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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Answer 58 PENSION FUND

(a)

In order to hedge against possible future falls in share prices stock index futures should be sold. If share prices do actually fall then the loss would be offset by a gain on such futures contracts, although in most cases the gain will not exactly match the cash market loss. As stock index futures relate to a portfolio with a beta of approximately 1 (the market portfolio), the size of any hedge will need to be adjusted for the relative systematic risks of the portfolio held and the market portfolio.

The 1 December market value of the portfolio is £40·492 million.

The market weighted beta of the eight share portfolio is:

3·3 (0·74) + 4·43 (1·15) + 3·276 (0·65) + 4·784 (1·32) + 3·192 (1·56) + 8·16 (0·82) + 8·01 (1·11) + 5·34 (1·43) = 44·18, which divided by the portfolio’s market value of £40·492 gives a beta of 1·091.

As the portfolio beta is higher than one, in order to protect against a fall in share price the number of contracts used should be increased to reflect this difference in beta.

The suggested hedge is to sell £40,492,00£38,500 0 × 1·091 March futures contracts or 1,147 contracts.

(b)

On 31 March the new portfolio value based upon the prices given is £36,454,000, a loss of £4,038,000.

The gain on the futures contracts is (3,850 – 3,625) 1,147 × £10 = £2,580,750

The hedge efficiency is ££2,580,7504,038,000 or 63·9%

The hedge has not made sufficient profit to offset the cash market loss. Possible reasons for this are:

The actual share prices of the portfolio have fallen by more than would be expected for a portfolio with a beta of 1·091.

The portfolio could not be hedged by an exact number of contracts. However, for a portfolio of this size the effect of an inexact hedge is likely to be insignificant.

(c)

Stock index futures have three major advantages over buying and selling of actual shares:

Transactions costs of futures contracts are much less than those associated with buying and selling shares. The futures hedge would have to be undertaken on many occasions before the cost was equivalent.

The pension fund manager may not wish to sell the actual shares, especially as he expects their prices to start to rise.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Even in well-developed markets the sale of several million shares might cause a price reduction, and the manager might not receive the desired price for the shares.

(d)

Halving the systematic risk could be achieved in a number of ways, but the simplest is probably to buy long term interest rate futures to the same value as the existing portfolio. The underlying government bonds related to the long term interest rate futures may reasonably be assumed to be almost risk free, i.e. have a beta of approximately zero. The combined beta of these futures contracts and the share portfolio will therefore be approximately half of the current portfolio beta (0·5 × 1·091 + 0·5 × 0 = 0·5455).

Answer 59 ACTIVE PORTFOLIO MANAGEMENT

(a)

A positive abnormal return will exist if the expected return from a security is higher than the required return. For shares this may be established by using the capital asset pricing model (CAPM). The betas of the individual shares may be found using:

For the bonds the relative durations are:

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

If these data are accurate, the shares of Polgin and the UK Government bond offer a positive abnormal return.

(b)

The beta of the revised portfolio is the weighted average of the betas of the components of the portfolio. The UK Government bond is virtually risk free and is assumed to have a beta of 0. As the pension fund wishes to keep the maximum possible investment in shares, £60 million will be invested in the shares of Polgin, and £40 million in bonds.

The new portfolio beta is: 1,000(0·62)+60(0·65)+ 40(0) = 0·599 1,100

The required portfolio return is 4% + (10·5% – 4%) 0·599 = 7·89%

(c)

The active strategy relies upon the pension fund managers being able to regularly correctly identify underpriced securities. The implication is that the securities markets are not continuously efficient, and that excess returns can be earned by trading in mispriced securities. Markets are certainly not perfectly efficient, but whether or not mispriced securities can be regularly found that will lead to an abnormal return, after any administrative and transactions costs, is debatable.

A policy of selecting only mispriced securities might mean that the portfolio risk and return are not consistent with the objectives of the portfolio or desire of the investment clients.

