1 Banking Finance

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UNIGE ECONOMIA | LINGUA INGLESE GRUPPO A - G | JUSTIN RAINEY | 2002/03

M1

Module 1 | Banking & Finance

a. Financial statements1. Accounting principles2. The Balance Sheet3. The P&L account of a bank

b . Banks and banking1. Banking activity2. Why banks are special3. Banking risks and how to cope with them4. A banking model for the EU

c. Financial instruments

1. Securities: bonds and shares2. Issuers and investors3. Facing risk


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MODULE 1 BANKING & FINANCE

GRUPPO A - G

.. | .. | a. Financial statements | 1. Accounting principlesFunction: to give a true & fair picture of the economic or financial position of a business at a certain date

Users: Stakeholders of the business (i.e. suppliers, creditors, investors, shareholders, etc.)

Accounting principles:PrudenceMatchingConsistencyGoing concernSubstance over formMateriality

Accounting periods:

Annual (at 31st December)Half-yearly (at 30th June)Quarterly

Principal documents present in annual report:

Balance sheet: assets & liabilitiesProfit & Loss account/Income StatementExplanatory notesAuditors Report

> Which accounting principle is being defined?

Principle Definition

The businesss is assumed to continue in existence for the foreseeable future

The accounting of an item if there is a statutory requirement to disclose it or ifinformation about an item will influence judgement of the company

Items should be accounted for in a consistent way within a period and from oneaccounting period to another

The matching of costs to revenues and their inclusion in the P&L for the periodto which they relate

The cautious handling of profits and losses: account for potential losses but dontaccount for future gains

The accounts must reflect the commercial reality rather than the strict letter of thelaw or accounting standards


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.. | .. | a. Financial statements | 2. The Balance Sheet

The Balance Sheet tells us what a company has ( its assets) and what it owes (liabilities) on a certain day. It reflectsthe financial health of the company.

Liabilities assets = Net worth

> Which of the following items is being defined below? Give the Italian equivalent of each

definition.

Definition Equivalent in italian Item

assets held by a business to use in generatingsales, and are not held for resale includingfinance leases

goodwill

work in progress

amounts owed by customers

bank loans and overdrafts

bonds issued

Other Balance Sheet items include:Provisions for liabilities and charges (e.g. deferred tax provisions, litigation settlement provisions)Capital and reserves (e.g. share capital, share premium account).

There are two main types of shares: Ordinary shares and Preference shares.Ordinary shares: it is possible for companies to have more than one type of ordinary share; with difference invoting rights, entitlement to dividend, ranking in case of liquidation.Preference shares: these have a fixed dividend which must be paid before other dividends can be paid.

Assets

Current (short-term) Fixed (at long-term)

Stock Tangible assetsDebtors Intangible assetsInvestments InvestmentsCash at bank and inhand

Liabilities

Short-term Long-term

Creditors: Creditors:amounts falling amounts fallingdue within a year due in more than a year


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GRUPPO A - G

The Profit & Loss Account

Revenues

Costs

Gross operating income operating expenses = Operating income

Operating income Provisions = Ordinary income

Ordinary income + (extraordinary income - extraordinary costs) =Pre-tax income

Pre-tax income income tax = Net profit.

.. | .. | a. Financial statements | 3. The P&L Account of a bank

The profit and loss account (P&L), or income statement in the US, identifies whether a company is managing to sell itsproducts/services for more or less than it costs to deliver them to the customer.

To do this it takes the sales in the period and deducts the costs that are associated with these sales to arrive at theprofit, or the loss.

Sales in the period costs associated to the sales = Profit (Loss).

What are costs?

Capital costs: relate to buying or improving assets.Revenue costs: relate to the sales in the period.

> In which financial statement are these costs included? Complete the table below:

Balance sheet

P&L


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Definitions

a. The positive or negative variation on the book value of an asset from its sale

b. Large or unusual unexpected items which occur in a period

c. The total in a period, excluding sales taxes

d. The share of a subsidiarys pre-tax profit payable to a company with a participating

interest

e. The costs of materials, labour and overheads used in sales, excluding sales taxes

(VAT)

f. The difference between interest received and interest paid

> Typical items found in the P&L. Choose the appropriate simple definition from the list

below and give the Italian equivalent.

