AFM TECHNICAL ARTICLES

Explain and evaluate the role and responsibility of the senior financial executive or advisor in
meeting conflicting needs of stakeholders and recognise the role of international financial
institutions in the financial management of multinationals (A)

A1 – Patterns of Behavior

Are all financial decisions rational? The assumption that they are underpins theories of economic
behaviour and stock market models, such as the efficient market hypothesis.

Why then do stock market booms and busts occur if investors are acting rationally? Rational
behaviour surely implies no shocks, with stock markets showing steady movements in share prices,
but not sudden spurts. However, unexpected and significant news could still result in sudden shocks.

Also, why are some mergers and acquisitions considered to be poor deals? If a listed company is
being acquired, surely the acquisition price should be based on the market value of its shares, if the
markets are valuing it fairly. Why then is there uncertainty about the true value of many acquired
companies? Why also do many acquisitions run into difficulties?

If proper due diligence has been done and decisions are made rationally, surely the directors of the
acquiring company will only go ahead if the combination stands a very good chance of success.

Behavioural finance attempts to explain how decision makers take financial decisions in real life, and
why their decisions might not appear to be rational every time and, hence, have unpredictable
consequences. Behavioural finance has been described as ‘the influence of psychology on the
behaviour of financial practitioners’ (Sewell, 2005). Behavioural finance seeks to examine the
following assumptions of rational decision making by investors and financial managers:

1. Financial decision makers seek to maximise their utility and do so by trying to maximise
portfolio or company value.

2. They take financial decisions based on analysis of relevant information.

3. The analysis of financial information that they undertake is rational, objective and risk-
neutral.

Let’s look at how behavioural factors may influence decision making and, therefore, stock markets’
and companies’ financial strategies.

Investors

Maximisation of utility
Rational decision making by investors implies that their decisions about their investment portfolios
will aim to maximise their long-term wealth and, hence, their utility. However, behavioural factors
may influence investors to take decisions that are not the best ones for achieving maximum value
from their portfolios. Investors may have preferences for particular stocks on non-financial grounds –
for example, companies that they consider are acting with social responsibility. They may also avoid
’sin stocks’ – companies operating in sectors that they regard as unethical.

Investor utility may also be linked to the process of decision making. Some investors hold on to
shares with prices that have fallen over time and are unlikely to recover. They may do this because it

1
will cause them psychological hurt to admit, even only to themselves, that their decision to invest
was wrong. This is known as cognitive dissonance.

Analysis of relevant information

Behavioural finance next looks at the basis that investors use to take decisions. It suggests that
decisions may not be based on an assessment of relevant financial information, but on other
grounds. Investors may use information that is not relevant but is readily available, possibly to
simplify the decision making process (known as anchoring). For example, investors may buy shares
that in the past have had high values, on the grounds that these represent their true potential values,
even though rational analysis suggests that the prices of these shares will remain low in the future

Investors may also believe that the probability of a future outcome will be influenced by how often
the same outcome has occurred in the past. A non-financial example of this idea would be the
situation when a coin is flipped eight times, comes up as tails every time and it is said that heads is
more likely the ninth time as, by the ‘law of averages’, heads must come up soon.

If the value of a company’s shares has risen for some time, investors will be using similar logic to the
coin example if they sell those shares on the grounds that the shares have gained in value for ‘long
enough’ and their price must therefore soon start to fall, even if rational analysis suggest that the rise
in price will continue. This is known as the gambler’s fallacy.

Another deviation from rational analysis is the herd instinct, where investors buy or sell shares in a
company or sector because many other investors have already done so. Explanations for investors
following a herd instinct include social conformity, the desire not to act differently from others.
Following a herd instinct may also be due to individual investors lacking the confidence to make their
own judgements, believing that a large group of other investors cannot be wrong. If many investors
follow a herd instinct to buy shares in a certain sector, for example the IT sector, this can result in
significant price rises for shares in that sector and lead to a stock market bubble.

Investors may not therefore base their decisions on rational analysis, but there is also evidence to
suggest that stock market ‘professionals’ often don’t do so either. Studies have shown that there are
traders in stock markets who do not base their decisions on fundamental analysis of company
performance and prospects. They are known as noise traders.

Characteristics associated with noise traders include making poorly timed decisions and following
trends. Chartism, using analysis of past share prices as a basis for predicting the future, is an example
of noise trading.

Fund managers may also be subject to behavioural influences. Fund managers who wish to give the
impression that they are actively managing their investment portfolios, may periodically reposition
their portfolios into new sectors, even though the old sectors continue to have good prospects. Some
fund managers also ignore companies with low market capitalisation, with the result that their
shares are not purchased and their value remains low (known as small capitalisation discount).

Rational, objective and risk-neutral analysis

Investors may base their decision on an analysis of available information, but behavioural finance has
highlighted that this analysis can be subjective. One aspect is confirmation bias, taking an approach
or paying attention to evidence that confirms investors’ current beliefs about their investments and
ignoring evidence that casts doubt on their beliefs. In the dotcom boom, some investors used a
variety of methods to value high-tech companies at a large premium, but ignored models such as
cash flow valuation models that indicated the worth of those companies was much lower.

2
Another aspect of investor bias is attitudes towards risks. Rational theory suggests that risk-neutral
investors will adopt a long-term approach based on expected values. However, behavioural finance
has highlighted various attitudes towards the risks of making profits or losses. Some investors may be
attracted by a company that offers the possibility of making very high returns, even if the possibility
is not very great (again, the dotcom boom provides evidence of this).

Other investors may have regret aversion, avoiding investments that have the risk of making losses,
even though expected value analysis suggests that, in the long-term, they will make significant
capital gains. Investors with regret aversion may also prefer to invest in companies that look likely to
make stable, but low, profits, rather than companies that may make higher profits in some years but
possibly losses in others.

There is also evidence that many investors pay most attention to the last set of financial results and
other recent information about a company, and take less notice of data that has been available for a
while. Explanations for this have included recent information being more readily accessible and more
immediate in investors’ minds than older information. A consequence of this may be over-reaction
when companies release information, with share prices rising or falling quickly after information is
released and then going back in the opposite direction to an equilibrium value over time.

Behavioural finance also suggests that there may be a momentum effect in stock markets. A period of
rising share prices may result in a general feeling of optimism that price rises will continue and an
increased willingness to invest in companies that show prospects for growth. If a momentum effect
exists, then it is likely to lengthen periods of stock market boom or bust.

Finance managers

Behavioural finance studies have also looked at decision making by managers of companies. They
have identified factors that affect investment decisions of all types, but particularly focused on
mergers and acquisitions, since many do not appear to fulfil the expectations of the acquiring
company.

Maximisation of utility
Companies can be regarded as maximising their utility by long-term maximisation of their
shareholders’ wealth. However, it is not just behavioural finance that casts doubt on whether
company managers are seeking this objective for their shareholders. Agency theory also highlights
that managers may have different objectives from shareholders, such as maximising their own short-
term rewards and expanding the company by acquisition or other means in order to enhance their
own reputation.

However, behavioural finance has highlighted that managers’ objectives may not be explainable
rationally. Studies have looked at contested takeovers, where different companies bidding against
each other has forced the acquisition price up to a level that was significantly greater than many
outside the companies involved thought was reasonable. One theory for this is that once managers
enter into competition, it makes acquiring a company that others have sought to buy as well, a
source of satisfaction in itself. The acquirer’s managers are unwilling to let someone else have what
they have been trying to acquire (known as loss aversion bias).

Analysis of relevant information

There is also evidence that when managers choose to bid for another company, the factor is
sometimes not a rational assessment of the target’s potential, but their belief in their own abilities.
Some managers of acquiring companies seem to believe that, however poor the outlook for the

3
target seems, their own considerable management skills will improve its prospects after the merger
takes place. A symptom of this belief could be managers arguing that the target should be valued not
using its own price-earnings ratio, but using the (higher) price-earnings ratio of the acquirer.

Once an acquisition or any other strategy has been implemented, what influences managers may be
the need to show that they have made the right decisions. Managers may feel that a failing strategy
would damage their reputation, and possibly their future prospects. Therefore, they may decide to
commit more funds trying to ensure that the strategy is successful, rather than admitting defeat and
taking steps to mitigate losses (known as entrapment).

Rational, objective and risk-neutral analysis

Managers may also be subjective when they analyse information. Also, they may have confirmation
bias, paying attention to information that suggests that an acquisition will enhance value and
ignoring evidence that indicates that the target will not be a good buy. They may also seek
information that provides a simple yardstick for their own decision making, however flawed that
information may be. The value put on the target company by its own directors may be subject to
considerable bias, but the acquirer’s directors may regard it as a good indication of what the target’s
fair value is.

Limitations of behavioural finance

Critics of the behavioural finance approach have argued that even if individuals make irrational
decisions when left by themselves, participating in finance markets helps discipline them to act
rationally by giving them opportunities to learn from their experiences. The consequences of
irrational decisions are short-term anomalies. In the longer-term general theories, such as the
efficient market hypothesis, will apply.

Conclusion

Behavioural finance has identified a number of factors that may take individuals away from a process
of taking decisions to maximise economic utility on the basis of rational analysis of all the
information supplied. If these factors apply in practice, they can lead to movements from what would
be considered a fair price for an individual company’s shares, and the market as a whole to a period
where share prices are collectively very high or low. For an acquisition, it can lead to a purchase price
that differs significantly from what appears to be a rational valuation.

If you’re asked in the Advanced Financial Management exam to consider behavioural factors that
may influence the decisions of investors or managers, you’ll need to read the question scenario very
carefully. Look out for information about how investors or managers may be taking decisions, or
factors in the situation that may trigger biases that the decision makers have.

You may not be able to come to a firm conclusion about what decision makers will do and why, but
you should be looking to discuss various possibilities. Bringing real life into your answer has to mean
questioning the assumption that all financial decisions are taken rationally, and at least admitting
that behavioural factors may influence decision makers.

Written by a member of the examining team for Advanced Financial Management

A2 – Topic explainer video: Dividend theory & dividend policy

4
Evaluate potential investment decisions and assessing their financial and strategic consequences,
both domestically and internationally (B)

B1- Green Finance

This short article looks at green financing, which is part of the AFM syllabus area B3.

What is green finance?

Green finance does not have a globally agreed definition, but for the purposes of AFM it can be
considered to be specific financing for projects or initiatives which will have a positive environmental
impact.

This means there is a commitment to investing the funds raised into ‘green’ projects such as:

• renewable energy

• low carbon solutions

• sustainability initiatives

• climate change resilience

As a result, the use of green finance means that sustainability and environmental factors become
part of mainstream financial decision making.

Advantages of green finance

Green finance, which is typically debt finance, is often cheaper than conventional debt finance,
thereby creating a saving on interest expense for an organisation.

Another aspect is that the use of green finance can demonstrate that a project is sustainable and
environmentally friendly. This can help to improve a corporate image and reputation.

Disadvantages of green finance

Green financing involves additional costs as a result of increased reporting requirements. It will need
to be shown that the project or initiative being financed will actually have a positive environmental
impact. This may require an independent audit and even if not, there is likely to be an increased
administrative burden because of this.

Conclusion

In many cases, the benefits related to savings and the impact of additional costs should be fairly
straightforward for an organisation to assess. Then a cost-benefit analysis can be undertaken to see
whether the green finance is worthwhile.

Written by a member of the AFM examining team

5
B2 - Using real options when making financial strategy decisions

While the use of real options in investment appraisal is increasingly accepted, the practicalities of
using option pricing techniques and ideas in making actual financial strategy decisions is less well
understood.

This article will initially consider how an individual traditional project could be reassessed using
option valuation. It will then consider how option valuation could assist when assessing a portfolio of
projects and will conclude with a brief discussion regarding inter-dependent projects.

A traditional project and option valuation

Let us imagine that a company is proposing a major expansion project. The operational management
team have forecast the cash flows relevant to the project in line with the standard assumptions and
policies set down by the financial management. The financial management have then discounted
these cash flows at a cost of capital of 11% and this has resulted in an NPV of just $5m. For the sake
of simplicity tax, inflation and other real world complications have been ignored.

NPV calculation – overall:

Those executives who are keen proponents of this expansion are disappointed by the low NPV and
fear that the project is unlikely to win approval when competing for funds against other projects.
They consider that the project is being undervalued and, hence, a meeting with the financial
management team is arranged. At this meeting the financial management team query the large net
cash outflow that is forecast to occur at the end of year two. As a result of this, it becomes apparent
that the project comprises an initial investment of $600m which will produce net cash inflows of
$110m for the following 10 years, followed by a further investment of $300m after two years which
will increase the net cash inflows by $48m to $158m per year for the remaining eight years. Further
discussion reveals that the additional investment after two years is discretionary and does not
necessarily need to be made.

Hence, the project could be viewed as an initial expansion costing $600m – phase 1 – followed by an
option to expand further after two years – phase 2.

If separate NPV calculations are carried out for each of these phases. The results below are obtained.

NPV calculation – phase 1:

6
NPV calculation – phase 2:

The total NPV is fundamentally unchanged as $47.8m – $43m = $4.8m, which is about the same as
the $5m calculated initially. To the extent there is a difference, this can be attributed to rounding.
This analysis alone provides some insight as, given that there is no obligation for the company to
carry out phase two, the overall NPV must be at least $47.8m which far exceeds the initial NPV
calculated of $5m.

