Saturday 23 May 2015

may 2014-CPA Part III Section 5 ADVANCED FINANCIAL MANAGEMENT

CPA Part III Section 5

ADVANCED FINANCIAL MANAGEMENT

Some candidates did not perform well in the following questions: Question No. 4 in which candidates were unable to differentiate between “futures contracts” and “forward contracts”. Candidates also experienced difficulties in evaluating the wisdom of hedging interest rate risk using an interest rate collar instead of an option. In addition, candidates had difficulties in explaining how basis risk arises. Candidates further experienced difficulties in calculating the current market price of a call option. In answering this question, the following was expected:


• Differences between futures and Forwards



 

• An interest rate collar involves the purchase of a put option and the simultaneous selling of a call option at different exercise prices. The main advantage is that it is cheaper than just purchasing the put option. This is because the premium received from selling the call option reduces the higher premium payable for the put option. The main advantage is that the benefit from any upside movement in interest rates is capped by the sale of the call option. With just the put option, the full upside benefit would be realised.

• Basis risk arises from the fact that the price of a futures contract may not move as expected in relation to the value of the instrument being hedged. Basis changes do occur and thus represent potential profit/losses to investors. Basis risk is the difference between spot and futures prices and so there is no basis risk where a futures contract is held until maturity. Thus, basis risk arises when the characteristics of the futures contract differ from those of the underlying asset. Thus, Basis = Spot – Future.

 

Suppose you purchase one share of stock and “h” call options. If stock price goes up, the pay off = 42 + 7h If stock price goes down, pay off = 31 +0h Hence, 42 + 7h = 31 + 0h h = - 11/7 Therefore a perfectly hedged portfolio can be formed by purchasing 1 share of stock and selling 11/7 call options. Hence, 42 + 7 (- 11/7) = 31 + 0 (- 11/7) 31 = 31 Therefore a perfectly hedged portfolio will pay Sh.31 with certainty in 6 months. This implies that the portfolio is identical to a Treasury bond that pays Sh.31 in six months. The price of such a Treasury bond would be 31¸ 1.02 = 30.39. But 30.39 must also be the net cost of buying 1 share of stock and selling 11/7 call options. Therefore 30.39 = 36 – (11/7) C C = 3.57 = Current market price of the call option

Question No. 5

in which candidates had difficulties in explaining the terms “locational arbitrage” and “triangular arbitrage”. Candidates were also unable to use the information provided to compute the expected spot rate and arbitrage profit. In addition, candidates were unable to explain four reasons why mergers and acquisitions fail.
• Locational arbitrage - this is an action to capitalise on a discrepancy in quoted exchange rates between banks.
• These differences are usually small and short-lived. The disparity in rates occurs since information is not always immediately available to all banks.
• Triangular arbitrage - this is an action to capitalize on a discrepancy where the quoted cross exchange rates is not equal to the rate that should exist at equilibrium.
• The appropriate cross rate can be determined given the value of the two currencies with respect to some other currency.
• Expected spot rate can be obtained from the purchasing power parity theorem:  
• Arbitrage profit rRF = (1 + rR) (1 + i) – 1 (1.025) (1.015) - 1 = 4.04% (US risk –free rate) (1.025) (1.02) - 1 = 4.55% (British risk – free rate) Borrow £ 689,700 in the U.K. at 4.55% for one year - must repay £721,081 ( i.e 689,700 x 1.0455) $ 1,000,000 invested for 1 year @ 4.04% = $1,040,400 $1,040,400 converted to U.K.£ at the forward rate = $1,040,400 x 0.6931 = £721,101 £721081 needed to pay U.K. loan Profit: £721,101 - £721,108 = £20.00

• Some reasons why mergers and acquisitions fail

–– Bidders pay too much. This usually arises from an overestimation or miscalculation of the potential payoffs arising from the merger.
–– Too many executives do not understand the importance of achieving appropriate levels of commonality in their processes and systems. Quite simply, a mismatch of cultures.
–– Executives are frequently unable to follow through on the difficult decisions related to post-acquisition and post-merger consolidation. This mainly arises from the euphoria and excitement that accompanies any merger or acquisition.
–– Failure to communicate the rationale behind the merger or acquisition, leading to a breakdown in the free flow of valuable information throughout the corporate structure.
–– Focusing on how the merger or acquisition will increase the size of the company and not how it will create value for shareholders.
–– Not enough effort being expanded on the due diligence process or screening of the target company.
–– Political pressures on the post merged company not to retrench staff.

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