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The Theory and Practice of Investment Management - Essay Example

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The Theory and Practice of Investment Management

The computations are shown in the following table. Table no.1 Number of contracts necessary to be hedged Contract Amount $ 7,500,000.00 Hedge Ratio 0.5 Price 97 No of contracts 38660 Part 2 I. In order to close the position, the company should buy futures contracts for March 2013, at the price 97.6. II. The transaction on the futures market brought a loss equal to: no of contracts *(selling price-buying price). The computations are shown in the following table. Table no.2 Final position from the futures transaction Price (short position) 97 Price (long position) 97.6 No of contracts 38660 Loss $ - 23,195.88 Part 3 I. The relationship between the price of the future contract and the interest rates on the market is an inverse relationship. So, for this example, the price of the future contract has raised implying a decline in the interest rate. II. The company has fixed its borrowing cost only for 50% of the exposure. The effective borrowing cost is computed as: r= 100- 97= 3% So, the company will borrow money at 3%. III. The company did not hedge all the risks involved by the transaction above. Firstly, it only hedged 50% of its interest rate exposure. Secondly, risks related to changes in the principal borrowed, or the currency in which this one is expressed are not hedged. Question 2 There are various theories related to dividend policies. One of the most important theories in this matter is the irrelevance thesis of Modigliani and Miller (Fabozzi and Drake, 2009). Under certain assumptions, Modigliani-Miller argues that dividend policy is irrelevant (no taxes, no transaction costs, no issuance costs, no insider information, a fixed investment policy). In other words, the management’s decision to change dividend value does not determine a shift in firm value too because the shareholder wealth is determined by the income generated through the investment policy of the firm, and not the way the firm distributes the income (Miller and Modigliani, 1961). Another theory is based on the “bird - in – the- hand” hypothesis. This assumes that the financial markets are characterized by uncertainty and imperfect information, and because of this, dividends should be considered differently than retained earnings. Moreover, all investors would want to receive dividends i.e. cash (“bird-in-the-hand”) rather than future capital gains from the evolution of the stock (“two in the bush”). So, a firm which offers a high dividend ratio would deliver good signals to the market, boosts the stock market, and finally increases the firm’s value (Walter, 1963). A theory which contradicts the “bird-in-the-hand” theory is based on the tax-effect hypothesis. This theory states that a lower dividend policy would lower the cost of capital of the firm and in this way increase the stock value and the shareholders wealth (Bajaj and Anand, 1990). The starting point for this conclusion is considering the higher taxation of dividends compared to capital gains. Furthermore, the dividends are taxed right after are paid, whereas capital gains are taxed until the moment of sell. This consideration of tax advantages of capital gains compared with receiving dividend determine investors to be attracted of companies with higher retained earnings than a higher dividend policy (Pettit, 1977). Considering the company Swan Dane Ltd., which is keeping constant a high dividend policy, can be supported by the “ ...Show more

Summary

Question1 2 Part 1 2 Part 2 2 Part 3 3 Question 2 4 Question 3 6 Question 4 9 Part B chosen 9 Reference List 12 Question1 Part 1 I. The company must choose the contract March 2013 in order to hedge its exposure. Usually, it is recommended that the hedge instrument to have a maturity greater with at least one month than the hedged asset…
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The Theory and Practice of Investment Management essay example
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