gen-Z. As a result, financial products (exchange-traded funds for example) following the ESG criteria appeared. According to the report from US SIF Foundation, “there has been an increase in the assets chosen by ESG criteria from $8.1 trillion in 2016 to $11.6 trillion in 2018.”

Components of ESG

ESG criteria provide investors insight into a company’s adherence (or lack of adherence) to ethical practices. The three components of ESG criteria are defined as follows:

Environmental Criteria

These criteria measure a company’s impact on the environment and its ability to alleviate potential risks that could harm the environment in the future. It includes issues such as a company’s energy use, waste, pollution, natural resource conservation, and treatment of animals.

Social Criteria

These criteria assess a company’s relations with other businesses, its standing in the local community, its commitment to diversity and incorporation among its workforce and board of directors, its charitable contributions, and whether it practices employee policies that foster health and safety.

Governance Criteria

These criteria assess a company’s internal processes, such as transparent accounting systems, executive compensation and board composition, and its relations with employees and stakeholders.

Types of ESG Criteria

The table below provides the different types of issues mentioned by the CFA institute for each criterion of the ESG component. They are as follows:

Table 1. ESG components.

Source: MSCI.

Why is ESG Growth Accelerating?

Global sustainability challenges such as natural disasters, privacy and data security, and changes in demographics are introducing new risk factors for investors that may not have been seen previously. As companies face rising complexity at a global level, investors may re-evaluate traditional investment approaches. The demand for ESG criteria is increasing for the following reasons:

1. The world is transforming

Global issues, such as climate risk, increased regulatory pressures, social and demographic changes, and privacy concerns, represent new or increasing risks for investors. Companies face increasing complexities and more significant analysis if they do not adequately manage their ESG aspects.

2. A new era of investors

Millennial investors actively want to contribute back to society leading to rapid growth in ESG investment. In a 2018 survey, Bank of America Merrill Lynch said that “they could conservatively estimate $20 trillion of assets growth in U.S. ESG funds alone in the next two decades.”

3. Advancing technology

Advanced technology, including artificial intelligence (AI) and alternative data extraction techniques, reduces the dependency on voluntary disclosure from organizations. Machine learning and natural language processing are helping increase the timeliness and precision of data collection, interpretation and validation to deliver dynamic content and financially relevant ESG insights.

Working of ESG Criteria

To evaluate a company based on ESG criteria, financial investors look at a broad range of factors. They mainly follow any or all of the three criteria: Environment, Social, and Governance.

It is unlikely for a company to pass all the tests in every category. Therefore, investors need to prioritize their personal agendas that align with the ESG criteria. At a pragmatic level, investment firms that follow ESG criteria must also set priorities. For example, as of March 2020, Trillium Asset Management, with $2.8 billion under management, uses various ESG factors to help identify companies positioned for strong long-term performance. Trillium’s ESG criteria include avoiding companies with known exhibition to coal mining, nuclear power or weapons. It also avoids investing in companies with disputes related to workplace discrimination, corporate governance, and animal welfare, among other issues.

Conclusion

Earlier, only rating agencies specializing in sustainability paid attention to ESG criteria and similar concepts, with some dependency on information from the sector of the analyzed company. These agencies would collect information from the sustainability or CSR teams and provide their customers with their assessments.

In recent years, a rise in the interest of climate and social issues has led some of the most significant asset management companies to create specialized teams, developing internal methodologies to assign sustainable ratings. It is especially true with passive management funds (like Vanguard, State Street, BlackRock) and some active management funds.

As a result, in the year 2020, there was a striking increment in analysis and demand for information on environmental and social issues from investors.

Useful resources

The US SIF Foundation

The Bank of America Merrill Lynch Global Research Issues

The Trillium Asset Management

About the author

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

Socially Responsible Investing

August 26, 2024July 28, 2021 by Anant JAIN

Socially Responsible Investing

In this article, Anant JAIN (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) talks about Socially Responsible Investing.