Item Definition Equivalent in Italian

Turnover

Operating costs

Exceptional items

Profit (Loss) on sales of

assets/subsidiaries

Interest

Income from interests inassociated undertakings(participating interest

of 20% or more)

Taxation

Minority interests

Dividends


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GRUPPO A - G

> Insert + , , = in the correct position.

+ / / = Item

TurnoverOperating costs

Other operating income

OPERATING PROFIT

Profit and losses on sale of fixed assets or subsidiaries

Interest

PROFIT BEFORE TAX

Tax

PROFIT AFTER TAX

Dividends

RETAINED PROFIT


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.. | .. | a. Financial statements | 3. The P&L Account of a bank

THE PROFIT & LOSS ACCOUNT OF A BANKINTEREST INCOME AND SIMILAR REVENUES

including:- loans and advances to customers- fixed-income securities

INTEREST EXPENSE AND SIMILAR CHARGESincluding:- amount owed to customers- securities issued

DIVIDENDS AND OTHER REVENUES(a) from shares, quotas and other equitysecurities

(b) from equity investiments(c) other

COMMISSION INCOME

COMMISSION EXPENSES

GAINS FROM FINANCIAL TRANSACTIONS, NET

OTHER OPERATING INCOME

ADMINISTRATIVE COSTS:(a) personnelincluding:- wages and salaries- social secutity coast

-termination indemnity

- pensions and similar commitments

(b) other administrative costs

DEPRECIATION AND AMORTIZATION OF INTANGIBLEFIXED ASSETS

OTHER OPERATING EXPENSES

PROVISIONS FOR LOAN LOSSES AND FORGUARANTEES AND COMMITMENTS

RECOVERIES OF LOANS AND REVERSAL OFPROVISIONS FOR GUARANTEES AND COMMITMENTS

ADDITIONAL PROVISIONS FOR LOAN LOSSES

WRITE-DOWNS TO FINANCIAL FIXED ASSETS

INCOME FROM ORDINARY ACTIVITIES

EXTRAORDINARY INCOME

EXTRAORDINARY EXPENSES

EXTRAORDINARY INCOME, NET

PROVISIONS FOR MERGER RESERVE

INCOME TAXES

NET INCOME


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GRUPPO A - G

.. | .. | b. Banks and bankings | 1. Banking activity

Assets

Current (short-term)

Fixed (long-term)

Liabilities

Short-term

Long-term

> Go back to Financial statements. Put the following items into their correct place, either

under assets or liabilities. Give the Italian equivalent first.

Amounts payable:

Amounts receivable:

Cash in hand:

Equity investments:

Intangible fixed assets:

Securities in portfolio(shares and bonds):

Tangible fixed assets:


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Banks have two main sources of income:

a. Interest incomeb. Service-generated income.

Banks borrow in the form of Deposits and offer funding in the form of Lending. Their profit is the difference (netinterest income) between the price they charge for lending money to customers (interest income based on a lendinginterest rate) and the price they pay for customer deposits (interest expenses based on a borrowing interest rate).Deposits can be divided into Direct and Indirect deposits.

Direct deposits

Current accounts

Deposit/saving accounts

Indirect deposits

Asset management

Securities and fund management securitiesMutual funds

Assets in custody

Debt securities

Equity

Current account:

Deposit account:

Fixed advance:

Mortgage:

Overdrafts:

Saving account:

> A banks intermediation can be divided into short-term (sight) and longer (term)

activities. Give the equivalent in your language of the following intermediation activities

and then put them into their correct place in the table:

Activity Maturity

Short-term (at sight) Longer-term (term)

Borrowing

Lending


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GRUPPO A - G

.. | .. | b. Banks and bankings | 2. Why Banks are special

Lets now convert these activities into balance sheet items.