The strategy is based upon using the capital asset pricing model, and presumes that the model presents an accurate measure of the required returns from securities. The CAPM, however, is based upon a number of unrealistic assumptions, such as a perfect capital market exists, borrowing and lending can take place at the risk free rate, investors have the same expectations about risk and return, investors are well diversified, and all investors consider only the same single time period. It also states that systematic risk is the only relevant measure of risk. It is likely that multi-factor models such as the arbitrage pricing theory offer better explanations of the relation between risk and return. Accurate data input for elements of the CAPM such as the market return and relevant betas are difficult to estimate, and the CAPM has empirical anomalies, for example it appears to overstate the required return on high beta securities and understate the required return on low beta securities.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 60 EWADE PLC

(a)The redemption yield on the convertible zero coupon debt may be found by solving:

£71·10 = (1100+ r)7 , (1 + r)7 = 1·4065, r = approximately 5%

The current annual yield on straight debt is 6%. This yield will comprise the present value of the semi-annual interest payments, and of any capital gain or loss on redemption in seven years’ time. The market price may be found by solving:

Market price = 1.034 + (1.03)4 2 + . . . (1.03)4 14 + (1.03)10014

The yield on a zero coupon bond and coupon bearing bond of the same maturity might differ slightly according to the preferences of investors for regular interest payments (coupon bearing), or a definite capital sum at the end of a period (zero coupon). Zero coupon bonds are not subject to reinvestment risk, but are subject to significant price risk if not held to maturity.

Because of the existence of the conversion option, the 5% redemption yield on the zero coupon bond is less than would be expected for a zero coupon bond without the conversion option. This lower yield affects the price of the bond. The main reasons for the £40·20 difference between the prices of the bonds are that the zero coupon is issued at a significant discount to the par value, and the coupon bearing bond has a coupon interest rate higher than the current redemption yield, meaning that its market price will be above the par value.

(b)

The minimum price of the zero coupon bond will be the greater of its value if converted immediately, and its value as a bond with fours years until maturity.

The value as a bond is: (1100.06)4 = £79·21

If converted:

At a price of 550 pence, the value is 12 × 550 pence = £66·00

At a price of 710 pence, the value is 12 × 710 pence = £85·20

With a share price of 550 pence the value will be the bond value of £79·21

With a share price of 710 pence the value will be the value if converted of £85·20

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(c)

A warrant is an option to purchase additional securities, at a specified price and time. If warrants are held as part of a portfolio, the delta and theta values are useful in developing hedging strategies.

The delta value shows the change in the price of the option (warrant) relative to the change in the price of the underlying share. It is possible to use the delta value to devise a delta neutral hedge which means that the total value of the options and underlying shares held is not expected to change as the price of the underlying share changes.

The theta value shows how the price of an option (warrant) changes over time.

Theta = Changein option price

Changein time

The nearer to the maturity date of the warrant, the lower will be the time value associated with the warrant.

Answer 61 IMF

A large current account deficit means that the value of exports of goods, services, investment income and current transfers is much less than the value of imports of these items. If the government believes that the deficit is not a temporary phenomenon, which will be largely self-correcting, it may attempt to reduce the deficit by taking one or more of a selection of economic measures. However, a country with large foreign currency reserves may decide to finance the deficit by running down some of those reserves and may not take significant additional actions for some time.

Economic measures include:

(1)Monetary policy. A government will often take deflationary measures to reduce the money supply. This may be through increases in interest rates, or attempting to reduce the money supply through actions such as credit restrictions, wage and/or price controls and reductions in government expenditure. Increased interest rates will tend to reduce local borrowing and demand for imports, and attract overseas funds into the country to take advantage of the higher interest rates (until interest rate and exchange rates are in equilibrium once more)

(2)Fiscal policy. Governments often reduce consumer spending, including spending on imports, by increasing taxation.

(3)Devaluation. If the country is part of a fixed exchange rate system the currency may be devalued in order to make imports more expensive and exports more competitive.

(4)Exchange controls, tariffs, and quotas are all measures, which may be used to reduce imports, and to reduce a current account deficit. However, these may be contrary to World Trade Organisation (WTO) agreements.

(5)Export stimulation through government subsidies, although these too are often restricted by the WTO.

(6)Borrowing. The government may finance the deficit by borrowing from international commercial banks or international organisations such as the IMF. Such borrowing, however, may not tackle the underlying symptoms of the deficit.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The IMF may provide loans to help finance a balance of payments deficit. An important feature of most IMF loans is the conditions attached to the loans. Countries receiving IMF loans are required to take strong economic measures to try to improve or eliminate the economic problems that made the loans necessary, and to stimulate medium to long-term economic development. These conditions typically include currency devaluation, controls over inflation via the money supply, public expenditure cuts to reduce government budget deficits and local tax increases. Most loans are for a period of up to five years. The IMF also offers loans under the Extended Fund Facility in order to overcome severe structural balance of payments problems, and special supplementary borrowing facilities, often at concessionary rates of interest, to countries with severe problems.