Introduction

Socially responsible investing (SRI) is a type of investment that is categorized to be socially responsible due to the nature of the operation the company conducts. SRI is an investment that considers two aspects: 1) social/environmental changes; and 2) financial performance.

SRI refers both to the firms which invest by considering the environment and society (on the assets side of their balance sheet) and financial investors (banks, funds, etc.) who brings financial resources (debt or equity) to finance the physical investment (on the liabilities side of firms’ balance sheet).

In other words, socially responsible investors promote practices that they personally believe will lead to environmental benefits, consumer protection, racial/gender diversity, etc. Some socially responsible investors also do the opposite of investing by avoiding companies that have a negative impact in society such as alcohol, tobacco, deforestation, pollution, etc.

Understanding SRI

For socially responsible investing, financial investors do not use the typical metrics such as financial performance to select a company for investment. While investing in SRIs, investors ensure that the operation and business practices of a company aligns with his or her personal values. Since every investor has a different set of personal values, the definition of SRI varies from person to person.

For example, if you are concerned about the environment, your portfolio may have investments in green energy (such as wind, water or solar energy). If you are enthusiastic about racial equality, you might invest in companies employing or founded by people from different racial groups.

In recent years, “socially conscious” investing has been increasing into a mass followed practice as there are multiple funds and investment opportunities available to investors.
For example, mutual funds and exchange-traded funds (ETFs) provide investors with exposure to multiple companies spread across various sectors with a single investment vehicle.

As mentioned above, SRIs have two main aspects: environmental/social impact and financial performance. But it does not mean both these aspects have to go hand-in-hand. There is no surety that an investment resulting in positive environmental impact, will also result in financial gains for investors. Therefore, investors should still access the financial outlook of the investment while focusing on its environmental/social value.

Ways to Make Socially Responsible Investments

Investors looking to make investments in SRIs focus on the following criteria: Environmental, Social and Governance (ESG). They use these criteria to access the sustainability or social impact of an investment. Socially responsible investors use different approaches to ensure their ventures achieve social goals: negative screening, positive investing and community investing.

Negative Screening

This method involves screening a company’s operations and products/services before taking a decision to invest in it. It means that if investors discover that a particular company indulges in practices that is against their personal values, for example, say gender discrimination, then investors won’t invest in that company.

Positive Investing

Investors agree to invest in companies whose operations align with their personal values. For example, an investor who cares about environment would invest in green energy.

Community Investing

If an investor is keen to invest in SRIs, community investing is an excellent approach. The investor basically puts his or her money in projects that boosts local communities economically. For example, investing in projects that utilize resources that are readily available and create employment opportunities for the unemployed.

Types of Socially Responsible Investments

There are different types of SRIs available to investors. Three of the most common mediums are mentioned below:

Mutual funds and exchange-traded funds (ETFs)

Some mutual funds and ETFs follow the Environmental, Social and Governance (ESG) criteria. For example, investors looking to invest in either of the two funds can visit the SIF website, which displays over 100 socially responsible mutual funds and socially responsible ETFs.

Community Investments

Investors can socially invest by directly putting their money into projects that benefit communities. An easy way to make such investments is by contributing to Community Development Financial Institutions (CDFIs).

Microfinance

Investors can also make socially conscious investments by offering micro-loans or small loans to start-ups. They can search for businesses in developing countries that require financial assistance.

SRI financial performance

A socially responsible investment may result in financial gains. A 2020 research analysis from asset-management firm Arabesque Partners found that 80% of the reviewed studies demonstrated that sustainability practices have a positive influence on investment performance.

Several studies have indicated that SRI mutual funds are not only at par with traditional mutual funds in performance, but they can sometimes perform better. There is also evidence that SRI funds may be less volatile than traditional funds.

In the past, there have been controversies about SRI, with opponents arguing that restricting the field of investment options can also lead to a restriction of investment returns. Now, there is a growing pool of evidence that indicates the opposite: SRI is not only good for the society, but also for you!