Intermediation activityCustomer depositsCustomer loans

Balance sheet itemsAmounts owed to customersLoans to customers

> Put these two items into the Balance sheet you completed on page 3.

We use a part of our assets to cover our liabilities. Banks do the same. However, a sizeable part of their assets isrepresented by amounts owed to customers. This is the key to understanding the intrinsically risky nature of banking.

Bank deposits/amounts owed to customers (many at sight) finance lending to customers/loans to customers (manyat term). This is called transformation of maturities or borrowing short and lending long.

We know when our liabilities fall due. However, a large part of a banks liabilities is of an uncertain maturity.

> Can you explain this?


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.. | .. | b. Banks and bankings | 3. Banking risks and how to cope with them

Banks have risks related to what they do.

Deposit risk and credit risk: the Domino effect

Deposit risk

Unexpected withdrawals Bank run Fire sale of assets Systemic contagion

Credit risksMispricing of loan Default Loss of customer Unexpected withdrawals ...................... ......................

Some solutions:

Risk managementCapital adequacy (Basle accord)Reserves for loan losses, provisionsBanking industry insurance schemes (FITD in Italy)Central bank lender of last resort.

> Can you think of the most common?

All business run risks.

Systemic risk and how to deal with it

Systemic risk is the danger that the sudden and unexpected demise of one or several banks could trigger a domino-like collapse throughout the financial system.

It is the externalities (side-effects) associated with bank failures that make them such a special case. If a steelmakergoes bust, its rivals may gain some advantage. When a bank goes bust its rivals may experience problems too. Aprofitable bank that takes in deposits and uses them in long-term loans generally keeps a small proportion of its liquid

assets handy just in case some depositors want their cash back quickly. This practice is known as fractional reservebanking. However, an unforeseen event - a sharp rise in interest rates, the collapse of an important borrower - raisesdoubts about whether the value of a banks assets (mainly loans) is enough to cover its liabilities (mainly deposits).

Because loans are hard for outsiders to value, some depositors may assume the worst and withdraw their cash. Asbanks work on a first come, first served basis, others will follow suit, leading to a run. This will force the bank intoa fire-sale of its less liquid assets to raise cash, further weakening its finances and prolonging the run.

A systemic risk arises if the first banks failure causes depositors who have doubts about other banks financial solidityto run on them too. This can happen either because they think that their banks have the same problems as the onethat has just failed, or because the failed banks fire-sale has depressed the market price of other banks assets.

Whatever the cause, once a system-wide panic has begun, it is extremely difficult to stop. It can also have a devastatingeffect on the economy, as the 1930s showed.

To tackle systemic risk, governments have developed a three-legged approach. The first leg is to establish a lender oflast resort, usually a countrys central bank, which will provide liquidity during a financial crisis, either to individualbanks or to the system as a whole.


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GRUPPO A - G

The second leg is to offer deposit insurance. Typically, this involves the government insuring small deposits, either intotal or in part, so that a banks customers are less likely to run if they suspect that it is in trouble. The snag with asafety net is that it tempts banks to take big risks in the knowledge that taxpayers will foot the bill if they fail. Thisdanger, known as moral hazard, creates a dilemma for governments. Without a net, bank failures could devastate an

economy; with it, the number of banks that take excessive risk could rise.To resolve the dilemma, governments rely on the third leg of their strategy: regulation and supervision. Yet in spiteof volumes of rulebooks and armies of regulators, the cost of bank bail-outs continues to rise. In response, politicians,pundits and the public are apt to call for even more regulation and more regulators. But a few central bankers arenow beginning to admit what some academic experts have been telling them for some time: that this traditionalapproach to banking regulation is ineffective and needs to be rethought.


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.. | .. | b. Banks and bankings | 4. A Banking Model for the EU

Which Banking Model for the European Union?

Harminisation requires harmonising towards a common reference point. The principle of European Union (EU) mutualrecognition, and freedom of movement of goods, services and people meant harmonising many aspects of Europeancitizenslives: laws, education, health and pensions, banking.

