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DERIVATIVES MARKETS & RISK MANAGEMENT - QUESTIONS

Dgangster54     11:25:00     0
                                        


QUESTION 1

(a)     A company buys five September sterling futures on the Chicago Mercantile Exchange at a price of $1.4235. 
Calculate the value of the contract.

Note: Each contract is for a standard amount of £62, 500 in sterling, and the tick size worthy $6.25 ($0.0001/£ x £62, 500).

(b)     Assume that, on 1st November the spot rate of the €/$ was $1.58 and the price on a December futures contract was $1.59. Assume that the euro depreciates over November, so that by 30th November it is worth $1.51.
I.        What do you think would happen to the futures price over the month of November? Why?
II.      If you expected this to occur, would you have purchased or sold a December futures contract on Euro on 1st November? Explain.

QUESTION 2


•         On Monday morning, you short one NSE Tshs. Futures contract containing Tshs. 50,000,000 at a price of Kshs. 0.0667. Suppose the broker requires a (initial) Margin account of Kshs. 350,000 and a maintenance margin of Kshs. 300,000. The settlement prices for Monday through Thursday are Kshs. 0.0680, Kshs. 0.0720, Kshs. 0.0650 and Kshs. 0.0640 respectively. On Friday, you close out the contract at a price of Kshs. 0.0652. 
•         Calculate the daily cash flows on your account. Describe any margin calls on your account. What is your cash balance with your broker as of the close of business on Friday? Assume that you begin with an initial margin of Kshs. 350,000 and that your round trip commission was Kshs. 10,000.



QUESTION 3


Kwetu Mbalizi plc is a company operating in the USA which imports goods from Gwantwa
Mwakibibi in the UK. Kwetu Mbalizi plc is due to pay £650, 000 to Gwantwa Mwakibibi on 20th February 2017. It is now 12th November 2017.
The following futures contracts (contract size £ 62, 500) are available on the Philadelphia exchange:
     Expiry      Current Futures rate
    December      1.4900$/£     
     March           1.4960$/£

(a)    Illustrate how Kwetu Mbalizi can use futures contracts to reduce the transaction risk if, on 20th February, the sport rate is 1.5030$/£ and March futures are trading at 1.5120$/£. The spot rate on 12 November is 1.4850$/£.
(b)    Calculate the hedge efficiency.
 





QUESTION 4


Show whether the following options are in-the-money or out-of-the money?                     
                                     
(i)                  A call option on 1,000 shares in TBL at a strike price of Tshs.1, 275 when the current share price is Tshs.1, 153.
(ii)                A put option on 2,000 shares in TCC at a strike price Tshs.630 when the current share price is Tshs.680
(iii)               A call option giving its holder the right to borrow Tshs.500, 000, 000 for three months at a LIBOR rate of 4.5% when the current LIBOR rate is 4.75%.
(iv)               A put option giving its holder the right to sell $100, 000 at $1 = Tshs. Tshs. 1200, when the spot exchange rate is $1 = Tshs 1, 180.
(v)                A call option on short dollar interest rate futures at a strike price of 9, 450 when the current market price for the futures is 9, 625.  



(b) The following are prices for traded options in shares of Stanbic bank on October 2007 as shown below.     

                                    Nairobi Traded options
Option                          Calls                                                     Puts
                                    Jan       Apr       July                         Jan       Apr       July
Stanbic 300      30        40        50                              10        15         20
*320                330      20        30        35                               25        30        35
                        360      10         20        -                                 40        45        -

Date 20 October 2007

* Underlying current security price

Notes 
•      These option prices are for call options and put options at three different strike prices, 300, 330, and 360 Kenyan Shillings.
•      With Nairobi traded options on shares at Nairobi Stock exchange listed companies, each option contract is for 1,000 shares.



Required- 


From the table of option prices above, how much would it cost to buy?
(i)                  Five April calls at a strike price of 330?
(ii)                Four July puts at a strike price of 300?
(iii)               What is the time value of the January puts at 360?








