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Financial management
1. 1) The BRIC thesis posits that China and India will become the world's dominant suppliers of manufactured
goods and services, respectively, while Brazil and Russia will become similarly dominant as suppliers of
raw materials. It's important to note that the Goldman Sachs thesis isn't that these countries are a political
alliance (like the European Union) or a formal trading association - but they have the potential to form a
powerful economic bloc. BRIC is now also used as a more generic marketing term to refer to these four
emerging economies.
Due to lower labor and production costs, many companies also cite BRIC as a source of foreign expansion
opportunity.
2) Meaning of Repo:
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale
of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price
should be greater than the original sale price, the difference effectively representing interest, sometimes called
the repo rate. The party that originally buys the securities effectively acts as a lender. The original seller is
effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest.
A repo is equivalent to a cash transaction combined with a forward contract. The cash transaction results in transfer
of money to the borrower in exchange for legal transfer of the security to the lender, while the forward contract
ensures repayment of the loan to the lender and return of the collateral of the borrower. The difference between
the forward price and the spot price is effectively the interest on the loan while one of the settlement dates of the
forward contract is the maturity date of the loan.
Reverse Repo:
A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the seller's. Hence, the
seller executing the transaction would describe it as a "repo", while the buyer in the same transaction would describe
it a "reverse repo". So "repo" and "reverse repo" are exactly the same kind of transaction, just described from
opposite viewpoints. The term "reverse repo and sale" is commonly used to describe the creation of a short position
in a debt instrument where the buyer in the repo transaction immediately sells the security provided by the seller on
the open market. On the settlement date of the repo, the buyer acquires the relevant security on the open market and
delivers it to the seller. In such a short transaction the seller is wagering that the relevant security will decline in
value between the date of the repo and the settlement date.
2. 3) Foreign Exchange
Domestic Fisher Effect:
In foreign exchange terminology, the Domestic Fisher Effect refers to the hypothetical long-term relationship
between a country’s interest rates and its observed inflation rate that was originally developed by Irving Fisher. His
hypothesis proposed that the real interest rate is equal to the nominal interest rate minus the rate of inflation.
Domestic Fisher Effect Example:
In practice, the Domestic Fisher Effect implies that a given increase in inflation will result in an equal increase in the
nominal interest rate, if the real interest rate holds steady. This theoretical relationship has been used to propose that
the real interest rate for an economy is independent of monetary measures, which would include a central bank
setting the nominal domestic interest rate, since such manipulation will be offset by changes in the rate of inflation.
International Fisher Effect:
An economic theory that states that an expected change in the current exchange rate between any two currencies is
approximately equivalent to the difference between the two countries' nominal interest rates for that time.
Calculated as:
Where:
"E" represents the % change in the exchange rate
"i1" represents country A's interest rate
"i2" represents country B's interest rate
Example
Suppose that the current spot exchange rate for U.S. Dollars into British Pounds is $1.4339 per pound. If the current interest rate
is 5 percent in the U.S. and 7 percent in Britain, what is the expected spot exchange per pound rate 12 months from now
according to the International Fisher Effect?
The International Fisher Effect estimates future exchange rates based on the relationship in nominal interest rates. Multiplying the
current spot exchange rate by the nominal annual U.S. interest rate and dividing by the nominal annual British interest rate yields
the estimate of the spot exchange rate 12 months from now ($1.4339 * 1.05) / 1.07 = $1.4071.
3. 4) Credit Derivatives
Credit Default Swap:
Credit Default Swaps (CDS) are a private contract between two parties in which the buyer of protection agrees to
pay premiums to a seller of protection over a set period of time, the most common period being five years. In return,
the seller of protection agrees to pay the buyer an amount of loss created by a "credit event" related to an underlying
credit asset (loan or bond) - the most common events are bankruptcy, restructuring or default. Each individual
contract lays out the specific terms of their agreement including identifying the underlying asset (loan or bond) and
what constitutes a credit event.
The following diagram illustrates how CDS were originally designed to function:
Protection Buyer Protection Seller
Tends to own underlying credit Does not usually own underlying
assets credit asset
Purchasing credit protection Selling credit protection
Short-selling credit exposure Long credit exposure
Example of Credit Default Swap
Example, suppose that Lloyds TSB has lent money to riskymortgage.co.uk in the form of a £1,000 bond.
Lloyds TSB may then purchase a credit default swap from another company e.g. a Hedge Fund.
If the firm (Riskymortgage.co.uk) defaults on the loan, then the hedge fund will pay Lloyds TSB the value of the
loan.
Thus Lloyds TSB have insurance against loan default. The hedge fund has the opportunity to make profit, so long as
the firm does not default on the loan.
The more risky the loan, the higher will be the premium required on buying a credit default swap.
4. 5) Value at Risk
The term “Value at Risk” (VaR) is commonly used in both financial mathematics and financial risk management. It
is a calculation and measurement of the possible risk of a loss for a certain portfolio of combined financial assets.
Value at Risk determinations are defined for a portfolio within a specific probability and time horizon, and offered
as a threshold value. This means that the probability that the loss on the portfolio in question, during a particular
time horizon, exceeds this value as the probability level. This assumes normal markets, as well as no trading within
the portfolio.
Measuring value at Risk:
There are three basic approaches that are used to compute Value at Risk, though there are numerous variations
within each approach. The measure can be computed analytically by making assumptions about return distributions
for market risks, and by using the variances in and covariance’s across these risks. It can also be estimated by
running hypothetical portfolios through historical data or from Monte Carlo simulations. In this section, we describe
and compare the approaches.