Useful resources

The US SIF Foundation

Arabesque

About the author

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

Impact Investing

August 26, 2024July 19, 2021 by Anant JAIN

Impact Investing

In this article, Anant JAIN (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) talks about Impact Investing.

Introduction

Impact investing is defined as the investment process made with the intention to generate positive social and environmental impact that can be measured, along with positive financial performance. The main point of impact investing is to utilize money and investment capital for positive social results.

Impact investing considers both the physical investments of firms (on the assets side of the balance sheet of firms) and their impact on the environment and society, and the financial investments of investors, debt or equity (on the liabilities/shareholders’ equity side of the balance sheet of firms) to finance the physical investments.

Impact investments can be made in both emerging and developed markets. Emerging markets are riskier compared to developed markets. An impact investor can target a desired market according to his or her strategic goals and desired returns from the investments.

Two key elements are present in impact investments:

Intentionality: an investor’s intention should include some element of both social impact and financial return.
Measurement: while there is more availability on metrics for financial performance, an impact investor should also aim to measure the social impacts of the investment.

All investments make an impact on society, either positive or negative. Impact investors intentionally make investments that lead to measurable positive social impacts.

Parts of Impact Investments

Impact investments come in different forms of project size and risk level. Just like any other type of investment, impact investments provide investors with a wide range of possibilities when it comes to investment expected returns. The only differentiating factor with impact investment is that it does not only provide investors with positive financial returns but also has a social or environmental impact via the physical investments of firms that it finances.

The market for impact investment may vary and investors may choose to invest their money into emerging or developed markets/economies. Impact investments cover a huge number of industries including healthcare, education, energy mainly renewable energy and agriculture.

There are mainly two parts of impact investment: the choice of criteria and the use of these criteria for investing (selection of firms in the portfolio of investors).

Environmental, Social, & Governance (ESG) Criteria

ESG criteria refers to healthy practices undertaken by an investment. It helps us to analyze potential investment that may have a prominent impact on the environment/society. ESG criteria are integrated to enhance the traditional financial analysis of an investment by identifying potential risks and opportunities beyond purely financial valuations. Even though there is a parallel social conscience, the main objective of ESG evaluation remains financial performance.

Socially Responsible Investing (SRI)

Socially responsible investing (SRI) is a step up to ESG since it actively eliminates or selects investments according to specific ethical agendas. SRI uses ESG criteria (which facilitate valuation) to apply negative or positive screens on the investments. SRI uses ESG criteria to select potential impact investments.

Benefits of Impact Investing

The following points mentioned below are some of the benefits of impact investing:

Return on investment (ROI)

An impact investor can invest a fixed amount of money in a series of socially beneficial projects or organization. The returns on the investment would vary from below-market to market rate. However, in impact investing, even a simple return of principal amount used for investing creates philanthropic leverage that is unattainable through tradition investing methods.

Alignment with goals of financial investors

Firms have traditionally been focused on achieving profit maximization. This is also known as shareholder theory where the main goal of the firm is to maximize the shareholders’ returns. With impact investing, firms can utilize more assets to be leveraged for social or environmental goals. This is also known as stakeholder theory where the goal of the firm is to maximize shareholders’ profit without harming the environment or society.

Negation of onvestor’s conflict

When investors utilize their money for impact investing, they are aware that the investments are in line with ethical values. As a result, investors do not find themselves in situations of conflict with the management regarding the utilization of money for social or environmental benefits.

Examples of impact investing

The Gates Foundation

One of the most commonly known impact investment funds is the Bill & Melinda Gates Foundation. It was launched with a total endowment of nearly $50 billion. The Foundation has a strategic investment fund with $2.5 billion under management, which is invested in ventures that align with the Foundation’s social goals.

Soros Economic Development Fund

Launched by billionaire philanthropist George Soros, the Soros Economic Development Fund is part of the Open Society Foundations. Out of the $18 billion contributed to the Open Society Foundations, the Soros Economic Development Fund uses $90 million to actively invest in impact ventures.

