Case Bank for International Financial Management (0) Objective of International Financial Management Question: Stakeholder objectives using UK as a case (a) 'The objective of financial management is to maximise the value of the firm.' You are required to discuss how the achievement of this objective might be compromised by the conflicts which may arise between the various stakeholders in an organisation. (10 marks) Answer: Stakeholder objectives (a) If it is agreed to maximise the value of the firm, it is necessary to ask two fundamental questions: · who is the firm? · what do we mean by value? In the United Kingdom the traditional view has been for the interests of a firm to equate with those of the current equity shareholders. But it is now recognised that this is much too narrow. The employees and lenders to a business certainly have a legitimate interest, probably also the government. Japanese influences on UK thinking would add a company's suppliers and customers as part of the stakeholders. Perhaps the general public also belong to the list. Each of the members of the above list has different key objectives. For example employees might want their labour remuneration to be larger, while the shareholders want labour costs to be low so that higher profits can lead to higher dividends. Shareholders might be uninterested whether the company invests in 'unethical' areas of business such as armaments or cigarettes, as long as their investment is
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Case Bank for International Financial Management
(0) Objective of International Financial Management
Question: Stakeholder objectives using UK as a case
(a) 'The objective of financial management is to maximise the value of the firm.'
You are required to discuss how the achievement of this objective might be
compromised by the conflicts which may arise between the various stakeholders in an
organisation. (10 marks)
Answer: Stakeholder objectives
(a) If it is agreed to maximise the value of the firm, it is necessary to ask two
fundamental questions:
· who is the firm?
· what do we mean by value?
In the United Kingdom the traditional view has been for the interests of a firm to equate
with those of the current equity shareholders. But it is now recognised that this is much
too narrow. The employees and lenders to a business certainly have a legitimate
interest, probably also the government. Japanese influences on UK thinking would add a
company's suppliers and customers as part of the stakeholders. Perhaps the general
public also belong to the list.
Each of the members of the above list has different key objectives. For example
employees might want their labour remuneration to be larger, while the shareholders
want labour costs to be low so that higher profits can lead to higher dividends.
Shareholders might be uninterested whether the company invests in 'unethical' areas of
business such as armaments or cigarettes, as long as their investment is profitable, while
certain sections of the public will discourage unethical products.
The value of an investment in terms of financial management theory is the present value
of the cash returns available from the investment. However this varies from investor to
investor depending on personal discount rate, tax position, period of investment, etc. For
example the value of a share bought today and expected to be sold in five years time will
be the present value of the five years dividends plus the present value of the expected
net realisable value at the end of the holding period. So the value of the same share will
be different to different shareholders, and the job of the managers to maximise the total
value becomes impossible.
A further problem arises in the conflict between short-term results and long-term viability.
Managers might be on annual service contracts and therefore are motivated to report the
highest possible short-term profits. This might involve cutting down on revenue
investment such as maintaining fixed assets, advertising, research costs, etc. Such a
policy is in the best interests of management, since they will be paid a bonus for reporting
good results, but is not in the long-term interests of the company.
Financial managers often deal with the above conflicts by adopting a satisficing approach
rather than an optimising approach. They hope to please everyone by following
moderate policies which are not exclusively in the interests of one of the sectional
stakeholders of the business.
Question: Five wealthy individuals
Five wealthy individuals have each put £200,000 at your disposal to invest for the next two
years. The funds can be invested in one or more of four specified projects and in the money
market. The projects are not divisible and cannot be postponed. The investors require a
minimum return of 24% over the two years.
Details of the possible investments are:
Return over Expected standard deviation
Initial cost two years of returns over two years
(£’000) (%) (%)
Project 1 600 22 7
Project 2 400 26 9
Project 3 600 28 15
Project 4 600 34 13
Money market minimum 100 18 5
Correlation coefficients of returns (over two years)
Between projects and Between projects and
Between projects the market portfolio the money market
1 and 2 0.70 1 and market 0.68 1 and money market
0.40
1 and 3 0.62 2 and market 0.65 2 and money market
0.45
1 and 4 0.56 3 and market 0.75 3 and money market
0.55
2 and 3 0.65 4 and market 0.88 4 and money market
0.60
2 and 4 0.57
3 and 4 0.76
Between the money market
and the market portfolio 0.40
The risk-free rate is estimated to be 16%, the market return 27% and the variance of returns
on the market 100% (all for the two year period).
You are required:
(a) to evaluate how the £1m should be invested using:
(i) portfolio theory,
(ii) the capital asset pricing model (CAPM).
