FM Flashcards

Question

NPV function =

Answer 1

NPV(discount rate, cell range) NOTE!! The NPV function assumes the first cell is a cash flow in year 1. To calculate the final NPV the net cash flow in year 0 will need to be included to this result.

Answer 2

The method can be summarised as follows: 1 For EACH possible economic life, calculate the NPV of a single asset cycle. 2 The NPV of each option is then converted into an 'Equivalent Annual Cost'. This is the equal annual cash flow (annuity) to which a series of uneven cash flows is equivalent in PV terms. It is calculated as: Equivalent annual cost = (PV of costs/Annuity factor) 3. LOWEST EAC wins

Answer 3

The technique assumes that:  the cost of the asset will not be subject to inflation  the operating efficiency of assets different ages will be similar – in practice, new technology and/or obsolescence will mean that regular replacement is preferred  The asset will be replaced in perpetuity or at least into the foreseeable future – in practice, products and therefore the assets required for their production usually have a finite life cycle.

Answer 4

If they are infidently divisible this means we can obtain part NPV for part investment, treat as limiting factor analysis Projects should be ranked according to the NPV earned per £1 invested in the cash-restricted period. Funds should then be applied to the projects in ranking order until they aregone.

Answer 5

These are projects where you can either do the project or not to ahcieve 100% NPV or nothing, Where projects cannot be done in part, the optimal combination can only be found by trial and error

Answer 6

NPV analysis does not take account of the strategic value of a project. A superior analysis would therefore be: Worth of a project = Traditional NPV + Value of any associated options Options would include: Follow on options-ie what a project could allow to do next each one project to porduce a product could allow production of another product in the future Abandonment options- eg considering 2 porjects one requires low resale value fixed asset investment, the other land but has a lower NPV -although it does the land presents a good abadnoment option if decide against project Timing options -E.g. A firm is looking at two projects. The first has to be started now; the second can be started at any point in the next five years. Growth options-E.g. A firm is looking at two projects, one requires a full commitment now, the other allows it to start with a small capacity but to expand later on if the market conditions are right.

Answer 7

Factors that enhance the NPV of the expected future cash flows (known as value drivers). Five that impact the size of the future cash flows: – sales and growth in sales (maximise) – margin (maximise) – investment in fixed assets (minimise) – investment in working capital (minimise) – tax (minimise). Two that impact their NPV: – discount rate (minimise) – length of time that detailed future plans are available for (maximise).

Answer 8

-Market attractiveness  For example, GDP and forecast demand in the region. -Competitive advantage  Do we have experience and understanding of this and/or similar markets? -Political risk  Is political or government action likely to affect value. This might include: – import quotas and/or tariffs – legal restrictions on products – restriction on foreign ownership – enforced nationalisation. -Cultural risk  Differences in culture and business behaviours in a foreign country.

Answer 9

– risk – quantifiable, where probabilities are known (e.g. a roulette wheel) – uncertainty – unquantifiable – outcomes cannot be mathematically predicted (most business decisions). All investors view risk differently. However, we assume in FM that investors are rational and risk averse. Risk averse means that:  investors demand an increase in return for an increase in risk or  if two projects offer the same expected return, the one with the lower risk is preferred. Even risk averse investors will have different attitudes to risk. Some will need greater levels of compensation than others for the same level of risk.

Answer 10

-sensitivity analysis -minimum payback period -prudent estimates of cash flows -assessment of best and worst outcomes -higher discount rates.

Answer 11

 discrete outcomes  subjective probabilities  ignores risk  not a possible outcome, so less applicable to one-off projects.

Answer 12

Sensitivity = the % age change in an estimate that gives an NPV of nil.

Answer 13

NPV of the whole project/NPV of the cash flows affected by the change Where corporation tax has to be considered, the principle is the same, but care must be taken to include the tax effect: Sensitivity = NPV of the whole project/NPV of the cash flows affected net of tax

Answer 14

Difference between the cost of capital and the IRR

Answer 15

Discounted payback

Answer 16

 assumes variables change independently of each other  does not assess the likelihood of a variable changing  does not identify a correct decision.

Answer 17

Monte carlo simulation, looks at many variables at once by using different factors in different quantiities thus producing a simulation environment (usually a probability distribution) Simulation can also assist with environmental risk analysis by giving more information about the impact of environmental costs on new ventures. However these can be time consuming without appropriate software or complex and can cost a lot, also requires assumptions which may be unreliable

Answer 18

predicitive eg decision trees or linear regression prescriptive is the above combined with AI and algorithms to come up with solutions based on the data analysis

Answer 19

-Selection bias – sample selection does not represent the population -Observer bias – the researcher allows their assumptions to influence the observation -Omitted variable bias – key data is not included in the analysis -Cognitive bias – the presentation of data may be misleading -Confirmation bias – people see data that confirms their beliefs and ignore other items -Survivorship bias – the sample contains only items that survived a previous event, which misses a significant part of the picture by not analysing the failures.

Answer 20

As long as the investments' return profiles differ to at least some degree, then risk will be reduced. Initial diversification will bring about substantial risk reduction as additional investments are added to the portfolio. However, risk reduction slows and becomes insignificant once 15 – 20 investments have been combined. i.e. not all risk can be eliminated by diversification.

Answer 21

The risk a shareholder faces is in large part due to the volatility of the company’s earnings. This volatility can occur because of:  Specific (or non-systematic) risk – company/industry specific factors.  Systematic risk – market wide factors such as the state of the economy. Systematic risk will affect all companies in the same way (although to varying degrees). The specific non-systematic factors will impact each firm differently depending on their circumstances. By diversifying, an investor can (almost) eliminate specific unsystematic risk, but cannot alter the systematic risk of the portfolio.

Answer 22

Because investors in listed companies are ALREADY fully diversified, they do not suffer specific risk. Therefore, in estimating their required return they ONLY need to be compensated for SYSTEMATIC risk. When directors of listed companies are making strategic decisions, they SHOULD NOT try to reduce risk for their shareholders by diversification. This is because the shareholders are already diversified and therefore cannot reduce their risk any further.