The actions of the IMF help to reduce volatility in international exchange rates, and to facilitate world trade. This has beneficial effects on the trading activities of multinational companies. However, the strong influence of the IMF on the macroeconomic policies of developing nations often leads to short term deflation and to reductions in the size of markets for multinational companies’ products. Conflicts may exist between multinationals, who wish to freely move capital internationally, and governments trying to control the money supply and inflation. Tax increases often accompany economic austerity measures, import tariff quotas may make operations more difficult and increases in interest rates raise the cost of finance. In the medium to long term the structural adjustments might stimulate economic growth and increase the size of markets for multinational companies, but IMF economic conditions may cause significant short to medium term difficulties for subsidiaries of multinationals in the countries concerned.

Most of the government policies discussed above tend to reduce domestic economic growth and increase unemployment, and are detrimental to a multinational company operating in the country concerned. For example, the impact of higher interest rates usually results in higher borrowing costs for a multinational company.

A possible beneficial effect is when the multinational exports a high proportion of its products, and the incremental demand stimulated by the devaluation/fall in value of the local currency results in an overall increase in the present value of cash flows to the multinational.

Answer 62 FORECASTS

(a)(i)

According to the International Fisher Effect (IFE) interest rate differentials between any two countries provide an unbiased predictor of future changes in the spot rate of exchange.

If interest rates are 6% in the UK, and 3·5% in the Euro bloc the expected annual change in

spot exchange rates is: 0.035−0.06 × 100% = –2·358% with the Euro STRENGTHENING 1.06

against the pound.

The expected exchange rate in two years’ time is 1.667 × (1-.02358)2 = Euro 1·589/£

The non-executive director has incorrectly used the relationships between interest rates and exchange rates, implying that sterling is expected to strengthen rather than weaken against the Euro. (1·667 × (1·02358)2 = 1·747/£).

(ii)

Forecasts of exchange rates using interest rate differentials are not likely to be accurate. Reasons for this include:

The interest rate differential may change during the next two years.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Even if the interest differential remains constant the IFE is an unbiased, not accurate, predictor of future exchange rates.

Exchange rates may not be in equilibrium at the current time. The IFE predicts movements from an equilibrium position.

Factors other than interest rates influence exchange rates, including government intervention in foreign exchange markets.

(b)

The order is not yet definite. If the subsidiary wishes to protect against foreign exchange risk at the tender stage, an over the counter option from a commercial bank is suggested. If the tender is not successful the option would not be exercised, and the total cost would be the option premium. An option to sell Kuwait Dinar (buy a put option on dinar) could be taken for either

(i)the full 18 month period until payment is due

(ii)the period until the result of the tender is known, and then a further hedge taken for the remainder of the period if the tender is successful.

For a short maturity option during the tender period the premium would be relatively low. The further hedge could be another option contract, or a money market hedge involving borrowing Kuwait dinar and converting to Euro at the current spot rate.

The sum to be borrowed, plus interest at 11% per year, would total the amount of the Dinar receipts in 18 months’ time. The funds converted to Euro at spot would be immediately available in Italy.

Estimates of future exchange rates may be made using either the purchasing power parity theorem (PPP) or interest rate parity theorem. Using the purchase price of Euro, 0·256

year premium on the Euro

In 18 months’ time the premium is expected to be (1+0·05825) (1+0·05825)0·5 = 8·864%

The expected spot is 10.0886.256 = 0·235 Euro/dinar

(This assumes that exchange rates are currently in equilibrium)

Interest rate differentials between the Euro and Dinar are 5% and 5·5% for borrowing and lending rates respectively. These could be used to estimate future spot rate, but evidence suggests that interest rate parity is not as accurate a predictor as purchasing power parity.

The normal price would be Euro 340,000 × 1·25 = Euro 425,000

At spot (using the purchase price of Euro) this is: 425,0000.256 = 1,660,156 dinars

However, in 18 months’ time the dinar is expected to have weakened. Using the forecast spot rate in 18 months’ time as the basis for the tender gives:

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

425,0000.235 = 1,808,511 dinars

If an option hedge is used the tender price could be increased by the amount of the option premium.