The Bottom Line

Socially and environmentally responsible practices tend to attract impact investors. It means that companies can gain financial benefits by committing to socially responsible practices. It is observed that impact investing is more attractive to younger generation, such as Millennials and Gen-Z, who want to give back to society.

Investors also tend to profit from impact investing. A 2020 survey by the Global Impact Investing Network (GIIN) found that more than 88% of impact investors reported that their investments were meeting or surpassing their financial expectations.

By engaging in impact investing, individuals or organizations essentially state their support to the vision and the mission of the company working towards a certain social or environmental change. As we see a shift in the investor’s perspective to be more socially conscience, and to engage in impact investing, it will most likely result in more companies to become socially conscious.

Useful resources

The Gates Foundation

The Open Society Foundation

The Global Impact Investing Network (GIIN)

About the author

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

Operating Profit

July 8, 2021 by Bijal GANDHI

Operating Profit

In this article, Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains the concept of Operating profit.

This read will help you understand in detail the meaning, components and formula for calculating operating profit along with relevant examples.

Operating Profit

Operating profit refers to the profit obtained from business operations before the deduction of interest and taxes. Operating profit is a good representation of the company’s profits as all the core expenses are taken into consideration except interest and tax. It is synonymously used with “EBIT” (Earnings before interest and taxes) and “operating income”. Although, EBIT may sometimes include non-operating revenue.

Components and Formula

Operating profit is equal to:

Operating revenue – COGS – Operating expenses – Depreciation –Amortization

Gross profit: We know from the blog on revenue, gross profit equals revenue less COGS (cost of goods sold). Therefore, operating profit is often simplified as, Gross Profit – Operating expenses – Depreciation – Amortization.
Operating expenses refers to the expenses that a business undertakes during its normal operations such as rent, electricity, salary, etc. These expenses are generally divided into broad categories in the income statement to make it concise. For example, in the LVMH example below, the operating expenses are divided into three broad categories like marketing and sales, general and administrative and other such costs.
Depreciation refers to the value of the assets that have been used up every year. It is a method to allocate the cost of a physical asset over its useful life.
Amortization refers to the accounting method of spreading the cost of an intangible asset over its useful life.

Example: LVMH

Let us once 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 (market capitalization in June 2021) of $329 billion. It is a consortium of 75 brands controlled under around 60 subsidiaries. Here, you can find a snapshot of LVMH Income statement for three years: 2018, 2019 and 2020.

Bijal Gandhi

The operating profit for the year 2020 is 7,972 million euros. This means that from a revenue of 44,651 million euros in 2020, the company is now left with 7,972 million euros after deducting all expenses except interest and tax.

Operating profit vs Net profit

Net profit refers to the amount that a company is left with after deducting all expenses including interest and tax. For example, in the snapshot above, net profit is 4,702 million euros as compared to the operating profit of 7,972 million euros. This means that the total interest and tax expenses amounted to 7,972 less 4,702 million euros. Net profit which is also referred to as “bottom line” gives us a picture of the overall performance of the company and its management.

Exclusions from operating profit

There are several exclusions from operating profit because operating profit is calculated with the purpose of understanding the performance of a company’s core business only.

The revenue from the sale of an asset is not part of the operating profit. Similarly, investment income, interest income and debt interest expenses are not part of the company’s core business and therefore excluded from the calculation of operating profit.

About the author

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

Depreciation

July 8, 2021 by Bijal GANDHI

Depreciation

In this article, Bijal GANDHI (ESSEC Business School, Master in Management, 2019-2022) explains briefly the meaning of Depreciation.

This reading will help you understand the concept of depreciation, its main components and types with examples.

What is depreciation?

Depreciation is the accounting technique of dividing the total cost of a physical asset over its useful life period. The amount allocated is the value of the asset used up in that particular financial year. Depreciation is used by companies to spread the cost of an asset over time. This method eliminates the cost burden in one particular year. If not for depreciation, the company’s profits would seriously be affected in the year of purchase.