Answer 23

The CAPM is a way of estimating the rate of return that a fully diversified equity shareholder would require from a particular investment. It does this by considering the level of systematic risk of the investment compared to average. The CAPM line is given in the form of an equation: Rj = Rf + ß (Rm – Rf) where: Rj = required return from an investment Rf = risk free rate – assumed to be the rate on Treasury Bills Rm = average return on the market (Rm – Rf) = equity risk premium ß = systematic risk of the investment compared to market and therefore amount of the premium needed.

Answer 24

Estimating Rm: In practise this is usually done using historic rather than expected future returns. -Estimating Rf: Gilts are not risk free, and returns on gilts will vary with the term of the bond. -Calculation of beta: Betas are calculated using statistical analysis of the difference between the market return and the return of a particular share or industry. There is plenty of research to show that this is too simplistic a way to estimate risk, and that risk premiums are made up of multiple different factors rather than just one single ‘market’ factor. -In addition, it is important to remember that beta takes account of SYSTEMATIC risk only, and therefore assumes that shareholders are FULLY DIVERSIFIED.

Answer 25

The CAPM equation is commonly used to find the required return from a project in situations where the project has a different risk profile from the company’s current business operations. Investors will also review these results to determine which shares to invest into. If returns from a company are currently higher than the CAPM return, then investors will be attracted to these shares. This is said to have a positive alpha value, where the alpha value is calculated as the difference between the current return and the CAPM return. Note: this is likely to be a short-term issue, as the additional attraction of these returns will cause the share price to increase and hence the returns will be more reflective of the CAPM return.

Answer 26

Required return = Rf + ß (Rm – Rf) Rj = 5 + 1.2 (12 – 5) = 13.4%

Answer 27

(MVe*Ke + MVp*Kp + MVd*Kd)/(MVe+MVp+Mvd) The average return required for investors, to be used as discount factor for project appraisal etc.

Answer 28

Equity is a constant or gorwing revenue stream to pay the dividend, pref is fixed revenue stream, debt is fixed interest or repayment or interest in perpetuity for irredeemable debt

Answer 29

If the proportions of debt and equity (gearing) are NOT going to change over the life of the project. If the gearing changes, then the WACC itself will change – and another approach (the APV approach, described in Chapter 6) is used. -If the level of risk is NOT going to change. The company’s current ke is dependent on the current level of risk the shareholders are suffering – which will depend on the type of business that the company is in. If the new project is in a different business sector to the existing operations, then the level of risk (and therefore the ke) may be different. In Chapter 6 we will see how the CAPM is used to calculate ke in this situation. -If the finance is NOT project-specific. The WACC utilises several different types of finance in order to calculate an average. If we use only one method of finance to invest in the project, then an average is not required and we will need to use an alternative approach, such as APV (chapter 6).

Answer 30

 A perfect market is operating to ensure that the share price is the present value of the future dividends discounted at ke. (In practise this will only be true if the shares/debentures are listed).  Dividends are paid only once a year (and either have just been or are just about to be paid. (In practise, a company will often pay interim dividends). Dividend growth is expected to be reasonably constant and predictable (In practise dividends may be non-existent or at best erratic).  If using historic dividends to predict growth – then we are assuming that the past is a good guide to the future (If circumstances change – for example the company getting a listing, this may not be true).  If using the earnings retention model to predict growth we are assuming that both the rate of return and the retention rate will remain constant over time (again, this may not be true if circumstances change).

Answer 31

Ideally we should only be using permanent long term sources of finance in the calculation of WACC (equity, prefs, debentures, loans), but arguably, some companies use overdrafts, leasing and even trade creditors for finance over long periods of time. Although we would not conventionally include these as part of our WACC calculation, there is no doubt that they could affect the true cost of capital. Calculating a WACC for a small, unquoted company is very difficult, because there are no market values to obtain accurate returns and the small size usually results in more expensive finance.

Answer 32

(D0*(1+g))/P0 + g eg A company has just paid a dividend of 20p. The company expects dividends to grow at 7% in the future. The company’s current cost of equity is 12%. Calculate the market value of the share. 20*1+0.07/P0 +0.07=12% therefore P0=(20*1.07)/(0.12-0.07)=428p=£4.28

Answer 33

Ke=D*(1+g)/P0 + g =10*(1.05)/1.05 +0.05 =15%

Answer 34

that is is the ex rights price (immediately following a dividend) Therefore in exam if given cum div price need to adjust to get the ex div price by removing the dividend from the cum div price

Answer 35

15p*(1.06)/(125-15) + 0.06=20.5%

Answer 36

Historic method , using excel can be calc as: g =POWER (most recent value/oldest value, 1/number of periods of growth) – 1 or g= (D0/Dn years ago)^1/n - 1 Gordons growth model : g=r*b r is ARR b is earnings retention rate

Answer 37

g= r*b Where: r is the ARR ie earnings/opening shareholders funds b is earning retention rate ie retained profit for the year/earnings

Answer 38

A perfect market

Answer 39

D/P0 as they dont grow over time eg A company has 50,000 8% preference shares in issue, nominal value £1. The current ex-div market value is £1.20/share. What is the cost of the preference shares? Kp=D/P0=8/120=6.7%

Answer 40

That current price=Present value of the expected future income discounted at the investor’s required return holds true for debt as well as equity. However, the income stream from the investment depends on whether the debt is irredeemable or redeemable. Note: if a price has been given as cum-interest or interest is ‘due to be paid shortly’ then the interest should be deducted from the market price to give the ex-interest price. For irredeemable debt the assumption becomes: price of debenture=Present value of the future interest stream received in perpetuity discounted at the investor’s required return

Answer 41

r=i/P0 where i is annual interest starting in one years time r = debt holders’ required return, (known as the 'yield') We therefore get Kd by factoring in tax shield that comes from debt finance therefore formula becomes Kd=(i*(1-T))/P0

Answer 42

Kd=i*(1-T)/P0 5%*(1-25%)/40=9.4%

Answer 43

There isnt one! Because the cash flows are not a simple perpetuity – there is no simple formula to calculate the NPV or the IRR for us. Instead we have to go back to basics and calculate the NPV or the IRR longhand.