The recommended tender price is not less than 1,660,156 dinars, plus the premium cost of an option to buy Euro in eighteen months time at the present spot rate, or 1,808,511 dinars if no foreign exchange hedge is undertaken.

Answer 63 EXCHANGE RATE SYSTEMS

Managed floating exchange rate

A managed floating exchange rate will be mainly influenced by the market supply and demand for a currency, but is also subject to intervention by the relevant government. The government will buy or sell the currency in order to influence the exchange rate, often to keep it within a desired range against the dollar or other key currency. The government will not normally reveal how or when it will intervene in the foreign exchange market, and floating exchange rates such as this are difficult to forecast as they directly respond to economic events, relevant new information and to government intervention. This could lead to volatility in foreign exchange rates, which might be a deterrent to foreign trade.

In theory, managed exchange rates should gradually adjust to changing economic relationships between nations. For example, as a country moves into a balance of trade deficit, this would normally lead to a fall in the value of the country’s currency, which in turn will make the country’s exports more attractive, and will reduce the trade deficit. Floating exchange rates should prevent persistent deficits, and result in fewer large speculative international movements of funds. From a multinational company’s perspective the difficulty in forecasting such rates makes accurate cash budgeting for international activities more onerous, increases currency risk, and in many cases makes some form of currency hedging essential.

Fixed exchange rate linked to a basket of currencies

An economy that fixes its exchange rate against the dollar or other major currency will inevitably be affected by the state of the economy and the policies of the country to which it has linked. For example, if inflation or the money supply increases in the US, similar effects may be experienced in countries which have their currencies tied to the dollar.

An exchange rate linked to a basket of currencies is less susceptible to economic influences from a single country, although if the basket is weighted by international trade, a dominant trade partner might still have a major influence. In theory, fixed exchange rates offer greater stability, and future rates should be easier to forecast, which reduces risk and aids international pricing and cash budgeting. However, fixed exchange rates do not remain fixed forever; devaluation or revaluation may occur if inflation, interest rates and other economic variables diverge between the relevant countries. The direction of a possible change in rates is quite easy to predict, but not the exact timing of devaluation or revaluation, or the magnitude of any change in currency values. Fixed rates are also more susceptible to currency speculation.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Fixed exchange rates backed by a currency board system

This type of exchange rate regime shares many characteristics of other fixed exchange rate systems, but the currency board means that any domestic currency issues are backed by an equal amount of some “hard” currency, such as the dollar. In theory the domestic currency could be converted at any time into the hard currency at a fixed exchange rate. This backing by a “hard” currency is aimed at achieving greater economic stability, and less exchange rate volatility. A currency board system might result in a fall in the domestic money supply, high interest rates, and thus high “local” financing costs for multinational companies. For some countries, such as Hong Kong, a currency board has proved successful. For others, such as Argentina, it has failed. A multinational company will normally experience lower inflation and more stable economic conditions when a currency board exists.

Answer 64 WTO

(a)

Historically, the most important protectionist measures were tariffs, a levy or effectively a tax on imports, and quotas, which restricted either the volume or value of imports. In most recent years import barriers have tended to become more subtle, largely in response to the actions of GATT (General Agreement on Tariffs and Trade) and the WTO, which sought to promote free trade. Such barriers include explicit or “hidden” subsidies favouring local companies, and regulations/red tape that made access to markets by importers difficult. These might include onerous environmental or health regulations, very lengthy bureaucratic process before permission to import is given, and very slow customs procedures which delay the entry of goods into a market. All of these measures are intended to deter overseas companies from exporting to the country.

(b)

The World Trade Organisation (WTO) in 1995 succeeded GATT (General Agreement on Tariffs and Trade) as the major world forum for international negotiations and agreement in trade. It now encompasses almost 150 countries, which represent the vast majority of world trade. In contrast to GATT, which focussed on the trade in goods, the WTO also covers trade in services including banks, insurance companies, telecommunications and hotels, intellectual property and agriculture.

The WTO’s overriding objectives are to promote freer trade and thereby to help trade flow smoothly, and to reduce or eliminate protectionist barriers. It administers trade agreements, acts as a forum for negotiations and settles trade disputes. Its activities involve:

(i)Extending trade concessions equally to all members of the WTO.

(ii)Encouraging lower tariffs and fairer trade around the world, including anti-dumping measures and subsidies.

(iii)Introducing rules that make trade more predictable.

(iv)Stimulating competition through cutting subsidies.

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