It is worth noting that the discretionary spend at the end of year two has also been discounted at the
11% cost of capital. Although this is the approach commonly taken it could be more accurate to
discount such discretionary expenditure at the risk free rate. This is because discretionary
expenditure has much less operational risk than the net cash inflows that it is hoped will arise from
such expenditure. If a risk free rate of 5% is used the present value of the $300m expenditure at the
end of year two would be $272.1m. This is $28.5m (272.1 – 243.6) more than the present value if the
cost of capital is used. Hence, the original overall NPV and the NPV of phase two should perhaps be
reduced by this $28.5m. This approach would be consistent with the treatment of the exercise price
in the Black Scholes Option Pricing model.

Although phase two does not currently seem worthwhile the option to carry out this phase can only
add value as an option can never have a negative value. If the cash flows expected from phase two
were to become favourable, the company will have the ability to carry out phase two and reap the
benefit. Hence, the overall NPV will be $47.8m plus the value of the option to carry out phase two.

In order to value the option to carry out phase two we must first attribute figures to the inputs
required for the Black Scholes option pricing (BSOP) formula:

• Pe = the investment required after two years to carry out phase two = $300m

• Pa = the PV of the net cash inflows currently forecast to arise from phase two = $200.6m
(this must exclude the Pe)

7
 • t = the time until phase two will begin = 2 years

• s = the volatility – assumed to be 0.4 (standard deviation)

• r = the risk free rate – assumed to be 5%

The Pe and Pa figures can be seen in the calculation of the NPV for phase two and, as we know, the
company has the option to expand into phase two after two years. The s and r will both be given
within any exam question and, hence, suitable figures have been assumed.

Using these inputs into the BSOP calculator given in the exam will give the following:

Option value:

d1 = 0.2519

d2 = – 0.8175

N(d1) = 0.4006

N(d2) = 0.2068

c = $24.22m

p = $95.07m

An option to expand (or follow-on) is a type of call option. Hence, the total NPV for the project with
the option to expand = $47.8m + $24.22m = $72.02m. As a result of the financial management taking
the time to better understand the project and the real options within it a project which seemed fairly
marginal, has been shown to be attractive and is far more likely to win approval.

The attractiveness of the project arises because phase one of the project is itself attractive and the
company can potentially benefit if the phase two expansion finally becomes worthwhile.

As discussed in the previous real options article, there are significant problems associated with using
BSOP to value real options and, hence, the option value of $24.22m calculated should be treated as
indicative only and should be used with care.

A portfolio of projects and option valuation

As soon as executives launch a strategy conditions change in the environment within which they are
operating and indeed their knowledge of that environment is updated. Hence, managers must
actively manage and respond accordingly. Traditional NPV analysis is probably too static a tool to
reflect this active management. This is because it tends to assume a company will follow a previously
agreed plan and does not account so well for how events may unfold. Instead managers should
perhaps view the projects they could undertake to achieve their goals as a portfolio of real options
which they could potentially exercise over time.

Imagine a company is faced with six independent projects as follows:

8
Given this basic NPV analysis projects U and V would be accepted and a total NPV of $8m would be
generated for the company.

Let us now imagine that projects U and X have to be carried out immediately or not at all. In other
words there is no option to delay these projects. Hence, project U would be accepted to generate an
NPV of $5m and project X would be rejected. A useful analogy here is that of fruit growing in a
garden. Projects U and X represent fruits which have to be picked now. Project U represents the
perfectly ripe fruit which can be sold or eaten, while project X represents the rotten fruit which must
be picked but then discarded.

The remaining projects can be delayed and represent fruits which do not have to be picked
immediately and which have the potential to develop into perfectly ripe fruit. Given the volatility of
the cash flows from these projects and the period by which they could be delayed option values can
be calculated for these projects. This data and the resulting option values are presented below:

These option values have been calculated using an assumed risk free rate of 5%.

These option values total to a value of $30.5m. If the NPV of project U, which has already been
accepted, is added to this a total value of $35.5m is created. This value is significantly higher than the
original NPV of $8m which could have been generated by accepting projects U and V. However,
careful management is necessary if as much value as possible is to be generated.

We will now consider each of projects V, W, Y and Z separately:

Project V:
This project looks most promising. It has a positive NPV if exercised now but its value as an option is
significantly higher. Hence, exercising now would appear sub-optimal as with further nurturing a
higher value could be generated. To continue the fruit analogy this project represents a fruit which
could be picked now and eaten or sold but which, with careful cultivation, could become a larger and
better fruit. However, just as ripening fruit can be eaten by pests, there is potential for project value
to be lost – through the actions of competitors for instance. Hence, the company may decide to
exercise the option early to realise the existing positive NPV.

Project W:
This project is not at all promising. It has a negative NPV if exercised now and, as it has a low
volatility and there is a relatively short time until a decision has to be made regarding this project, it
has a low option value. Hence, this project will probably never be worth exercising. This project could
be thought of as the small, late developing fruit which is unlikely to ripen before the season ends.

Project Y:
Despite currently having a negative NPV this project has a high value as an option. This is due to the
fact that it will not expire for three years and has a relatively high volatility when compared to the
other projects. Hence, this project will probably be worth exercising at some later date. This project

9
represents the unripe fruit which cannot be picked now, but which is expected to mature into a
perfectly ripe fruit in the future.

Project Z:
This project is similar to project Y but is much less promising. It currently has the same negative NPV
as project Y but as it has a lower volatility and a shorter time until it expires it has a lower value as an
option when compared to project Y. This project seems unlikely to be worth exercising but there is
still a reasonable chance that it could move ‘into the money’ and, hence, may become worth
exercising in the future. As with project Y this project is also an unripe fruit which cannot be picked
now. However, its chances of maturing into a perfectly ripe fruit seem much less.

How does the use of option valuation analysis help when compared to a traditional NPV analysis?

As previously stated traditional NPV analysis would lead to the acceptance of projects U and V,
resulting in an NPV of $8m, and the rejection of the other four projects. However, option valuation
analysis results in the acceptance of project U generating an NPV of $5m, the rejection of project X
and options to carry out the four other projects in the future the total value of which has been
estimated as $30.5m.

Further the analysis encourages active management:

Project V has been identified as worthy of careful management to ensure it is carried out at the
optimal time to maximise the value created but at the same time ensuring that the existing positive
NPV is not destroyed.

Of the remaining projects Project W has been identified as the project deserving least attention
while with careful nurturing project Y and even project Z could finally create value for the company.

It is crucial to recognise that projects, just like fruit, do require nurturing. This is because as the time
approaches when the project must be carried out or abandoned, the option value will always tend to
decline assuming all other variables remain constant. This is because the time to maturity falls and
the present value of the exercise price, the investment to be made to carry out the project, is rising.

Hence, without nurturing all the option values will move to zero over time. For this not to happen
there must be good luck or active management. Good luck could add value to a project because, for
instance, sudden growth in the economy could mean the returns from a project become higher than
originally forecast. Active management could involve taking action to reduce the costs or increase
the revenues associated with a project. Equally action could be taken to reduce the initial investment
required in the project.

Using the option valuation approach has helped identify those projects most likely to benefit from
such nurturing and, hence, is useful as a company follows and develops its financial strategy.

Inter-dependent projects

So far this article has looked at how our understanding of a single project and a portfolio of
independent projects could be enhanced by the use of option valuation. Let us now consider briefly
interdependent projects.

Just as you and I are faced with a myriad of options when buying a new car the car manufacturer also
has many options.

For instance a car manufacturer may have a project to launch a new saloon model. From this saloon
model, an estate model could then be launched, and from this a 4x4 version of the estate model

10
could be launched. This is a strategy followed by Skoda with their Octavia and Superb ranges. In
effect the company has the initial project (the launch of the saloon), followed by a call option on the
launch of the estate, which itself has a call option on the launch of the 4x4 estate. Hence, the
company has a call on a call! This is known as a nest of options or nested options.

Another car manufacturer may also have a project to launch a new saloon model. From this saloon,
an estate model could be launched and a sports utility vehicle (SUV) model could also be launched.
This is a strategy followed by BMW with their 3 series and 5 series ranges. In effect the company has
the initial project (the launch of the saloon), followed by a call option on the launch of the estate and
a call option on the launch of the SUV model (the BMW X3 and X5). While these options are not
nested they are obviously still very much related.

Understanding how these options inter-relate is obviously useful to a company as they develop their
strategy. Once again good luck and active management play their part. For instance a few bad
winters is likely to enhance future sales of SUV’s and 4x4 estates. This in turn enhances the value of
the call options to manufacture these models and, hence, the value of the original product launch.

Active management could involve the development of a new more fuel efficient 4x4 system. Any
such increase in fuel efficiency is also likely to enhance the sales of 4x4 equipped SUV’s and estates,
and enhance the value of the call options to manufacture these models and, hence, the value of the
original product launch. Conversely, extra sales of 4x4 equipped models may reduce sales of other
models.

Obviously the initial product launch should be marketed in such a way as to maximise its success.
Active management should also ensure that this initial product launch should ensure consumers’
perception of the new model is developed in such a way that the chances of success of the follow on
models is optimised.

Our knowledge of the determinants of option values can also be useful. For instance if sales of SUV’s
are high in a more volatile market such as China this adds value to the option to develop the SUV
variant of the model in the future, and, hence, enhances the value of the initial project to launch the
saloon.

Conclusion

This article has demonstrated how option valuation techniques can help understand the potential
value of projects and how financial strategy decisions can be made using this knowledge in order to
maximise the results arising from projects and, hence, maximise company value.

William Parrott, freelance tutor and senior FM tutor, MAT Uganda

References

• Investment Opportunities as Real Options: Getting Started on the Numbers

• Timothy A. Luehrman, Harvard Business Review, July/August 1998

• Strategy as a Portfolio of Real Options

• Timothy A. Luehrman, Harvard Business Review, September/October 1998

11
B3 - Investment appraisal and real options

Real options’ valuation methodology adds to the conventional net present value (NPV) estimations
by taking account of real life flexibility and choice. This is the first of two articles which considers how
real options can be incorporated into investment appraisal decisions. This article discusses real
options and then considers the types of real options calculations which may be encountered
in Advanced Financial Management, through three examples. The article then considers the
limitations of the application of real options in practice and how some of these may be mitigated.

The second article considers a more complex scenario and examines how the results produced from
using real options with NPV valuations can be used by managers when making strategic decisions.

Net present value (NPV) and real options

The conventional NPV method assumes that a project commences immediately and proceeds until it
finishes, as originally predicted. Therefore it assumes that a decision has to be made on a now or
never basis, and once made, it cannot be changed. It does not recognise that most investment
appraisal decisions are flexible and give managers a choice of what actions to undertake.

The real options method estimates a value for this flexibility and choice, which is present when
managers are making a decision on whether or not to undertake a project. Real options build on net
present value in situations where uncertainty exists and, for example: (i) when the decision does not
have to be made on a now or never basis, but can be delayed, (ii) when a decision can be changed
once it has been made, or (iii) when there are opportunities to exploit in the future contingent on an
initial project being undertaken. Therefore, where an organisation has some flexibility in the decision
that has been, or is going to be made, an option exists for the organisation to alter its decision at a
future date and this choice has a value.

With conventional NPV, risks and uncertainties related to the project are accounted for in the cost of
capital, through attaching probabilities to discrete outcomes and/or conducting sensitivity analysis or
stress tests. Options, on the other hand, view risks and uncertainties as opportunities, where upside
outcomes can be exploited, but the organisation has the option to disregard any downside impact.

Real options methodology takes into account the time available before a decision has to be made
and the risks and uncertainties attached to a project. It uses these factors to estimate an additional
value that can be attributable to the project.

Estimating the value of real options

Although there are numerous types of real options, in Advanced Financial Management, candidates
are only expected to explain and compute an estimate of the value attributable to three types of real
options:

(i) The option to delay a decision to a future date (which is a type of call option)
(ii) The option to abandon a project once it has commenced if circumstances no longer justify the
continuation of the project (which is a type of put option), and
(iii) The option to exploit follow-on opportunities which may arise from taking on an initial project
(which is a type of call option).

In addition to this, candidates are expected to be able to explain (but not compute the value of)
redeployment or switching options, where assets used in projects can be switched to other projects
and activities.

12
For the Advanced Financial Management exam purposes, it can be assumed that real options are
European-style options, which can be exercised at a particular time in the future and their value will
be estimated using the Black-Scholes Option Pricing (BSOP) model and the put-call parity to estimate
the option values. However, assuming that the option is a European-style option and using the BSOP
model may not provide the best estimate of the option’s value (see the section on limitations and
assumptions below).

Five variables are used in calculating the value of real options using the BSOP model as follows:

1. The underlying asset value (Pa), which is the present value of future cash flows arising from
the project.

2. The exercise price (Pe), which is the amount paid when the call option is exercised or amount
received if the put option is exercised.

3. The risk-free (r), which is normally given or taken from the return offered by a short-dated
government bill. Although this is normally the discrete annualised rate and the BSOP model
uses the continuously compounded rate, for Advanced Financial Management purposes the
continuous and discrete rates can be assumed to be the same when estimating the value of
real options.

4. The volatility (s), which is the risk attached to the project or underlying asset, measured by
the standard deviation.

5. The time (t), which is the time, in years, that is left before the opportunity to exercise ends.

The following three examples demonstrate how the BSOP model can be used to estimate the value
of each of the three types of options.

Example 1: Delaying the decision to undertake a project

A company is considering bidding for the exclusive rights to undertake a project, which will initially
cost $35m.

The company has forecast the following end of year cash flows for the four-year project.

Year 1 2 3 4

Cash 20 15 10 5
flows
($m)

The relevant cost of capital for this project is 11% and the risk free rate is 4.5%. The likely volatility
(standard deviation) of the cash flows is estimated to be 50%.