Portfolio risk may be estimated using the formula:
(15 marks)
(b) to explain why portfolio theory and CAPM might give different solutions as to how the £1m
should be invested. (5 marks)
(c) to discuss the main problems of using CAPM in investment appraisal. (10 marks)
(Total: 30 marks)
Answer: Five wealthy individuals
Possible portfolios Return
Projects 1 and 2 0.6 ´ 22 + 0.4 ´ 26 = 23.6 X
Projects 2 and 3 0.4 ´ 26 + 0.6 ´ 28 = 27.2
Projects 2 and 4 0.4 ´ 26 + 0.6 ´ 34 = 30.8
Project 2 and money market (mm) 0.4 ´ 26 + 0.6 ´ 18 = 21.2 X
Project 1 and mm 0.6 ´ 22 + 0.4 ´ 18 = 20.4 X
Project 3 and mm 0.6 ´ 28 + 0.4 ´ 18 = 24
Project 4 and mm 0.6 ´ 34 + 0.4 ´ 18 = 27.6
Of the above the three marked X yield returns less than 24% and will therefore not be
considered further.
(a) (i) Evaluation of investment using portfolio theory
Projects 2 and 3
= = =11.7%
Projects 2 and 4
= =
=10.3%
Project 3 and mm
= = = 10.2%
Project 4 and mm
= = = 9.1%
Summary
Portfolio Return Standard deviation
2 and 3 27.2% 11.7%
2 and 4 30.8% 10.3%
3 and mm 24% 10.2%
4 and mm 27.6% 9.1%
Conclusions
(1) Projects 2 and 4 are better (more ‘efficient’) than 2 and 3 as they offer a higher return
and a lower risk (as measured by standard deviation).
(2) Project 4 and the money market is better than Projects 2 and 3 and Project 3 and the
money market since returns are higher and risk is lower.
(3) Projects 2 and 4 appears better than Project 3 and the money market - much higher
return with virtually the same risk.
It is not possible to choose between:
(1) Projects 2 and 3 and Project 3 and money market or
(2) Projects 2 and 4 and Project 4 and the money market.
This is because Projects 2 and 3 offer a higher return and a higher risk than Project 3 and the
money market. Similarly, Projects 2 and 4 offer a higher return and higher risk than Project 4
and the money market.
To make a final choice using portfolio theory, it would be necessary to consider the effect of
the investment on the risk and return of the investors’ total portfolio of investments, not just
the 2 asset portfolios considered above. Even then it may be necessary to consider the utility
preferences of the five individuals in order to ascertain which investments would maximise
their utility.
(ii) Evaluation of investment using the capital asset pricing model (CAPM)
(Tutorial note: to use CAPM it is necessary to do two things:
(1) Find the beta (b) value - the measure of systematic risk - for each project.
(2) Find the b for each portfolio ie, each combination of projects. This will simply be a
weighted average of the b for each project within the portfolio. This is because b is a
measure of systematic or non diversifiable risk and will therefore not be reduced
when projects are combined into a portfolio. This contrasts with the portfolio theory
approach where it is necessary to identify the standard deviation (total risk) of each
portfolio, which will usually be less than the weighted average of the standard
deviations of the individual projects - because of the risk reduction effect of
Although country 1 scores highly, except for inflation, economic growth and interest rates
country 4 scores poorly, and is heavily indebted to the IMF relative to its small population
size. Other data such as per capita GNP and international indebtedness other than to the
IMF would be useful to the analysis. The managing director’s major concern is economic
exposure, the impact of foreign exchange rate changes on the sterling expected NPV of
overseas operations.
Strategic decisions should not be made on the basis of the above information alone.
The information provides a macro-economic analysis. Even with a relatively weak
economy at the micro level a subsidiary within a particular industry may perform well.
Examining macro-economic data fails to give a complete picture.
Additionally it is possible that a depreciation in the value of a foreign currency might have
a beneficial effect rather than a detrimental effect on economic exposure of Forun. If the
price elasticity of demand is such that export sales from the foreign subsidiary increase
substantially because of the relatively cheaper prices in a depreciated currency, the
overall effect in sterling NPV terms might be an increase, not a decrease. If the managing
director is concerned about economic exposure one way to reduce such exposure is by
diversifying international operations, and financing, among many different countries.
Concentrating activities in two foreign countries might lead to greater economic exposure
risk, not less. The manager’s strategy to concentrate on countries 1 and 4 is based upon
incomplete information and is not recommended.
