Stock Dilution

What is dilution? 

Dilution occurs when a company issues out more shares to the public, at less than the market value of the company. So lets say that if stock XYZ is trading at $100/share, any other shares that enter the market which the company receives cash of less than $100/share will have a dilutive effect on the company's stock. So, if XYZ issues out stock options priced at $10/share to their employees, whenever those options get exercised, there will be a net dilution to the company of roughly $90/share.

Why do companies dilute their shares? 
The two primary answers involve employee stock options, and buyouts/mergers involving stock swaps.
In the case of a stock swap/merger, the larger company issues out shares in exchange for the smaller company's shares. In most cases, the company that is being bought out has a book value far less than what it is being bought out for - the dilution is the market value of the stock issued minus the book value of the acquired company. The rest is entered as "Goodwill" in the balance sheet of a company.
Everybody knows about employee stock options: They are issued to employees at some price (usually less than the market value of the company) so that employees have an incentive to work harder in order to get the company's stock price up. Both sides win - the company and the employee. Not only that, but with current accounting methods, the issuance of stock options are not considered a cost to the company. In theory, the company could just forgo any cash salaries and issue stock options. This way, the company can report higher profits, as they do not have to deduct the cash salaries to their employees.
Who really pays for the employees then when a company decides to issue stock options? The existing shareholders do when they have their ownership in the company reduced. I am not implying that stock options are bad - when a company can increase its profitability at a rate greater than the dilution, then generally speaking the dilution is acceptable by the shareholders. However, when options are issued rapidly beyond prudence, the shareholders suffer badly.

An example: Amazon

I will be looking at Amazon between July 31, 1997 and July 31, 1999. Amazon split 2:1 and 3:1 between those time periods, and I have accounted for this. I have obtained this information by looking at previous SEC filings which you can access by clicking on the two dates above.
Over this time period, what happens to somebody's ownership of the company? Lets assume that you owned 25% of Amazon on July 31, 1997. What would happen to your ownership stake in the company after two years? Also, lets just pretend that Amazon actually made $200 million a year for the trailing 12 months behind those dates, and issued it out directly to their shareholders in a dividend. This is the chart of data we get:
Date SharesOutstanding SharesOwned Ownership DividendPerShare NetDividend 
07/31/1997 143,152,212 35,788,053 25.0% $1.40 $50,000,000

07/31/1999 168,602,175 35,788,053 21.2% $1.19 $42,452,659

The result of having an extra 25,449,963 shares of Amazon has reduced your net ownership in the company by 3.8%. However, in relative terms, that turns out to be a 15.2% dilution of your previous ownership. That 15.2% turns out to cut your dividend by 15.2%. So we can learn from this that shareholders ultimately pay for dilution. In order for our hypothetical owner to continue getting his original dividend, Amazon has to make 17.9% more income in 1999 than it did in 1997.

Question: What? You just said that the shares are diluted by 15.2%, but why do you need 17.9% more income to make up for it? Don't you just need 15.2% more income? Think of this: If you buy a stock and it sinks 50%, what gain from that point does the stock need in order to break even? 

Not 50%, but 100%. The math with dilution is similar. For those mathematically inclined, if a stock is diluted by a factor of x (lets say 0.152 = 15.2%), then the profit increase has to be ((1/(1-x))-1)% in order to break even with the dilution. If a stock is diluted 50%, you need to make a 100% profit increase in order to break even with the dilution.

A question which should be asked is: So what? That investment in Amazon has appreciated nearly 21 times during those two years even though the shares have been diluted. The answer is psychological: Amazon is perceived as making even more profits in the future in the past two years, and therefore its stock price has risen in greater proportion than the dilution. The problem is nobody actually thinks that when they put down $1,000,000 in Amazon stock today (which will buy 0.00315% of the company assuming a $31.7 billion capitalization) that they will continue to own 0.00315% of the company in five years when it will allegedly become profitable. The fact is that they won't. Assuming that Amazon keeps up a 5% dilution rate for the next 5 years, that person's investment will shrink down to around 0.00246% of the company. Even if Amazon turns out to be incredibly profitable in the future, wouldn't you want to be owning the same slice you paid for it today, rather then the smaller one you will have tomorrow? Whether this has been implicitly priced in the stock is a philosophical debate.
Shareholders pay for dilution. Shareholders have to trust management that when they give up 20% of their ownership in the company, that management will be able to deliver more than 25% of a return on their investment.