Solution:
NPV without any option to delay the decision

13
 Year Today 1 2 3 4

Cash flows ($) -35m 20m 15m 10m 5m

PV (11%) ($) -35m 18.0m 12.2m 7.3m 3.3m

NPV = $5.8m

Supposing the company does not have to make the decision right now but can wait for two years
before it needs to make the decision.

NPV with the option to delay the decision for two years

Year 3 4 5 6

Cash flows 20m 15m 10m 5m

($)

PV (11%) 14.6m 9.9m

5.9m 2.7m
($)

Variables to be used in the BSOP model

Asset value (Pa) = $14.6m + $9.9m + $5.9m + $2.7m = $33.1m
Exercise price (Pe) = $35m
Exercise date (t) = Two years
Risk free rate (r) = 4.5%
Volatility (s) = 50%

Using the BSOP model

Putting the above values into the BSOP calculator given in the exam will give the following:

d1 0.4019

d2 -0.3052

14
 N(d1) 0.6561

N(d2) 0.3801

Call value $9.56m

Put value $8.45m

Based on the facts that the company can delay its decision by two years (a call option) and a high
volatility, it can bid as much as $9.56m instead of $5.8m for the exclusive rights to undertake the
project. The increase in value reflects the time before the decision has to be made and the volatility
of the cash flows.

Example 2: Exploiting a follow-on project

A company is considering a project with a small positive NPV of $3m but there is a possibility of
further expansion using the technologies developed for the initial project. The expansion would
involve undertaking a second project in four years’ time. Currently, the present values of the cash
flows of the second project are estimated to be $90m and its estimated cost in four years is expected
to be $140m. The standard deviation of the project’s cash flows is likely to be 40% and the risk free
rate of return is currently 5%.

Solution:
The variables to be used in the BSOP model for the second (follow-on) project are as follows:

Asset Value (Pa) = $90m

Exercise price (Pe) = $140m
Exercise date (t) = Four years
Risk free rate (r) = 5%
Volatility (s) = 40%

Using the BSOP model

Putting the above values into the BSOP calculator given in the exam will give the following:

d1 0.0977

d2 -0.7023

N(d1) 0.5389

15
 N(d2) 0.2412

Call value $20.85m

Put value $8.45m

As stated earlier, a follow-on project is also a call option. Therefore, the overall value to the company
is $23.85m, when both the projects are considered together. At present the cost of $140m seems
substantial compared to the present value of the cash flows arising from the second project.
Conventional NPV would probably return a negative NPV for the second project and therefore the
company would most likely not undertake the first project either. However, there are four years to go
before a decision on whether or not to undertake the second project needs to be made. A lot could
happen to the cash flows given the high volatility rate, in that time. The company can use the value
of $23.85m to decide whether or not to invest in the first project or whether it should invest its funds
in other activities. It could even consider the possibility that it may be able to sell the combined
rights to both projects for $23.85m.

Example 3: The option to abandon a project

Duck Co is considering a five-year project with an initial cost of $37,500,000 and has estimated the
present values of the project’s cash flows as follows:

Year 1 2 3 4 5

Present values 1,496.9 4,938.8 9,946.5 7,064.2

13,602.9
($ 000s)

Swan Co has approached Duck Co and offered to buy the entire project for $28m at the start of year
three. The risk free rate of return is 4%. Duck Co’s finance director is of the opinion that there are
many uncertainties surrounding the project and has assessed that the cash flows can vary by a
standard deviation of as much as 35% because of these uncertainties.

Solution:
Swan Co’s offer can be considered to be a real option for Duck Co. Since it is an offer to sell the
project as an abandonment option, a put option value is calculated based on the finance director’s
assessment of the standard deviation and using the Black-Scholes option pricing (BSOP) model,
together with the put-call parity formula.

Although Duck Co will not actually obtain any immediate cash flow from Swan Co’s offer, the real
option computation below, indicates that the project is worth pursuing because the volatility may
result in increases in future cash flows.

Without the real option

16
 Year 1 2 3 4 5

Present values 1,496.9 4,938.8 9,946.5 7,064.2 13,602.9

($ 000s)

Present value of cash flows approx. = $37,049,300

Cost of initial investment = $37,500,000
NPV of project = $37,049,300 – $37,500,000 = $(450,700)

With the real option

The asset value of the real option is the sum of the PV of cash flows foregone in years three, four and
five, if the option is exercised ($9.9m + $7.1m + $13.6m = $30.6m)

Asset value (Pa) $30.6m

Exercise Price (Pe) $28m

Risk-free rate (r) 4%

Time to exercise (t) Two years

Volatility (s) 35%

d1 0.5885

d2 0.0935

N(d1) 0.7219

17
 N(d2) 0.5373

Call Value $8.20m

Put Value $3.45m

Net present value of the project with the put option is approximately $3.00m ($3.45m – $0.45m).

If Swan Co’s offer is not considered, then the project gives a marginal negative net present value,
although the results of any sensitivity analysis need to be considered as well. It could be
recommended that, if only these results are taken into consideration, the company should not
proceed with the project. However, after taking account of Swan Co’s offer and the finance director’s
assessment, the net present value of the project is positive. This would suggest that Duck Co should
undertake the project.

Limitations and assumptions

Many of the limitations and assumptions discussed below stem from the fact that a model developed
for financial products is used to assess flexibility and choice embedded within physical, long-term
investments.

European-style options or American-style options

The BSOP model is a simplification of the binomial model and it assumes that the real option is a
European-style option, which can only be exercised on the date that the option expires. An
American-style option can be exercised at any time up to the expiry date. Most options, real or
financial, would, in reality, be American-style options.

In many cases the value of a European-style option and an equivalent American-style option would
be largely the same, because unless the underlying asset on which the option is based is due to
receive some income before the option expires, there is no benefit in exercising the option early. An
option prior to expiry will have a time-value attached to it and this means that the value of an option
prior to expiry will be greater than any intrinsic value the option may have, if it were exercised.

However, if the underlying asset on which the option is based is due to receive some income before
the option’s expiry; say for example, a dividend payment for an equity share, then an early exercise
for an option on that share may be beneficial. With real options, a similar situation may occur when
the possible actions of competitors may make an exercise of an option before expiry the better
decision. In these situations the American-style option will have a value greater than the equivalent
European-style option.

Because of these reasons, the BSOP model will either underestimate the value of an option or give a
value close to its true value. Nevertheless, estimating and adding the value of real options embedded
within a project, to a net present value computation will give a more accurate assessment of the true
value of the project and reduce the propensity of organisations to under-invest.

18
Estimating volatility

The BSOP model assumes that the volatility or risk of the underlying asset can be determined
accurately and readily. Whereas for traded financial assets this would most probably be the case, as
there is likely to be sufficient historical data available to assess the underlying asset’s volatility, this is
probably not going to be the case for real options. Real options would probably be available on large,
one-off projects, for which there would be little or no historical data available.

Volatility in such situations would need to be estimated using simulations, such as the Monte-Carlo
simulation model, with the need to ensure that the model is developed accurately and the data input
used to generate the simulations reasonably reflects what is likely to happen in practice.

Other limitations of real options

The BSOP model requires further assumptions to be made involving the variables used in the model,
the primary ones being:

(a) The BSOP model assumes that the underlying project or asset is traded within a situation of
perfect markets where information on the asset is available freely and is reflected in the asset value
correctly. Further it assumes that a market exists to trade the underlying project or asset without
restrictions (that is, that the market is frictionless)
(b) The BSOP model assumes that interest rates and the underlying asset volatility remain constant
until the expiry time ends. Further, it assumes that the time to expiry can be estimated accurately
(c) The BSOP model assumes that the project and the asset’s cash flows follow a lognormal
distribution, similar to equity markets on which the model is based
(d) The BSOP model does not take account of behavioural anomalies which may be displayed by
managers when making decisions, such as over- or under-optimism
(e) The BSOP model assumes that any contractual obligations involving future commitments made
between parties, which are then used in constructing the option, will be binding and will be fulfilled.
For example, in example three above, it is assumed that Swan Co will fulfil its commitment to
purchase the project from Duck Co in two years’ time for $28m and there is therefore no risk of non-
fulfilment of that commitment.

In any given situation, one or more of these assumptions may not apply. The BSOP model therefore
does not provide a ‘correct’ value, but instead it provides an indicative value which can be attached
to the flexibility of a choice of possible future actions that may be embedded within a project.

Conclusion

This article discussed how real options thinking can add to investment appraisal decisions and in
particular NPV estimations by considering the value which can be attached to flexibility which may be
embedded within a project because of the choice managers may have when making investment
decisions. It then worked through computations of three real options situations, using the BSOP
model. The article then considered the limitations of, and assumptions made when, applying the
BSOP model to real options computations. The value computed can therefore be considered
indicative rather than conclusive or correct.

The second article will consider how managers can use real options to make strategic investment
appraisal decisions.

Written by a member of the Advanced Financial Management examining team

19
B4 – International project Appraisal – 1

International project appraisal is an integral part of the Advanced Financial Management syllabus.

The purpose of this series of articles is to assist your preparation for the exam by demonstrating how
to attempt exam questions on this area of the syllabus. Coupled with a comprehensive mode of
study and revision, you should be ready for whatever the exam may contain. International project
appraisal will be a large component of your studies, and I will demonstrate a systematic method of
answering a question on this topic for each section of the exam.

In this article, I will demonstrate how to answer a ‘Section B’ style 25-mark question.

Penn Co

Penn Co is successful company based in a European country where the local currency is the dollar
and inflation has been stable at 5% pa. Income tax is charged on company profits at the rate of 25%
and is payable in the same year as the profits are earned.

The company is listed on several major stock exchanges as it has operations all over the globe. Its
market capitalisation is $655m. The company has bonds with varying maturities trading at $145m.

The treasury department of the company regularly computes the company’s nominal cost of capital
and this has been fairly stable at 10%. However, when Penn Co have carried out projects in
developing markets it has used a nominal risk-adjusted rate of 12%.

Penn Co’s primary business is construction and laying of train tracks and tramlines. Their main
consumers are governments due to Penn Co’s position as the market leader. Penn Co has a record of
completing long and complex contracts within schedule, as well as conducting its business in an
ethical manner.

The CEO of Penn Co recently attended a trade delegation to Africa where he met the prime minister
of the fast developing country called Zanadia. The prime minister and his political team provided
Penn’s CEO with an outline of a contract that the Zanadian government would like to award to Penn
Co.

Tramline project

Zanadia is situated on the African West coast, with the local currency being the dinar. Although being
relatively small when compared to its neighbours, its economy has grown at over 15% pa for the past
five years, but this has led to an inflation rate currently running at 30% pa. The democratically
elected government has taken full credit for this economic prosperity.

The prime minister is adamant that the performance of the country is a result of trade links he
created with European-based multinational corporations (MNCs). He believes that by encouraging
investment from these entities in his country, the MNCs will generate substantial returns with
minimal risk, as many of the projects are government contracts.

There has been varied success when European MNCs have invested in Zanadia, with political
interference, particularly from the prime minister, being blamed for below par returns. Rumours
have been rife that the prime minister has been ordering his government to make ad hoc requests

20
for payments to be made at various times during the contracted period. The government themselves
have stated that, on a very rare basis, penalty charges have been levied when companies have not
been keeping to schedule.

The Zanadian government’s latest project is to create an environmentally friendly electric tramline
network to connect all areas of Enat, which is Zanadian’s capital city. The project will ultimately take
20 years to complete. However, the initial contract will be to lay the tramline to connect Enat to the
national airport located 23 kilometres away. Providing this is completed to the satisfaction of the
Zanadian government, they will extend the contract to allow initial supplier connect the rest of the
city.

Following the recent meeting between the prime minister and the CEO of Penn Co, the prime
minister has authorised his government officials to release financial projections to Penn Co to allow it
to assess the financial viability of the contract.

Financial details

The government will pay a fixed price of dinar 5000m for the initial contact to lay the tramline
between Enat and the national airport. This will be paid in stages:

Time period %

6 months 10

12 months 20

18 months 40

24 months 30

Machinery needs to be purchased in Zanadia at a cost of dinar 1000m at the start of the project. The
other costs will be locally incurred labour costs, which are estimated to be 30% of the revenue. All
values are given in nominal terms. The government has already purchased sufficient materials from a
low cost provider based in the US for the initial 23 kilometres of the tramline. They only require Penn
Co to lay and test the tramline.

The government taxes company profits at 40% and this is to be paid in the year in which the profit is
earned. The government has no provision to offset tax allowable depreciation (TAD).

The current spot rate Dinar/$ 150 – 175 and this is expected to change in the future based upon the
relative inflation rates.

21
After two years, the prime minister will personally review the work carried out by Penn Co and he
expects to extend the contract to complete Enhat’s city tramline. The exact terms of this contract
extension will be subject to negotiation but the returns are expected to be substantial.

Requirement
(a) Prepare a financial assessment of the project covering the initial two-year period assuming Penn
Co appraises projects by discounting nominal $m cash flows at the appropriate cost of capital. State
clearly any assumptions that you make. (11 marks)
(b) Explain the main risks and issues faced by Penn Co if it chooses to undertake this project. (14
marks)

(25 marks)

The key to a good Advanced Financial Management answer is to have a clear plan when answering
the question. Knowing where to start and how to progress through in a smooth and efficient way is
vital.

Time allocation

The 25-mark question needs to be completed in 45 minutes, allowing 1.8 minutes per mark. A split
of 20 minutes for part (a) and 25 minutes for part (b) is a good starting point in terms of allocation,
but with students often finding the numerical elements challenging, allowing a minimum of 20
minutes for part (b) will give flexibility.

Understand the requirements

What are you been asked to do? Read the requirements and understand the key words. Match them
to your Advanced Financial Management knowledge.