The model chosen for European banking was, not surprisingly, that which offered banks the greatest choice in therange of products and services they can choose. The universal model presented in the Second Banking Directivestates those services subject to mutual recognition. There is, however, one important condition: suitable capitaladequacy provided by joint-stock, limited liability (plc) status:

> Give the Italian equivalent of the text above. Then try to translate back into English!


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GRUPPO A - G

ANNEX LIST OF ACTIVITIES SUBJECT TO MUTUAL RECOGNITION

01. Accceptance of deposits and other repayable funds from the public02. Lending *03. Financial leasing

04. Money transmission services05. Issuing and administering means of payment (e.g. credits cards, travellers cheques and bankers drafts)06. Guarantees and commitments07. Trading for own account or for account of customers in:

(a) money market instruments (cheques, bills, CDs, etc.);(b) foreign exchange;(c) financial futures and options;(d) exchange and interest rate instruments;(e) trasferable securities.

08. Participation in share issues and the provision of services related to such issues09. Advice to undertakings on capital structure, and industrial strategy and related questions and advice

and services relating to mergers and the purchese of undertakings

10. Money broking11. Portfolio management and advice12. Safekeeping and administration of securities13. Credit reference services14. Safe custody services.

*Including inter alia:consumer credits | mortgage credit | factoring, with or whitout recourse | financing of commercial transactions(including forfaiting).

ALLEGATO ELENCO DELLE ATTIVIT CHE BENEFICIANO DEL MUTUO RICONOSCIMENTO

01. Raccolta di depositi o di altri fondi rimborsabili

02. Operazioni di prestito *03. Leasing finanziario04. Servizi di pagamento05. Emissione e gestione di mezzi di pagamento (carte di credito, travellers cheques, lettere di credito)06. Rilascio di garanzie e di impegni di firma07. Operazioni per proprio conto o per conto della clientela in:

a) strumenti di mercato monetario (assegni, cambiali, certificati di deposito, etc.)b) cambic) strumenti finanziari a termine e opzionid) contratti su tassi di cambio e tassi dinteressee) valori mobiliari.

08. Partecipazione alle emissioni di titoli e prestazioni di servizi connessi09. Consulenza alle imprese in materia di struttura finanziaria, di strategia industriale e di questioni connesse,

nonch di consulenza e servizi nel campo delle concentrazioni e dei rilievo di imprese10. Servizi di intermediazione finanziaria del tipo money broking11. Gestione o consulenza nella gestione di patrimoni12. Custodia e amministrazione dei valori mobiliari13. Servizi di informazione commerciale14. Locazione di cassette di sicurezza.

*Comprende in particolare:credito al consumo | credito con garanzia ipotecaria | factoring, cessioni di credito pro soluto e pro solvendo credito

commerciale (compreso il forfaiting)


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.. | .. | c. Financial instruments | 1. Securities bonds and sharesSecurities - shares and bonds - are in essence only the receipts that savers get

for lending money to, or investing in, a firm or government.

BONDS (1)Key words: issuer, bondholder, principal, price, maturity, coupon, yield

> Give the Italian equivalent of the following 5 topic sentences:

A bond is a loan that can be traded between investors

A bond is an agreement to repay an amount of principal at a future date, along with a schedule of interestpayments over a period time, usually several years

Bonds come in countless flavours and the type often depends on the nature of the issuer

The market price of a bond will vary over time in response to several factors

One way of summarising a bonds value is its yield


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GRUPPO A - G

BONDS (2)

> Match each paragraph to its topic sentence on sheet no. 1 and then complete the

paragraphs using the phrases given below.

(a)American treasury bonds are a well-known example. An investor who today buys a newly issued $10,000 facevalue, 30-year Treasury bond with a 6% coupon will receive 6% interest per year (or $600) until maturity, whenhe will also get back his $10,000 principal.

(b)Government debt includes municipal bonds, central or federal government bonds, and the bonds of relatedagencies. Corporate issues include the relatively safe debt of a large company such as AT&T, as well as thehigh-yielding ____________________ of riskier firms.

