seminar5materials / P4AFM-SQB_PDF_j08 / P4AFM-SQB-As_j08

ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

If the futures price moves to 94.0, the option will not be exercised, and the loss will be the premium paid of

125 × 48 × £12.5 = £75,000

Outcomes

£12 million deficit £(63,000)

1% decrease

£12 million deficit £(15,000)

Neither futures nor options hedges can satisfy, with certainty, the requirement that the interest payment should not increase by more than £10,000.

However, one way to achieve this would be to use a collar option, whereby downside risk is protected, but potential gains are also limited. A collar effectively fixes a maximum and minimum interest rate.

If a company expects to be borrowing and is worried about interest rate increases, a suitable collar can be achieved by buying put options and selling call options, to reduce the cost of protection.

For example a collar could be achieved by buying 48 9400 put options at 1.84 and selling 9400 call options at 1.74, a net premium cost of 0.10 (other alternatives are possible).

Murwald doesn’t want interest to move adversely by more than £10,000 for a six month period on a £12 million loan.

In annual terms this is a £10,000 × 2 = 0.167%

———

£12m

A put option at the current interest rate (6%) and a total premium cost of less than 0.167% will satisfy the company’s requirement. In the above example the total premium cost is 0.10%, and no matter what happens to interest rates Murwald can fix its borrowing cost at:

7.6% (100 – 94.00 + 0.10 net option premium plus the 1.5% risk premium)

This satisfies the requirement. (Interest payments would be £12m × 7.6% × 0.5 = £456,000 which is £6,000 worse than current interest rates.)

The use of a collar is the recommended hedging strategy, but the company should consider the implications of the collar if a cash surplus were to occur rather than a cash deficit.

1092

STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(b)Alternative interest rate hedges include:

(i)Forward agreements (FRAs).

(ii)OTC interest rate options – including interest rate Guarantees.

(iii)Interest rate swaps.

(i)A forward agreement is a contract to agree to pay a fixed interest rate that is effective at a future date. As such Murwald could fix now a rate of interest of 6.1% (for example) to be effective in three month’s time for a period of six months. If interest rates were to rise above 6.1% the counter-party, usually a bank, would compensate Murwald for the difference between the actual rates and 6.1%. if interest rates were to fall below 6.1% Murwald would compensate the counter-party for the difference between 6. 1 % and the actual rate.

(ii)OTC options. Instead of market traded interest rate options such as those that are available on LIFFE, Murwald might use OTC options through a major bank. This would allow options to be tailored to the company’s exact size and maturity requirements. An OTC collar would be possible, and the cost of this should be compared with the cost of using LIFFE options. Interest rate options for periods of less than one year are sometimes known as interest rate guarantees.

(iii)Interest rate swaps. Murwald expects to borrow at a floating rate of interest. It might be possible for Murwald to swap its floating rate interest stream for a fixed rate stream, pegging interest rates to approximately current levels (the terms of the swap would have to be negotiated). Interest rate swaps are normally for longer periods than six months.

Answer 36 GLOBAL DEBT

(a)

The “global debt problem” has existed for some countries for nearly thirty years. It developed partly as a result of a massive increase in petrol and other commodity prices during the 1970’s and 1980’s. This together with widespread economic recession, reductions in the imports of many advanced countries from developing countries, and relatively high levels of international interest rates, meant that many countries were forced to borrow internationally in order to meet their import requirements of essential goods such as fuel and foodstuffs. Such countries often experienced large current account deficits, and could not get access to the necessary hard currency to pay for imports other than by borrowing. Many also suffered from capital flight, with funds leaving the country to find what was perceived to be a safer international home. Major international banks were very willing to lend to sovereign nations, as historically country default risk had been low. Arguably banks’ risk assessment took too optimistic a view and vast amounts of sovereign loans were agreed, with countries such as Mexico and Brazil borrowing in excess of 100 billion dollars. Debt servicing payments in some countries exceeded 50% of total export earnings, and domestic savings were insufficient to provide the necessary funds to repay international debts. Continuing current account deficits made the situation even worse in many countries. Many countries had insufficient hard currency to meet the debt servicing conditions of their loans.