Interest Rate

CRR Rate :Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive money from the banks.

Reverse Repo rate :Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money are in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system. Due to this fine tuning of RBI using its tools of CRR, Bank Rate, Repo Rate and Reverse Repo rate our banks adjust their lending or investment rates for common man.

Repo Rate : Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.
Statutory Liquidity Ratio :SLR (Statutory Liquidity Ratio) is the amount a commercial bank needs to maintain in the form of cash, or gold or govt. approved securities (Bonds) before providing credit to its customers. SLR rate is determined and maintained by the RBI (Reserve Bank of India) in order to control the expansion of bank credit.

Leverage Ratio
1. The most well known financial leverage ratio is the debt-to-equity ratio. For example, if a company has $10M in debt and $20M in equity, it has a debt-to-equity ratio of 0.5 ($10M/$20M).

2. Companies with high fixed costs, after reaching the breakeven point, see a greater increase in operating revenue when output is increased compared to companies with high variable costs. The reason for this is that the costs have already been incurred, so every sale after the breakeven transfers to the operating income. On the other hand, a high variable cost company sees little increase in operating income with additional output, because costs continue to be imputed into the outputs. The degree of operating leverage is the ratio used to calculate this mix and its effects on operating income

Sovereign Debt Default

You've heard it before: someone runs into credit card or mortgage payment problems and needs to work out a payment plan to avoid going bankrupt. What does an entire country do when it runs into a similar debt problem? For a number of emerging economies issuing sovereign debt is the only way to raise funds, but things can go sour quickly. How do countries deal with their debt while striving to grow?

Most countries – from those developing their economies to the world's richest nations – issue debt in order to finance their growth. This is similar to how a business will take out a loan to finance a new project, or how a family might take out a loan to buy a home. The big difference is size; sovereign debt loans will likely cover billions of dollars while personal or business loans can at time be fairly small.

Sovereign Debt
Sovereign debt is a promise by a government to pay those who lend it money. It is the value of bonds issued by that country's government. The big difference between government debt and sovereign debt is that government debt is issued in the domestic currency, while sovereign debt is issued in a foreign currency. The loan is guaranteed by the country of issue.

Before buying a government's sovereign debt, investors determine the risk of the investment. The debt of some countries, such as the United States, is generally considered risk free, while the debt of emerging or developing countries carries greater risk. Investors have to consider the government's stability, how the government plans to repay the debt, and the possibility of the country going into default. In some ways, this risk analysis is similar to that performed with corporate debt, though with sovereign debt investors can sometimes be left significantly more exposed. Because the economic and political risks for sovereign debt outweigh debt from developed countries, the debt is often be given a rating below the safe AAA and AA status, and may be considered below investment grade.

Debt Issued in Foreign Currencies
Investors prefer investments in currencies they know and trust, such as the U.S. dollar and pound sterling. This is why the governments of developed economies are able to issue bonds denominated in their own currencies. The currencies of developing countries tend to have a shorter track record and might not be as stable, meaning that there will be far less demand for debt denominated in their currencies.

Risk and Reputation
Developing countries can be at a disadvantage when it comes to borrowing funds. Like investors with poor credit, developing countries must pay higher interest rates and issue debt in foreign stronger currencies to offset the additional risk assumed by the investor. Most countries, however, don't run into repayment problems. Problems can arise when inexperienced governments overvalue the projects to be funded by the debt, overestimate the revenue that will be generated by economic growth, structure their debt in such a way as to make payment only feasible in the best of economic circumstances, or if exchange rates make payment in the denominated currency too difficult.

What makes a country issuing sovereign debt want to pay back its loans in the first place? After all, if it can get investors to pour money into its economy, aren't they taking on the risk? Emerging economies want to repay the debt because it creates a solid reputation that investors can use when evaluating future investment opportunities. Just as teenagers have to build solid credit in order to establish creditworthiness, countries issuing sovereign debt want to repay their debt so that investors can see that they are able to pay off any subsequent loans.