(c) A government might issue a bond because it spends more than it receives in tax revenues, and needs to borrowthe difference. Bonds are often called ____________________ because they g ive the investor a regularstream of interest payments, called coupons.

(d)This is the measure of the return a bondholder receives on investment, ____________________ . As a bondsprice falls, investors can purchase its stream of interest payments for less. Likewise, when the bonds pricerises, investors pay more dearly for its cash flow. This gives rise to the apparent paradox about bonds: thecheaper they are, the more they yield.

(e)____________________ . The less worried investors are that inflation will erode the value of both interest and

principal, the more they will pay for a bond. Bond prices are, therefore, a good reflection of investorsexpectations of future inflation. When interest rates offered on new investments rise, the fixed payments ofolder bonds become less attractive; so investors will bid the prices of these bonds down.

(a) fixed-income securities | (b) expected inflation, interest rates on competing investments

and the creditworthiness of the borrower | (c) stated as a percentage of the bonds market

price |(d) junk bonds


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SHARESKey words: equities, issuer, shareholder, p/e ratio, ownership, cashflows, earnings yield

> Complete the text with the sentences a, b, & c.

Shares, or equities, are little slices of ownership in private firms. As owners, shareholders elect a boardof directors and vote on company business. (1) __________________ .This is known as the dividend. Thisis one way to see that shares generally ca rry more risk than bonds: bondholders have a higherlegal claim, or seniority, on the cashflows of a business than do shareholders. If a firms businessdeclines, bondholders will be paid first, and shareholders last, if at all. But if business booms, shareholderswill do better.

For share valuation, one commonly cited measure is the price to earnings, or p/e ratio. The p/e ratio is themarket price of shares divided by the firms profits. (2) __________________ ; in fact, the inverse of thep/e ratio measures a firms profits as a percentage of the market price of its shares, or earnings yield.

From the savers perspective, bonds appear safer than shares. (3) __________________ . For a companyissuing securities to fund its growth, shares are the least risky choice. Shareholders, unlike bondholders,receive no legal promise to be repaid in cash at a certain time. Shareholders can exchange their shares inthe stockmarket at the market price, but the firm promises them no particular return.

(a) P/e ratios are to shares what yields are to bonds | (b) From the issuers perspective,

things look different | (c) They are also entitled to the firms profits - the income that remains

after payments for wages, materials, and interest on the companys debt


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GRUPPO A - G

CAPITAL MARKETS (1)

> Choose the correct word (a, b, c or d) to complete the spaces 1 to 8.

Modern capital markets can be real or virtual. Traditional financial exchanges had a trading floor on whichmembers (1) __________________ to buy and sell securities. Floor traders have become icons of modernfinance. Yet today the NYSE is one of the few examples of an exchange with a floor. Increasingly, exchangesonly address is in cyberspace, with traders l inked by a computer network.The most successful example of such screen-based exchanges is Americas Nasdaq. The Tokyo Stock Exchangerecently (2) _________________ its trading floor with a computer.

In the past, stock exchanges were almost always owned (3) __________________ by their members, butnow several of the largest plan to issue shares to the public, following the example of Australias stockexchange, which is now (4) __________________ on its own market.

And there are different trading mechanisms. Dealer exchanges, such as Nasdaq, rely on market-makers to(5) __________________ buy and sell orders, while auction markets, such as the Frankfurt exchange,match such trades electronically. The NYSE is a hybr id of the two. The trading method chosen canaffect (6) __________________ , a measure of how fast securiti es can be sold and how much suchsales affect prices.

Most capital-market trading takes place between one investor and another. This is known as the secondarymarket, since it does not involve the company or government that (7) __________________ the security.New shares and bonds, however, are born on what is called the primary market, where the money(8) __________________ flows directly into the coffers of the issuers. The primary market includes initialpublic offerings (IPOs) of shares in the stockmarket as well as new debt in the bond market.

