Managing Capital Markets and Finance - Assignment Example

Essay Option D. First we will calculate the net worth what we will be getting at the end of year. This net worth will be equal to the selling price of stock less the amount that we will have to pay to the bank for the borrowed amount of money. This will give us the total inflow of cash we will be getting from the sale of stock. Net worth = selling price of stock – amount paid back to the bank at the end of year……. (1) Amount Paid back to the bank at year end = amount borrowed x ( 1 + i/100) Amount Paid back to the bank = 25 x ( 1 + 12/100) = 28 Putting this amount in equation (1) Selling price = 55 Net worth = 55 – 28 Net worth = 27. To find the return we will use the following formula: Return = (cash inflow – cash outflow) / cash outflow Cash inflow = net worth + dividend Cash inflow = 27 + 2 = 29 Return = (29 – 25) / 25 Return = 16% 2. Option C. Since the short sales mean that you sell the stocks rather than holding them. The risk with such a strategy is that the stock prices may increase over time if the market conditions improve. In such a case, you will lose the capital gain that you could earn otherwise if u hold the stock for some time. 3. 10.6% The expected Return on stock is calculated using SML (security market line) equation. Expected Return = RF + (RM – RF) x bi Where RF is the Risk Free Rate, RM is the Market Return and bi is the Beta of the stock. Here, RF = 7% RM = 10% and bi = 1.2. Expected Return = 7 + (10 - 7) x 1.2 = 10.6 %. 4. Option C. First we will calculate the net worth what she will be getting at the end of year. This net worth will be equal to the selling price of stock less the amount that she will have to pay to the bank for the borrowed amount of money. This will give us the total inflow of cash she will be getting from the sale of stock. Net worth = selling price of stock – amount paid back to the bank at the end of year……. (1) Amount Paid back to the bank at year end = amount borrowed x ( 1 + i/100) Amount Paid back to the bank = 35 x ( 1 + 12/100) = $ 39.2 Putting this amount in equation (1) Here, Selling price = 100 Net worth = 100 – 39.2 Net worth = 60.8 To find the return we will use the following formula: Return = (cash inflow – cash outflow) / cash outflow Cash inflow = net worth + dividend Cash inflow = 60.8 + 0 (since no dividends are paid) = 60.8 Return = (60.8 – 35) / 35 Return = 73.71% 5. Option C Since Future is contract that put the buyer and seller into an agreement to sell or receive a specified amount of Financial Instrument at a future specified price and date. 6. Option A. If the speculators believe that the interest rates will increase today, it means that the discount on T-bills will also increase in future which will cause the exposure to interest rate risk. Therefore the speculators will sell a Future T bills contract today to earn profit. 7. For a financial institution, the assets are the loan-interest receipts and if they are rate sensitive then an increase in interest rates will increase their inflow and a decrease in interest rates will decrease their inflow. Therefore they will be adversely affected by a decrease in interest rates since they will have to adjust for the prevalent interest rates. To hedge this exposure, it will sell interest rates future contracts to allow a floor to its interest rate receipts which will cover its downside Interest Rates Risk. 8. by the uses of interest rate futures to hedge the exposure to interest rate risk, a financial institution will be able to generate high returns but in ca concentrated period of time. This will generate a closely packed distribution of returns with low variance and hence low standard deviation. A low standard deviation means low risk, so using interest futures to hedge exposure reduces the risks. 9. Futures contract are the contract to buy or sell an underlying instrument at a specified date in future at a pre-specified price. Both the parties who enter the contract are in obligation to buy/sell the underlying security as per the contract terms at a specified date call settlement date and a specified price called settlement price. They are traded in future exchange. As compared to Futures, Options are the contract, also with an underlying asset but with a right (but not an obligation) to the buyer or holder to exercise the option. The seller or writer of the option in this case is in obligation to follow the terms of option contract incase the holder exercise the option. The seller of the option gets an option premium from the buyer at the time of contract. Incase of call option, the buyer has the right (not an obligation) to buy the underlying asset at a pre-specified price at a pre-specified date. They are also traded on Futures and Option Exchange. 10. a put options enables the buyer of option contract to sell the underlying security at a specified price at a specified date. Speculator uses put option when they expect the price of the underlying asset to go down in future. When the prices for the underlying asset will go down in the future the option holder will exercise its option by selling the security at a higher price as compared to the price prevailing in the market and thus making profit. At the time of buying an option, the option buyer has to pay a premium which goes to the option writer. In case where the option buyer decides to expire or lapse the option without exercising it, he will have to lose the option that he paid to the option writer at the beginning and nothing more. Hence the maximum loss that purchaser of a put option can incur is the option premium he paid at the beginning, incase if he opts to lapse the option. 