Where Theory Meets Practice - FIN 622 Topics in Action (A.J. Brown)

The purpose of this page is to supplement classroom concepts with practical contemporary examples. Specifically, periodic updates will attempt to link theoretical class topics with examples from industry and practice. A brief illustration of the theory in practice will follow a brief explanation of the concept. External links and outside sources will be provided.

Topics will be organized in chronological order, beginning with Chapter 1.

Chapter 1

In chapter 1 we are introduced to many foundational concepts concerning corporate finance, but the primary topic focuses on providing students with an understanding of how firms raise capital. One tool a private firm can use to obtain capital in order to expand is what's considered an Initial Public Offering (IPO). An IPO represents the first sale of a companies stock to the public. This is commonly referred to as "going public."

The November 15 edition of the Wall Street Journal describes how the National Hot Rod Association plans to take the non-profit association public.

Chapter 2

The most frequently used source of external financing is debt financing. Chapter 2 provides an introduction to many of the sources of debt financing. Debt financing instruments include: bank loans, leases, commercial paper, and debt securities.

The chapter describes commercial paper as the most commonly used source for short-term capital. According to our text, commercial paper is defined as a contract by which a borrower promises to pay a pre-specificied amount to the lender of the commercial paper at some date in the future.

Consider this example published in the November 8th edition of the Wall Street Journal, which describes how the Commercial Paper market is taking hits and contracting (or correcting) due to the recent sub-prime mortgage woes.

Chapter 3

The second major source of external capital for firms is equity. At its root, equity refers to ownership interest in a corporation through the form of (1) common stock, (2) preferred stock, and (3) warrants.

One of the primary differentiators between Preferred stock and common stock is that with preferred, holders have a claim on the firm's earnings prior to the distribution of dividends on the firm's common stock. Furthermore, Convertible Preferred Stock is an instrument that allows preferred shares to be converted to common stock at the holder's discretion.

To illustrate the concept of convertible preferred stock, consider the recent $2 billion stake that Bank of America acquired in Countrywide. The August 23, 2007 edition of the Wall Street Journal describes the activity.

Chapter 4

A portfolio is simply a combination of financial assets. Chapter 4 introduces us to the tools needed to value and analyze portfolios. Fundamentally, the chapter revisits many basic statistical concepts (means, variances, standard deviations, covariances, and correlations) that are rooted in investment theory and corporate finance.

A great resource that supplements the knowledge and portfolio tools presented in the text is Investopedia.com. Investopedia was originally founded as a comprehensive on-line investing dictionary and has since expanded to building educational content and tools to help empower the individual investors.

Chapter 5

This chapter takes a deeper dive into the mean-standard deviation diagram, while providing students with advanced valuation tools, such as beta valuation and the linkage with the tangency portfolio. Furthermore, the Capital Asset Pricing Model was introduced as a theory that identifies the tangency portfolio as the market portfolio.

Our text explains that "The Feasible Set" of the mean standard deviation as the set of means and standard deviation outcomes achieved from all feasible portfolios. We also know that in achieving higher means and lower variance is considered the mean-variance efficient portfolio.

Consider this article from Pension & Investments Online, which describes the launching of a new ETF (Exchange Traded Index Fund) that invests in other ETFs in order to achieve superior mean-variance optimization.

Chapter 7

One of the most significant financial theory concepts is Derivative Pricing, which is introduced in Chapter 7. Derivative Pricing came about with a simple call option introduced by the Chicago Board Options Exchange in 1973. Essentially, a derivative is a financial instrument whose value today or at some future date is derived entirely from the value of another asset, known as the underlying asset.

In the derivative world, a recent article in the Wall Street Journal describes how the U.S. and European derivative trading arms of the NYSE Euronext plan to link their trading system in the next year.

Chapter 8

The next chapter in our text delves into 'Options,' and basically, there are two types of options—call options and put options. A call (put) option is the right to buy (sell) a underlying asset at some time in the future. This future date can either be at any time (American option) or at the strike price, at a specific point in time (European option).

Fundamentally, an option is implicitly priced if the stock is traded. This concept, developed in 1973 by Fisher Black, Robert Merton, and Myron Scholes, is illustrated in what is commonly referred to as the Black-Scholes Valuation model. The model is regarded as one of the best ways of determining an options fair price. The single greatest limitation to the Black-Scholes Valuation model is that it cannot be used to accurately price American style options as the model only calculates a price at one point in time—the expiration.

In order to see how Black-Scholes valuation is used in practice, consider this recent publication in the October 22, 2007 edition of the WSJ, in which Zion Bancorp was cleared by SEC to allow the organization to use an auction process to value employee stock options. Zion contends that using the auction model lowers the price for options--which results in a lower hit to earnings. Furthermore, executives complained that the traditional models used to value options (such as Black-Scholes), oversetimate the options cost.

Chapter 12

This chapter introduces several advanced valuation techniques for analyzing capital allocation. The advanced techniques include:

  • Real Options Approach: Refers to the application of derivatives (methodology introduced in Chapter 7 & 8).
  • Ratio Comparison Approach: Ability to compare the value of projects, firms, or assets to other traded firms, projects or assets.
  • Competitive Analysis Approach: The realization that in a competitive market, firms can only achieve a positive Net Present Value if the firm has a distinct competitive advantage over competitors.

Interestingly, taking a closer look into the Real Options approach, also referred to as Strategic Options, our text refers us to an article published in Business Week entitled: "Exploiting Uncertainty: The Real Options Revolution in Decision Making," which describes how Enron was adopting the Real Options approach to the firm's power plant operations. In short, Enron's plants were options, allowing the company to mine profits by controlling capacity, and in effect, prices.

Chapter 21

According to our text, risk management entails assessing and managing the firm's exposure to various sources of risk through the use of several financial activities. The chapter provides an overview and introduction to hedging—the ability for a firm to take offsetting financial positions to mitigate or eliminate exposure to financial risk, and describes when and when not a firm should hedge.

To illustrate the importance of risk management, consider J.P. Morgan's recent appointment of Barry Zubrow to Chief Risk Officer in November 2007. The position had been vacant for about a year, but according to JP Morgan--the appointment should further strengthen the firm's position among the recent credit crunch.

Chapter 22

This chapter further describes the importance of hedging through the illustration of specific hedging techniques, such as forwards, futures, swaps, and options to eliminate and/or reduce a firm's exposure to risk. One of the greatest take-aways from this chapter is the realization that almost any hedging problem can and should be tackled by a skilled and competent manager, and not just left to technicians to perform the hedging formulation and analysis.

An interesting article published in the October 27, 2007 edition of the Wall Street Journal illustrates how investors today are more able and have more access to hedging techniques, which has better prepared investors for "deep jolts" in the market.

Chapter 23

Alloted class time only allowed for the first section of Chapter 23, "The Dollar Value of One Basis Point Decrease (DV01)" to be adequately presented and discussed. In short, the DV01 is a measure of the slope of the price-yield curve. Stated differently, the DV01 is the measure of much a bond's price will increase in response to a one basis point decline in a bond's yield to maturity. Therefore, the DV01 is useful for estimating the interest rate risk.

In practice, another financial option has emerged that allows investors to diversify away from the U.S. interest rate risk and the weakening U.S. dollar through a Foreign-Bond ETF. For further information, see the recent publication in the October 8, 2007 edition of the Wall Street Journal, which describes the structure and advantages to the Bond ETF.

The End :-)