(ii) This question requires evaluation of suggested hedges against translation exposure,
and whether or not such exposure should be hedged.
The non-executive director is concerned about the effects of translation exposure,
specifically on expected foreign exchange loss of £15 million.
If a foreign currency is expected to depreciate relative to sterling, translation exposure
may be reduced by reducing net exposed assets.
Early collection by foreign subsidiaries of foreign currency receivables will not reduce net
exposure (unless the foreign currency is expected to depreciate by more than the
currency of the foreign subsidiary). A better tactic would be to delay collection of foreign
currency receivables until after significant depreciation of the subsidiary’s currency had
occurred, the receivables will then yield a higher amount of the subsidiary’s currency.
From a group viewpoint early collection could increase translation exposure rather than
reduce it.
Early repayment of foreign currency loans could be beneficial, if the loans are in relatively
hard currencies, and if the subsidiary has the funds available to make such a repayment
without detrimental effects on its operations.
Reducing stock levels in foreign countries will reduce net asset exposure. However,
before this, or any other balance sheet hedging techniques are used, the effect on the
efficient operation of the company must be considered. There is little point in reducing
stock levels if this causes production bottlenecks or failure to satisfy customer demand,
and potentially a loss of orders.
The non-executive director is concerned about a loss on translation of £15 million.
Translation losses are not realised economic losses. Part of such a loss may be from
translating the historic cost of overseas fixed assets; in reality the sterling economic value
of such assets may be little changed if inflation in the foreign country increases the
market value of such assets. Hedging against translation losses might result in reducing
rather than increasing sterling NPV as such hedges may be opposite in direction to
hedges that would be undertaken to protect against transaction exposure.
Will the reported £15 million loss have an adverse effect on Forun’s share price? If the
stock exchange is efficient the company’s share price will react to relevant changes in the
company’s expected cash flows, not reported translation losses. The reported loss could
have little or no effect on share price. Hedging is normally undertaken to protect against
the risk of transaction exposure, not translation exposure.
(b)(i) Candidates are required to show knowledge of the advantages of multilateral
netting within a multinational company, and how to estimate the benefits of such netting.
Multilateral netting is an effective means of reducing the transactions costs associated
with foreign exchange transactions that are payable to banks. The netting of Forun’s
intra-company US dollar exposures gives the following net payments and receipts.
$’000
UK 1 2 3 4 Total Net
rec. receipts
(payments)
UK - 300 450 210 270 1,230 (470)
1 700 - 420 - 180 1,300 220
2 140 340 - 410 700 1,590 380
3 300 140 230 - 350 1,020 (110)
4 560 300 110 510 - 1,480 (20)
Total_____ _____ _____ _____ _____ _____ ___
payments 1,700 1,080 1,210 1,130 1,500 6,620 -
_____ _____ _____ _____ _____ _____ ___
Some dollar payments will still need to be made from the UK, country 3 and country 4 to
countries 1 and 2. However, such payments will total a maximum of $600,000 against the
total trade value of $6,620,000, saving transactions and other costs on more than
$6,000,000.
(ii) Candidates are required to assess what short-term foreign exchange exposures
require hedging using given data and to demonstrate how such exposures might be
hedged using forward markets, currency futures and currency options.
As Forun is risk averse with respect to short-term foreign exchange risk, the company is
recommended to hedge against any transaction exposure hedging. In order to reduce
foreign exchange transaction hedging should take place after establishing the net
exposure position in all currencies. The net group dollar exposure on the intra-company
trade is of course zero, as dollar receipts equal dollar payments. Hedging will be
undertaken on the net transaction exposure of third party trade.
Exposure
(Note: Sterling transactions are not exposed!)
Receipts Payments Net
Australia $3 million $3 million -USA $12 million - $12 million
Germany - DM13 million (DM13
million)
Italy L32 billion - L32 billion
These net figures are the only ones that require hedging.
Hedging may be undertaken on the forward foreign exchange market, currency futures
market, or currency option markets.
Forward market
The relevant outright rates are:
3 months 6 months
US$/£ 1.4720 - 1.4770 1.4550 - 1.4600
DM/£ 2.4140 - 2.4180 2.3830 - 2.3870
Lire/£ 2,217 - 2,224 2,225 - 2,232
$US receipts = £8,219,178
DM payments = £5,455,308
Lire receipts. As the date of the receipt is uncertain, an option forward contract will be
used. This will be available at the least favourable exchange rate to Forun between three
months and six months forward in this case the six month offer rate.