Answer 44

=PV(investor’s required return, number of time periods, interest value, redemption value) eg A company has in issue 12% redeemable debt with 5 years to redemption. Redemption will be at par. The investors require a gross yield of 10%. What is the market value of the debt? =PV(0.1, 5, -12, 100)

Answer 45

=RATE (number of time periods, interest payment, market value, redemption value) OR =IRR(cash flows) Both of these functions provide the same answer, which is the average return per year for the investment.

Answer 46

a) Yield is rate= (5, 6, -80, 110)=13.3% b) Therefore Kd=I(1-T)/P0 =13.3%*(1-25%)=9.9%

Answer 47

=RATE (number of time periods, interest payment, market value, redemption value) Where: Number of time periods = 5 years × twice a year = 10 Interest payment= 4% × 6/12 = 2% Market value = £90 Redemption value = £100 =RATE(10, 2, -90, 100) = 3.2% This is a 6-month rate and needs to be converted to an annual rate: Annual rate = 3.2% × 2 = 6.4%

Answer 48

6 month Yield =RATE(10,3,–80,110) = 6.5% Number of periods has changed to 10 because interest is paid every 6 months for a total of 5 years, giving 10 interest payments overall. The interest of 6% is being paid in 2 intervals during the year – giving an interest payment of £3 per £100. To convert this to an annual yield: 6.5% × 2 = 13%

Answer 49

Bank and other non-tradable fixed interest loans simply need to be adjusted for tax relief  Cost = interest rate × (1 – T)

Answer 50

Organic growth is achieved through internally generated projects whether funded with retained earnings or new finance. Pros: Organic growth rather than acquisition: – spreads costs – no disruption. Cons – risk – slower – barriers.

Answer 51

Treat as redeemable debt with the following adjustment: -compare the redemption value with the value of the conversion option – select the higher of the two values as the amount to be received at tn – find the internal rate of return of the cash flows.

Answer 52

Businesses may combine to achieve: – synergy – risk reduction – reduced competition – vertical protection.  An acquisition may be considered successful if it increases shareholder wealth, i.e. if: – the additional cash flows exceed the cost of acquisition and/or – overall risk reduction is achieved. Disadvantages of growth by acquisition  Synergy is not automatic; it must be pursued  Restructuring costs following the acquisition may be significant  Buying company may end up paying more in terms of both price and fees than it gains in synergistic benefits.

Answer 53

-How desperate is the seller to sell – do they have any other potential buyers? -How desperate is the buyer to buy – do they have anything else to spend their money on? -If the target company is listed, what is the existing share price? -Is the consideration to be paid in cash or shares? (see below) -Is the purchase of a controlling interest? (in which case a premium might be paid). As well as practical factors such as: -Are key employees or key clients likely to leave after the acquisition? (thus reducing the value of the target).

Answer 54

-Asset valuation ie NRV or replacement cost -income based approaches ie dividend, earnings EBITDA cash flwo

Answer 55

The value of intangibles not included on the balance sheet will be missed (for example the value of staff, client relationships, brand value etc.). The specific valuation of digital assets is outside the scope of the Financial Management exam, but it is important to note that these assets can be very valuable and are not taken into account in the traditional asset based valuation.

Answer 56

normally used on minority share interest The value is simply the present value of the future expected dividend payments discounted at ke: rearrnage the formula for ke we get PV=(d*(1+g))/(ke-g) can also use dividend/yield if have estimate for yield based on similar companies as a simplified version

Answer 57

 Estimating future dividends  Finding similar listed companies  If ke is estimated by using the CAPM, or by looking at other quoted companies, then a private company valuation will need to be adjusted downwards to reflect the lack of marketability.

Answer 58

This is commonly used to value controlling interests, as the investor can control dividend policy and could therefore extract all of the earnings from the company as dividends if they wanted to. There are two key methods for earnings based valuations and both are simply a multiple of the relevant earnings for an investor.

Answer 59

 If earnings have been erratic, then the latest earnings figure may be misleading  Accounting policies can be used to manipulate earnings figures (although the EBITDA multiple attempts to reduce this manipulation)  Finding appropriately similar listed companies  A private company valuation will need to be adjusted downwards to reflect the lack of marketability

Answer 60

Equity value = Earnings × PE ratio  Earnings are taken as profit after tax and preference dividends, but before ordinary dividends  The PE ratio is generally found by looking at the PE ratios of a range of similar listed companies  A high PE ratio implies a high level of investor confidence that earnings will grow strongly  A low PE ratio implies the opposite. Therefore, it is important to select a PE ratio from listed companies that have similar growth expectations to the target.

Answer 61

Enterprise value = EBITDA × EBITDA multiple  This valuation gives us the Enterprise value, rather than just the value of equity -Enterprise value = market value of equity + preference shares + Minority interest + debt – cash and cash equivalents And so, if we are looking for the market value of equity only, we need to deduct the market value of other types of finance and add back cash and cash equivalents. -An EBITDA multiple indicates how long it would take for an acquisition to earn enough to pay off its cost and so a high valued company will have a high multiple  As with the PE multiple, in an exam question it is important to use a multiple that is not of the company you are valuing, otherwise it doesn’t give us a useful valuation.

Answer 62

The value is calculated by estimating the post-tax operating cash flows of the target company to infinity and discounting at the investing companies WACC. (Normally a detailed cash flow forecast is done for the next few years and then a simplifying assumption is made about cash flows from that point to infinity). Therefore, the value is calculated as: PV of cash flows to infinity, discounted at WACC-MV of debt=equity If the company holds any investments, then the value of these must be added separately. This is theoretically the best approach, however it may be difficult to estimate the future cash flows and the relevant discount rate.

Answer 63

One common way of estimating the cash flows to infinity is to use estimates of the seven value drivers of shareholder value analysis listed earlier. The value drivers are estimated for the competitive advantage period (normally three or five years) and then an assumption is made about cash flows from that point to infinity. As for normal cash flow valuation, the value calculated will be debt plus equity, therefore the value of debt must be deducted.