In this case:
(a) Compute a net present value in $m. ‘Nominal’ cash flows means adjusted for relevant inflation.
‘Appropriate’ cost of capital – my initial thoughts are either the company’s weighted average cost of
capital (WACC) or a risk adjusted WACC. I need to list out any assumptions I make.
(b) ‘Risks and issues’ – I assume I will be able to derive most of these from the main body of the
question coupled with the relevant Advanced Financial Management knowledge areas.

Which part to attempt first?

From experience, most candidates attempt the question in the order it is set. There are no
instructions that says you have to do this. Decide which order you feel most comfortable with, but
ensure you make a valid attempt at both parts of the question.

As for me, I would attempt Part (b) first. I feel I am more likely to be in control of my time this way.
However, I will show my answer in the order the question was set.

The read through

I understand the requirements. Now, I need to digest the details of the question. My approach is a
simple one.

22
Part (a) – Answer
To address this requirement I need to show a disciplined approach. Let me break this down into
stages and explain my thought process for each step.

(1) Dinar cash flows

Now 6 months 12 months 18 months 24 months

Description
Dinar (m) Dinar (m) Dinar (m) Dinar (m) Dinar (m)

Revenue 500 1,000 2,000 1,500

Variable cost (150) (300) (600) (450)

(30%) _______ _______ _______ _______

Taxable cash
350 700 1,400 1,050
flows

Taxation
(140) (280) (560) (420)
@ 40%

Initial investment (1,000)

______ _______ _______ _______ ______

Project cash flows (1,000) 210 420 840 630

The points to notes here:

• Columnar layout corresponding with the timing of the cash flows specified in the question.

• Cash flows are in nominal dinars; they have already been adjusted for Zanadian inflation.

• Revenue is dinar 5000m allocated per the percentages specified in the question. I see no
reason to show a working for this.

• Variable cost is just 30% of the revenue figures as indicated on the schedule.

23
 • Sub-totalled to show the taxable ‘profits’. As there is no TAD in this question, these are equal
to the operating cash flows.

• Taxation is a relevant cash flow. On the read through stage, I noted that there was no time
delay in the payment of the tax to the Zanadian government.

• Initial investment is a simply copy and paste.

• The total project cash flows show that Penn Co will need to initially buy dinars (sell $s) to
make the investment. Subsequently, Penn Co will be receiving dinars that it will convert into
$s. Care needs to be taken when choosing/calculating the spot rates.

(2) Spot rates and conversion to $m

Project cash flows (1,000) 210 420 840 630

Spot rate (W1) Dinar/$ 150 196 217 243 269

Free cash flows ($m) (6.67) 1.07 1.94 3.46 2.34

The question stated that the current spot rate was dinar 150 – 175/$. As Penn Co needs to sell $s
initially, the bid rate of dinar 150/$ will apply. As all other cash flows are receipts in dinars, a working
is needed to compute the projected offer spot rates via the purchasing power parity theory (PPPT)
formula.

Dinar/$

Now 175

6 months (175 + 217) / 2 196

12 months 175 x 1.30 / 1.05 217

24
 18 months (217 + 268) / 2 243

24 months 217 x 1.30 / 1.05 269

The PPPT formula is used to calculate the annual spot rates. The intervening half-year rates are
average values.

Finally, many students fail to convert the foreign cash flows into the home currency correctly. Based
on my experience, I have seen many answers where confusion has reigned supreme, as students are
not sure whether to divide or multiply. In this case the project cash flows are in dinars and our spot
rates are dinar/$. We divide the dinar cash flows to convert to $m.

(3) Final answer

Now 6 months 12 months 18 months 24 months

Description
Dinar (m) Dinar (m) Dinar (m) Dinar (m) Dinar (m)

Revenue 500 1,000 2,000 1,500

Variable cost (150) (300) (600) (450)

_______ ______ _______ _______ _______

Taxable
350 700 1,400 1,050
cash flows

Taxation
(140) (280) (560) (420)
@ 40%

Initial (1,000)
investment ______ ______ _______ _______ _______

25
 Project
(1,000) 210 420 840 630
cash flows

Spot rate
150 196 217 243 269
(W1) Dinar/$

Free cash
(6.67) 1.07 1.94 3.46 2.34
flows ($m)

Cost of
1.000 0.945 0.893 0.844 0.797
capital
______ ______ _______ ______ ______
(12%)

Present (6.67) 1.01 1.73 2.92 1.87

values ($m) ______ ______ _______ _______ ______

Net present
+$0.86m
value ($m)

Discounting at the risk adjusted WACC of 12% (see assumptions below) should be the easy part. The
discount factors for 12 and 24 months can be taken from the tables provided at the back of the
exam. Those same tables provide the formula to use to calculate the six-month and 18-month
discount factors remembering that r = 0.12 and n = 0.5 and 1.5 respectively.

(4) Assumptions
The requirement invites the students to state any assumptions. Here is a sample of some that could
be made:

• The nominal risk adjusted cost of capital of 12% is the appropriate discount rate given that
the project is based in a developing country.

• There is no additional taxation to pay in Penn Co’s home country on the remitted dinar cash
flows.

• Inflation rates in both countries will remain constant at their respective rates for the next
two years.

• The PPPT formula provides a materially accurate assessment of the projected spot rates.

26
 • There is no residual value for the machinery after two years, as it will continue in use after
this initial period.

Part (b) – Answer

As stated above, students could choose to ‘front load’ the answer to this requirement. My thought
process here is to derive as many relevant points from the information in the scenario that relate to
‘risks and issues’ and expand on these. The examiner is looking for students to apply their knowledge
to the details given in the question. It is these points that will ensure you achieve a sound pass mark
for this requirement.

In addition, I will include the relevant factual points that can be found in any of the Advanced
Financial Management approved textbooks. They will certainly earn some marks.

Risks and issues facing Penn Co

• Sensitivity analysis – irrespective of the final NPV, the values used to arrive at this number
are subject to estimation errors. The ones of particular concern are the cost of capital and
predicted spot rates. Penn Co should carry out sensitivity analysis to identify how any
changes to these variables affect the NPV.

• Recent history – although many MNCs have invested in Zanadia, this has not always led to
success. Penn Co needs to investigate and ascertain a little more detail as to why this has
been the case. Blame could lie with both parties to the contract.

• Ad hoc Payments – Penn Co needs to obtain some clarity on this matter. These charges
would reduce the NPV of the project and may even change the decision that the company
takes. The terms of the contract need to be carefully reviewed to ensure that Penn Co is
aware of what the Zanadian government expects.

• Supplier – Penn Co has a reputation for manufacturing as well as laying tramlines. In this
case, they will be installing lines purchased from another supplier. There may well be quality
and specification issues.

• Prime minister – the prime minister has a lot of influence over this contract. He will
‘personally’ review the work carried out by Penn Co before deciding to extend the contract.
The criteria on which his decision will be made are not specified and may well be highly
judgmental.

• 20-year contract – this is a long project and the risks associated with time are very high. The
returns are said to be substantial but again not quantified.

• Other issues – there are a number of other issues Penn Co should accrue for:
– The company would need to be aware of local customs and work practices.
– The legal and regulatory issues would need to be quantified.
– If managers would be recruited in Zanadia or sent from Penn Co’s home country.
– The project will not damage Penn Co’s business and ethical reputation.

International project appraisal questions are challenging, but far from impossible. Students need to
follow a disciplined approach. The format is very similar to when preparing a standard ‘home country

27
based’ NPV which candidates have practised many times as it is part of both Financial
Management and Advanced Financial Management.

For projects based abroad it is about starting with the relevant nominal foreign currency cash flows.
The key differences are the computation of the spot rates and conversion of foreign currency cash
flows to domestic currency values. Discounting at risk-adjusted rates should not be unexpected given
the change in risk levels when investing abroad.

There are certain skills that we have not seen tested above such as royalties, transfer pricing and
double taxation. These will be part of my next article when we return to Penn Co and look at another
international project it is considering as an investment opportunity.

Sunil Bhandari, freelance tutor

www.SunilBhandari.com

B5 – International project Appraisal part 2

The first part of this article highlighted the importance of international project appraisal within
the Advanced Financial Management syllabus. There was also a demonstration as to how to tackle a
Section B, 25-mark question using material from your studies.

It is just as important to prepare for a Section A 50-mark test on international project appraisal.
There will be a large section of text containing far more information than a Section B type question.
However, this is compensated by a greater mark allocation and, hence, more time to produce an
acceptable answer. As shown in the previous article, students need to adopt a methodical approach
to ensure they are rewarded with high marks.

Let us now return to Penn Co and consider another international investment opportunity.

Penn Co

Penn Co is a successful company based in the European country, Ayjai. The local currency is the
dollar ($), inflation has been stable at 2.75% pa and income tax is charged on profits, in the year in
which they are earned, at a rate of 25% pa. The company is listed on several major stock exchanges
as it has operations all over the globe. Its market capitalisation is $655m. The company has bonds
with varying maturities trading at $145m.

Penn’s nominal cost of capital has been stable at 10%. However, Penn Co uses a nominal risk-
adjusted rate of 12% when carrying out projects in developing markets.

Penn Co’s main operation is constructing and laying of train tracks and tramlines. Due to its position
as the market leader, its primary consumers are governments. Penn Co is renowned for its ethical
business style, and ability to complete long and complex contracts within schedule.

Penn Co sets up wholly owned subsidiary companies in each country where it has business interests,
including in Nuruk.

Nuruk

Nuruk is a fully-fledged member of the euro zone and shares a border with Ayjai. Its currency is the
euro (€). Nuruk is a well-developed country and, unlike most of the euro zone, its economy is
growing at a healthy rate.

28
The primary reason for Nuruk’s current economic state is its low level of taxation. Income tax is
charged at 20% pa and can be paid up to one year after profits are earned. In addition, the Nurukian
government reacted to the global recession with a substantial fiscal expenditure plan, leading to the
enhancement of the national railway network.

Since 2009, the government have invested in replacing and upgrading the state-owned national
railway network to allow the lines to run the new 'SuperFast2 (SPF2)' trains. The government
committed to a 10-year plan to ensure SPF2 trains could operate on lines nationwide.

Penn Co, via its Nurukian subsidiary, has benefited from the government investment in the railway
network. The subsidiary was granted preferred supplier status by the government in 2009. It has
been the primary, but not the exclusive, business partner to the government. To date, Penn Co have
supplied the entire specialist train track required to run the SPF2 and have consulted and advised the
various construction companies, contracted by the government, on the laying and testing process.
Currently, all stakeholders are content with the progress made.

Final Phase

The final phase of the project will take five years to complete. The track is to be laid on a national
heritage site, the Linus mountain range, by which there are many small villages.

The government has been scrutinised by both the villagers and environmental protest groups,
concerned that the new line would cause substantial ecological damage. In 2010, the government
pushed back the start date to 1 January 2014 in order to hold a public enquiry and hear the concerns
of the stakeholders. They decided that environmental considerations should be prioritised when
laying the SPF2 rail line and it should be considered a 'special case'. The government accepted these
findings and decided that Penn Co would be the most suited company to carry out the upgrades due
to its ethical approach.

Penn Co is required to supply, fit and test the line via its subsidiary. The government will closely
monitor the project due to the outcome of the enquiry and, in addition, has allocated extra
resources to this phase, as it understands the task of laying the new rail-line will be onerous.

Penn Co wishes to consider the financial and other implications of the project before making a final
decision. The subsidiary will need to buy specialist machinery at the commencement of the project
for €1,000m. The company can claim tax allowable depreciation (TAD) on only €250m of this
investment, claimed on a straight-line basis over the life of the project.

Penn Co’s treasury department believes at this financial investment will not alter the company’s
gearing level nor will the project affect its business risk profile. However, the necessary amount of
funds to purchase specialist machinery will have to be raised in Ayjain dollars via the financial
markets.

One key stipulation of the public enquiry was to specify how many metres of line could be laid in
each calendar year:

29
 Year ending 31 December Metres

2014 5,700

2015 6,500

2016 10,900

2017 8,100

2018 6,300

The government will pay Penn Co, €55,000 per metre at the end of 2014, increasing by 3% pa.
Material and local labour costs are expected to be €23,000 per metre at the end of 2014, with
expected increases at a rate of 5% pa thereafter. Fixed operating costs will increase by €40m at the
end of 2014 and this amount will rise by 6% pa.

Penn Co has a standard policy that all its foreign subsidiaries must make a fixed annual royalty
payment of $15,000 per metre back to the holding company at the end of each respective year. This
is a fair arms length value to cover the investment made by Penn Co to develop the train track
technology.

Working capital funds will be needed from 1 January 2014. The initial amount can be estimated to be
10% of the revenue earned at the end of year 2014. Each year, this will need to be adjusted by €10
for each €100 change in annual sales revenue. Working capital will be recovered in full on 31
December 2018. On the same day, the Nurukian government has guaranteed to purchase from Penn
Co the specialist machinery for a nominal value of €500m.

Economic forecasters believe that the mid-point spot exchange rate on 1 January 2014 will be
€0.7810/$. The Ayjain Central Bank expects the dollar to devalue at a rate of 5% pa. The current risk
free rate is 4.5% pa. The estimated standard deviation of the future free cash flows is 30%.

A bilateral tax treaty exists between the countries of Ayjai and Nuruk – hence, taxable profits earned
in Nuruk will be liable to the differential income tax rate on company profits that applies between
the two countries. The Ayjain government expects this to be paid in the same year as the taxable
profits are earned.

30
Offer from Elders Inc

Elders Inc is the largest construction company based in Nuruk. Since 2009, it has laid and tested a
substantial amount of the new SPF2 train line in Nuruk. It has worked closely with Penn Co as it
supplied this train track.