= £14,336,918
(3) Case for Group Study and Presentation
Fidden
(a) Discuss briefly 4 techniques a company may use to hedge against the foreign
exchange risk involved in foreign trade (9 m)
(b)Fidden is a medium sized UK company with export and import with USA. The
following transactions are due within the next six months. Transactions are in the
currency specified.
Purchase of components, cash payment due in three months: £116,000, Sale of
finished goods, cash receipt due in three months: $197,000
Purchase of finished goods for resale, cash payment due in six months: $447,000
Sale of finished goods, cash receipt due in six months:$154,000
Exchange rate (London market) $/£
Spot 1.7106-1.7140
Three month forward 0.82-0.77 cents premium
Six months forward 1.39-1.34 cents premium
Interest rates
Three months or six months Borrowing Lending
Sterling 2.5% 9.5%
Dollars 9% 6%
Foreign currency option prices (New York market)
Prices are cents per £,contract size £12,500
Call Put
Exercise price ($) March June Sep March June Sep
1.6 15.20 2.75
1.7 5.65 7.75 3.45 6.40
1.8 1.7 3.6 7.9 9.32 15.35
Assume that it is now Dec with three months to expiry of the march contract and that
the option is not payable until the end of the option period, or when the option is
exercised.
You are required to :
1) calculate the net sterling receipts/payments that Fidden might expect for both its
three and six month transactions if the company hedges foreign risk on
(1) the forward exchange market
(2) the money market(8m)
2 ) if the actual spot rate in six months time was with hindsight exactly the present six
months forward rate, calculate whether Fidden would have been better to hedge
through foreign currency options rather than the forward market or money
market(8m)
3) explain briefly what you consider to be the main advantage of foreign currency
options. (5m)
(4) Interest Rate Hedge - Case for Group Study and Presentation
Panon Panon plc has a commitment to borrow 6m in 5 months for a period of 4 months. A general election is due in 4 months time and the managers of Panon are concerned that interest rates could significantly increase just after election. Panon can currently borrow at LIBOR+1%. Three month LIBOR is 7.5%. Current LIFFE 500,000 sterling three month futures price are:Sept 92.60Dec.92.10Assume it is now the end of June and futures contracts mature at the end of the relevant month.Required:(a) illustrate how Panon plc could use a futures hedge to protect against its potential interest raet risk. The type and number of contract must be included in your illustration (10)(b) Estimate the basis risk for this hedge both now and at the time the contract is likely to be closed out. Comment upon the significance of your estimates for Panon. Illustrate your answer with reference to the impact of a 2% increase in LIBOR.(10)
PZP plc wishes to raise 15million of floating rate finance. The company’s bankers have suggested using a five year swap. PZP has an AAB rating and can issue fixed rate finance at 11.35% or floating rate at LIBOR plus 60 basis points. Foreten plc has only a BBC credit rating and can raise fixed rate finance at 12.8% or floating rate at LIBOR + 13.5% A five year interest rate swap on a 15million loan could be arranged with Gibbank acting as an intermediary for a fee of 10.25% per annum. PZP will only agree to the swap if it can make annual savings of at least 40basis points. LIBOR is currently 10.5%. Required:(a) Evaluate whether or not the swap is likely to be agreed. (3)(b) Estimating the present value of the differences in cask flow that would exit for PZP from using a floating rate swap rather than borrowing fixed rate directly in the market if
(1) LIBOR moves to 11.8% after one year and then remains constant(2) LIBOR moves to 8.8% after three years and then remains constant.
The market may be assumed to be efficient and the discount rate to be the prevailing effective floating rate swap rate for PZP. Interest may be assumed to be paid annually at the end of the year concerned.(10) Comment upon your findings and discuss whether they would be likely to influence PZP’s decision to undertake a swap. (7) (5) Option pricing
Question Gibb plc
(a) Options in Gibbs plc are actively traded on the London traded options market. The
chairman of the company does not understand how the option prices quoted are
determined and has asked you for a brief report explaining the determinants of option
values,
Required: Outline the main determinants of the value of an option explaining how and
why they affect the price of the option. (6 marks)
(b) The chairman’s daughter is currently studying for a master degree at a well known
university. She has told him that the best way to value an option is to use the Black
Scholes Option valuation model.