11. Fixed for floating swaps means that one company would be getting floating interest rate payments and the other will be getting fixed interest payments and the two will exchange their cash flows. Now if the North Pier company is getting Fixed Interest Payments from the other party by giving it floating interest payments and interest rates decline, then the North Pier Company will be having benefits because the cash inflow which North Pier will be getting will not decline since it is based on fixed interest payments while the cash flows for the other company will decline since it was sensitive with the floating interest rates. Hence the North Pier Company will be benefited from the swaps, since it is getting more by paying less. 12. a) Cleveland Insurance Company. Year 1: Dollar amount received = (fixed Interest Rates – floating interest rates) x principle = {8% - (Libor + 1)} x 50,000,000 = {8 – (7 + 1)} / 100 x 50,000,000 = 0 No payments will be made from or to any of the party since fixed and floating interest rates are same. Year 2: Dollar amount received = (fixed Interest Rates – floating interest rates ) x principle = {8% - (Libor + 1)} x 50,000,000 = {8 – (9 + 1)} / 100 x 50,000,000 = $1 million (Receipt Year 3: Dollar amount received = (fixed Interest Rates – floating interest rates) x principle = {8% - (Libor + 1)} x 50,000,000 = {8 – (10 + 1)} / 100 x 50,000,000 = $1.5 million (Receipt) 12. b) For Counterparty: Year 1: Dollar amount paid = (fixed Interest Rates – floating interest rates) x principle = {8% - (Libor + 1)} x 50,000,000 = {8 – (7 + 1)} / 100 x 50,000,000 = 0 No payments will be made from or to any of the party since fixed and floating interest rates are same. Year 2: Dollar amount paid = (fixed Interest Rates – floating interest rates ) x principle = {8% - (Libor + 1)} x 50,000,000 = {8 – (9 + 1)} / 100 x 50,000,000 = $1 million (payment) Year 3: Dollar amount paid = (fixed Interest Rates – floating interest rates) x principle = {8% - (Libor + 1)} x 50,000,000 = {8 – (10 + 1)} / 100 x 50,000,000 = $1.5 million (payment) 13. If the inflation increases suddenly in then according to PPP theory the currency value of Mexican Peso will go down since too much of money will be chasing few goods therefore the value of the currency will go down as people will be ready to pay higher price for the scarce commodities to fulfill their needs. 14. The annual interest payment for these bonds will be same and will be calculated by: Interest Payment = principle amount x coupon rate / 100 Here, Principle Amount = 60,000,000 New Zealand dollars Coupon Rate = 6% Interest Payment = 60,000,000 x 6 / 100 Interest Payment = 3,600,000 Now we will calculate the cash flow required each year with the changing exchange rates. Year 1: cash flow required in $ = (amount in New Zealand Dollar) x Exchange rate Cash flow required in $ = 3,600,000 x .5 = $ 1,800,000 Year 2: cash flow required in $ = (amount in New Zealand Dollar) x Exchange rate Cash flow required in $ = 3,600,000 x .53 = $ 1,908,000 Year 3: cash flow required in $ = (amount in New Zealand Dollar) x Exchange rate Cash flow required in $ = 3,600,000 x .57 = $ 2052000. 15. off-balance sheet activities are the assets or debt that is not listed on the balance sheet of a company. They may include derivatives such as futures, forwards or letter of credit or any other subsidiary. The regulators have a great concerned about these activities when they examine the Financial statements of any company because this may inflate the company’s worth to make its image better in the industry and the corporate world or deflate the company’s worth to reduce taxation and other regulatory payments. 16. Camel Rating System is a rating system used to rate financial institutions. It is an acronym of six elements which are: Capital Adequacy, Asset Quality, Management Quality, Earnings, Liquidity, and Sensitivity to Market Risk (investopedia, 2007). Capital Adequacy means the institution is in the right balance of capital and assets. Each institution is required to maintain a minimum capital requirement to avoid cases of bankruptcy and maintain liquidity. Asset Quality means the amount of credit risk associated with the institutions assets such as loans and investment portfolios. Management Quality means the qualification of the management starting from the president of the institution to the from office executives. Institution is rated as per the qualification and experience of Management staff they have in their firm. Earnings mean the quality of earnings is assessed in which it is seen that whether the earnings are inflated due to the prevailing inflation or they have truly increased in size due to the operational efficiency. Liquidity is the ability of institutions, deposits in case of Financial Institution from investor, to pay off its liabilities at the instance demanded by the depositors. Sensitivity to Market Risk is measured by examining the variation in the earnings of the institution with respect to variations in the market conditions. 17. A Bank’s Gap is the difference between the rate sensitive assets and the rate sensitive liabilities of a bank. The rate sensitive assets and liabilities include maturing instruments and floating and variable rate instruments. It is appeared on a balance sheet and measured in the dollars. It helps in the measurement of the interest rate risk. A negative gap means a bank has more of rate sensitive liabilities than the rate sensitive assets. The best measurement of GAP can only be done by taking into account the overall risk and return profile of bank. 18. A bank’s beta is the variability of its earnings of its asset with the variation in market conditions. A banks portfolio consists of separate assets. Each asset has its own beta. And the Bank’s Beta is the weighted average of all the betas of its assets. 19. Interest rate risk is primarily associated with the value of an underlying asset whose price is affected by the variation in interest rates. Examples of such assets are bonds, t-bills, t-bonds and Eurodollars. Now the value of such assets varies inversely with the market rate risk. We can hedge or minimize our risk exposure to such variations by using a derivative that will change in value by the same amount. For effective hedging these two changes should be same. If the interest rates decline, the payments on mortgages will be same while the payments on the deposits will decline. Now we can have an option on future with an asset whose value will rise with the decline in the interest rates. So that in case of decline in interest rates when our cash inflow will decline we can use this future option whose asset’s price will increase with declining interest rate and can compensate for the loss we incur. The institution can buy options on futures contract, so when the future rate declines the institution can sell the options at higher amount to get profits and this profits will be utilized to pay the mortgage payments. 20. The beta of a portfolio is the weighted average of individual betas of all the securities in that portfolio. B (portfolio) = wIBM x BIBM + wLUV x BLUV + wODP x BODP Here, wIBM = .4, BIBM = 1.31, wLUV = .3, BLUV = .85, wODP = .3, BODP =.94 B (portfolio) = .4 x 1.31 + .3 x .85 + .3 x .94 = 1.061. Bibliography Investopedia (2007). Camel Rating System. Retrieved on February 9, 2007. http://www.investopedia.com/terms/c/camelrating.asp Read More