(1) a. collected b. gathered c. united d. recruited(2) a. replaced b. sold c. rejected d. bought

(3) a. singly b. solely c. mutually d. collectively

(4) a. quoted b. intermediated c. rented d. chartered

(5) a. compare b. contrast c. separate d. match

(6) a. depth b. volume c. liquidity d. profits

(7) a. offered b. issued c. acquired d. distributed

(8) a. rose b. risen c. raised d. rated


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CAPITAL MARKETS (2)

> Complete the missing information summarising the articles main points.

Trading location:

Ownership form:

Method of trading:

Types of market:


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GRUPPO A - G

.. | .. | c. Financial instruments | 2. Issuers & investors

The trading of bonds and shares bring two sides of the transaction together: those with amounts to invest, and thoserequiring funding, public limited companies. A centralised location for the two sides of the transaction is the market.

Typically the participants in this trade are corporate issuers, and institutional and retail investors.

What is a joint stock company or corporation? They have 5 core structural characteristics:

1. Full legal personality2. Shared ownership by contributors of capital3. Limited liability4. Centralised management under a board structure5. Transferable shares.

The Agency Problem.Agency problems confront all firms with delegated management and multiple owners (Hansmann and Kraakman).

The agency problem is the problem of one party, the principal, whose interests depend upon another party, theagent, of motivating the agent to act in the principals interest rather than in the agents own interest.

> Can you think of some everyday examples where you or members of your family are

principals?

In companies there are three general agency problems:

1. the conflict between the firms owners and its managers: managers must put the interests of the owners

before theirs;2. the conflict between majority owners or controlling shareholders and minority owners: majority owners

should respect minority owners rights;3. the conflict between shareholders and other stakeholders of the same company: shareholders should

not behave opportunistically.


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.. | .. | c. Financial instruments | 3. Facing risks

Financial instruments are exposed to 2 main types of risk:Loss of value (value erosion)

Loss of earnings potential (underperformance).

These loss scenarios may stem from:

Market risk (risks associated to where the security is traded)orIntrinsic risk (risks associated with the security itself).

There are two strategies in managing risk:

PassiveActive.

The active management of risk involves either:

Covering risk positionsSpeculating on risk positions.

Derivatives are used for both.They are:

ContractsThey derive from an underlying financial instrumentThey resemble financial instruments:

issued on primary derivatives markets;traded on secondary derivatives markets.

> What is the euro/dollar rate today? What is the expected trend over the next six months?

Consider this situation: a euroland importer paying in US dollars needs $ 100,000 for payment in six months time (30th

September). The company is exposed to exchange rate risk (not knowing the/$rate in six months so effectively notknowing the real price of the goods being imported).

It can do one of the following things:

Do nothing and purchase the dollars at the spot price on 30th SeptemberPurchase the dollars now at the present market rateAgree to purchase the dollars at the present market rate with the obligation to pay for them at 30th September(i.e. underwrite a forward contract).

Each scenario has its risks. Try and imagine them by asking questions beginning What will happen if ?

One solution is the use of a currency option contract. Read the text and then do the exercises. As you read, bear in

mind the limitations of the three solutions you analysed above.


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GRUPPO A - G

Currency options

The option buyer (or holder) has the right to demand the purchase or sale of a specified financial asset (in this caseforeign currency), but does not have the obligation to do so. The party selling the option right, the option writer, hasthe obligation to buy or sell at the strike price - namely the agreed exchange rate - on demand.

An option which provides the right to buy a currency and sell the base currency is a call option. A put option providesthe right to sell currency and buy the base currency at the agreed rate.

The option buyer has the right to deal at the price he agreed, or he can let the option drop when the contract expires,or indeed he can sell it back to the writer. This particular derivative offers several advantages. A principal advantageis that with an option the holder has an insurance-like product: he has cover against downside risk. The major reasonwhy most companies seek forward cover is to kill off downside risk. Unlike a forward contract, however, a currencyoption does not kill off the upside. The holder evaluates the worst case scenario and pays his option premium on thisbasis.

