Posts Tagged ‘Works’

Anti-Dilution Provision: Definition, How It Works, Types, Formula

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Anti-Dilution Provision: Definition, How It Works, Types, Formula

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What Is an Anti-Dilution Provision?

Anti-dilution provisions are clauses built into convertible preferred stocks and some options to help shield investors from their investment potentially losing value. When new issues of a stock hit the market at a cheaper price than that paid by earlier investors in the same stock, then equity dilution can occur. Anti-dilution provisions are also referred to as anti-dilution clauses, subscription rights, subscription privileges, or preemptive rights.

Understanding Anti-Dilution Provisions

Anti-dilution provisions act as a buffer to protect investors against their equity ownership positions becoming diluted or less valuable. This can happen when the percentage of an owner’s stake in a company decreases because of an increase in the total number of shares outstanding. Total shares outstanding may increase because of new share issuance based on a round of equity financing. Dilution can also occur when holders of stock options, such as company employees, or holders of other optionable securities exercise their options.

When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.

Sometimes the company receives enough cash in exchange for the shares that the increase in the value of the shares offsets the effects of dilution; but often this is not the case.

Anti-Dilution Provisions at Work

Dilution can be particularly vexing to preferred shareholders of venture capital deals, whose stock ownership may become diluted when later issues of the same stock hit the market at a cheaper price. Anti-dilution provisions can discourage this from happening by tweaking the conversion price between convertible securities, such as corporate bonds or preferred shares, and common stocks. In this way, anti-dilution clauses can keep an investor’s original ownership percentage intact.

Dilution in Action

  • As a simple example of dilution, assume that an investor owns 200,000 shares of a company that has 1,000,000 shares outstanding. The price per share is $5, meaning that the investor has a $1,000,000 stake in a company valued at $5,000,000. The investor owns 20% of the company.
  • Next, assume that the company enters a new round of financing and issues 1,000,000 more shares, bringing the total shares outstanding to 2,000,000. Now, at that same $5 per share price, the investor owns a $1,000,000 stake in a $10,000,000 company. Instantly, the investors’ ownership has been diluted to 10%.

Types of Anti-Dilution Provisions

The two common types of anti-dilution clauses are known as “full ratchet” and “weighted average.”

With a full ratchet provision, the conversion price of the existing preferred shares is adjusted downward to the price at which new shares are issued in later rounds. Very simply, if the original conversion price was $5 and in a later round the conversion price is $2.50, the investor’s original conversion price would adjust to $2.50.

The weighted average provision uses the following formula to determine new conversion prices:

  • C2 = C1 x (A + B) / (A + C)

Where:

  • C2 = new conversion price
  • C1 = old conversion price
  • A = number of outstanding shares before a new issue
  • B = total consideration received by the company for the new issue
  • C = number of new shares issued

Key Takeaways

  • Anti-dilution provisions are clauses built into convertible preferred stocks to help shield investors from their investment potentially losing value.
  • Dilution can occur when the percentage of an owner’s stake in a company decreases because of an increase in the total number of shares outstanding. 
  • Anti-dilution provisions are also referred to as anti-dilution clauses, subscription rights, subscription privileges, or preemptive rights.

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Asset Swap: Definition, How It Works, Calculating the Spread

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Asset Swap: Definition, How It Works, Calculating the Spread

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What Is an Asset Swap?

An asset swap is similar in structure to a plain vanilla swap with the key difference being the underlying of the swap contract. Rather than regular fixed and floating loan interest rates being swapped, fixed and floating assets are being exchanged.

All swaps are derivative contracts through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount agreed upon by both parties. As the name suggests, asset swaps involve an actual asset exchange instead of just cash flows.

Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts between businesses or financial institutions.

Key Takeaways

  • An asset swap is used to transform cash flow characteristics to hedge risks from one financial instrument with undesirable cash flow characteristics into another with favorable cash flow.
  • There are two parties in an asset swap transaction: a protection seller, which receives cash flows from the bond, and a swap buyer, which hedges risk associated with the bond by selling it to a protection seller.
  • The seller pays an asset swap spread, which is equal to the overnight rate plus (or minus) a pre-calculated spread.

Understanding an Asset Swap

Asset swaps can be used to overlay the fixed interest rates of bond coupons with floating rates. In that sense, they are used to transform cash flow characteristics of underlying assets and transforming them to hedge the asset’s risks, whether related to currency, credit, and/or interest rates.

Typically, an asset swap involves transactions in which the investor acquires a bond position and then enters into an interest rate swap with the bank that sold them the bond. The investor pays fixed and receives floating. This transforms the fixed coupon of the bond into a LIBOR-based floating coupon.

It is widely used by banks to convert their long-term fixed rate assets to a floating rate in order to match their short-term liabilities (depositor accounts).