Depreciation for long-term assets may also be practiced by companies for tax benefits in a particular year. The reduction in taxable income can be achieved through tax deduction for the cost of an asset. Note that there are standard rules regarding the accounting practices of depreciation and firms cannot do what they want.

Types of depreciable assets

The guidelines for the types of assets to be depreciated is set by Internal revenue service (IRS) in the U.S. The following criteria are to be met with,
• The asset should be owned by the company.
• The asset should be used in the business to generate income.
• The life of the asset is determinable and is more than a year.

The most common examples of depreciable assets include plant and machinery, equipment, furniture, computers, software, land and vehicles.

Components of a depreciation schedule

A depreciation schedule is a detailed document that comprises of the information pertaining to depreciation for each asset owned by the company. It generally includes the following,
• Description and purchase price of asset
• Date of purchase and expected useful life.
• Depreciation method and salvage value.

Depreciation types with examples

Depreciation can be carried in several ways. The company can use any one of the four depreciation methods highlighted by Generally accepted accounting principles (GAAP) guidelines. GAAP is the set of rules and guidelines that are to be adhered to by accountants. The four methods for depreciation include the following,

Straight-line depreciation

Straight-line is one of the simplest methods of depreciation. In this method, the value of the asset is split evenly over the useful life of the asset. The value of the asset is calculated by subtracting the salvage value (scrap value) from the original cost incurred to purchase the asset. For example, if an equipment is bought for 10,000 euros, with a useful life of 10 years and a salvage value of 1,000 euros, the depreciation is computed as follows:

Depreciation per year= (asset cost – salvage value) / useful life
= (10,000-1,000) / 10
= 900 euros per year.
Therefore, 900 euros will be written off each year for 10 years.

Declining balance depreciation

The declining balance method of depreciation is an accelerated version of the straight-line method. Instead of an equal amount of depreciation for each year of useful life, unequal amounts depending upon the use are written off. In this method, more of the assets value is depreciated in the initial years than afterwards. This method is practiced by businesses who wish to recover maximum value upfront. For example, the equipment bought for 10,000 euros with a useful life of 10 years and salvage value of 1,000 will be depreciated by 20% each year,

For first year, the depreciable amount will be (9,000*20%) = 1,800 euros
For second year, the depreciable amount will be ((9,000-1,800) *20%) = 1,440 euros and so on.

Sum-of-the-years’ digits depreciation

This method serves a similar purpose as the declining balance method. It allows to depreciate more in the initial years as compared to the later years. It is a bit more even in terms of distribution per year as compared to the declining balance method.

The formula is as follows,
(Remaining life in years / SYD) x (asset cost – salvage value)
Where, SYD is the sum of the years of the asset’s useful life. SYD for an asset with a useful life of 4 years is equal to 11, which we get from (1 + 2 + 3 + 4).

Units of Production Depreciation

A simple way to depreciate would be to quantify an asset’s use every year. For example, an equipment can be depreciated in proportion to the units produced. This is exactly what the units of production method of depreciation works.

The formula is as follows,
Depreciation: (asset cost – salvage value) / units produced in useful life.
The number will vary each year, depending upon the use of the asset.

About the author

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

Revenue

July 8, 2021 by Bijal GANDHI

Revenue

In this article, Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) delves deeper into the accounting concept of revenue.

This read will help you understand in detail the meaning, types and calculation of revenue along with relevant examples.

What is revenue?

Revenue is referred to the money brought into a company from the sale of either goods, services, or both. Revenue is synonymous to sales and top line. This is because it first line on the income statement and it is a good indicator of a business’s performance. Revenue consists of two components, the price and the number of products/services sold. It is then calculated in the following manner:

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Gross revenue vs net revenue

Gross revenue is simply the income generated from a sale without consideration for any expenses that might have occurred. Net revenue is the income after subtracting all the cost of goods sold and other expenses related to running the business.

For example, if Alpha sells 2,000 toy cars at $100 each, its gross revenue for the month would be $200,000. If the cost of producing each car was $25, their net revenue would be 2,000 x ($100 – $25) toy cars or $150,000.

