Key Concepts in Finance: Trading, M&A, and Risk

Posted on Jan 8, 2025 in Economy

Key Financial Trading Terms

  • Spot Trade: An agreement to trade currencies based on the exchange rate today for settlement within two business days.
  • Forward Trade: An agreement to exchange currency at some time in the future.
  • APPP: PFC = S0 * PUS
  • RPPP: E(S1) = S0 * [1 * (hFC – hUS)]

Mergers and Acquisitions (M&A)

  • Merger: The complete absorption of one company by another, wherein the acquiring firm retains its identity and the acquired firm ceases to exist as a separate entity.
  • Consolidation: A merger in which an entirely new firm is created and both the acquired and the acquiring firms cease to exist.
  • Horizontal Merger: A merger between firms in the same industry.
  • Vertical Merger: A merger between firms at different steps of the production process.
  • Going-Private Transactions: Transactions in which all publicly owned stock in a firm is replaced with complete equity ownership by a private group.
  • Leveraged Buyouts: Going-private transactions in which a large percentage of the money used to buy the stock is borrowed.

M&A Defense Strategies and Terms

  • Greenmail: In a targeted stock repurchase, payments made to potential bidders to eliminate unfriendly takeover attempts.
  • Standstill Agreements: Contracts wherein the bidding firm agrees to limit its holdings in the target firm.
  • White Knight: A firm facing an unfriendly merger offer might arrange to be acquired by a different, friendly firm.
  • Poison Pill: A financial device designed to make unfriendly takeover attempts unappealing, if not impossible.
  • Golden Parachute: Some target firms provide compensation to top-level managers if a takeover occurs.
  • Crown Jewel: Firms often sell or threaten to sell major assets when faced with a takeover threat.
  • Bear Hug: An unfriendly takeover offer designed to be so attractive that the target firm’s management has little choice but to accept it.
  • Lockup: An option granted to a friendly suitor giving it the right to purchase stock or some of the assets of a target firm at a fixed price in the event of an unfriendly takeover.
  • Split-Up: The splitting up of a company into two or more companies.
  • Equity Carve-Out: A parent company creates a separate company of which the parent is the sole shareholder. Next, the parent company arranges an initial public offering in which a fraction of the parent’s stock is sold to the public, thus creating a publicly held company.
  • Synergy: The positive incremental net gain associated with the combination of two firms through a merger or acquisition.

Risk and Return in Finance

  • Expected Return: The return on a risky asset expected in the future.
  • Risk Premium: Expected return minus the risk-free rate.
  • Systematic Risk: A risk that influences a large number of assets. Also known as market risk.
  • Unsystematic Risk: A risk that affects at most a small number of assets. Also known as unique or asset-specific risk.
  • Beta: The amount of systematic risk present in a particular risky asset relative to that in an average risky asset.
  • SML (Security Market Line): A positively sloped straight line displaying the relationship between expected return and beta.

SML Components

  1. The risk-free rate, Rf.
  2. The market risk premium, E(RM) – Rf.
  3. The systematic risk of the asset relative to average, which is called beta.

Expected Return Formula

E(RE) = Rf + betaE * [E(RM) – Rf]

Capital Asset Pricing Model (CAPM)

E(Ri) = Rf + [E(RM) – Rf] * Betai