Another use is to insure against loss due to credit risk, such as default or bankruptcy, of the bond’s issuer. Here, the swap buyer is also buying protection.

The Process of an Asset Swap 

Whether the swap is to hedge interest rate risk or default risk, there are two separate trades that occur.

First, the swap buyer purchases a bond from the swap seller in return for a full price of par plus accrued interest (called the dirty price).

Next, the two parties create a contract where the buyer agrees to pay fixed coupons to the swap seller equal to the fixed rate coupons received from the bond. In return, the swap buyer receives variable rate payments of LIBOR plus (or minus) an agreed-upon fixed spread. The maturity of this swap is the same as the maturity of the asset.

The mechanics are the same for the swap buyer wishing to hedge default or some other event risk. Here, the swap buyer is essentially buying protection and the swap seller is also selling that protection.

As before, the swap seller (protection seller) will agree to pay the swap buyer (protection buyer) LIBOR plus (or minus) a spread in return for the cash flows of the risky bond (the bond itself does not change hands). In the event of default, the swap buyer will continue to receive LIBOR plus (or minus) the spread from the swap seller. In this way, the swap buyer has transformed its original risk profile by changing both its interest rate and credit risk exposure.

Due to recent scandals and questions around its validity as a benchmark rate, LIBOR is being phased out. According to the Federal Reserve and regulators in the U.K., LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates will no longer be published after Dec. 31, 2021. 

How Is the Spread of an Asset Swap Calculated?

There are two components used in calculating the spread for an asset swap. The first one is the value of coupons of underlying assets minus par swap rates. The second component is a comparison between bond prices and par values to determine the price that the investor has to pay over the lifetime of the swap. The difference between these two components is the asset swap spread paid by the protection seller to the swap buyer.

Example of an Asset Swap

Suppose an investor buys a bond at a dirty price of 110% and wants to hedge the risk of a default by the bond issuer. She contacts a bank for an asset swap. The bond’s fixed coupons are 6% of par value. The swap rate is 5%. Assume that the investor has to pay 0.5% price premium during the swap’s lifetime. Then the asset swap spread is 0.5% (6 – 5 – 0.5). Hence the bank pays the investor LIBOR rates plus 0.5% during the swap’s lifetime.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.

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Assignment: Definition in Finance, How It Works, and Examples

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Amsterdam Stock Exchange (AEX) .AS Definition

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What Is an Assignment?

Assignment most often refers to one of two definitions in the financial world:

  1. The transfer of an individual’s rights or property to another person or business. This concept exists in a variety of business transactions and is often spelled out contractually.
  2. In trading, assignment occurs when an option contract is exercised. The owner of the contract exercises the contract and assigns the option writer to an obligation to complete the requirements of the contract.

Key Takeaways

  • Assignment is a transfer of rights or property from one party to another.
  • Options assignments occur when option buyers exercise their rights to a position in a security.
  • Other examples of assignments can be found in wages, mortgages, and leases.

Property Rights Assignment

Assignment refers to the transfer of some or all property rights and obligations associated with an asset, property, contract, etc. to another entity through a written agreement. For example, a payee assigns rights for collecting note payments to a bank. A trademark owner transfers, sells, or gives another person interest in the trademark. A homeowner who sells their house assigns the deed to the new buyer.

To be effective, an assignment must involve parties with legal capacity, consideration, consent, and legality of object.

Examples

A wage assignment is a forced payment of an obligation by automatic withholding from an employee’s pay. Courts issue wage assignments for people late with child or spousal support, taxes, loans, or other obligations. Money is automatically subtracted from a worker’s paycheck without consent if they have a history of nonpayment. For example, a person delinquent on $100 monthly loan payments has a wage assignment deducting the money from their paycheck and sent to the lender. Wage assignments are helpful in paying back long-term debts.

Another instance can be found in a mortgage assignment. This is where a mortgage deed gives a lender interest in a mortgaged property in return for payments received. Lenders often sell mortgages to third parties, such as other lenders. A mortgage assignment document clarifies the assignment of contract and instructs the borrower in making future mortgage payments, and potentially modifies the mortgage terms.

A final example involves a lease assignment. This benefits a relocating tenant wanting to end a lease early or a landlord looking for rent payments to pay creditors. Once the new tenant signs the lease, taking over responsibility for rent payments and other obligations, the previous tenant is released from those responsibilities. In a separate lease assignment, a landlord agrees to pay a creditor through an assignment of rent due under rental property leases. The agreement is used to pay a mortgage lender if the landlord defaults on the loan or files for bankruptcy. Any rental income would then be paid directly to the lender.