Required: place a value on a call option in Gibbs plc. The following information is
available:
The price of the share £5
The exercise price £4.5
The standard deviation 25%
Expiry date in 6 months
Risk free rate 10.25% p.a. (5% per six month)
The value of a call option = Po{N(d1)} –Exe-rt{N(d2)} (5marks)
(c) Required : use put-call parity theory to place a value on put option with the same
exercise price and expiry date used for the call option in part (b) (5marks))
As is predictable, from Deal's higher contribution per transplant, Deal's NPV is far more
sensitive to changes in demand than is Stoke's.
Stoke breaks even at a slightly lower level (about 19 transplants, from the graph), but
Deal's NPV increases rapidly, overtaking Stoke's at about 26 transplants (reading from
the graph).
(c) There are two types of approximation used in DCF analysis. The first, and less
significant, is mathematical. Discount factors to two or three decimal places are used
and calculations are often carried out in round thousands or millions.
However, a greater mathematical accuracy would be misleading, as the second type of
approximation lies in the use of estimates. Investment appraisal, by its very nature,
involves predictions of future cash flows, inflation rates, tax rates, interest rates and so
on. Some of these may be easy to predict, for example if a fixed price has been agreed
on a contract spanning a number of years; but most of them can be estimated only very
roughly. For example, probably the two least accurate estimates given in the scenario
are the rate of inflation (which has been applied to all cash flows) and demand.
In many instances the effect of changing the estimates can be investigated using
sensitivity analysis, as in part (b), but ultimately, any investment decision will be based on
approximate data.
(11) Case for Student Group Presentation
Question: KYT Inc.
Assume that is now 30 June. KYT Inc. is a company located in the USA that has a contract to
purchase goods from Japan in two months time on 1 September. The payment is to be made
in yen and will total 140 million yen.
The managing director of KYT Inc wishes to protect the contract against adverse movements
in foreign exchange rates, and is considering the use of currency futures. The following data
are available.
Spot foreign exchange rate:
Yen/$ 128.15
Yen currency futures contracts on SIMEX (Singapore Monetary Exchange)
Contract size 12,500,000 yen, contract prices are in $US per yen.
Contract prices:
September 0.007985
December 0.008250
Assume that futures contracts mature at the end of the month.
Required:
(a) Illustrate how KYT might hedge its foreign exchange risk using currency futures.
(4 marks)
(b) Show what basis risk is involved in the proposed hedge. (3 marks)
(c) Assuming the spot exchange rate is 120 yen/$ on 1 September and that basis risk
decreases steadily in a linear manner, calculate what the result of the hedge is expected to
be. Briefly discuss why this result might not occur. Margin requirements and taxation may be
ignored. (8 marks)
(15 marks)
(12) Case for Student Group Presentation
Question Kulpar
The finance director of Kulpar plc is concerned about the impact of capital structure on the
firm’s value and wishes to investigate the effect of different capital structures. He is aware that
as gearing increases the required return on equity will also increase and the firms’ interest
cover is likely to increase. An increase in interest cover can lead to a change in firms’ credit
rating by the leading rating agent. He has been informed the following changes are likely:
Interest Cover Credit rating Cost of long term debt
More than 6.5 AA 8%
4-6.5 A 9%
1.5-4 BB 11%
The firm is now A
Summarised financial data
million pounds
Net operating income 110
Depreciation 20
Earnings before Interest and tax
90
Interest 22
Taxable income 68
Tax 30% 20.4
Net Income 47.6
Capital spending 20
Market value of equity is 458 million and of debt 305, Kulpar’s equity beta is1.4. The beta of
debt may be assumed zero. The risk free rate is 5.5% and the market return 14%. The firms
growth rate of cash flow may be assume to be constant and to be unaffected by any change
in capital structure.
Required:
(a) Determine the likely effect on firms cost of capital and corporate value if the firms capital
structure was:
80% equity,20% debt by market value
40% equity , 60% debt by market value
recommend which capital structure should be used.
Any change in capital structure will be achieved by borrowing to repurchase exiting equity oro
by using additional equity to redeem exiting debt as appropriate.
The current total firm value is consistent with the growth model CF1/(k-g) applied on a
corporate basis,CF1 is next years free cash flow, k is the WACC and g the expected growth
rate. Company free cash flow may be estimated using EBIT(1-t) + depreciation – capital
spending. State clearly any assumptions you make.