The Impact of DefaultingDefaulting on sovereign debt can be more complicated than defaults on corporate debt because domestic assets cannot be seized to pay back funds. Rather, the terms of the debt will renegotiated, often leaving the lender in an unfavorable situation, if not an entire loss. The impact of the default can thus be significantly more far-reaching, both in terms of its impact on international markets and of its effect on the country's population. A government in default can easily become a government in chaos, which can be disastrous for other types of investment in the issuing country.

The Causes of Debt Default
Essentially, default will occur when a country's debt obligations surpass its capacity to pay. There are several circumstances in which this can happen:

• During a currency crisis
  The domestic currency loses its convertibility due to rapid changes in the exchange rate. It becomes too expensive to convert the domestic currency to the currency in which the debt is issued.
• Changing economic climateIf the country relies heavily on exports, especially in commodities, a significant reduction in foreign demand can shrink GDP and make repayment costly. If a country issues short-term sovereign debt, it is more vulnerable to fluctuations in market sentiment.
• Domestic politicsDefault risk is often associated with unstable government structure. A new party that seizes power may be reluctant to satisfy the debt obligations accumulated by the previous leaders.

Debt Default Throughout History
There have been several prominent cases in which emerging economies got in over their heads when it came to their debt.

• North Korea (1987)Post-war North Korea required massive investment in order to jump start economic development. In 1980 it defaulted on most of its newly-restructured foreign debt, and owed nearly $3 billion by 1987. Industrial mismanagement and significant military spending led to a decline in GNP and ability to repay outstanding loans.
• Russia (1998)A large portion of Russian exports came from the sale of commodities, leaving it susceptible to price fluctuations. Russia's default sent a negative sentiment throughout international markets as many became shocked that an international power can default. This catastrophic event resulted in the well documented collapse of long-term capital management.
• Argentina (2002)Argentina's economy experienced hyperinflation after it began to grow in the early 1980s, but managed to keep things on an even keel by pegging its currency to the U.S. dollar. A recession in the late 1990s pushed the government to default on its debt in 2002, with foreign investors subsequently ceasing to put more money into the Argentine economy.

Investing in Debt
Global capital markets have become increasingly integrated in recent decades, allowing emerging economies access to a more diverse pool of investors using different debt instruments. This gives emerging economies more flexibility, but also adds uncertainty since debt is spread over so many parties. Each party can have a different goal and tolerance for risk, which makes deciding the best course of action in the face of default a complicated task.

Investors purchasing sovereign debt have to be firm yet flexible. If they push too hard on repayment, they might accelerate the economy's collapse; if they don't press hard enough, they might send a signal to other debtor nations that lenders will cave under pressure. If restructuring is required, the goal of the restructure should be to preserve the asset value held by the creditor while helping the issuing country return to economic viability.

• Incentives to repay
  Countries with unsustainable levels of debt should be given the option of approaching creditors to discuss repayment options without being taken to task. This creates transparency and gives a clear signal that the country wants to continue loan payments.
• Providing restructuring alternativesBefore moving to debt restructuring, indebted nations should examine their economic policies to see what sorts of adjustments can be made to allow them to resume loan payments. This can be difficult, if the government is headstrong, since being told what to do can push them over the edge.
• Lending prudentlyWhile investors might be on the lookout for diversification into a new country, that doesn't mean that flooding cash into international securities will always have a positive result. Transparency and corruption are important factors to examine before pouring money into expensive endeavors.
• Debt forgivenessDue to the moral hazard associated with letting debtor countries off the hook, creditors consider wiping a country's debt clean to be the absolute last thing that they want. However, countries saddled with debt, especially if that debt is owed to an organization such as the World Bank, can seek to have their debt forgiven if it will create economic and political stability. A failed state can have a negative effect on surrounding countries.

Conclusion
The existence of international financial markets makes funding economic growth a possibility for emerging economies, but it can also make debt repayment troublesome by making collective agreements between creditors more complex. With no strict mechanism in place to make the resolution of problems streamlined, it is important for both the sovereign debt issuer and investors to come to a mutual understanding – that everyone is better off coming to an agreement instead of letting the debt go into default.