QUESTION 5


Rafiki Financial Consultants plc is an international construction business that is based in the UK. The company expects to receive €10 million in six months’ time as the final payment for a bridge that the company recently completed in Germany.
The senior executives of the company have been debating whether, and if so, how, to hedge against the foreign exchange risk associated with the receipt.

The euro has been falling against the £ sterling in recent months and some commentators believe that this trend will continue. Others believe, however, that the euro is likely to strengthen against the £ sterling in the near future as the euroland economies begin to grow. Faced with this uncertainty, the company is considering three possible options.

(i)                  To take out a currency option to hedge against the risk. An over-the-counter option is available from a bank at an exercise price of £1 = €1·50 and at a premium cost of £1·20 per €100.
(ii)                To take out a forward exchange contract. Exchange rates are:
£/€ spot                  1·4904 – 1·4944 
6 months forward   €0·0095 – 0·0085 premium
(iii)               To do nothing.

 
 

Required:

(a) Show the effect of each of the three options that are being considered, assuming that the exchange rate has moved in six months’ time to:
(i)                  £1          =         €1·55
(ii)                £1         =          €1·45                                                                 (8 marks)
(b)  Discuss the results from (a) above.                                                   (4 marks)
(c)  Briefly outline the main characteristics of currency options and forward exchange contracts and explain the main advantages and disadvantages of each.                  (8 marks)

(Total 20 marks)


QUESTION 6

Gwakisa has recently commenced exports to Kenya, a developing country and a former British colony. A payment of 100 million shillings is due from a customer in Kenya in three months’ time. The Kenyan government sometimes restricts the movement of funds from the country, but has indicated that payment to Gwakisa has a good chance of receiving approval. No forward market or derivatives markets exist for the Kenyan Shilling in her country, but a colonial link between UK and Kenya provides quotation for the pound and KSH respectively.
The Kenyan shilling is currently linked to the US dollar.
Exchange rates:                                                 KSH/£              $/£
Spot rate                                              126·4 – 128·2             1·775 – 1·782
3 month forward rate                            Not available             1·781 – 1·789

Gwakisa can borrow at 6% per annum or invest at 4% per annum in the UK, can borrow at 7% and invest at 4·5% in the USA, and at 14% and 10% respectively in Kenya.
Gwakisa currently has a £800,000 overdraft in the UK.

Inflation rates:
UK = 3%, USA = 4%, and Kenya = 14%
Gwakisa’s Kenyan customer has indicated that it might be willing to make a lead payment in return for a 1·5% discount on the sale price.

Required:
(a) Discuss the advantages and disadvantages of the alternative currency hedges (including relevant cross hedges) that are available to Gwakisa. Calculate the expected outcome of each hedge, and recommend which hedge should be selected.               

(12 marks)

(b)   Evaluate whether or not Gwakisa should agree to its Kenyan customer receiving the 1·5%
discount.                                                                       (4 marks)
(c)   Suggest possible action that Gwakisa might take if the government decides not to allow the transfer of money out of Kenya.  (4 marks)

(20 marks)


QUESTION 7

Kimoja Kitamu sana Co is a UK-based company which has the following expected transactions.
One month:                                Expected receipt of $240,000
One month:                                Expected payment of $140,000
Three months:                            Expected receipts of $300,000

The finance manager has collected the following information:
Spot rate ($ per £):                                  1.7820 ± 0.0002
One month forward rate ($ per £):         1.7829 ± 0.0003
Three months forward rate ($ per £):     1.7846 ± 0.0004

Money market rates for Kimoja Kitamu sana Co
Borrowing                     Deposit
One year sterling interest rate: 
 4.9%  

4.6
One year dollar interest rate:      
 5.4% 

 5.1

Assume that it is now 1 April.

Required:

(a)  Discuss the differences between transaction risk, translation risk and economic risk.
(b)  Explain how inflation rates can be used to forecast exchange rates. 