(20 marks)
(b) Discuss possible reasons for errors in the estimating value in part a above
(13) Kulpar
The finance director of Kulpar plc is concerned about the impact of capital structure on the
firm’s value and wishes to investigate the effect of different capital structures. He is aware that
as gearing increases the required return on equity will also increase and the firms’ interest
cover is likely to increase. An increase in interest cover can lead to a change in firms’ credit
rating by the leading rating agent. He has been informed the following changes are likely:
Interest Cover Credit rating Cost of long term debt
More than 6.5 AA 8%
4-6.5 A 9%
1.5-4 BB 11%
The firm is now A
Summarised financial data
million pounds
Net operating income 110
Depreciation 20
Earnings before Interest and tax
90
Interest 22
Taxable income 68
Tax 30% 20.4
Net Income 47.6
Capital spending 20
Market value of equity is 458 million and of debt 305, Kulpar’s equity beta is1.4. The beta of
debt may be assumed zero. The risk free rate is 5.5% and the market return 14%. The firms
growth rate of cash flow may be assume to be constant and to be unaffected by any change
in capital structure.
Required:
(a)Determine the likely effect on firms cost of capital and corporate value if the firms capital
structure was:
80% equity,20% debt by market value
40% equity , 60% debt by market value
recommend which capital structure should be used.
Any change in capital structure will be achieved by borrowing to repurchase exiting equity oro
by using additional equity to redeem exiting debt as appropriate.
The current total firm value is consistent with the growth model CF1/(k-g) applied on a
corporate basis,CF1 is next years free cash flow, k is the WACC and g the expected growth
rate. Company free cash flow may be estimated using EBIT(1-t) + depreciation – capital
spending. State clearly any assumptions you make.
(20 marks)
(b) Discuss possible reasons for errors in the estimating value in part a above (10 marks)
Interest Rate Swap
(14)Manling plc has 14million of fixed rate loans at an interest rate of 12% per year which are due to mature in one year. The company’s treasurer believes that interest rates are going to fall but dose not wish to redeem the loans because large penalties exist for early redemption.
Manling’s bank has offered to arrange an interest rate swap for one year with a company that has obtained floating financed at London Interbank Offered Rate (LIBOR) plus 1.125%. The bank will charge each of the companies an arrangement fee of 20,000 and the proposed terms of the swap are that Manling will pay LIBOR plus 1/1/2% to the other company and receive from the company 11.625% Corporate tax is at 35% and the arrangement fee is a tax allowable expense. Manling could issue floating rate debt at LOBOR plus 2% and the other company could issue fixed rate debt at 113/4%. Assume that any tax relief is immediately available. Required:(a)Evaluate whether Manling plc would benefit from the interest rate swap
(1) If LIBOR remains at 10% for the whole year (2) If LIBOR falls to 9% after six months. (8)
(b) If LIBOR remains at 10% evaluate whether both companies could benefit from the interest rate swap if the terms of the swap were altered. Any benefit would be equally shared. (7)
(15)Murwarld The corporate treasury team of Murwald plc is debating what strategy to adapt to interest rate risk management. The company’s financial projections show an expected cash deficit in three months time of 12million, which will last for a period of approximately six months. Base rte is currently 6% per year and Murwald can borrow at 1.5% over base or invest at 1% below base. The treasury team believes economic pressure from reunification of Germany will soon force Germany to raise interest rates by 2% per year, which can lead to a similar rise in UK interest rates. The Bundesbank move is not certain as there has recently been significant economic pressure on Germany from other European Union countries not to raise interest rates. In UK the economy is still recovering from a recession and representatives of industry are calling for interest rates to be cut by 1%. Opposing representations are being made by pensions who don’t wish their investment income to fall further due to an interest rate cut. The corporate treasury team believes interest rates are more likely to rise than fall and does not want interest payments during the six month period to increase by more than 10,000 from the amounts that would be paid at current interest rates .It is now December 1st. LIFFE price (1 Dec) FuturesLIFE 500,000 three month sterling interest rate (point of %100)Dec 93.75Mar 93.45Jun 93.10 OptionsLIFFE 500,000 short sterling options (points of 100%) Calls PutsExercise price June June 9200 3.33 -9250 2.93 -9300 2.55 0.929350 2.2 1.259400 1.74 1.849450 1.32 2.909500 0.87 3.46Required(a) Illustrate results of futures and option hedges if by 1 march
(1) interest rate rise by 2% Futures prices move by 1.8%(2) Interest rate fall by 1% Futures prices move by 0.9%
Recommend with reasons how Murwald plc should hedge its interest rate exposure all relevant calculations must be shown. Taxation transactions costs and margin requirements may be ignored. State clearly the assumptions you have made (22).(b) Discuss the advantages and disadvantages of other derivative products that Murwald might have used to hedge the risk (8)