Government bonds are usually referred to as risk-free bonds, because the government can raise taxes to redeem the bond at maturity. Some counter examples do exist where a government has defaulted on its domestic currency debt, such as Russia in 1998 (the "ruble crisis"), though this is very rare. As an example, in the US, Treasury securities are denominated in US dollars. In this instance, the term "risk-free" means free of credit risk. However, other risks still exist, such as currency risk for foreign investors (for example non-US investors of US Treasury securities would have received lower returns in 2004 because the value of the US dollar declined against most other currencies). Secondly, there is inflation risk, in that the principal repaid at maturity will have less purchasing power than anticipated if the inflation outturn is higher than expected. Many governments issue inflation-indexed bonds, which should protect investors against inflation risk.

Sensitivity Analysis

A technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that will depend on one or more input variables, such as the effect that changes in interest rates will have on a bond's price.

Sensitivity analysis is a way to predict the outcome of a decision if a situation turns out to be different compared to the key prediction(s). 

Sensitivity analysis allows decision makers to analyze the sensitivity of each program’s criteria input to the ranking of the programs. The sensitivity analysis can be performed on all programs or only those at a specific gate.

The system looks at a specific program and calculates the necessary criteria change to the inputs to move that program up or down one slot in the ranked list. The change is calculated for each criterion independently.

Changes on some criteria will not have enough impact to change the program rank, while changes to others will. Some changes could result in the program moving more than one slot because of the relationships among the criteria weights, criteria inputs, and the range of criteria input values.

The programs are marked before calculating the sensitivity. Sensitivity analysis can be used to test the impact of moving a program either up, down, or both up and down in rank. The results are displayed by criteria for each program. You can select a criterion to change and re-calculate a new ranked program list with that change.

A new approach for sensitivity analysis that enabled the decision makers to test the program rankings and re-evaluate their assessment of the programs. 

The one thing we know with absolute certainty is that the strategic financial plan is wrong. Various externalities will find a way to interrupt any long-range plan. It is therefore important to know what is the most impactful. Where must management devote its attention and endure sleepless nights? Through sensitivity analysis, one assumption at a time is adjusted and the results are summarized in Table

Credit default swap and Credit derivative

Credit default swap is the most basic form of credit derivative trade. It is constructed to transfer the credit risk of an asset without transferring ownership of that asset.
A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default.
A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities, or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative "credit event." The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. It is important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond involved in the transaction is called the "reference entity." A contract can reference a single credit, or multiple credits.
Credit derivatives are instruments that allow one party to transfer an asset's credit risk to another party without transferring ownership of the underlying assets.
Credit derivative structures such as credit default swaps, total return swaps and credit-linked notes, have become hugely popular both for managing credit risk and outright speculation.
A credit derivative is a financial instrument that allows participants to decouple credit risk from an asset (for example, a loan, bond or swap) and to place it with another party.
Credit derivatives can be structured to create a range of credit strategies for investors. For example, by combining a credit derivative with a risky bond, a credit derivative can be used to:
create a risk-free position in the assetspeculate on credit events such as the likelihood of a bond credit rating downgradeinsure against the default of emerging market sovereign debtCredit derivatives are similar to interest rate and currency derivatives in that they enable an investor to speculate on a market move without actually purchasing the underlying asset.

