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

Bijal Gandhi

Main components of an income statement

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

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

Example: LVMH

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

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).

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).

History of Options Markets

February 4, 2024June 20, 2021 by Akshit GUPTA

History of the options markets

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

Introduction

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

A brief history

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

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

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

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

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

Market participants

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

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