1) Variance-Covariance Method:
This method assumes that stock returns are normally distributed. In other words, it requires that we
estimate only two factors - an expected (or average) return and a standard deviation - which allow us to plot
a normal distribution curve
2) Historical Method :
The historical method simply re-organizes actual historical returns, putting them in order from worst to
best. It then assumes that history will repeat itself, from a risk perspective.
3) Monte Carlo Simulation :
The third method involves developing a model for future stock price returns and running multiple
hypothetical trials through the model. A Monte Carlo simulation refers to any method that randomly
generates trials, but by itself does not tell us anything about the underlying methodology.
The Variance-Covariance Method:
This method assumes that stock returns are normally distributed. In other words, it requires that we estimate only
two factors - an expected (or average) return and a standard deviation - which allow us to plot a normal distribution
curve. Here we plot the normal curve against the same actual return data:
5. The idea behind the variance-covariance is similar to the ideas behind the historical method - except that we use the
familiar curve instead of actual data. The advantage of the normal curve is that we automatically know where the
worst 5% and 1% lie on the curve. They are a function of our desired confidence and the standard deviation ( ):
The blue curve above is based on the actual daily standard deviation of the QQQ, which is 2.64%. The average daily
return happened to be fairly close to zero, so we will assume an average return of zero for illustrative purposes. Here
are the results of plugging the actual standard deviation into the formulas above:
6. 6) Overall tools and techniques
B)
Company A - Expected Value
Company A - Variance and Standard Deviation
Company B - Expected Value
9. Covariance is the sum of the (Difference * Probability) for each state:
Correlation Coefficient can then be calculated by dividing the covariance by the product of the standard deviation
for Company A and standard deviation for Company B.
In summary there is a weak-to-strong positive correlation between expected value for Company A and expected
value for company B.
10. 7) Fixed Income
Default Risk: The event in which companies or individuals will be unable to make the required payments on their
debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To
mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor's level of default
risk. The higher the risk, the higher the required return, and vice versa.
8) Commodities
B)
Calculation of Forward Contract Price:
f = S×
f = Forward price
S = Current (spot) price
T = Maturity time
t = Time the contract is entered into
r = The risk free interest rate
e = Euler's Constant
(T-t) is expressed as a fraction of a year so is actually
According to the Question:
S = $100
T = 90 days
T-t = 90/360 = 0.25
r = 1.25%
f = 100 ×
f = 100 ×
f = 100 ×1.003129888
f = 100.3129888
The price of this forward contract is $100.31 based on a risk free rate of 1.25% and a spot price of $100.00. So in 90
days’ time the commodity represented by this Forward Contract will be sold / bought for $100.31.
If spot price of the oil is $125 in 90 days the profit or loss incurred is calculated as under:
If spot rate of $125.00, then the seller hedged themselves out of:
125 – 100.31 = 24.69
If the seller hadn't locked themselves into a forward contract they would be $24.69 better off.
11. Calculation of 10 month forward price of a dividend security:
Present of each dividend payment can be calculated as:
C ×
Simplifies to:
Dividend When Risk Free Rate Amount
1 90 days 1.25% $0.33 0.25
2 180 days 1.25% $0.33 0.5
3 270 days 1.25% $0.33 0.75
For Dividend Payment 1:
= 0.32897
For Dividend Payment 2:
= 0.32794
For Dividend Payment 3:
= 0.32692
We then sum the present value of the dividend payments:
0.32897 + 0.32794 + 0.32692 = 0.98383
So the present value of the dividend payments is: $0.98. Or
I = 0.98383
Now we can return to the formula introduced in the first section to calculate the forward contract price, but now it
includes the variableI calculated above:
f = (S- I) ×
f = Forward price
S = $12.50
T = 10 months
t=0
r = $1.25
12. e = Euler's Constant
(T-t) = 10×30/360 = 0.83
f = (12.50 – 0.98) ×
f = 11.52 × 1.01
f = 11.64
So the Forward Price (10 months) of this dividend paying asset is $11.64
9) Money Markets
B) Calculation of Discount Rate:
Given:
Face Value = £5000.00
Purchase Price = £4950.00
Days from settlement = 30 days
Discount Rate = Face Amount – Purchase Price × 360
Face Amount Days from settlement
= 5000 – 4950 × 360
5000 30
= 0.12
= 12 %
Calculation of Discount Price:
Given:
Discount Rate = 4.75%
Days from settlement = 90 days
Discount Price = 1–(Discount Rate × Days from settlement)
360 days
=1-
= 1 – 0.011875
= 0.988125
Apply this to the face value of £5000:
13. 5000 × 0.988125 = £4940.625
Therefore the discount price is £4940.625
Calculation of Discount Dollar Amount:
Given:
Face Amount = £10000.00
Discount Rate = 3.75%
Days from settlement = 360 days
Discount Dollar Amount = Face Amount × Discount Rate ×
= 10000 × 0.0375×
= £375
14. 10) Equities
B)
Use Zero Growth Model:
Replacing the variables with values from the question:
The share price is £14.38.
Share price is the investors demand is 12%
Use Zero Growth Model:
The new share price will be £9.58
Share price if both scenarios dividends grow by a rate of 1% pa
15. Using the Gordon Growth Model:
Replacing the variables with values from the question where investor return is 8% and dividend
growth is 1%:
The new share price will be: £16.43
Replacing the variables with values from the question where investor return is 12% and dividend
growth is 1%:
The new share price will be: £10.45
Share price be under both scenarios if dividends decline at a rate of 1% pa
16. Replacing the variables with values from the question where investor return is 8% and dividend
growth is -1%:
The new share price will be: £12.78
Replacing the variables with values from the question where investor return is 12% and dividend
growth is -1%:
The new share price will be: £8.85