In this post, some of the other important terms related to shares and the stock exchange have been taken up for discussion.
Derivatives
A derivative is a contract whose value depends on the underlying asset. Futures, forwards and options are all of derivatives. Now, let us briefly understand them
Forwards and futures
A forward contract is a customised agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. For example, A and B enter into an agreement on 1/06/2011 under which A will buy from B 12 mangoes on 1/07/2011 at Rs. 5 each.
Futures are nothing but a special type of forward contracts because they are standardised in nature and are traded in stock exchanges.
Options
An Option is a contract which gives the buyer the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price (also called Strike Price). The buyer of an option pays the “option premium” to the seller of the option to get the right to exercise his option. The writer of an option is obliged to sell/buy the asset if the buyer exercises it on him. It should be noted that the option premium is forfeited in case the option is not exercised and is adjusted in the price initially decided if the option is exercised.
Options can be classified as American options and European options. In the former case the option can be exercised on any day up to the expiry date, whereas in the latter case it can be exercised only on the expiry date. The options traded in India are all American options.
Options are of two types - Calls and Puts options:
‘Calls’ give the buyer the right to buy a given quantity of the underlying asset; and ‘Puts’ give the buyer the right to sell a given quantity of underlying asset (at a given price on or before a given future date).
A call option is exercised if the market value of the asset is more than the price agreed upon. On the other hand a put option is exercised if the market value of the asset is less that the price agreed upon (adjusted for the premium in both cases).
The concept of leverage
Time and again we come across the term leverage in newspapers and magazines (with respect to shareholders). Leverage is the benefit that the shareholders get due to the loan taken by the company in the form of debentures, bonds, etc.
We shall understand the concept of leverage with the help of the following example:
There are two companies A and B, which have a profit of Rs 100,000 each. Both the companies required Rs 100000 for expansion. Company A raises the required amount by issuing 10000 shares worth Rs 10 each. Company B on the other hand issues 5000 shares worth Rs 10 each and issued 5000 10% debentures worth Rs 10 Each . Now, let us compare the Earnings per share (EPS) of the two companies:
COMPANY A
|
COMPANY B
|
Profit before interest Rs 100000
|
Profit before interest Rs 100000
|
Interest (Rs 0)
|
Interest (Rs 5000)
|
PBT Rs100000
|
PBT Rs 95000
|
Tax (Rs 50000)
|
Tax (Rs 47500)
|
PAT Rs 50000
|
PAT Rs 47500
|
EPS Rs 5
|
EPS Rs 9.5
|
(PBT= Profit before Tax, PAT= Profit after Tax, EPS= PAT/(number of shares) Figures in brackets mean an expense and the tax rate is 50%)
From the above example it is clear that the EPS is higher in case of the company that has taken a loan.
With this post, I come to an end of the series of articles pertaining to the stock exchange and shares. I have purposefully kept mutual funds out of the discussion because I would later come up with an entire post related to mutual funds. I hope that the readers found the posts useful. Feedback, suggestions and comments are welcome.
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