(c)  Calculate the expected sterling receipts in one month and in three months using the forward market. 
(d)  Calculate the expected sterling receipts in three months using a money-market hedge and recommend whether a forward market hedge or a money market hedge should be used.  (e) Discuss how sterling currency futures contracts could be used to hedge the three-month dollar receipt. 


QUESTION 8

(a) Mwanazuoni plc wishes to borrow $10 million in six months time for a threemonth period. It normally borrows from its bank at LIBOR + 0.5%. The current three-month LIBOR rate is 5.25, but the company is worried about the risk of a sharp rise in interest rates in the near future.
A bank quotes FRA rates of:
3 v 6:   5.45 - 5.40%
6 v 9:   5.30 – 5.25%
(i)                  How should the company establish a hedge against its interest rate risk using an FRA?
(ii)                Suppose that at settlement date for the FRA, the LIBOR reference rate is fixed at 6.5%. What will be the effective borrowing rate for the company?

(b) It is early January. EPA a limited company intends to borrow £2 million in May for three months, and is concerned about the risk of rising interest rates. It can borrow at LIBOR plus 1%. 
The current three-month LIBOR rate (spot rate) is 4.625%. June futures for short sterling have a current market price of 95.35.
(i)                  How should a hedge be set up for the exposure to the risk of increase in the three-month LIBOR rate?
(ii)                Suppose that when the company does borrow £2 million in May, threemonth LIBOR is 5.50% and the June futures price is 94.25? Calculate the gain/loss from the interest rate futures contract

QUESTION 9

It is now March. Wajanja sisi plc has recognized from its short-term cash budgets that it is likely to have a surplus of £10 million arising in 2 months time (May) for a period of three months, which it plans to invest in short-term money market instruments. It is concerned that interest rates in the next 2 months may fall and wishes to hedge this risk using futures contract.
June three-month sterling interest rate futures contracts are available with a contract size of £500, 000. They are currently priced at 96.00. Interest rates currently stand at 4%.
  

Required:

Illustrate how Wajanja sisi plc can hedge its interest rate exposure using the above futures contracts if, in 2 months time, market interest rates have fallen to 3% and the futures price has moved to 97.00

QUESTION 10

A company expects to borrow £4 million in two months time for a six month-period, and is thinking of using a borrower’s option to hedge its risk. It is worried about the risk of an increase in the three-month LIBOR rate, which is currently 5% per annum. It can borrow at LIBOR plus 1%.
It normally buys a borrower’s option at a strike rate of 5.25%, which has a premium cost of £8,000. The option is for an expiry date in two months, and the notional interest period is sixmonths and the notional principal is £4 million.
Suppose that at expiry, the six-month LIBOR is 6%. 

Required: 

Will the company exercise the option? How will a hedge be constructed?
 

QUESTION 11

Yote Heri and Maisha safari  face the following interest rates (adjusted for the differential impact of taxes)
                                     
            Yote Heri

Maisha Safari
US dollars (floating rate):
            LIBOR + 0.5%

LIBOR + 1.0%
Canadian dollars (Fixed rate):
              5.0% 

6.5%



Assume that Yote Heri wants to borrow US dollars at a floating rate of interest and Maisha Safari wants to borrow Canadian dollars at a fixed rate of interest. A financial Institution is planning to arrange a swap and requires a 50-basis-point spread. If the swap is equally attractive to Yote Heri and Maisha Safari, what rates of interest will Yote Heri and Maisha Safari end up paying?
 

QUESTION 12

Dogodogo plc wishes to borrow US dollars at a fixed rate of interest. Sisi kwa Sisi plc wishes to borrow Japanese yen at a fixed rate of interest. The amounts required by the two companies are roughly the same at the current exchange rate. The companies have been quoted the following interest rates, which have been adjusted for the impact of taxes:
             




Yen


Dollars
Dogodogo plc:




5.0%


9.6%
Sisi kwa Sisi:




6.5%


10.0%

Required:

Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap equally attractive to the two companies and ensure that all foreign exchange risk is assumed by the bank.
     