The board of directors (BoD) were bemused that the Nurukian government did not offer them the
SPF2 contract for the final phase. They believe that they have gone through the learning curve and
could do the work on an efficient basis.

The BoD decided to approach Penn Co with an offer of $1,200m to purchase the contract from them
in two years time (31 December 2015). Penn Co’s lawyers have advised them that the Nurukian
government has not expressly precluded Penn Co from exiting the contract early, but advise Penn Co
to consider their ethical stance should they decide to do so.

Alternative Sources of Finance

The chief financial officer (CFO) of Penn Co has concerns about the substantial initial investment
required to start the project, relative to Penn Co’s market value. The company’s financial advisers
agree with the CFO and are suggesting two alternative methods of raising the funds.

• €1,000m five-year 6.25% syndicated bank loan – Penn Co’s advisers believe that a number of
Nurukian banks would be willing to participate in such a transaction. They also believe that
they may be able to persuade the Nuruk government to provide a subsidised interest rate of
4% pa on an element of this loan.

• To raise the required funds using Islamic finance in the form of sukuk bonds. The advisers
feel that the project’s characteristics are within the Sharia law regulations and this would
give Penn Co access to low cost finance.

Requirement
Prepare a report to the Board of Directors (BoD) of Penn Co that:

a) Provides a financial assessment of the final phase of the Nuruk train line project as at 1 January
2014. All cash flows are to be presented in nominal terms and the project’s dollar free cash flows are
to be discounted at the appropriate nominal cost of capital. Ignore the offer from Elders Inc and the
alternative finance options. (22 marks)

b) A discussion of the assumptions made in arriving at the financial assessment.

(5 marks)

c) An assessment of the offer made by Elders Inc to purchase the contract from Penn Co in two years
time. This should include an estimate of the financial value of the real option. (9 marks)

d) A discussion of the two alternative finance options specifically addressing:

(i) If Penn Co raised the funds from the banks based in Nuruk, how this would affect the financial
assessment of the project.

No further calculations are required.

(4 marks)

31
(ii) The key differences that Penn Co should be aware of between raising money via the Islamic
finance option as opposed to traditional forms of debt capital. (6 marks)

Professional marks awarded for format, structure and presentation of the report.
(4 marks)

(50 Marks)

Students will not be surprised to see a scenario-based question 1 containing a vast amount of
information. Several areas of the syllabus will be tested, including international project appraisal.
Before focusing on the primary topic, I wish to demonstrate my step-by-step approach to answering
question 1.

Understand The Requirements and Allocate Your Time

This question represents 50% of the exam – therefore, the answer should be completed in 90
minutes. However, the requirements of the question should be understood. ‘Topic recognition’ as I
call it entails identifying which part of the syllabus is being targeted by each requirement.
Simultaneously, I will allocate my time based upon the standard approach of 1.8 minutes per mark.

a) Keywords ‘financial assessment’, ‘project’s dollar nominal cash flows’ and ‘discounted’ would
trigger my thoughts. I have to prepare a schedule of free cash flows and compute the net present
value (NPV). 22 marks would indicate a time allotment of 40 minutes. However, there are four
professional marks for structure and presentation, which I can spread across the requirements.
Revised time allocation – 45 minutes.

b) ‘Assumptions’ relating to the financial assessment – lots of scope to score marks here within nine
minutes.

c) ‘Real option’ takes my thought process directly to the Black-Scholes Option Pricing model (BSOP). I
have to compute the value of this PUT option and add the relevant discussion points. Allocate 17
minutes.

d) The topic under scrutiny here appears to be two different forms of debt finance. However, the
requirements need to be interpreted very carefully.

(i) How raising loan finance will affect the project appraisal. My initial thoughts are to explain the
Adjusted Present Value (APV) appraisal method. (8 minutes)

(ii) Islamic finance – I need to apply my knowledge of Islamic finance (sukuk bonds) to answer this
final requirement. (11 minutes)

Answer Format

The question has clearly stated that the answer should be presented in a report format. The best way
to do this is have appendices showing the computational elements, followed by the discussion parts
in the main body of the headed report. In this case, I would layout my answer:

• Appendix 1 – NPV and relevant workings

• Appendix 2 – Real option valuation using BSOP model

• Headed report – With four subheadings matching the requirements.

32
From reading the examiner’s report published after each exam, there appear to be a worrying
number of candidates who don’t format their answer as requested, and then missing out on the
‘easy-to-earn’ marks.

The Read Through

I understand the requirements. Now, I need to digest the details of the question. My approach is a
simple one.

Let me now return and concentrate on preparing an answer on the international project appraisal
aspects of this question.

Appendix 1 – NPV and Workings

Time 0 Time 1 Time 2 Time 3 Time 4 Time 5 Time 6

Description
€m €m €m €m €m €m €m

Revenue 313.50 368.23 636.01 486.81 389.99

(W1) _____ _____ _____ _____ _____ _____ _____

Variable cost
131.10 156.98 276.40 215.67 176.13
(W2)

Incremental
40.00 42.40 44.94 47.64 50.50
fixed costs

Royalty
63.44 68.72 109.48 77.29 57.11
(W3)

50.00 50.00 50.00 50.00 50.00

TAD (250/5)
_____ _____ _____ _____ _____

33
 284.54 318.10 480.82 390.60 333.73
Total costs
_____ _____ _____ _____ _____ _____ _____

Taxable cash
28.96 50.13 155.19 96.21 56.25
flows

Taxation
(5.79) (10.03) (31.04) (19.24) (11.25)
@ 20%

Add:
50.00 50.00 50.00 50.00 50.00
TAD

Initial
(1000.00)
investment

Scrap
500.00
proceeds

Working (31.35) (5.47) (26.78) 14.92 9.68 39.00

capital ______ _____ ______ _____ ______ ______ ______

€m (1031.35) 73.49 67.56 210.08 124.86 626.01 (11.25)

34
Spot rate
0.7810 0.7420 0.7049 0.6696 0.6361 0.6043 0.5741
(W4) €/$

$m $m $m $m $m $m $m

Remitted
(1320.55) 99.05 95.84 313.74 196.28 1035.89 (19.60)
amounts

Royalty
85.50 97.50 163.50 121.50 94.50
income (W3)

Taxation
on royalty
(21.38) (24.38) (40.88) (30.38) (23.63)
Income
@ 25%

Additional
tax on €
Taxable
profits (1.95) (3.56) (11.59) (7.56) (4.65)
(W5) _______ _____ _____ ______ _____ ______ ______

Free cash
(1320.55) 161.22 165.41 424.78 279.84 1102.11 (19.60)
flows

35
 Cost of
1.000 0.909 0.826 0.751 0.683 0.621 0.564
capital (10%)

________ ______ ______ ______ ______ ______ ______

Present (1320.55) 146.55 136.63 319.01 191.13 684.41 (11.05)

values ($m) ________ ______ ______ ______ ______ ______ ______

Net present
value ($m) +146.13

My explanations and workings are as follows:

• Columnar layout corresponding with the timing of the cash flows specified in the question.
Even though the project will finish in Year 5, there will be some taxation to pay one year later.

• Revenue needs to be supported with a working:

(W1) Revenue Time 1 Time 2 Time 3 Time 4 Time 5

Metres 5,700 6,500 10,900 8,100 6,300

55,000 56,650 58,350 60,100 61,903

Price (€)
______ ______ ______ _____ ______

313.50 368.23 636.01 486.81 389.99

€m
______ ______ ______ _____ ______

36
I have noted that €55,000 is the nominal price at the end of Year 1 and then it increases by 3% pa. So
many past questions have asked students to adopt this approach for converting real cash flows into
nominal values.

• When computing the variable cost, my working incorporates the 5% pa increase in the unit
cost from Year 2 onwards.

(W2) Variable cost Time 1 Time 2 Time 3 Time 4 Time 5

23,000 24,150 25,358 26,625 27,957

Unit cost ______ ______ ______ _____ ______

Metres x unit cost 131.10 156.98 276.40 215.67 176.13

(€m) ______ ______ ______ _____ ______

• Incremental fixed costs can be directly entered on to the schedule of cash flows accruing for
the 6% pa increase from Year 2.

• Royalty – this needs some care. I have incorporated this twice on the schedule of cash flows.
The royalty will be income earned in dollars for Penn Co in Ayjai. However, it will be an
operational cost for the Nurukian subsidiary and the dollar values need to be converted, at
the predicted spot rate, into euros.

(W3) Royalty Time 1 Time 2 Time 3 Time 4 Time 5

Metres x $15,000
$85.50 $97.50 $163.50 $121.50 $94.50
($m)

Spot rate €0.7420 €0.7049 €0.6696 €0.6361 €0.6043

(€/$) – (W4) ______ ______ ______ ______ ______

37
 63.44 68.72 109.48 77.29 57.11
€m
______ ______ ______ _____ ______

The predicted spot rate is a mid-point number (an average of the bid and offer rates) and is the value
of one dollar in euros. The dollar is predicted to devalue by 5% pa.

Time Time Time Time Time Time Time

(W4) Spot rates
0 1 2 3 4 5 6

Spot
rate €0.7810 €0.7049 €0.6696 €0.6361 €0.6043 €0.5741
(€/$) €0.7420

• TAD is not a cash flow. It is an allowable expense so I can compute the taxable profit and the
relevant taxation cash flow. The TAD is then added back.

• Taxation is computed at the rate of 20% of the taxable profit. However, it will be paid one
year after the profit was earned.

• Initial investment and scrap proceeds are just a copy and paste.

• Working capital – my ‘thought process’ is to assume the project needs to have a unique bank
account. It needs a cash investment on 1 January 2014 of €31.35m (10% x €313.50m). At end
of the first year an incremental adjustment is needed that can be computed as 10% x
(€368.23m – €313.50m). Similar adjustments are made at the end of T2, T3 and T4. At the
end of the project, I assume this bank account is closed and whatever is left is withdrawn.

(W5) Additional taxation Time 1 Time 2 Time 3 Time 4 Time 5

€m €m €m €m €m

Taxable profit 28.96 50.13 155.19 96.21 56.25

38
(25–20)% x
(1.45) (2.51) (7.76) (4.81) (2.81)
Taxable Profit

€0.7420 €0.7049 €0.6696 €0.6361 €0.6043

Spot Rate (€/$) – W4
______ ______ ______ ______ ______

(1.95) (3.56) (11.59) (7.56) (4.65)

$m
______ ______ ______ ______ ______

• The euro cash flows are converted into dollars at the predicted spot rates. As I stated in my
last article, some students make errors at this point. In this case, I have to divide the euro
cash flows by the spot rate (euro per dollar) to find the dollar amounts.

• As mentioned above, the dollar value of the royalty appears twice on the schedule. Penn Co
will receive the royalties and these will be subject to taxation in Ayjai.

• The bi-lateral tax agreement mentioned in the question leads to an additional cash flow. The
working clarifies the position.

• As the project will not alter Penn Co’s business and financial risk, the appropriate cost of
capital is 10%, the company’s WACC.

Extract from the Report

Let me turn my attention to the report. I will show you an extract from this so as you can get a feel as
to what you need to produce in the exam.

To: BoD of Penn Co

From: xxxxxx
Subject: Nurukian Train Line Project
Date: xx-xx-xx

-------------------------------------------------------------------------------

Financial assessment
I have prepared a forecast of the nominal free cash flows for the Nurukian train line project in
Appendix (1). After discounting these at the Penn Co’s current cost of capital (10%), the project
increases shareholder wealth by just under $150m. Based on this value, the company should accept
this project.

All forecasts are subject to estimation errors. This should be taken into account when the BoD arrives
at its final decision.

39
Assumptions
There are a number of assumptions that have been made when computing the NPV. Some of these
are considered below:

• Inflation – specific inflation rates have been incorporated into the appraisal and are expected
to remain constant for the five-year period.

• Taxation – the current tax rates and allowances used to arrive at the taxation cash flows may
vary over the life of the project.

• Scrap proceeds – the Nuruk government have guaranteed to purchase the machinery for a
value of €500m. This may be subject to the condition of the machine as there will be wear
and tear.

• Exchange rates – future spot rates are affected by many factors and, hence, the values used
in the assessment may be incorrect.

• Finance – the project requires €1,000m ($1280m) initial finance. It has been assumed that
this will be raised in the Ayjain financial markets. This is a large value relative to the
company’s current entity value. The project may be too big for Penn Co to undertake.

Sensitivity analysis should be carried out to identify how changes in key variables affect the NPV.

Appendix (2) and Remaining Part of the Report

The primary objective of this second article was to show how to deal with international project
appraisal within Section A of Advanced Financial Management. This has now been achieved.
Appendix (2) and the remaining elements of this report are on other key areas of the Advanced
Financial Management syllabus. Although, these are just as important, they are not the focus of
these series of articles. My intention was to provide you with a logical way of attacking questions on
international project appraisal only.

International project appraisal is an important element within the Advanced Financial

Management syllabus. Students preparing to attempt this exam should ensure they study this topic
very carefully. Know your subject well.

As I have demonstrated in this series of articles, a question on this area can appear in either section
of the exam. As long as you take a disciplined approach and apply the knowledge you gave gained
from your studies, you can earn a mark worthy of a pass.

Sunil Bhandari, freelance tutor

www.SunilBhandari.com

B6 – Bond Valuation and Bond yields

Bonds and their variants such as loan notes, debentures and loan stock, are IOUs issued by
governments and corporations as a means of raising finance. They are often referred to as fixed
income or fixed interest securities, to distinguish them from equities, in that they often (but not
always) make known returns for the investors (the bond holders) at regular intervals. These interest
payments, paid as bond coupons, are fixed, unlike dividends paid on equities, which can be variable.