Revenue example: LVMH

Let us once 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. It is a consortium of 75 brands controlled under around 60 subsidiaries. Here, you can find a snapshot of LVMH Income statement for three years: 2018, 2019 and 2020.

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Here, the revenue, also known as top line, is 44,651 million euros for the year 2020. The revenue is the sum of income generated from all divisions. In the snapshot below, the revenue is a consolidation of income generated by several brands that sell wines, spirits, fashion, leather goods, perfumes, etc.

Accrued vs deferred revenue

Accrued revenue refers to the revenue earned by a company for which the goods are delivered but the payment is yet to be received. In this type of accounting, the revenue is recorded irrespective of whether the cash is received or not.

Deferred revenue refers to the revenue for which the customer has already made the payment, but the company is yet to deliver the goods. Here, in accounting the company will record the cash payment but that the revenue is unearned, but it will not recognize the revenue on the income statement.

How do revenue & earnings differ?

Revenue refers to the income generated by a company before deducting expenses, while earnings refer to the profit earned by the company after deducting the expenses, interest, and taxes from revenue.

Earnings is synonymous to net income or the bottom line. Along with revenue, it is also a very important indicator of a company’s performance.

How do revenue & cash flows differ?

Cash flow refers to the total amount of cash that moves into or out of the company. While revenue is the indicator of a company’s overall effectiveness, the cash flow is an indicator of liquidity.

About the author

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

Cost of goods sold

July 7, 2021 by Bijal GANDHI

Cost of goods sold

In this article, Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains Cost of goods sold.

This read will help you understand in detail the meaning and components of cost of goods sold along with relevant examples.

Introduction

Cost of goods sold (COGS) refers the sum of all costs directly related to the production of the goods. It is fundamentally very similar to cost of sales and hence synonymously used. Some examples of items that make up COGS include,

Cost of raw materials
Direct labor costs
Heat and electricity charges
Overheads

Components and Formula

The COGS is calculated using the following formula,

COGS = (Beginning Inventory + Purchases) – Ending Inventory

• Beginning Inventory is the total value of the inventory left over or not sold from the previous year.

• Cost of goods is the sum of all costs directly related to the production of the goods or the purchase value of the same (in case of retailer or distributor)

• Ending inventory is the total value of the remaining inventory that was not sold till the end of the financial year. This number is carried forward to next year.

Example: LVMH

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In the income statement, COGS is placed just below revenue (Link to the blog) to easily compare the numbers and derive the gross margin. For example, in the snapshot of LVMH income statement below, the cost of sales for the year 2020 is 15,871 million euros for the revenue of 44,651 million euros resulting in a gross margin of 28,780 million euros.

Direct costs vs indirect costs

Direct cost refers to the costs that are directly associated with the production of goods and services. They are generally variable in nature as they fluctuate depending upon the production. Some examples of direct costs include, raw materials, direct labour, manufacturing supplies, fuel, power, wages, etc. Most importantly, direct costs are the ones that can be directly assigned to the product or service.

Indirect costs are those which cannot be assigned to one specific product or service. These costs are those that apply to more than one business activity. For example, rent, employee salary, utility and administrative expenses, overheads, etc. These costs may be fixed or variable in nature.

COGS vs operating costs

Operating costs are expenses that are not directly related to the production of goods or services. The operating expenses are a separate line item in the income statement, and they include indirect costs like salaries, marketing, rent, utilities, legal and admin costs, etc.

It is important to classify the costs correctly as either COGS or operating. This will help managers differentiate well between the two and effectively build a budget for the same.

About the author

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

Why do governments issue debt?

July 5, 2021 by Rodolphe CHOLLAT-NAMY

Why do governments issue debt?

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) gives the reasons why governments issue debt.