Options Assignment

Options can be assigned when a buyer decides to exercise their right to buy (or sell) stock at a particular strike price. The corresponding seller of the option is not determined when a buyer opens an option trade, but only at the time that an option holder decides to exercise their right to buy stock. So an option seller with open positions is matched with the exercising buyer via automated lottery. The randomly selected seller is then assigned to fulfill the buyer’s rights. This is known as an option assignment.

Once assigned, the writer (seller) of the option will have the obligation to sell (if a call option) or buy (if a put option) the designated number of shares of stock at the agreed-upon price (the strike price). For instance, if the writer sold calls they would be obligated to sell the stock, and the process is often referred to as having the stock called away. For puts, the buyer of the option sells stock (puts stock shares) to the writer in the form of a short-sold position.

Example

Suppose a trader owns 100 call options on company ABC’s stock with a strike price of $10 per share. The stock is now trading at $30 and ABC is due to pay a dividend shortly. As a result, the trader exercises the options early and receives 10,000 shares of ABC paid at $10. At the same time, the other side of the long call (the short call) is assigned the contract and must deliver the shares to the long.

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Automatic Stabilizer: Definition, How It Works, Examples

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Automatic Stabilizer: Definition, How It Works, Examples

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What Is an Automatic Stabilizer?

Automatic stabilizers are a type of fiscal policy designed to offset fluctuations in a nation’s economic activity through their normal operation without additional, timely authorization by the government or policymakers.

The best-known automatic stabilizers are progressively graduated corporate and personal income taxes, and transfer systems such as unemployment insurance and welfare. Automatic stabilizers are called this because they act to stabilize economic cycles and are automatically triggered without additional government action.

Key Takeaways

  • Automatic stabilizers are ongoing government policies that automatically adjust tax rates and transfer payments in a manner that is intended to stabilize incomes, consumption, and business spending over the business cycle.
  • Automatic stabilizers are a type of fiscal policy, which is favored by Keynesian economics as a tool to combat economic slumps and recessions.
  • In the event of acute or lasting economic downturns, governments often back up automatic stabilizers with one-time or temporary stimulus policies to try to jump-start the economy.

What are Automatic Stabilizers?

Understanding Automatic Stabilizers

Automatic stabilizers are primarily designed to counter negative economic shocks or recessions, though they can also be intended to “cool off” an expanding economy or to combat inflation. By their normal operation, these policies take more money out of the economy as taxes during periods of rapid growth and higher incomes. They put more money back into the economy in the form of government spending or tax refunds when economic activity slows or incomes fall. This has the intended purpose of cushioning the economy from changes in the business cycle. 

Automatic stabilizers can include the use of a progressive taxation structure under which the share of income that is taken in taxes is higher when incomes are high. The amount then falls when incomes fall due to a recession, job losses, or failing investments. For example, as an individual taxpayer earns higher wages, their additional income may be subjected to higher tax rates based on the current tiered structure. If wages fall, the individual will remain in the lower tax tiers as dictated by their earned income.

Similarly, unemployment insurance transfer payments decline when the economy is in an expansionary phase since there are fewer unemployed people filing claims. Unemployment payments rise when the economy is mired in recession and unemployment is high. When a person becomes unemployed in a manner that makes them eligible for unemployment insurance, they need only file to claim the benefit. The amount of benefit offered is governed by various state and national regulations and standards, requiring no intervention by larger government entities beyond application processing.

Automatic Stabilizers and Fiscal Policy

When an economy is in a recession, automatic stabilizers may by design result in higher budget deficits. This aspect of fiscal policy is a tool of Keynesian economics that uses government spending and taxes to support aggregate demand in the economy during economic downturns.

By taking less money out of private businesses and households in taxes and giving them more in the form of payments and tax refunds, fiscal policy is supposed to encourage them to increase, or at least not decrease, their consumption and investment spending. In this case, the goal of fiscal policy is to help prevent an economic setback from deepening.

Real-World Examples of Automatic Stabilizers

Automatic stabilizers can also be used in conjunction with other forms of fiscal policy that may require specific legislative authorization. Examples of this include one-time tax cuts or refunds, government investment spending, or direct government subsidy payments to businesses or households.

Some examples of these in the United States were the 2008 one-time tax rebates under the Economic Stimulus Act and the $831 billion in federal direct subsidies, tax breaks, and infrastructure spending under the 2009 American Reinvestment and Recovery Act.

In 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act became the largest stimulus package in U.S. history. It provided over $2 trillion in government relief in the form of expanded unemployment benefits, direct payments to families and adults, loans and grants to small businesses, loans to corporate America, and billions of dollars to state and local governments.

Special Considerations

Since they almost immediately respond to changes in income and unemployment, automatic stabilizers are intended to be the first line of defense to turn mild negative economic trends around. However, governments often turn to other types of larger fiscal policy programs to address more severe or lasting recessions or to target specific regions, industries, or politically favored groups in society for extra-economic relief.  

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