Question 13

Differentiate and briefly explain the following terms as used in derivative markets
a)      Futures contract Vs Forward contract
b)      Futures contract Vs Option contract
c)      Ticks, Interest rate futures, Variation Margin Vs Initial Margin
d)      Call option Vs Put option, Intrinsic value Vs Time value
e)      American option Vs European option
f)        Interest rate option, Swaptions, Interest rate cap, Interest rate Floor and Interest rate collar options.
g)      Forward Rate Agreements (FRAs) Vs Forward Forwards
h)      Currency Swaps Vs Interest rate swaps
i)        Credit risk, Market risk and Sovereign Risk




Credit - Erick Lusekelo Mwambuli (Lecturer- Faculty of Accounting, Banking and Finance)

INFERENCE STATISTICS - tutorial questions [Estimation of population parameters]. (Business statistics 2)

Dgangster54     13:15:00     0
6)    A sample of 10 items has a mean 20 and a standard deviation 0.5. A second sample of 15 items has a mean 19.5 and standard deviation 0.4. Assuming that the population variances are equal,, estimate 99% confidence interval for the difference between the two population means.  

7)    As an aid in the establishment of personnel requirements, the director of MMC wishes to estimate the mean number of people who are admitted to emergency room during a 24-hour period. The director randomly selects 64 different 24-hour periods and determines the number of admissions for each. For this sample a  x̄ = 19.8 and s =25. Estimate the number of admissions per 24-hour period with 95% confidence interval at MMC.

UNDERSTANDING EARNINGS PER SHARE (EPS)

Dgangster54     02:08:00     0
as per IAS 33
IAS 33 - Earnings per Share
  
The objective of this Standard is to prescribe principles for the determination and presentation of Earnings Per Share, so as to improve performance comparisons between different entities in the same reporting period and between different reporting periods for the same entity.  The focus of this Standard is on the denominator of the earnings per share calculation.

This Standard shall be applied by entities whose ordinary shares or potential ordinary shares are publicly traded and by entities that are in the process of issuing ordinary shares or potential ordinary shares in public markets. An entity that discloses earnings per share shall calculate and disclose earnings per share in accordance with this Standard.

An ordinary share is an equity instrument that is subordinate to all other classes of equity instruments.

A potential ordinary share is a financial instrument or other contract that may entitle its holder to ordinary shares.

An entity shall present in the statement of comprehensive income basic and diluted earnings per share for profit or loss from continuing operations attributable to the ordinary equity holders of the parent entity and for profit or loss attributable to the ordinary equity holders of the parent entity for the period for each class of ordinary shares that has a different right to share in profit for the period. An entity shall present basic and diluted earnings per share with equal prominence for all periods presented.

An entity that reports a discontinued operation shall disclose the basic and diluted amounts per share for the discontinued operation either in the statement of comprehensive income or in the notes.

                                                                                                                          

Basic earnings per share

Basic earnings per share shall be calculated by dividing profit or loss attributable to ordinary equity holders of the parent entity (the numerator) by the weighted average number of ordinary shares outstanding (the denominator) during the period.

For the purpose of calculating basic earnings per share, the amounts attributable to ordinary equity holders of the parent entity in respect of: 
(a)   profit or loss from continuing operations attributable to the parent entity; and
(b)   profit or loss attributable to the parent entity shall be the amounts in (a) and (b) adjusted for the after-tax amounts of preference dividends, differences arising on the settlement of preference shares, and other similar effects of preference shares classified as equity.

For the purpose of calculating basic earnings per share, the number of ordinary shares shall be the weighted average number of ordinary shares outstanding during the period.  [Paragraph 19]  The weighted average number of ordinary shares outstanding during the period and for all periods presented shall be adjusted for events, other than the conversion of potential ordinary shares, that have changed the number of ordinary shares outstanding without a corresponding change in resources. [Paragraph 26]

Diluted earnings per share

For the purpose of calculating diluted earnings per share, an entity shall adjust profit or loss attributable to ordinary equity holders of the parent entity, and the weighted average number of shares outstanding, for the effects of all dilutive potential ordinary shares.