In normal times, governments use debt (bills, notes and bonds) to cover expenses and finance investments that will create new wealth, which will make it possible to repay the debt. This is what companies do when they use credit to buy new machinery for example. It is also what public authorities do when they build schools, hospitals or roads that will increase the productive capacity of the country and improve the living conditions of its inhabitants. However, the interest for a state to go into debt could not be limited to this. What are the other reasons to go into debt?

Public debt allows the mobilization of private savings

The level of savings directly influences investment in the economy and, therefore, the level of consumption. However, there are many factors that can push savings away from their optimal level, i.e. the level that maximizes consumption. It is therefore necessary for a government to find solutions to adjust this level of savings. Recourse to debt is one of the solutions.

Indeed, recourse to debt is a means of mobilizing, in return for remuneration, the savings of individuals, and in particular those of households with sufficiently high incomes to save. Today, there are not enough borrowers who issue good quality assets. The proof is that interest rates are very low on public debt. Savers are competing with each other and accepting lower and lower yields for this type of savings medium. Thus, in a world of asset shortages, it is the state that will provide sufficient savings vehicles. The state is then faced with a dilemma: to provide adequate and safe savings vehicles and to increase taxes in order to pay the interest on new public debt.

Public debt helps limit fluctuations in production levels

As we have seen with the Covid-19 crisis, an economy can be confronted with one or more shocks that temporarily push the level of production away from its potential level. Such fluctuations represent a cost. Indeed, a higher volatility in the level of output translates into a lower growth rate. In addition, a temporary fall in output from its potential level can lead to the failure of long-term viable businesses.

Investments financed by debt can be used to limit the magnitude of changes in the level of output. Changes in government spending or tax obligations significantly affect the level of output. An increase in expenditure usually results in an increase in output. Thus, public debt is an effective way of stabilizing output. This is what happened during the 1980s and 1990s. Governments around the world used massive debt to support their economic activity. During the Covid-19 crisis, the “whatever it takes” approach saved many companies. However, it has also kept unprofitable companies on life support, which should have disappeared, due to a lack of hindsight.

Public debt is a redistribution within the present generations

Public debt is often presented as a burden to be borne by future generations. However, this statement is far from obvious. Indeed, it is very difficult to measure the extent of transfers between generations. Future generations will also benefit from part of the money borrowed today that will have been invested and distributed to households that will be able to save it and then pass it on to their children. Thus, it is difficult to assess the real burden of the debt for future generations.

What is more certain, however, is that the public debt is primarily a transfer within the households at the present time. The State borrows from an agent X to redistribute to an agent Y or to make an investment that will benefit an agent Z. Thus, from this point of view, the use of debt is a good tool for redistribution among households.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

About the author

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

Earnings per share

June 30, 2021 by Bijal GANDHI

Earnings per share

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.

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.

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.

About the author

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

Income Statement

June 30, 2021 by Bijal GANDHI

Income Statement

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

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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.

Bijal Gandhi

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.

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?

June 21, 2021 by Raphaël ROERO DE CORTANZE

Could the 2008 financial crisis been foreseen?

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.

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

June 21, 2021 by Raphaël ROERO DE CORTANZE

Stock split

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.

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:

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

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

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?

June 21, 2021 by Raphaël ROERO DE CORTANZE

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

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).

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.

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%.

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.

About the author

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

Dividend policy

June 21, 2021 by Raphaël ROERO DE CORTANZE

Dividend policy

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.

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

February 4, 2024June 20, 2021 by Akshit GUPTA

Options

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:
   C_T = Call option value at maturity T
   S_T = 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:
   C_T = Call option value at maturity T
   S_T = 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:
   P_T = Put option value at maturity T
   S_T = 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:
   P_T = Put option value at maturity T
   S_T = 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

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

June 20, 2021 by Akshit GUPTA

Forward Contracts

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 (S_T) 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
S_T = 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.

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

June 20, 2021 by Akshit GUPTA

Futures

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
F_T = 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

▶ 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

February 16, 2025June 20, 2021 by Akshit GUPTA

Option Trader – Job description

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 Trade 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.

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.

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.

▶ 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).

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