Answer 64

Valuing start-ups and technology companies is complicated due to a number of challenges, such as no profits, unknown competition or the volume of digital assets. Possible approaches  Asset method – This can be difficult to apply because the value of tangible assets may not be high. Value could be assessed by estimating how much it would cost an investor to create the assets of the company from scratch, including R&D etc.  Earnings method – There may be no earnings in the early years, or suitable PE ratio to apply. Therefore, this is not a suitable method.  Dividend method – It is unlikely that a dividend will be paid and so this method is not appropriate.  Market multiples – It is possible to use ratios based on other valuations of similar companies. However, it may be difficult to find a similar company, or the stock market may have over-valued that sector.  Discounted cash flow – This is likely to be the most valid approach. Different scenarios and cash flows could be modelled based on companies with a similar business model. Cash flows should be discounted at a risk adjusted discount rate.

Answer 65

Pros:  the buyer gets full control of the target as well as full entitlement to future profits  in addition, the seller may prefer this method, as they receive a certain, unconditional amount. Disadvantages  the buyer will have to find the cash from somewhere  also, the seller’s expertise may be lost from the business as there is no motivation for them to stay to ensure the success of the new venture  capital gains tax liabilities arise immediately.

Answer 66

Advantages  no need to fund a cash payment  also, the seller is motivated to stay to work for the success of the combination  CGT effects are deferred. Disadvantages  control is diluted and future profits will be shared with the seller.

Answer 67

 this has the advantages of a cash payment without the need to find immediate finance  the buyer will of course have to pay interest on the debt until it is redeemed.

Answer 68

 raising cash  lack of fit  diseconomies of scale  cheaper than liquidation.

Answer 69

Once the decision to sell a subsidiary has been made, it may be sold to:  the existing management (an MBO) – this can be difficult to finance and often involves the use of junk bonds or mezzanine debt  an external management team (an MBI)  another established business (a trade sale).

Answer 70

Where shares in a subsidiary company are ‘given’ to the shareholders of the parent in proportion to their shareholdings. Thus a group of companies are split into two separately held entities. No cash changes hands. Reasons for a spin off might include:  lack of fit  diseconomies of scale  forced division due to a competition commission ruling.

Answer 71

Reasons for a repurchase from shareholders in proportion to their holdings would be:  to reduce the level of equity and therefore increase gearing  to get unused funds back into the hands of the shareholders  to maintain EPS following divestment. Reasons for a share repurchase from a single shareholder might be:  to provide an exit route for an investor  to take a listed company off the market and back into private ownership.

Answer 72

Where creditors (normally banks or bond holders) give up their debt in return for an equity stake in the company. This generally happens if a company is in trouble and is unable to pay the interest and/or repayment on its debt. The lenders COULD force the company into liquidation – but that way, they might get nothing at all. By taking equity and allowing the company to continue, they might feel they stand a better chance of a decent return. Often the shareholders will lose a significant amount of control as a result.

Answer 73

Where a company is wound up, and its assets passed out to its shareholders (although before any assets can be passed to shareholders, all creditors must be paid in full). A company may be forced into liquidation by its creditors because it can’t pay its debts. In this situation, the shareholders are very unlikely to receive anything from the liquidation. Alternatively, a solvent company may be put into liquidation simply because its shareholders wish to wind up the company and take their money.

Answer 74

A forward is a binding agreement to buy or sell (or borrow or lend) something in the future at a price agreed today. It is a tailor-made agreement between two parties and therefore can be for any amount of any product at any point in time. Because a forward is a tailor-made agreement between two parties, and requires the physical delivery of the goods (or money), it can be awkward to cancel if the need arises.

Answer 75

Futures are just forward contracts that have been standardised (in terms of delivery date and quantity). The contract which guarantees the price (known as the futures contract) is separated from the transaction itself, allowing the contracts to be easily traded.

Answer 76

Purchase for 1.6k futures contract, actual price is 1700 therefore save 100

Answer 77

When futures contracts are entered into, a deposit known as the initial margin must be made to the futures exchange. This deposit is refunded when the contract is closed out. The initial margin should cover any potential losses from the first day’s trading. Any further losses must be covered by topping up this account, known as a variation margin. This process is known as marking to market.

Answer 78

An option gives the right but not the obligation to buy or sell (or borrow or lend) a specific quantity of an item at a predetermined price (the exercise price) within a stated period (American-style) or on a fixed date (European-style). Options can therefore be:  exercised if the exercise price is better than the spot rate  abandoned if the exercise price is worse than the spot rate. In order to be given the option, the buyer pays a fee (known as an option premium) to the writer of the option. An option to buy something (or to lend money) is known as a call option. The option to sell something (or to borrow money) is known as a put option. OTC: Like a forward, this is a tailor-made agreement between two parties. It can be for any amount, or any date.

Answer 79

An option to buy something (or to lend money) is known as a call option. The option to sell something (or to borrow money) is known as a put option.

Answer 80

In a similar way to futures being a standardised version of forwards, the standardised version of an OTC option is known as a traded option. As for futures, the options contract is separated from transaction itself allowing the contracts to be easily traded.

Answer 81

a) Premium of 30 always paid 1600 exercise price on august a) price is 1700 which is higher therefore do exercise the option, total price is prem of £30 and £1600 for options=£1630 b) price is less therefore do not exercise the option, total paid is 1550+30 prem=£1580

Answer 82

-pooling of assets and liabilities ie risks may be netted off where both assets and liabilities are subject to interest rate risk. -forward rate agreements (FRAs) - interest rate futures - interest rate options - interest rate swaps.

Answer 83

 Rounding the number of contracts If the transaction is not an exact number of contracts, then the number of contracts must be rounded to the nearest whole number. This will mean that an element of risk remains.  Closing out before the expiry date If the transaction occurs (and the future is closed out) before its expiry date, the futures price may not exactly match the spot rate at the date it is closed out. This difference (known as basis risk) will mean that the hedge is again, imperfect. (You will not need to calculate basis risk in the exam, but you may be asked to identify it or explain what it is.)

