Question

Short questions and definitions. Briefly define the following objects or terms (at most 100one sentence) and provide examples if necessary:

(f)   Why do shareholders always have a preference for continuing operations rather than 10 liquidating a company which is in or headed for insolvency?

(g) Why do bondholder prefer less risk but shareholds prefer more? 10

(h) Define a futures contract and explain the principal difference between a futures and a 10 forward contract.

(i) What is the principal contractual difference between an option and a forward contract? 10

1. (j) Define an American put and explain how it differs from a European one. 10

Answer 1

(f) Why do shareholders always have a preference for continuing operations rather than 10 liquidating a company which is in or headed for insolvency?

Shareholders are last one to be paid in the pecking order in case of liquidation due to insolvency. They are most likely not to be paid in case of liquidation. In case of continuing operations, there is still some probability of positive free cash flows to equity holders. Hence, shareholders always have a preference for continuing operations rather than liquidating a company which is in or headed for insolvency

(g) Why do bondholder prefer less risk but shareholds prefer more?

Bondholders are earlier in the pecking order. Their cash flows are prior to any cash flows to the shareholders. They therefore prefer projects where cash flows may be lower but assured so that they get paid. Shareholders are last one to be paid in the pecking order and they get only residual cash flows. Hence, shareholders always prefer projects that tend to generate higher cash flows (so that there are some positive residual cash flows for shreholders) even if they are risky.

(h) Define a futures contract and explain the principal difference between a futures and a forward contract.

Future contracts are similar to forward contracts in nature but are standardized and trade on organized exchanges. Hence they are also called exchange traded products. Some of the exchanges where future contracts are traded are New York Mercantile Exchange, Chicago Board of Trade and International Money Market Wing of the Chicago exchange. Exchange decides on the notional amount, maturity dates and daily settlements during the contract tenure. Future contracts are usually settled before maturity by net cash payments.

Difference between Futures and Forwards:

Sl. No.	Parameter	Future Contracts	Forward Contracts
1.	Nature	Exchange traded	OTC
2.	Nature	Standardized hence lesser flexibility	Customized hence more flexible
3.	Liquidity	Since exchange traded, it’s relatively more liquid	Relative lesser liquid, finding a counterparty is more difficult
4.	Default risk	Lower	Higher
5.	Valuation	Marked to market daily	Not possible to mark to market as they are not exchange traded
6.	Closure	Can be closed by offsetting trade	Delivery compulsory

(i) What is the principal contractual difference between an option and a forward contract?

An option is a contract between two parties wherein the buyer or the long position holder has the right but not the obligation to purchase the underlying asset in lieu of a nominal premium payment at the beginning of the contract.

A forward is a contract between two parties wherein the buyer or the long position holder has the obligation to purchase the underlying asset and the seller or the short position holder has the obligation to sell the underlying asset, at a pre determined price.

(j) Define an American put and explain how it differs from a European one.

American Put is an option (right but not the obligation) to sell the underlying asset at an agreed price on or before a specified time.

American options can be exercised anytime up to expiration. European options can be exercised only at expiration