Terminology

Monte Carlo simulation : is used to calculate risk in business.
Potential Exposure (PE) : HOW TO GET A HANDLE ON YOUR CREDIT RISK
Expected Positive Exposure (EPE) :
Collateralized Debt Obligations (CDOs) crisis
CDS
Potential Future Exposure (PFE)
collateral management : is the function responsible for reducing credit risk in unsecured financial transactions.
MTM(Mark to Market) exposure – Money you lose if the counterparty defaults today
PVCF Potentials : Present Value cash flow potentials
DF : Disproportion factor
IR change - Market Factor
Credit Default Swaps(CDS) :A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default.CDS is similar to credit insurance
SAR
Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties.
Books :
Value At Risk Theory and Practice Glyn A. Holton
Settlement risk is the risk that a settlement in a transfer system does not take place as expected.
BookRunner :In investment banking, a bookrunner is usually the main underwriter or lead-manager/arranger/coordinator in equity, debt, or hybrid securities issuances.The bookrunner usually syndicates with other investment banks in order to lower its risk. The bookrunner is listed first among all underwriters participating in the issuance.
Debt instruments is also known as fixed income or bonds
LIBOR is the interest rate that banks charge each other for one-month, three-month, six-month and one-year loans. LIBOR is an acronym for London InterBank Offered Rate. This rate is that which is charged by London banks, and is then published and used as the benchmark for bank rates all over the world.
LIBOR is compiled by the British Bankers Association (BBA), and is published 11 am each day in conjunction with Reuters. It is comprised from a panel of banks representing countries in each currency.
DLE : Derivative load adjustments
EDF : Expected default frequency
EAD : Exposure at default (EAD)
LIED : Loss in the event of default (LIED)
Loan commitment == Sanction letter for loan
ECAI - External credit assessment institutions
CVA - credit value adjustment
DVA - Derivative value adjustment
CDO - Collateralized Debt obligations
CRA - Credit Risk Adjustment
What Does Capital Structure Mean?A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.
A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered
What Does Debt/Equity Ratio Mean?
A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.
Calculated as: Debt/Equity Ratio= Total Liabilities/Owner's Equity
Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation. Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial statements as well as companies'. A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.
If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.
What Does Debt-To-Capital Ratio Mean?A measurement of a company's financial leverage, calculated as the company's debt divided by its total capital. Debt includes all short-term and long-term obligations. Total capital includes the company's debt and shareholders' equity, which includes common stock, preferred stock, minority interest and net debt.
Calculated as: Debt-To-Capital Ratio = Debt/(Share Holder's Equity + Debt)
Companies can finance their operations through either debt or equity. The debt-to-capital ratio gives users an idea of a company's financial structure, or how it is financing its operations, along with some insight into its financial strength. The higher the debt-to-capital ratio, the more debt the company has compared to its equity. This tells investors whether a company is more prone to using debt financing or equity financing. A company with high debt-to-capital ratios, compared to a general or industry average, may show weak financial strength because the cost of these debts may weigh on the company and increase its default risk.
Because this is a non-GAAP measure, in practice, there are many variations of this ratio. Therefore, it is important to pay close attention when reading what is or isn't included in the ratio on a company's financial statements.
What Does Return On Debt - ROD Mean?1. A measure of a company's performance or net income as related to the amount of debt it has issued.
2. The amount of profit generated for each dollar that a company holds in debt.
3. A necessary factor when using the adjusted present value (APV) discounted cash flow method for valuing levered assets. The APV method is often used in a leveraged buyout as a way of valuing a firm that has a changing capital structure.
Return on debt (ROD) is a complex financial modeling skill and not a commonly used financial reporting factor.
Companies that carry significant amounts of debt relative to capital and/or assets are more at risk during an economic downturn when earnings are likely to decline and credit measures may be tightened.
What Does Swap Ratio Mean?The ratio in which an acquiring company will offer its own shares in exchange for the target company's shares during a merger or acquisition. To calculate the swap ratio, companies analyze financial ratios such as book value, earnings per share, profits after tax and dividends paid, as well as other factors, such as the reasons for the merger or acquisition.
For example, if a company offers a swap ratio of 1:1.5, it will provide one share of its own company for every 1.5 shares of the company being acquired.
This can also be applied as a debt/equity swap, when a company wants investors to trade their bonds with the company being acquired for the acquiring company's own shares.
What Does Debt/Equity Swap Mean?A refinancing deal in which a debt holder gets an equity position in exchange for cancellation of the debt. There are several reasons why a company may want to swap debt for equity. For example, a firm may be in financial trouble and a debt/equity swap could help avoid bankruptcy, or the company may want to change capital structure to take advantage of current stock valuation.
Covenants in the bond indenture may prevent a swap from happening without consent.


Amortization usually refers to spreading an intangible asset's cost over that asset's useful life. For example, a patent on a piece of medical equipment usually has a life of 17 years. The cost involved with creating the medical equipment is spread out over the life of the patent, with each portion being recorded as an expense on the company's income statement.

Depreciation, on the other hand, refers to prorating a tangible asset's cost over that asset's life. For example, an office building can be used for a number of years before it becomes run down and is sold. The cost of the building is spread out over the predicted life of the building, with a portion of the cost being expensed each accounting year.

Depletion refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well's setup costs are spread out over the predicted life of the oil well.