Answer 84

An FRA is a commitment to an interest rate on a future loan - like a future, the contract which guarantees the interest rate is separate to the underlying loan transaction The working of an FRA  Imagine a company has a requirement to borrow money in the future. To offset the risk of an interest rate rise, the company enters into an FRA. – The capital amount is borrowed and interest is paid on the loan in the normal way – if the interest is greater than the agreed forward rate the bank supplying the FRA contract pays the difference to the company – if the interest is less than the agreed forward rate the company pays the difference to the bank supplying the FRA. The outcome  The company ends up suffering a fixed rate of interest.

Answer 85

 ‘5 – 8 FRA’ – An FRA on a notional three-month loan/deposit starting in five months’ time  ‘An FRA priced at 3.2 – 2.6’ – would effectively fix borrowing cost at 3.2% or investment return at 2.6% - bank always wins!  ‘Selling an FRA’ fixes the interest received on a deposit  ‘Buying an FRA’ fixes the interest paid on a loan.

Answer 86

Need to buy FRA as need capital, so buy 2 - 5 FRA, as this is 5% as paying interest 5%*8m *3/12 a) if market rate becomes 7% then bank pays 2%*8m back to company *3/12 b) if goes to 4% then still pay 5% *3/12 pay a fixed rate, FRAs fix therefore protect against risk but also wont allow for benefiting from favourable movement

Answer 87

These operate in a very similar way to FRAs, however they are for standardised amounts, starting on predetermined dates. The working of an IRF:  Imagine a company intending to borrow money in the future. To offset the risk of an interest rate rise, futures contracts will be sold to guarantee the rate of borrowing. – The capital amount is borrowed on the open market and interest is paid on the loan in the normal way – If interest rates rise, the more expensive cost of borrowing is offset by a profit on the futures contract – If rates fall, the fall in the cost of borrowing is offset by a loss on the futures contract. The outcome  The company ends up suffering a fixed rate of interest.

Answer 88

 100-i --- Interest rate futures are quoted at ‘100 – the expected market reference rate’ as a percentage (i.e. 95.5 would imply an interest rate of 4.5%)  Selling a futures contract fixes the interest paid on borrowing  Buying a futures contract fixes the interest received on deposits.

Answer 89

5% as 100-i, selling as borrowing if at exp it is 6.5% then essentially saved 1.5%*3/12*1m=3750 so would pay 6.5%*3/12*1m then deduct 3750 to get net cost

Answer 90

The number of contracts required must cover:  the size of the loan/deposit  the length of the loan/deposit. Number of contracts = Loan or deposit amount/Contract size × Loan or deposit period in months/3 months

Answer 91

3m/1m*6months/3 months =6 contracts required Want to deposit so buying futures. at interest of 94.5 means 5.5% on deposit thus 3m*6/12*5.5%=82.5k rates fall to 5% therefore profit from buying 5.5% futures is 0.5% would acc receive 5% initally thus 3m*6/12*5.5% (thus 7500 loss) However, when this will be netted off by the gain when the position is closed out by selling 6 June futures: 6*1m*3/12*0.5% (ie by the profit/gain) oer futures contract.

Answer 92

An interest rate option gives the buyer the right, but not the obligation, to borrow/lend at an agreed interest rate at a future date. An interest rate guarantee is a term for an interest rate option which hedges the interest rate for a single period (less than one year). These are also called short term interest rate caps (put option) or short term interest rate floors (call option). Over the counter interest rate options: These are tailor made agreements between two parties, that give the party buying the option, the right but not the obligation to borrow (put option) or lend (call option) at a fixed rate. Like all options, they require a premium to be paid up front, regardless of whether the option is exercised or not.

Answer 93

i) pay premium of 0.3% regardless so : 0.3%*4/12*10m if spot is 4% then this is worse than 5% therefore should exercise the option thus 5%*4/12*10m earned less 0.3% prem =net interest receieved ii) 5% is the same so doesnt really matter if exercise or not as still have to pay premium and thus remove from 5%*4/12*10m interest earnt iii) 6% hgihers therefore shouldnt exercise so 6%*4/12*10m less the 0.3%*4/12*10m premium paid

Answer 94

These are in fact options on interest rate futures. They give the holder the right to buy (call option) or sell (put option) one futures contract on or before the expiry of the option at a specified price (known as the strike price). The working of a traded interest rate option  Imagine a company is intending to borrow money in the future. To offset the risk of an interest rate rise, the company buys a put option (i.e. the right to sell) on a futures contract. – The capital amount is borrowed on the open market and interest is paid on the loan in the normal way. – If interest rates rise, the option is exercised, therefore the more expensive cost of borrowing is offset by a profit on the futures contract. – If rates fall, the option is allowed to lapse and the company therefore benefits from a cheaper cost of borrowing. The outcome  The company ends up with an interest rate no higher than the guaranteed maximum – but which could be lower if rates fall.

Answer 95

The choice of put or call options depends on whether the company plans to borrow or invest in the future:  intention to borrow – purchase put options  intention to invest – purchase call options.

Answer 96

Intrinsic vallue and time value intrinsic: The difference between the exercise price of the option and the current market value of the product. An option with intrinsic value is known as 'in the money' (that is, if it were to be exercised today, a profit would be made). An option which is out of the money has no intrinsic value. For example, if a share has a market price of £5 then a call option of £4.50 would have an intrinsic value of 50p (£5 – £4.50). time value: The difference between the actual premium and the intrinsic value. Time value of a call option increases with:  time to expiry  volatility of the underlying share  interest rates (since the present value of the exercise price decreases). For example, if the above call option had a premium of 75p then 50p would be the intrinsic value leaving 25p as the time value.

Answer 97

 time to expiry  volatility of the underlying share  interest rates (since the present value of the exercise price decreases).

Answer 98

Forward/future  Eliminates risk completely  No downside risk, but no upside potential  If the underlying transaction falls through, the business is re-exposed to risk. Option  Downside risk is eliminated  Upside potential is retained  If the underlying transaction falls through, there is still no risk. Therefore, more flexible than a forward; but  more expensive.

Answer 99

OTC  Can be for any amount and any date  Tend to be more expensive unless for large amounts. Standardised  Only set dates and amounts, therefore may not provide a perfect hedge  Can be closed out easily if the underlying transaction falls through.