1093

ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Financial contagion refers to the spread of economic and financial problems from one country to another. As barriers to trade, investment and capital flows are reduced or eliminated the resultant more “global” economy is more susceptible to contagion. As can be seen from the problems of the Thai baht in 1997, the problems of even a relatively small economy can easily have severe economic impacts on neighbouring countries and even upon larger countries such as Brazil and Russia. Financial contagion potentially worsens the impact of the international debt problem. If financial problems in one country directly lead to similar problems in several others it accentuates the debt servicing difficulties.

(b)Attempts to resolve the international debt problem have included:

Lending additional funds to the countries, sometimes to meet current interest payments and prevent default. Most lending has been accompanied by suggested or imposed economic reforms to try and address the fundamental causes of the problem. Such reforms are often based upon stringent conditions set by the IMF.

Rescheduling the repayment of debt to extend the repayment period and reduce current cash outflows.

Writing off some or all of the debt. Where lenders are institutions such as international banks this naturally requires their agreement, and has substantial cost for them.

Sale of debt for less than face value.

Swapping debt into some other form of commitment. This includes swaps from debt into the equity of local companies, or even promises to reduce pollution, provided enhanced education etc.

Financial problems are most often experienced in those countries that have fixed exchange rates and an overvalued currency; suffer from large short-term capital outflows; or have overheated parts of the economy (especially the property sector). Fixed exchange rate systems are also much more likely to be the subject of speculative attacks. Financial crises are also associated with weak economic fundamentals such as high unemployment, low growth in GDP, high short-term debt to currency reserves, balance of payments deficits and high real interest rates.

Governments might reduce the risk of financial problems and the potential associated contagion by altering the exchange rate system and trying to address these economic issues. For example, the government might adopt a floating rate regime (although this will impact upon other aspects of the economy), or possibly a currency board system. Governments should closely monitor important sectors of the economy to assess the risks within those sectors, and consider the use of taxation, monetary policy and/or exchange controls to prevent a crisis occurring.

1094

STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 37 BEELA ELECTRONICS

(a)

The consultant’s report should not be used as the only basis for the African investment decision, because:

The decision should be taken after evaluating the risk/return trade-off; financial factors (e.g. the expected NPV from the investments); strategic factors; and other issues including political risk. Political risk is only one part of the decision process (although in extremely risky countries it might be the most important one).

The scores for the three countries are:

Just because previous clients have not invested in countries with scores of less than 30 does not mean that Beela should not. The previous countries may not have been comparable with these in Africa. This decision rule also ignores return. If return is expected to be very high, a relatively low score might be acceptable to Beela.

The factors considered by the consultant might not be the only relevant factors when assessing political risk. Others could include the extent of capital flight from the country, the legal infrastructure, availability of local finance and the existence of special taxes and regulations for multinational companies.

The weightings of the factors might not be relevant to Beela.

Scores such as these only focus on the macro risk of the country. The micro risk, the risk for the actual company investing in a country, is the vital factor. This differs between companies and between industries. A relatively hi-tech electronics company might be less susceptible to political actions than, for example, companies in extractive industries where the diminishing bargain concept may apply.

There is no evidence of how the scores have been devised and how valid they are.

(b)

Prior to investing Beela might negotiate an agreement with the local government covering areas of possible contention such as dividend remittance, transfer pricing, taxation, the use of local labour and capital, and exchange controls. The problem with such negotiations is that governments might change, and a new government might not honour the agreement.

The logistics of the investment may also influence political risk:

If a key element of the process is left outside the country it may not be viable for the government to take actions against a company as it could not produce a complete product. This particularly applies when intellectual property or know-how is kept back.

Financing locally might deter political action, as effectively the action will hurt the local providers of finance.

Local sourcing of components and raw materials might reduce risk.

1095

ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

1098