40
Most corporate bonds are redeemable after a specified period of time. Thus, a ‘plain vanilla’ bond
will make regular interest payments to the investors and pay the capital to buy back the bond on the
redemption date when it reaches maturity.

This article, the first of two related articles, will consider how bonds are valued and the relationship
between the bond value or price, the yield to maturity and the spot yield curve. It addresses, in part,
the learning required in Sections B3a and B3e of the the Advanced Financial Management Syllabus
and Study Guide.

Bond value or price

Example 1
How much would an investor pay to purchase a bond today, which is redeemable in four years for its
nominal value or face value of $100 and pays an annual coupon of 5% on the nominal value? The
required rate of return (or yield) for a bond in this risk class is 4%.

As with any asset valuation, the investor would be willing to pay, at the most, the present value of
the future income stream discounted at the required rate of return (or yield). Thus, the value of the
bond can be determined as follows:

If the required rate of return (or yield) was 6%, then using the same calculation method, the price of
the bond would be $96.53. And where the required rate of return (or yield) is equal to the coupon –
5% in this case – the current price of the bond will be equal to the nominal value of $100.

Thus, there is an inverse relationship between the yield of a bond and its price or value. The higher
rate of return (or yield) required, the lower the price of the bond, and vice versa. However, it should
be noted that this relationship is not linear, but convex to the origin.

The plain vanilla bond with annual coupon payments in the above example is the simpler type of
bond. In addition to the plain vanilla bond, candidates – as part of their Advanced Financial
Management studies and exam – are required to have knowledge of, and be able to deal with, more

41
complicated bonds such as: bonds with coupon payments occurring more frequently than once a
year; convertible bonds and bonds with warrants which contain option features; and more
complicated payment features such as repayment mortgage or annuity type payment structures.

Yield to maturity (YTM) (also known as the [Gross] Redemption Yield (GRY))
If the current price of a bond is given, together with details of coupons and redemption date, then
this information can be used to compute the required rate of return or yield to maturity of the bond.

Example 2
A bond paying a coupon of 7% is redeemable in five years at nominal value ($100) and is currently
trading at $106.62. Estimate its yield (required rate of return).

The internal rate of return approach can be used to obtain r. Since the current price is higher than
$100, r must be lower than 7%.

Initially, try 5% as r:

$7 x 4.3295 [5%, five - year annuity] + $100 x 0.7835 [PV 5%, five - year] = $30.31 + $78.35 = $108.66

Try 6% as r:
$7 x 4.2124 [6%, five - year annuity] + $100 x 0.7473 [PV 6%, five - year] =
$29.49 + $74.73 = $104.22

Yield = 5% + (108.66 – 106.62 / 108.66 – 104.22) x 1% = 5.46%

The 5.46% is the yield to maturity (YTM) (or redemption yield) of the bond. The YTM is the rate of
return at which the sum of the present values of all future income streams of the bond (interest
coupons and redemption amount) is equal to the current bond price. It is the average annual rate of
return the bond investors expect to receive from the bond till its redemption. YTMs for bonds are
normally quoted in the financial press, based on the closing price of the bond. For example, a yield
often quoted in the financial press is the bid yield. The bid yield is the YTM for the current bid price
(the price at which bonds can be purchased) of a bond.

Term structure of interest rates and the yield curve

The yield to maturity is calculated implicitly based on the current market price, the term to maturity
of the bond and amount (and frequency) of coupon payments. However, if a corporate bond is being
issued for the first time, its price and/or coupon payments need to be determined based on the
required yield. The required yield is based on the term structure of interest rates and this needs to
be discussed before considering how the price of a bond may be determined.

It is incorrect to assume that bonds of the same risk class, which are redeemed on different dates,
would have the same required rate of return or yield. In fact, it is evident that the markets demand
different annual returns or yields on bonds with differing lengths of time before their redemption (or
maturity), even where the bonds are of the same risk class. This is known as the term structure of
interest rates and is represented by the spot yield curve or simply the yield curve.

42
For example, a company may find that if it wants to issue a one - year bond, it may need to pay
interest at 3% for the year, if it wants to issue a two - year bond, the markets may demand an annual
interest rate of 3. 5%, and for a three-year bond the annual yield required may be 4.2%. Hence, the
company would need to pay interest at 3% for one year; 3.5% each year, for two years, if it wants to
borrow funds for two years; and 4.2% each year, for three years, if it wants to borrow funds for three
years. In this case, the term structure of interest rates is represented by an upward sloping yield
curve.

The normal expectation would be of an upward sloping yield curve on the basis that bonds with a
longer period of maturity would require a higher interest rate as compensation for risk. Note here
that the bonds considered may be of the same risk class but the longer time period to maturity still
adds to higher uncertainty.

However, it is entirely normal for yield curves to be of many different shapes dependent on the
perceptions of the markets on how interest rates may change in the future. Three main theories have
been advanced to explain the term structure of interest rates or the yield curve: expectations
hypothesis, liquidity-preference hypothesis and market-segmentation hypothesis. Although it is
beyond the remit of this article to explain these theories, many textbooks on investments and
financial management cover these in detail.

Valuing bonds based on the yield curve

Annual spot yield curves are often published by the financial press or by central banks (for example,
the Bank of England regularly publishes UK government bond yield curves on its website). The spot
yield curve can be used to estimate the price or value of a bond.

Example 3
A company wants to issue a bond that is redeemable in four years for its nominal value or face value
of $100, and wants to pay an annual coupon of 5% on the nominal value. Estimate the price at which
the bond should be issued.

The annual spot yield curve for a bond of this risk class is as follows:
One-year 3.5%
Two-year 4.0%
Three-year 4.7%
Four-year 5.5%

The four-year bond pays the following stream of income:

Year 1 2 3 4
Payments $5 $5 $5 $105

This can be simplified into four separate bonds with the following payment structure:

Year 1 2 3 4
Bond 1 $5
Bond 2 $5
Bond 3 $5

43
Bond 4 $105

Each annual payment is a single payment in that particular year, much like a zero-coupon bond, and
its present value can be determined by discounting each cash flow by the relevant yield curve rate, as
follows:

The sum of these flows is the price at which the bond can be issued, $98.57.

The yield to maturity of the bond is estimated at 5.41% using the same methodology as example 2.

Some important points can be noted from the above calculation; firstly, the 5.41% is lower than 5.5%
because some of the ret urns from the bond come in earlier years, when the interest rates on the
yield curve are lower, but the largest proportion comes in Year 4. Secondly, the yield to maturity is a
weighted average of the term structure of interest rates. Thirdly, the yield to maturity is calculated
after the price of the bond has been calculated or observed in the markets, but theoretically it is
term structure of interest rates that determines the price or value of the bond.

Mathematically:

In this article it is assumed that coupons are paid annually, but it is common practice to pay coupons
more frequently than once a year. In these circumstances, the coupon payments need to be reduced
and the time period frequency needs to be increased.

Estimating the yield curve

There are different methods used to estimate a spot yield curve, and the iterative process based on
bootstrapping coupon paying bonds is perhaps the simplest to understand. The following example
demonstrates how the process works.

Example 4
A government has three bonds in issue that all have a face or nominal value of $100 and are
redeemable in one year, two years and three years respectively. Since the bonds are all government
bonds, let’s assume that they are of the same risk class. Let’s also assume that coupons are payable
on an annual basis. Bond A, which is redeemable in a year’s time, has a coupon rate of 7% and is
trading at $103. Bond B, which is redeemable in two years, has a coupon rate of 6% and is trading a t

44
$102. Bond C, which is redeemable in three years, has a coupon rate of 5% and is trading at $98.

To determine the yield curve, each bond’s cash flows are discounted in turn to determine the annual
spot rates for the three years, as follows:

The annual spot yield curve is therefore:

Year
1 3.88%
2 4.96%
3 5.80%

Discussion of other methods of estimating the spot yield curve, such as using multiple regression
techniques and observation of spot rates of zero coupon bonds, is beyond the scope of the Advanced
Financial Management syllabus.

As stated in the previous section, often the financial press and central banks will publish estimated
spot yield curves based on government issued bonds. Yield curves for individual corporate bonds can
be estimated from these by adding the relevant spread to the bonds. For example, the following
table of spreads (in basis points) is given for the retail sector.

Rating 1 year 2 year 3 year

AAA 14 25 38
AA 29 41 55
A 46 60 76

Example 5
Mason Retail Co has a credit rating of AA, then its individual yield curve – based on the government
bond yield curve and the spread table above – may be estimated as:

Year 1 Year 2 Year 3

4.17% 5.37% 6.35%

These would be the rates of return an investor buying bonds issued by Mason Retail Co would
expect, and therefore Mason Retail Co would use these rates as discount rates to estimate the price
or value of coupons when it issues new bonds. And Mason Retail Co’s existing bonds’ market price
would reflect its individual yield curve.

45
Conclusion
This article considered the relationship between bond prices, the yield curve and the yield to
maturity. It demonstrated how bonds can be valued and how a yield curve may be derived using
bonds of the same risk class but of different maturities. Finally it showed how individual company
yield curves may be estimated.

A following article will discuss how forward interest rates are determined from the spot yield curve
and how they may be useful in determining the value of an interest rate swap. It will address the
learning required in Sections E1 and E3 of the Advanced Financial Management Syllabus and Study
Guide.

Written by the Advanced Financial Management examining team

B7 – Securitization and Tranching

Securitisation became a topical issue during the credit crunch, and still remains a relevant issue for
financial management and Advanced Financial Management students

Please note:
This is an updated version of the 'Toxic Assets' technical article

Securitisation through Collateralised Debt Obligations (CDOs)

One common use of securitisation occurs when banks lend through mortgages, credit cards, car
loans or other forms of credit, they invariably move to ‘lay off’ their risk by a process of
securitisation. Such loans are an asset on the statement of financial position, representing cash flow
to the bank in future years through interest payments and eventual repayment of the principal sum
involved. By securitising the loans, the bank removes the risk attached to its future cash receipts and
converts the loan back into cash, which it can lend again, and so on, in an expanding cycle of credit
formation.

Securitisation is achieved by transferring the lending to specifically created companies called ‘special
purpose vehicles’ (SPVs). In the case of conventional mortgages, the SPV effectively purchases a
bank’s mortgage book for cash, which is raised through the issue of bonds backed by the income
stream flowing from the mortgage holder. In the case of sub-prime mortgages, the high levels of risk
called for a different type of securitisation, achieved by the creation of derivative-style instruments
known as ‘collateralised debt obligations’ or CDOs.

Securitisation may be also appropriate for an organisation which wants to enhance its credit rating by
using low-risk cash flows, such as rental income from commercial property, which will be diverted
into a "ring-fenced" SPV.

CDOs are a way of repackaging the risk of a large number of risky assets such as sub-prime
mortgages. Unlike a bond issue, where the risk is spread thinly between all the bond holders, CDOs
concentrate the risk into investment layers or ‘tranches’, so that some investors take proportionately
more of the risk for a bigger return and others take little or no risk for a much lower return.

Each tranche of CDOs is securitised and ‘priced’ on issue to give the appropriate yield to the
investors. The investment grade tranche of CDOs will be the most highly priced, giving a low yield but
with low risk attached. At the other end, the ‘equity’ tranche carries the bulk of the risk – it will be

46
very lowly priced but with a high potential, but very risky, yield. There is more detail on this in the
next section.

CDOs are, therefore, a mechanism whereby losses are transferred to investors with the highest
appetite for risk (such as hedge funds), leaving the bulk of CDOs’ investors (mainly other banks) with
a low risk source of cash flow.

The structure of CDOs

An example of a possible structure for a CDO is as follows. For a pool of mortgages taken over by the
SPV, three tranches of CDOs are created:

• Tranche 1 (highest risk) known as the ‘equity’ tranche and normally comprising about 10% of
the value of the mortgages in the pool. Throughout the CDOs’ life, the equity tranche will
absorb any losses brought about by default on the part of mortgage holders, up to the point
that the principal underpinning the tranche is exhausted. At this point the investment is
worthless.

• Tranche 2 (intermediate risk or ‘mezzanine’ tranche) consists of around 10% of the principal
and will absorb any losses not absorbed by the equity tranche until the point at which its
principal is also exhausted.

• Tranche 3 (AAA or ‘senior’ tranche) consists of the balance of the pool value and will absorb
any residual losses.

The proportion of the principal held in each tranche is known as the CDO ‘structure’, and if there is
perceived to be little risk of default then the percentage of value in the mortgage pool forming the
equity and mezzanine tranches will be quite small. However, if the risk is high then CDOs will be
created with a greater proportion of the principal in the equity and mezzanine tranches and a
relatively smaller proportion in the senior tranche.

When cash flows are received from borrowers in the form of interest payments and loan
repayments, these payments are paid to tranche 3 first until their obligation is fulfilled, then tranche
2, and anything left over is paid to the equity tranche. Any defaults hit tranche 1 first, then tranche 2
and so on. The repayments represent a ‘waterfall’ of cash with the investors holding the tranches like
buckets. The senior tranches get filled first, the mezzanine holders get filled next and anything left
falls into the equity pools at the bottom.

Example

A bank has made a number of mortgage loans to customers with a current total value of $350
million. The mortgages have an average term to maturity of ten years. The net income from the loans
is 7% per year. The bank will use 85% of the mortgage pool as collateral for a securitisation with the
following structure:

• 75% of the collateral value to support a tranche of A-rated loan notes offering investors 6%
per year.

• 15% of the collateral value to support a tranche of B-rated loan notes offering investors 11%
per year.

• 10% of the collateral value to support a tranche of subordinated certificates which are
unrated.