Answer 100

a) Wishes to borrow so need to purchase a put futures for 97 thus 3% 3%*2m*3/12 +5%*3/12*100k if you 4.2 contracts needed - imperfect hedge - just buy 4 b) 5% therefore as agreed to 3% would benefit from not having increased interest rate THUS 2% profit on hedge, however because its an imperfect hedge only covering 2m the other 100k is left unhedged thus suffers the 5% rate, the effective rate is therefore the 3%*2m*3/12+5%*100k*3/12=3.1% c) Effective interest rate = 17,300/2,100,000 × 12/3 = 3.3% note the difference here is due to the spot now being 5.2% not 5% as it wouldve been if closed out at expiry, the profit on the future would still be 2% as this was committed to ie 97 futures and in both cases futures price is then 95 In addition to the 100k of borrowing that was unhedged, this time there is further inefficiency. Basis risk of 0.2% (the difference between the spot rate and the futures price at the date the contract was closed out (5.2-5%) has increased the cost of borrowing.

Answer 101

An agreement whereby two parties agree to swap a floating stream of interest payments for a fixed stream of interest payments and via versa. There is no exchange of principal. The companies involved are termed ‘counter-parties’ The scenario One company (A) will want to borrow at a fixed rate, but has been offered a relatively good deal on a variable loan. Another company (B) will want to borrow at a variable rate, but has been offered a relatively good deal on a fixed rate loan. Instead of the companies' borrowing as they want to:  A will borrow at a variable rate and B will borrow at a fixed rate.  B will make a variable interest payment to A and A will make a fixed interest payment to B – thereby the companies effectively swap interest payments.

Answer 102

In order to calculate the payments required from A to B and vice versa, a 3 step process needs to be followed: 1 Establish the total benefit to be gained from the swap (the reduction in the total interest rate paid by doing the swap) 2 Establish the final rates that can be achieved by each party, by splitting the benefit between them (equally unless told otherwise) 3 Establish the payments between the parties that will achieve this result.

Answer 103

 Swaps can be used to hedge against an adverse movement in interest rates. Say a company has a $200m floating loan and the treasurer believes that interest rates are likely to rise over the next five years. The treasurer could enter into a five-year swap with a counter party to swap into a fixed rate of interest for the next five years. From year six onwards, the company will once again pay a floating rate of interest.  A swap can be used to obtain cheaper finance. A swap should result in a company being able to borrow what it wants at a better rate under a swap arrangement, than borrowing it directly itself.  Swaps can run for up to 30 years – therefore preferable to futures for long term borrowing.  Transaction costs involved in a swap may be cheaper than costs involved in refinancing.

Answer 104

 Counterparty risk (the risk the counter party will default)  Market risk (the risk of an adverse movement in interest or exchange rates)  Transparency risk (the risk that the accounts may be misleading).

Answer 105

Without swap A goes for 7% fixed B goes for 2% + SONIA =9% + SONIA With swap A goes for 3% + SONIA B goes for 4% fixed =7% + SONIA Therefore benefit is 2% which needs splitting equally between the companies hence A must end up paying 6% (7% without swap less 1% benefit) B must end up paying 1% + SONIA as less 1% benefit if A takes 3% + SONIA B takes 4% fixed to get 6% B must pay SONIA and A must pay 3% to B to get to what they should have with 1% benefit

Answer 106

An index future is a futures contract whose value depends on the value of the FTSE100 Index. The working of an index future Imagine a company has a portfolio of shares which it will need to sell in the future. To protect against a fall in the market, the company will sell index futures. Later on, the portfolio is sold on the open market and the futures position is closed out (the futures contracts are bought back). If the market has fallen, the loss in value of the portfolio is offset by the profit on the futures contract. If it has risen, the increased value of the portfolio is offset by a loss on the futures contract. The outcome Regardless of what happens to the FTSE100, the company receives a guaranteed value for its portfolio.

Answer 107

Index futures are quoted in 'points' (just like the stock market index). The contract size is always equal to the futures price × £10 (i.e. if the futures price stands at 4,500 points, then each futures contract will cover a value of £45,000).

Answer 108

An index option is an option to buy (call) or sell (put) a notional portfolio of shares whose value mirrors the FTSE Index. The working of an index option Imagine a company has a portfolio of shares which it will need to sell in the future. To protect against a fall in the market, the company will buy put options on index futures. Later on, the portfolio is sold on the open market. If the market has fallen, the option will be exercised and the loss in value of the portfolio is offset by the profit on the futures contract. If it has risen, the option is allowed to lapse and the company benefits from the increased value of the portfolio. The outcome The company ends up with a minimum price for its portfolio – but this could be higher if the stock market rises more than expected.

Answer 109

a) Sells its portfolio on 30th June when FTSE 100 and futures price is 5290 Therefore must sell index futures, needs to protect 300k thus 300k/52000=5.77 thus need 6 contracts rounded if sell at 5200 futures contract and then futures price becomes 5290 There is an increase of 317400 for portfolio less 90*6*10=5400 loss on futures contracts =£312,000 b) portfolio now 294,000 still have 5200 but now 4950 means 2500*6=15000 gain on portfolio thus =309,000 net position.

Answer 110

An index option is an option to buy (call) or sell (put) a notional portfolio of shares whose value mirrors the FTSE Index. The working of an index option Imagine a company has a portfolio of shares which it will need to sell in the future. To protect against a fall in the market, the company will buy put options on index futures. Later on, the portfolio is sold on the open market. If the market has fallen, the option will be exercised and the loss in value of the portfolio is offset by the profit on the futures contract. If it has risen, the option is allowed to lapse and the company benefits from the increased value of the portfolio. The outcome The company ends up with a minimum price for its portfolio – but this could be higher if the stock market rises more than expected.