Dilution is a reduction in earnings per share or an increase in loss per share resulting from the assumption that convertible instruments are converted, that options or warrants are exercised, or that ordinary shares are issued upon the satisfaction of specified conditions. 

For the purpose of calculating diluted earnings per share, the number of ordinary shares shall be the weighted average number of ordinary shares calculated in accordance with paragraphs 19 and 26, plus the weighted average number of ordinary shares that would be issued on the conversion of all the dilutive potential ordinary shares into ordinary shares.

Potential ordinary shares shall be treated as dilutive when, and only when, their conversion to ordinary shares would decrease earnings per share or increase loss per share from continuing operations.

An entity uses profit or loss from continuing operations attributable to the parent entity as the control number to establish whether potential ordinary shares are dilutive or antidilutive. In determining whether potential ordinary shares are dilutive or antidilutive, each issue or series of potential ordinary shares is considered separately rather than in aggregate.
                                                                                                                            

Retrospective adjustments

If the number of ordinary or potential ordinary shares outstanding increases as a result of a capitalisation, bonus issue or share split, or decreases as a result of a reverse share split, the calculation of basic and diluted earnings per share for all periods presented shall be adjusted retrospectively. 
                                                                                                                           

FINANCIAL Statements As per accounting standard (IAS1)

Dgangster54     01:59:00     0
IAS 1 - Presentation of Financial Statements

This Standard prescribes the basis for presentation of general purpose financial statements to ensure comparability both with the entity’s financial statements of previous periods and with the financial statements of other entities.  It sets out overall requirements for the presentation of financial statements, guidelines for their structure and minimum requirements for their content. 

A complete set of financial statements comprises:
(a)   a statement of financial position as at the date;
(b)   a statement of profit and loss and other comprehensive income for the period;
(c)   a statement of changes in equity for the period;
(d)   a statement of cash flows for the period;
(e)   notes, comprising a summary of significant accounting policies and other explanatory information; and
(f)    a statement of financial position as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements.

An entity whose financial statements comply with IFRSs shall make an explicit and unreserved statement of such compliance in the notes.  An entity shall not describe financial statements as complying with IFRSs unless they comply with all the requirements of IFRSs.  The application of IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation. 

When preparing financial statements, management shall make an assessment of an entity’s ability to continue as a going concern.  An entity shall prepare financial statements on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so.  When management is aware, in making its assessment, of material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern, the entity shall disclose those uncertainties.

An entity shall present separately each material class of similar items. An entity shall present separately items of a dissimilar nature or function unless they are immaterial. 

An entity shall not offset assets and liabilities or income and expenses, unless required or permitted by an IFRS.

An entity shall present a complete set of financial statements (including comparative information) at least annually. 

Except when IFRSs permit or require otherwise, an entity shall disclose comparative information in respect of the previous period for all amounts reported in the current period’s financial statements.  An entity shall include comparative information for narrative and descriptive information when it is relevant to an understanding of the current period’s financial statements. 

When the entity changes the presentation or classification of items in its financial statements, the entity shall reclassify comparative amounts unless reclassification is impracticable. 

An entity shall clearly identify the financial statements and distinguish them from other information in the same published document.

An entity may present a single statement of profit or loss and other comprehensive income, with profit or loss and other comprehensive income presented in two sections. The sections shall be presented together, with the profit or loss section presented first followed directly by the other comprehensive income section. An entity may present the profit or loss section in a separate statement of profit or loss. If so, the separate statement of profit or loss shall immediately precede the statement presenting comprehensive income, which shall begin with profit or loss.