47
The estimated cash flows for this arrangement would be as follows:

Cash inflows

Inflows from mortgages $350m x 7% = $24.5m

Cash outflows

A-rated loan notes

$350m x 85% x 75% x 6% = $13.4m

B-rated loan notes

$350m x 85% x 15% x 11% = $4.9m

Total outflows = $13.4m + $4.9m = $18.3m

The difference between the inflows and the outflows is returned to the high-risk unrated certificates.

Difference in cash flows = $24.5m – $18.3m = $6.2m

The subordinated certificates have a value of $350m x 85% x 10% = $29.75m.

The return on this high-risk investment is $6.2m/$29.75m = 20.8%

However this return is at risk should there be a reduction in the income from the mortgages resulting
from customers defaulting on their mortgages. Because of this level of risk, the equity tranche may
be unattractive to investors for some securitisation arrangements.

Note that all of the income from the mortgages is used to pay the tranche holders, not just 85%
representing the securitised amount. The reason why the securitisation is performed is to get money
in quickly. In order to sell the various tranches there needs to be an incentive; for this to be present
for all tranches not all of the available pool of mortgages is securitised, but all of the income from the
pool is distributed. The bank, in theory, loses out from this approach by distributing 100% of the
income instead of keeping 15%, but has achieved the objective of getting the initial funds from the
tranche holders as quickly as possible.

Written by a member of the examining team for Advanced Financial Management

B8 – Aspects of Islamic Finance

This article aims to continue to develop the understanding of Islamic finance and follows the first
article on this subject, 'Islamic finance – theory and practical use of sukuk bonds'. The first article
focused on Sukuk finance and case studies where Sukuk finance was utilised. This article is more
general and considers different aspects, issues and developments of Islamic finance. It also extends
the explanations provided in the appendix to the first article.

Questions are likely to focus on the application of Islamic finance as an additional source of finance,
and assessing its benefits and drawbacks, in different business scenarios and situations.

Overview

Islamic virtues and tenets specify the need for ethical behaviour and fair treatment. Within a
business context, this means that organisations should maintain high ethical standards in all business
dealings. Specifically, business and enterprise should be conducted with honesty and integrity,

48
maintaining truthfulness and morality in all dealings. In particular, such business and enterprise
should not capitalise on the misfortune of others or take unfair advantage. For example, higher
prices should not be charged to an individual because they lack knowledge and information about
the fair price of a product that they are purchasing. Profit creation should be the result of business
activity that benefits society at large.

Within this context, the Islamic finance framework is based on certain prohibitions. In particular,
money (and money substitute products such as gold and silver) should not be viewed as
commodities, but rather as means of exchange. Therefore, interest (or riba) cannot be paid or
received on loans. Furthermore, although it is fully acceptable to engage in profitable business
activities, such business should be ethical. In particular dealing in alcohol, pork-related products,
armaments, gambling and other socially detrimental activities is not acceptable. Engaging in
activities involving speculation is also not allowed, limiting the use of derivative instruments and
money markets, which are based on interest.

Operationalising Islamic finance

Organisations need access to short-term and long-term sources of finance. The basic, fundamental
function of banks is to provide a channel that enables the flow of financial resources from investors
to borrowers, and thereby provides a source of finance for organisations. Investors invest their excess
funds to earn interest, and borrowers use the funds in business activity to generate profits, some of
which are then used to pay interest on the borrowings. Among other sources of finance that involve
the payment and receipt of interest are corporate and government bonds.

The question that could be asked is how could finance flow between investors and borrowers
without involving interest. The answer provided by Islamic finance, in its basic form, is through profit-
sharing arrangements or partnerships. The article on Islamic finance published in February 2013
explained it as follows:

In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead
channelled into an underlying investment activity, which will earn profit. The depositor is rewarded by
a share in that profit, after a management fee is deducted by the bank.

Islamic finance institutions (IFIs), including banks, could raise finance via Mudaraba and Musharaka
equity-type contracts through multi-partnership contracts (see below). Here, investors (known as
rub-ul-mal) would invest funds with the IFI (known as the mudareb or investment manager). The
funds are then pooled and used in profit-making projects while also keeping within Sharia rules.
Therefore, the IFI would effectively become the rub-ul-mal and the corporation that uses the funds
for investment purposes becomes the mudareb. In each case, the emphasis is on partnerships, and
the profits earned are shared between the corporation, the bank and the investors. It is possible that
all three parties share the losses as well, if the business venture is not successful.

However, with corporations requiring different modes of finance and IFIs keen on providing these,
different types of Islamic financial products have been developed. The challenge for IFIs is to ensure
that the products comply with Sharia rulings, as well as normal financial regulations and law.

Common Islamic financial products

IFIs offer two broad categories of financial products: equity-based and fixed income-based. The
appendix to the February 2013 article on Islamic finance explained many of these financial products
and it is recommended that this article is read in conjunction with the first article for further detail.

49
Equity-based financial products
Equity-based financial products consist of Mudaraba and Musharaka contracts. With these contracts,
the investor or IFI (rub-ul-mal) and the investment manager or corporation (mudareb) share the
profits from the business venture, in which the funds are invested, in a pre-arranged agreement. The
key differences between the two contracts are two-fold.

With a Mudaraba contract:

• all losses are borne solely by the investor (IFI), although provisions can be set up to carry
forward these losses against future profits, and

• the mudareb, as the expert in the business venture takes the sole responsibility for running
the business.

With a Musharaka contract:

• losses are shared between the two parties in proportion to their monetary investment or
investment-in-kind, and

• both parties would participate in managing and running the venture jointly.

Diminishing Musharaka contracts are a recent innovation where not only are the profits shared
between rub-ul-mal and the mudareb, but the mudareb would pay greater amounts to the rub-ul-
mal. In this way the mudareb owns greater and greater proportion of the asset, until eventually the
ownership of the asset is passed to the mudareb entirely.

Fixed-income based financial products

With Murabaha contracts, the IFI purchases the asset and then sells it to the business or individual at
cost plus a fair profit. The business or individual pays for the asset in pre-agreed instalments and over
a pre-agreed time period.

Ijara contracts are similar to short-term leases where the IFI purchases an asset for the business or
individual to use. The lease payments, the lease period and payment terms are agreed at the start of
the contract. The lessor is responsible for the maintenance and insurance of the asset. Provisions can
be made to allow the lessee to purchase the asset for a nominal fee at the end of the contract.

Sukuk bonds were covered in some detail in the February 2013 article on Islamic finance and it is
recommended that you study that article in detail. Sukuk bonds have been based on underlying
securitised Islamic contracts such as Ijara and Mudaraba, as well on individual or groups of physical
assets. Some Sukuk bonds have been based on securitised Murabaha contracts, but there is some
debate on whether these comply with Sharia rulings, as they may be viewed as debt on debt and
therefore attracting riba. Some Sharia rulings have allowed minor proportions of Murabaha and
Istisna contracts within the securitised asset portfolio, used as the underlying asset portfolio.

Salam contracts are similar to forward contracts, where a commodity (or service) is sold today for
future delivery. Cash is received immediately from the IFI and the quantity, quality, and the future
date and time of delivery are determined immediately. The sale will probably be at a discount so that
the IFI can make a profit. In turn, the IFI would probably sell the contract to another buyer for
immediate cash and profit, in a parallel Salam arrangement. Salam contracts are prohibited for
commodities such as gold, silver and other money-type assets.

Istisna contracts are often used for long-term, large construction projects of property and machinery.
Here, the IFI funds the construction project for a client that is delivered on completion to the IFI’s

50
client. The client pays an initial deposit, followed by instalments, to the IFI, the amount and
frequency of which are determined at the start of the contract.

Sharia boards

Sharia Boards (SBs) ensure that all products and services offered by IFIs are compliant with the
principles of Sharia rules. They review and oversee all new product offerings made by the IFI and
make judgments on an individual case-by-case basis, regarding their acceptability with Sharia rulings.
Additionally, SBs often oversee Sharia compliant training programmes for an IFI’s employees and
participate in the preparation and approval of the IFI’s annual reports.

SBs are normally made up of a mixture of Islamic scholars and finance experts to ensure that fair and
reasonable judgments are made. Where necessary, the finance experts can explain the products to
the Islamic scholars. The Islamic scholars often sit on several SBs of a number of different IFIs. SBs are
in-turn supervised by the International Association of Islamic Bankers (IAIB).

SBs face several challenges when making judgments. Sharia law can be open to different
interpretations, leading to different outcomes on the acceptability of the same products by different
SBs and Islamic scholars. Furthermore, precedents set by SBs are not binding, and changes in SB’s
personnel over time may shift the balance of the SB’s collective opinions and judgments on the
acceptability of existing and new products.

SBs need considerable resources to operate effectively, especially where Sukuk finance is concerned.
IFIs need to ensure that their SB members are well informed about the developments and trends in
global financial markets.

Benefits, drawbacks and challenges

Benefits
Corporations, individuals and IFIs engaged in raising and issuing funding based on Islamic finance
virtues may be viewed as belonging in stakeholder-type partnerships that are engaged in deriving
benefits from ethical, fair business activity. The result of these partnerships is one of mutual interest,
trust and co-operation. The ethical stance and fair dealing of Islamic finance virtues means that
partnerships, business activity and profit creation comes from benefiting the community as a whole.

Since the virtues of Islamic finance and enterprise prohibit speculation and short-term opportunism,
it encourages all parties to take a longer term view of success from the partnership. It focuses all the
parties’ attention on creating a successful outcome to the venture. This should result in a more stable
financial environment. Indeed, literature in this area suggests that had banks and other financial
institutions conducted their business activity based on Islamic finance principles, the negative impact
of the banking and sovereign debt financial crises would have been much reduced.

IFIs or conventional financial institutions with products based on Islamic finance principles gain
access to Muslim funds across the world and provide finance for organisations and individuals who
need them. As the February 2013 article stated, it is estimated that Islamic financial assets have
exceeded $1,600bn worldwide. As the world emerges from the global financial crisis and business
activity increases, this should increase. Furthermore, access to Islamic finance is not restricted to
Muslim communities only. The wider business community could have access to new sources of
finance. This may be particularly attractive to corporations focused on ethical investments that
Islamic finance virtues stipulate.

51
Drawbacks and challenges
Because of the prohibitions of riba and on speculation, IFIs may be slower to react to market demand
and changes. They may lack sufficient flexibility in their product offering when compared to
conventional financial institutions and may be less able to take advantage of short-term
opportunities.

Moral hazard and principal-agent issues may be more pronounced between IFIs and organisations
and individuals to whom they lend funds. This is because Islamic finance virtues stipulate close
relationships from partnership-like arrangements. However, information asymmetry between the IFI
and the borrower of funds will always exist. Therefore, costs related to increased level of due
diligence and negotiating are probably higher for IFIs.

Costs related to developing new financial products may also be higher for IFIs because not only will
the products have to comply with normal financial laws and regulations but also with Sharia rules. As
stated above, the resources required by SBs can be considerable.

Added to this, because these financial products need to go through stages of compliance and layers
of complications before they are approved, the approval process can take time. The pace of
innovation of new Islamic financial products may be considerably slower than that of conventional
products. This may make the IFI less able to compete with conventional financial institutions and may
make it restrict its activities to smaller, niche markets.

Some Islamic financial products may not be compatible with international financial regulation – for
example, a diminishing Musharaka contract may not be an acceptable mortgage instrument in law,
although it could be constructed as such. The need to ensure that such products comply with
regulations may increase legal and insurance costs.

The interpretation of Sharia rulings may allow certain Islamic finance products to be acceptable in
some markets, but not in others. This has led to some Islamic scholars, who are experts in Sharia and
finance, to criticise a number of product offerings. For example, some Murabaha contracts have been
criticised because their repayments have been based on prevailing interest rates rather than on
economic or profit conditions within which the asset will be used. Some Sukuk bonds have faced
similar criticisms in that their repayments have been based on prevailing interest rates, they have
been credit-rated and their redemption value is based on a nominal value rather than on a market
value, and thereby, perhaps, making them too close to conventional bonds and their repayments too
similar to riba. On the other hand, the opposite argument could be that in order to make Islamic
financial products competitive in all markets, their valuations need to be comparable. Therefore,
benchmarking them using conventional means is necessary.

So far the discussion on drawbacks and challenges has focused on IFIs, as providers of Islamic
finance. It is also important to consider the drawbacks and challenges that corporations may face
when using Islamic finance.

From the above discussion, the costs related to developing and gaining approval for Islamic financial
products is likely to be passed down to customers and possibly make these products more expensive.
In addition to this, access to new products and flexibility within existing products may be limited, due
to the more complicated approval process that is necessary. These more expensive and less flexible
sources of finance may make the corporation using them less competitive when compared to rivals
who have access to cheaper, more flexible sources of finance.

52
The partnership nature of Islamic finance contracts may also cause agency type issues within
corporations. These may be more prevalent in joint venture type situations or where the diverse
range of stakeholders may make it more difficult for corporations to determine and act upon the
importance of various stakeholder groups. For example, in the case of a Musharaka contract, where
the IFI and the organisation are both involved in the management of a project, dealing with other
stakeholder groups may be more challenging.

Before the financial crisis, trading in asset backed and securitised Sukuk products, issued by
corporations, has been limited (a notable exception was Sukuk products denominated in Malaysian
ringgits). Furthermore, since the financial crisis, issuance in new Sukuk products has reduced
somewhat.

Using Islamic finance may also increase the cost of capital for a corporation. For example, it may be
more difficult to demonstrate that repayments for Mudaraba, Musharaka and Sukuk contracts are
like debt, and therefore they may not attract a tax-shield. However, an equivalent organisation which
raises the same finance using conventional debt finance may be able to lower its cost of capital due
to tax-shields and therefore increase the value of its investment.