Answer 111

wants to sell so need to get put options and june so prem is 146 (as at 5100 FTSE) 800k portfolio wants to protect , 800k/51k=16 contracts in june at sale worth 828k then less prem of 1460*16 contracts if it then stands at FTSE 1580 it has fallen by 20 points therefore do not exercise option sell price: 1500 buy price: 1580 hence loss therefore net is £804,640

Answer 112

Transaction risk is the risk that an exchange rate will change between the transaction date and the subsequent settlement date i.e. it is the gain or loss arising on conversion. It arises primarily on imports and exports.  For example, a firm enters into a contract on 1 January to buy a piece of equipment from the US for $300,000. The invoice is to be settled on 31 March.  The exchange rate on 1st January is $1.6/£ therefore the firm expects the cost to be £187,500.  However, by 31st March, the pound may have – strengthened to $1.75/£ in which case the cost will have fallen to £171,429 or – depreciated to $1.45/£ in which case the cost has risen to £206,897.

Answer 113

Economic risk is the variation in the value of the business (i.e. the present value of future cash flows) due to unexpected changes in exchange rates. It is the long-term version of transaction risk.  For an export company it could occur because: – the home currency strengthens against the currency in which it trades – a competitor’s home currency weakens against the currency in which it trades.  A favoured, but long term solution, is to diversify all aspects of the business internationally

Answer 114

The product was previously selling at £16 × 1.56 = €24.96 After the movement in exchange rates the exporter has an unhappy choice: Either they must  raise the price of the product to maintain their profits: £16 × 1.71 = €27.36, but risk losing sales as the product is more expensive and less competitive, or  maintain the price to keep sales volume but risk eroding profit margins. (€24.96 ÷ 1.71 = £14.60 sales revenue). The exporter is facing economic risk.

Answer 115

Where the reported performance of an overseas subsidiary in homebased currency terms is distorted in consolidated financial statements because of a change in exchange rates. Note: This is an accounting risk rather than a cash based one.

Answer 116

Banks dealing in foreign currency quote two prices (a ‘spread’) for an exchange rate:  a lower ‘offer’ price  a higher ‘bid’ price. E.g. a dealer might quote a price for US$/£ of 1.4325 – 1.4330.  The lower rate, 1.4325, is the rate at which the dealer will sell the variable currency (US dollars) in exchange for the base currency (sterling).  The higher rate, 1.4330, is the rate at which the dealer will buy the variable currency (US dollars) in exchange for the base currency (sterling). The bank will always trade at the rate that is more favourable to itself.

Answer 117

Company A would get 1.4325 as it is lower Company B would get 1.4330 as it is higher 100k/1.4325=69808, 100k/1.4330=69783 ie company A would have the lower rate as will need to pay more £ to get dollars and b wants to sell dollars so use higher rate to get a smaller conversion to £ think always demoniator if you rearrange

Answer 118

-Invoice in home currency (however this transfers risk to the other party and may not be commercially acceptable) -Leading and lagging: If an exporter expects that the currency it is due to receive will depreciate over the next few months it may try to obtain payment immediately (i.e. leading). This may be achieved by offering a discount for immediate payment.  If an importer expects that the currency it is due to pay will depreciate, it may attempt to delay payment (lagging).  This may be achieved by agreement or by exceeding credit terms.  NB: Strictly this is NOT hedging – it is speculation – betting on the exchange rate changing in your favour! -Matching-When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other. It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions. -foreign currency bank accounts:  Where a firm has regular receipts and payments in the same currency, it may choose to operate a foreign currency bank account  This operates as a permanent matching process  The exposure to exchange risk is limited to the net balance on the account

Answer 119

Forward rates are quoted as a premium or a discount on the spot rate. Discount more $ per £ therefore depreciated Premium less $ per £ therefore appreciated An arrangement fee may be required to access the forward contract

Answer 120

Receive dollars and then converting to £, so higher rate as will get less £ therefore 1.4535, 0.25 cents discount 400,000 1.4535+0.003=1.4565 =£332,364

Answer 121

Instead of hedging currency exposure with a forward contract, a company could use the money markets to lend or borrow, and achieve a similar result. Hedging a payment  buy the present value of foreign currency amount today at the spot rate: – this is like the firm making an immediate and certain payment in sterling – and may involve borrowing the funds to pay earlier than the settlement date  the foreign currency purchased is placed on deposit and accrues interest until the transaction date  the deposit is then used to make the foreign currency payment.

Answer 122

Make payment of dollars in 3 months time so need to exchange £ for $, therefore need rate that will give least amount of $ per pound using a forward 3 month: $/£=1.6902 is lowest rate so use that in 3 months time its actually 1.7 but agreed to forward so need to pay above rate regardless hence sterling payment is: 450k/1.6902=£266,240 using money market hedge: now deposit rate 3 months $444,444 <<< 1+ 3/12*US 5% 450k$ Immediately convert at spot 1.7 £261437 >>>> using sterling borrowing rate 7.5% convert > £266,338 forward is marginally cheaper

Answer 123

 If you are hedging a receipt, borrow the present value of the foreign currency amount today – sell it at the spot rate – this results in an immediate and certain receipt in sterling – this can be invested until the date it was due  the foreign loan accrues interest until the transaction date  the loan is then repaid with the foreign currency receipt.

Answer 124

Forward contract expecting 900k$ so using 6 month forward rate and will be converting into £ so $/£=1.6944 will give least amount of £: 900k/1.6809=£535427 Using money hedge: Due to receive the $ so need £ now 6 months $871671 < loan US rate < 900k Convert at spot 1.704 511,544 <<

Answer 125

Whether to buy or sell futures contracts depends on whether the contract is denominated in sterling or the foreign currency. The examiner will give you contracts denominated in sterling, therefore the decision will depend on what you will be doing with sterling. If a company is going to be buying currency in the future, then it will be SELLING sterling. It therefore needs to SELL sterling contracts. If a company is going to be selling currency in the future, then it will be BUYING sterling. It therefore needs to BUY sterling contracts

Answer 126

As usual, this will be the transaction amount divided by the contract size. However, when using sterling contracts, the contract size will be in £ but the transaction amount will be in currency. Therefore, you will need to convert the transaction amount into £ first (using the futures price).