An option is particularly useful for covering contingent cash flows; a cash flow which might be there or not. Tendersare an example where a company might get an order, which in turn presents potential currency risk, or it might not.A currency forward does not cover that type of risk because it exists independently of the underlying commercialdeal. The option right does not have to be exercised.

Another advantage is in the range of strike prices. The forward contract obliges the user to deal at the market price.The option offers the holder the possibility of choosing the exchange rate to deal at. Obviously, the premium willreflect the amount of risk the holder is prepared to take on. Most companies are prepared to accept negativemovements in exchange rates of a few cents. They are not prepared to accept shifts of ten or twenty cents. To coverdownside risk in the form of a few cents will cost considerably less in the way of a premium than movements of tenor twenty cents.

Profit lock is another advantage offered by the currency option. If a company is long in dollars (i.e. it has substantialliquidity in that currency), and the dollar is continuing to rise against other currencies, the company may be afraid ofa negative change in dollar rates. However, the company cannot be sure that the dollar rise is finished. Here acurrency option can be taken out to sell the dollars at their current level. This provides cover against a negative movein the dollar (the cost is the premium), whilst at the same allowing the company a lock into future profits if the dollarcontinues to rise (the option is not exercised).


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The party selling the option right:

The party purchasing the option right:

The option giving the right to buy afinancial asset:

The option giving the right to sell afinancial asset:

The option sellers maximum gain:

The financial instrument related to theoption:

The price decided by the parties forpurchase or sale of the related financialinstrument:

The risk of losing the value of the relatedfinancial instrument:

The risk of losing the profit potential ofthe related financial instrument:

Definition Phrase from text


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> Which of the following can be considered advantages of the currency option over a

currency forward?

1. Greater flexibility in managing cash flows

2. The possibility of working with market prices3. Range of strike prices4. The locking into of potential favourable currency movements5. The obligation of settling at the end of the contract.

How to keep your options open

How can one use traded options to boost the return on a share portfolio? One way is sell options on shares alreadyin possession in an effort to achieve a realistic performance target.

Many investors believe that buying call options is the road to riches. There are, however, considerable advantages inselling options rather than buying them. If one purchases a call option one has the right, but not the obligation, to buya particular share at a specified price (the strike price) until the option expires. This can be very profitable, since itis possible to buy a call option for only a fraction of the cost of actually buying the underlying share.

If the share price jumps by, say, 20 per cent, it may be possible to sell the option for a profit of more than 100 percent. You have geared exposure to the share price. The disadvantage is that you have to be able to select sharesthat are going to increase rapidly in value. If you are wrong, however, you can lose all the money paid to purchase theoption. Buying a call option is like backing a horse: if youre right you win, if youre wrong, you lose the entire stake.

In contrast, one can set a profit target and achieve this by selling call options, giving someone else the right to claimshares from you at a specified price. While fantastical profits cannot be made in this way, you can be content with anoverall return from your portfolio of 20 per cent a year. Using simple rules, this can be realistic target.

When you have a call option you immediately receive a cash lump sum - known as the premium - from the purchaser.If the strike price is a little higher than the price you pay for the shares you will also receive a capital gain if the optionis exercised.

For example, the present share price of Dixons plc (a British electrical appliances retailer) is 226p and so it costs about

2,260 to purchase 1,000 shares. It is possible to sell a call option exercisable in June with a striking price of 240pand receive a premium of 27p per share. This is an immediate return of 270 on an outlay of 2,260, a return ofnearly 12 per cent. If the option is exercised, there will be a further 14p profit per share, making a total profit of 18 percent in six months.

The system requires some rules. Firstly, there are only about 100 shares on which traded options are available. Theseare listed in Britain under the Liffe Equity Options. Secondly, of these 100 shares, only about 20 will be suitable. Thismeans waiting for the right circumstances before buying the share and selling the call option. For example, tradingwhen the share chosen might have dropped in value to near the bottom of its trading range or when it exhibits a steadyrising price trend.

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