The other comprehensive income section shall present line items for amounts of other comprehensive income in the period, classified by nature (including share of the other comprehensive income of associates and joint ventures accounted for using the equity method and grouped into those that, in accordance with other IFRSs
:  
(a)   will not be reclassified subsequently to profit or loss; and 

(b)   will be reclassified subsequently to profit or loss when specific conditions are met. 

An entity shall recognise all items of income and expense in a period in profit or loss unless an IFRS requires or permits otherwise.


The notes shall:
(a)   present information about the basis of preparation of the financial statements and the specific accounting policies used in accordance with paragraphs 117–124;
(b)   disclose the information required by IFRSs that is not presented elsewhere in the financial statements; and 
(c)   provide information that is not presented elsewhere in the financial statements, but is relevant to an understanding of any of them.

An entity shall disclose, in the summary of significant accounting policies or other notes, the judgements, apart from those involving estimations (see paragraph 125), that management has made in the process of applying the entity’s accounting policies and that have the most significant effect on the amounts recognised in the financial statements.

An entity shall disclose information about the assumptions it makes about the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year. 

An entity shall disclose information that enables users of its financial statements to evaluate the entity’s objectives, policies and processes for managing capital.  An entity shall also provide additional disclosures on puttable financial instruments classified as equity instruments.

CASH FLOWS STATEMENT as per official IAS 7

Dgangster54     01:53:00     0
IAS 7 - Statement of Cash Flows

The objective of this Standard is to require the provision of information about the historical changes in cash and cash equivalents of an entity by means of a statement of cash flows which classifies cash flows during the period from operating, investing and financing activities.

Cash flows are inflows and outflows of cash and cash equivalents.  Cash comprises cash on hand and demand deposits.  Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

Information about the cash flows of an entity is useful in providing users of financial statements with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilise those cash flows.  The economic decisions that are taken by users require an evaluation of the ability of an entity to generate cash and cash equivalents and the timing and certainty of their generation.

The statement of cash flows shall report cash flows during the period classified by operating, investing and financing activities.

Operating activities

Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.  Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the entity.  Therefore, they generally result from the transactions and other events that enter into the determination of profit or loss.

The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the entity have generated sufficient cash flows to repay loans, maintain the operating capability of the entity, pay dividends and make new investments without recourse to external sources of financing. 

                                                                                                                 
 
An entity shall report cash flows from operating activities using either: 

(a)   the direct method, whereby major classes of gross cash receipts and gross cash payments are disclosed; or
(b)   the indirect method, whereby profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows.

Investing activities

Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.  The separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

The aggregate cash flows arising from obtaining and losing control of subsidiaries or other businesses shall be presented separately and classified as investing activities.

Financing activities

Financing activities are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity.  The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of capital to the entity.

An entity shall report separately major classes of gross cash receipts and gross cash payments arising from investing and financing activities.

Non-cash transactions

Investing and financing transactions that do not require the use of cash or cash equivalents shall be excluded from a statement of cash flows.  Such transactions shall be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities.

Foreign currency cash flows

Cash flows arising from transactions in a foreign currency shall be recorded in an entity’s functional currency by applying to the foreign currency amount the exchange rate between the functional currency and the foreign currency at the date of the cash flow. 

The cash flows of a foreign subsidiary shall be translated at the exchange rates between the functional currency and the foreign currency at the dates of the cash flows.

Unrealised gains and losses arising from changes in foreign currency exchange rates are not cash flows. 
However, the effect of exchange rate changes on cash and cash equivalents held or due in a foreign currency is
                                                                                                                            
reported in the statement of cash flows in order to reconcile cash and cash equivalents at the beginning and the end of the period. 

Cash and cash equivalents

An entity shall disclose the components of cash and cash equivalents and shall present a reconciliation of the amounts in its statement of cash flows with the equivalent items reported in the statement of financial position.

An entity shall disclose, together with a commentary by management, the amount of significant cash and cash equivalent balances held by the entity that are not available for use by the group.

                                                                                                                           

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