Answer 127

If using sterling contracts, the futures prices will be given as currency per £ (e.g. $/£), therefore the profit or loss on the future will end up in the foreign currency and will need to be translated at the spot rate on the transaction date. This will also be the case with the premium on an option (see below). Because a premium is paid up front, it must be translated at the current spot rate.

Answer 128

140k/1.40=£100k now /50k=2 contracts now it is 1.32 so buy 140k euros = £106060 Close out the future: Sell price 1.4 Buy price 1.32 Profit 0.08 *2*50k =8000 into £ /1.32=(6060) =£100,000

Answer 129

Cryptocurrency is a digital currency that uses cryptography to make sure payments are sent and received safely. They can be useful for transactions involving foreign currency, as both parties can agree to settle the transaction with a cryptocurrency, such as Bitcoin (BTC) rather than using foreign currency hedging techniques. However, this presents two key problems:  Exchangeability – can only exchange for a narrow range of major currencies.  Price volatility – cryptocurrency exchange rates are extremely volatile. However, there are opportunities to hedge this risk. Forward contracts are tailored to the individual and allow a business to hedge the value of a cryptocurrency in advance. A spread of rates will be quoted in the exam and it is important to select the correct rate for the transaction. As with foreign currency rates, the bank will always offer the least attractive rate for the business other methods too eg futures

Answer 130

Bitcoin futures are standardised contracts (standard amounts and dates) that can be traded on an exchange, to protect against future changes in the value of Bitcoin. Whether to buy or sell For a payment in Bitcoin, the company is concerned the price of Bitcoin will rise and make the purchase of the required Bitcoin more expensive = BUY futures today. For a receipt in Bitcoin, the company is concerned the Bitcoin price will fall and therefore receive less from exchanging Bitcoin = SELL futures today. Number of contracts Bitcoin futures are in a standardised size, such as 5 Bitcoin. The number of contracts will be the transaction divided by the standard size.

Answer 131

If use forward then will agree to 1 bitcoin=8450 as less bitcoin for £ Therefore need to pay £169k

Answer 132

receive 40 bitcoin in september now july so 2 months futures curretly quoted at 8275 and min contract size is 5 bitcoin 40/5=8 contracts concerned value will fall so will SELL futures today @ 1 bitcoin=8275 Actual transaction sell 40 BTC @ 7500 = 300k then close out the future to get : futures price is now 7500 (ie buy price) but sold future for 8275 therefore profit of £775*5 BTC*8=£31000 net receipt = 331k

Answer 133

PPP claims that the rate of exchange between two currencies depends on the relative inflation rates within the respective countries. PPP is based on 'The Law of One Price'  In equilibrium, identical goods must cost the same regardless of the currency in which they are sold.  The country with the higher inflation will be subject to a depreciation of its currency.  To estimate the expected future spot rates, apply the following formula: Current spot rate × (1 + inflf)/(1 + influk) = Future spot rate  where – inflf = expected foreign currency inflation rate for the period – influk = expected UK inflation rate for the period.

Answer 134

1.5*1.05/1.03=1.5291 the law of one price means they must always cost the same therefore if you inflate each by their respective inflation the $ to £ prices must equal, so could also divide those by one another to get the same result eg 3k*1.05=3150 and 2k*1.03= 2060 therefore 3150/2060 also gives 1.5291

Answer 135

Interest Rate Parity theory claims that the difference between the spot and the future exchange rates is equal to the differential between interest rates available in the two currencies. This is used by banks to calculate the forward rate quoted on a currency.  The formula is: Current spot rate × (1 + if)/(1 + iuk) = Forward rate  where: if = foreign currency interest rate for the period iuk = UK interest rate for the period IRP holds true in practice. There are no bargain interest rates to be had on loans/deposits in one currency rather than another.  However, where a government imposes controls on currency trading, or otherwise intervenes in the currency markets, its effectiveness is limited.

Answer 136

1.5*1.092/1.0712=1.5291 IRPT states that an investor would receive the same as if they had invested in Uk goernment bonds therefore what you gain in extra interest you lose in adverse forex movement so £1.0712m will equal $1.638m thuse giving the above answer also of 1.5291

Answer 137

Options give the right but not the obligation to buy or sell currency at some point in the future at a predetermined rate. A company can therefore:  exercise the option  let it lapse if: – the spot rate is more favourable – there is no longer a need to exchange currency. The option therefore eliminates downside risk but allows participation in the upside. The additional flexibility comes at a price – a premium must be paid to purchase an option whether or not it is ever used. Once again, a company may buy a tailor made OTC option, or use traded currency options.

Answer 138

OTC options are generally denominated in a foreign currency, so to decide whether you need a put or call, you need to consider what you will be doing with the foreign currency. If the company is going to be BUYING currency in the future, then it will need to buy a CALL option. If the company is going to be SELLING currency in the future, then it will need to buy a PUT option.

Answer 139

receiving Kr and quoted in Kr therefore what are we doing with Krona? will be selling Krona to buy £ therefore purchase put option thus 28p per Kr1000 premium therefore 20m/1000*28p=£5600 premium In march exchange rate turns out to be Kr8.7/£ as agreed to 8.45 exercise option as otherwie will lose out therefore 0.25Kr profit on option Exercising the option Kr20/8.45= £2366864 Less premium (5600) net receipt = £2361264

Answer 140

As for futures, the examiner will give you contracts denominated in STERLING, therefore: if a company is going to be buying currency in the future, then it will be SELLING sterling. It therefore, needs to buy PUTS. If a company is going to be selling currency in the future, then it will be BUYING sterling. It therefore needs to buy CALLS.

Answer 141

It has an invoice due for $ therefore need to sell £ to buy $ to pay the invoice therefore need to purchase put options, due to pya in June so June put therefore using table at 1.5 strike price the June put premium is 6.7 cents per £ 562500 at current spot is 370309.4/62500=5.92 contracts - round to 6 contracts start with what you do without any hedging so 562500/1.4663=£383,618 option -convert at future spot sell as put at $1.5/£ buy at spot in June $1.4663/£ profit of $0.0337/£ per contract*6*62500=$12637.5 profit/1.4663=8619 premium (6*0.067*62500) = ($25125)/1.519 convert at current spot = (£16540) =£391,540 net cost