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Author: Bill Campbell
Marginal Cost of Capital: Break Points
Typically, the more capital a company wants to raise, the more expensive it will be for each additional increment; i.e., as its capital budget grows, its marginal cost of capital (MCC) increases. Because a company will undertake a project only when that project’s internal rate of return (IRR) is greater than the cost of capital…
Justified Ratios (Price Multiples)
In general, price multiples – P/E ratio, price-to-book-value, and so on – are used for relative value comparison, not absolute value. That is, a company’s price multiples are generally compared to those of similar companies to determine whether the company’s stock is overpriced, fairly priced, or underpriced compared to the stock of its peers. The…
Convexity
As we’ve seen in the article on duration, the duration of a bond (whether Macaulay duration, modified duration, or effective duration) is not constant; amongst the factors that cause (all types of) duration to change is the bond’s yield to maturity (YTM). Because duration changes with YTM, using only a bond’s (or bond portfolio’s) modified…
CFO – Indirect Method
There are two methods to arrive at a company’s cash flow from operations (CFO): the direct method and the indirect method. Companies that file their financial statements with the SEC are required to use the indirect method to present CFO, covered here. The direct method is covered in a companion article. The idea of the…
CFO – Direct Method
There are two methods to arrive at a company’s cash flow from operations (CFO): the direct method and the indirect method. Companies that file their financial statements with the SEC are required to use the indirect method to present CFO, covered in a companion article. Because the direct method is not required by the SEC…
Mark-to-Market Value of a Currency Forward Contract
In Level II economics we’re given the formula for the mark-to-market value of a currency forward contract. Similarly, in Level II derivatives we’re given the formula for the value of a currency forward contract. These two formulae look rather different from each other. In fact, they are identical (after accounting for the difference between nominal…
The Synthetics: Cash, Equity, and Fixed Income
Creating synthetic cash from an equity portfolio or a fixed income portfolio, creating synthetic equity from cash, and creating synthetic bonds from cash are, in principle, no different than adjusting the value/beta of an equity portfolio, or adjusting the value/duration of a fixed income portfolio, except for that one pesky characteristic of cash: cash always…
Adjusting the Value/Duration of a Fixed Income Portfolio using Bond Futures
Adjusting the Value of a Fixed Income Portfolio The typical formula for computing the number of bond futures contracts needed to adjust the value of a fixed income portfolio is: \[N_f\ =\ \frac{V_T\ -\ V_P}{V_f}\left(\frac{Dur_P}{Dur_f}\right)\left(yield\ \beta\right)\] where: \(N_f\): number of bond futures contracts to buy (i.e., take the long position) or sell (i.e., take the…
Adjusting the Value/Beta of an Equity Portfolio using Equity Futures
Adjusting the Value of an Equity Portfolio The typical formula for computing the number of equity futures contracts needed to adjust the value of an equity portfolio is: \[N_f\ =\ \frac{V_T\ -\ V_P}{V_f}\left(\frac{\beta_P}{\beta_f}\right)\] where: \(N_f\): number of equity futures contracts to buy (i.e., take the long position) or sell (i.e., take the short position) \(V_T\):…
Cash (Currency): the Wonky Commodity
Throughout Level II and Level III – and a little bit at Level I – we see calculations that involve commodities; e.g., calculating the price or value of a forward or futures contract on an underlying commodity. In all of those calculations, the quantity of the commodity is constant; for example, if you’re given the…