Conclusion

The increasing global interest in and use of Islamic finance means that this is an important source of
finance which organisations need to consider. Its many attributes that are common to ethical
investment and finance would make it an attractive source of finance particularly to organisations
that place importance on ethical issues. The innovations in Islamic financial products by IFIs, such as
Sukuk and diminishing Musharaka, have meant new and innovative Islamic finance products are
being developed and are coming into the market. This is likely to continue as the impact of the
financial crisis recedes.

However, IFIs face a number of challenges such as agency-related issues, increased costs, lack of
flexibility, difficulties with complying with Sharia rulings, and also normal regulations and law. The
IFIs (and the wider Islamic finance regulatory bodies) need to put into place mechanisms and
strategies that will help to overcome these challenges, and thereby ensure that Islamic finance-based
products compete and compare with conventional riba-based financial products.

Written by a member of the Advanced Financial Management examining team

B9 – Islamic finance – theory and practical use of sukuk bonds

This article looks at Islamic finance as a growing and important source of finance, including the
success and failure of the use.

The growth and popularity of the use of Islamic finance has been exceptional since the Central Bank
of Bahrain issued the first sovereign sukuk bonds in 2001. It is estimated that by the end of 2012
Islamic financial assets will have exceeded $1,600bn, which is around 1–2% of global financial assets
worldwide.

A successful Advanced Financial Management student must: ‘Demonstrate an understanding of the

role of, and developments in, Islamic financing as a growing source of finance for organisations;
explaining the rationale for its use, and identifying its benefits and deficiencies.’

53
This article is focused on Islamic finance as a growing and important source of finance. In particular,
it looks at the success and failure of the use of sukuk bonds to finance the purchase of assets.
However, for the purpose of reference, the attached appendix explains the basic principles of Islamic
finance.

Sukuk finance

What is sukuk finance? The official definition provided by the Accounting and Auditing Organization
for Islamic Financial Institutions (AAOIFI), the Bahrain-based Islamic financial standard setter, is
‘certificates of equal value representing undivided shares in the ownership of tangible assets,
usufructs and services or (in the ownership of) the assets of particular projects or special investment
activity.’

Sukuk is about the finance provider having ownership of real assets and earning a return sourced
from those assets. This contrasts with conventional bonds where the investor has a debt instrument
earning the return predominately via the payment of interest (riba). Riba or excess is not allowed
under Sharia law.

There has been considerable debate as to whether sukuk instruments are akin to conventional debt
or equity finance. This is because there are two types of sukuk:

• Asset based – raising finance where the principal is covered by the capital value of the asset
but the returns and repayments to sukuk holders are not directly financed by these assets.

• Asset backed – raising finance where the principal is covered by the capital value of the asset
but the returns and repayments to sukuk holders are directly financed by these assets.

There are fundamental differences between these. The diagrams set out below explain the
mechanics of how each sukuk operates.

Asset-based sukuk

Sukuk Al-ijarah: financing acquisition of asserts or raising capital through sale and lease back.

1. Sukuk holders subscribe by paying an issue price to a special purpose vehicle (SPV) company.

54
 2. In return, the SPV issues certificates indicating the percentage they own in the SPV.

3. The SPV uses the funds raised and purchases the asset from the obligor (seller).

4. In return, legal ownership is passed to the SPV.

5. The SPV then, acting as a lessor, leases the asset back to the obligor under an Ijarah
agreement.

6. The obligor or lessee pays rentals to the SPV, as the SPV is the owner and lessor of the asset.

7. The SPV then make periodic distributions (rental and capital) to the sukuk holders.

Asset-backed sukuk

Sukuk: Securitisation of Leasing Portfolio

1. Sukuk holders subscribe by paying an issue price to a SPV company.

2. In return, the SPV issues certificates indicating the percentage they own in the SPV.

3. The SPV will then purchase a portfolio of assets, which are already generating an income
stream.

4. In return, the SPV obtains the title deeds to the leasing portfolio.

5. The leased assets will be earning positive returns, which are now paid to the SPV company.

6. The SPV then makes periodic distributions (rental and capital) to the sukuk holders.

7. With an asset-based sukuk, ownership of the asset lies with the sukuk holders via the SPV.
Hence, they would have to maintain and insure the asset. The payment of rentals provides
the return and the final redemption of the sukuk is at a pre-agreed value. As the obligor is
the lessee, the sukuk holders have recourse to him if default occurs. This makes this type of
sukuk more akin to debt or bonds.

Asset-backed sukuk certainly have the attributes of equity finance – the asset is owned by the SPV.
All of the risks and rewards of ownership passes to the SPV. Hence, should the returns fail to arise the

55
sukuk holders suffer the losses. In addition, redemption for the sukuk holders is at open market
value, which could be nil.

Sukuk finance case studies

For Emirates airline, the use of sukuk finance has been a huge success. The company issued its first
sukuk (Islamic Bond), with a seven-year term, in 2005, which was listed on the Luxembourg Stock
Exchange. The $550m was repaid in full in June 2012.

‘The repayment of our first ever sukuk bond is part of Emirates’ varied financing strategy and reflects
our robust financial position,’ said Sheikh Ahmed bin Saeed Al Maktoum, chairman of the Emirates
Group and chief executive of Emirates airline.

Emirates’ initial injection of equity finance at the time of its creation 24 years ago has been
supplemented by a variety of financing options, including leasing, EU/US export credits, commercial
asset-backed debt, Islamic financing, conventional bonds, as well as sukuk.

Tim Clark, Emirates’ president, recently stated that the airline had traditionally used European debt
to finance purchase of its fast-growing Boeing and Airbus fleet. The French banks were particularly
forthcoming with finance solutions.

However, since the global debt crisis in 2008, the traditional debt markets have taken a risk averse
position – even with a business like Emirates, which has an unbroken profit-making record.

Clark outlined that obtaining funding for new planes using sukuk could be tricky because Islamic
finance, in addition to forbidding payment of interest, prohibits pure monetary speculation and
requires deals to involve concrete assets. It would be harder to win a seal of approval from Islamic
finance scholars for a sukuk that was based on assets, which the airline did not yet own.

For new aircraft, it is not impossible but it is much more complicated as the cash would have to go
from investors through a special purpose vehicle to the manufacturer before a lease-back
arrangement is put in place. Hence, using existing assets to obtain sukuk finance is far easier.

Emirates currently has two aircraft-based sukuk instruments that have been issued globally, and is
backed by existing aircraft: a $500m issue from GE Capital in November 2009, and a $100m deal for
Nomura in July 2010.

Emirates is not the only success story when it comes to the use of sukuk finance. Dubai shopping
mall developer Majid Al Futtaim decided against issuing a conventional bond because of pricing
concerns. It mandated its banks to set up a separate sukuk programme. Turkish Airlines has followed
suit and will finance the purchase of its expanding fleet with Islamic bonds.

The sukuk market has been relatively resilient during the instability in global financial markets, which
has made it more difficult for even highly rated companies around the world to issue conventional
bonds. That is partly because Islamic investors in the Gulf remain cash-rich, partly due to the limited
supply of sukuk, and partly since sukuk investors tend to hold the bonds until maturity. If these
bonds are not being sold on to other investors, there is little or no chance of the bond value
fluctuating.

Recent events have shown the same is not true for conventional bonds. The influence of the credit
rating agencies with their regular reassessment of government and corporate credit ratings has

56
caused downward movement in prices. As one commentator recently stated: ‘Equities are the only
game in town – bonds carry more risk.’

However, the story of Dubai World, the sovereign investment fund of the Dubai royal family, gives
the other side of the story when it comes to the use of Islamic finance. On 25 November 2009, the
financial world was shocked when Dubai World requested a restructuring of $26bn in debts. The
main concern was the delay in the repayment of the $4bn sukuk, or Islamic bond, of Dubai World’s
developer Nakheel, which was especially known for construction of the Dubai Palm Islands.

The Nakheel sukuk was quite a complicated instrument. It was broadly based on the aforementioned
Ijarah structure. In theory, the SPV has legal ownership over the asset in this sale and leaseback
arrangement. However, in this case the SPV only had a long leasehold interest for a period of 50
years. The issue is that leasehold right is not seen as a real right or property right under UAE law as
applicable in Dubai. What may have seemed secure was not.

Nevertheless, the Nakheel sukuk was backed by a few additional guarantees that should have
provided sukuk investors with some recourse. As such, these guarantees gave investors the
confidence to invest in the sukuk. A guarantee from the state-owned parent company, which
implicitly provides a government guarantee for the sukuk (despite the fact that the prospectus
clearly stated otherwise), had reassured investors. This misplaced assumption misled investors in
their risk–return decision on the investment.

The issue, however, did not end there; the complications worsened when the parent company that
acted as guarantor found itself in a situation that made it no better placed than Nakheel to repay the
sukuk. Dubai World is also just a holding company for a number of other companies beside Nakheel.
However, all of Dubai World’s subsidiaries have their own creditors and their own debts to service,
and the important thing for Nakheel sukuk-holders is that the creditors of Dubai World, through the
guarantee, are subordinated to the creditors of the subsidiaries of Dubai World.

A public statement on 30 November 2009 by the Dubai Finance Department director-general, that
the Dubai World debts are ‘not guaranteed by the government’, appears to correctly reflect the legal
position, as the Dubai government was not required by the lenders, and nor did it provide, any
contractual guarantees in respect of the Dubai World debt.

As history tells us, Nakheel did not default on its Islamic bond. The well reported $10bn bailout,
including providing $4.1bn to assist Nakheel directly from Dubai’s rich neighbours Abu Dhabi, calmed
the markets. But this was only part of the solution. Nakheel also issued new sukuk bonds to some of
its creditors in lieu of amounts due to them. This was a key part of the company's restructuring.

In a prospectus attached to the new sukuk, Nakheel revealed that it wrote down the value of its
property and project portfolio by almost Dh74bn (US$20.14bn) in 2009 as its fortunes flagged. The
company also said it changed tactics in response to the financial crisis, forging ahead with a selection
of its projects and putting others on hold.

Conclusion

The global debt crisis sent shockwaves through the financial markets and, at the time of writing this
article, the western banks remain reluctant to loan cash to the business community. Islamic finance,
and in particular sukuk, has to some extent filled the gap left by the traditional debt markets.

57
The Sharia principle on which it is based is fundamentally important and should ensure it is a safe
and sensible finance option for both the company needing the finance as well as the sukuk holder.
Clearly, companies like Emirates have shown the way on how to make sukuk one part of their finance
portfolio.

However, the Nakheel story paints a different picture. A complicated Ijarah structure and a lack of
legal clarity as to ownership of the underlying asset have clouded the water. If the Abu Dhabi bailout
failed to materialize, then the story may have been significantly different.

Sunil Bhandari is a freelance tutor (www.SunilBhandari.com)

Appendix – The basic principles of Islamic finance

The Islamic economic model has developed over time based on the rulings of Sharia on commercial
and financial transactions. The Islamic finance framework is based on:

• equity, such that all parties involved in a transaction can make informed decisions without
being misled or cheated

• pursuing personal economic gain but without entering into those transactions that are
forbidden (for example, transactions involving alcohol, pork-related products, armaments,
gambling and other socially detrimental activities). Also, speculation is also prohibited (so
options and futures are ruled out)

• the strict prohibition of interest (riba = excess).

As stated above, earning interest (riba) is not allowed.

In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead
channelled into an underlying investment activity, which will earn profit. The depositor is rewarded
by a share in that profit, after a management fee is deducted by the bank.

A typical illustration would be how an Islamic bank may purchase a property from a seller and resell
it to a buyer at a profit. The buyer will be allowed to pay in instalments. Compare this to a typical
mortgage where the bank lends money to the buyer and charges interest.

Hence, returns are made from cash returns from a productive source – for example, profits from
selling assets or allowing the use of an asset (rent).

In Islamic banking there are broadly two categories of financing techniques:

• ‘fixed Income’ modes of finance – murabaha, ijara, sukuk

• equity modes of finance – mudaraba, musharaka.

Fixed income modes

(a) Murabaha
Murabaha is a form of trade credit or loan. The key distinction between a murabaha and a loan is
that, with a murabaha, the bank will take actual constructive or physical ownership of the asset. The

58
asset is then sold to the ‘borrower’ or ‘buyer’ for a profit but they are allowed to pay the bank over a
set number of instalments.

The period of the repayments could be extended, but no penalties or additional mark-up may be
added by the bank. Early payment discounts are not within the contract.

(b) Ijara
Ijara is the equivalent of lease finance. It is defined as when the use of the underlying asset or service
is transferred for consideration. Under this concept, the bank makes available to the customer the
use of assets or equipment such as plant or motor vehicles for a fixed period and price. Some of the
specifications of an Ijara contact include:

• the use of the leased asset must be specified in the contract

• the lessor (the bank) is responsible for the major maintenance of the underlying assets
(ownership costs)

• the lessee is held for maintaining the asset in proper order.

(c) Sukuk
Companies often issue bonds to enable them to raise debt finance. The bond holder receives interest
and this is paid before dividends.

This is prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are linked to an underlying
asset, such that a sukuk holder is a partial owner in the underlying assets and profit is linked to the
performance of the underlying asset. So, for example, a sukuk holder will participate in the
ownership of the company issuing the sukuk and has a right to profits (but will equally bear their
share of any losses).

Equity modes

(a) Mudaraba
Mudaraba is a special kind of partnership where one partner gives money to another for investing it
in a commercial enterprise. The investment comes from the first partner (who is called ‘rab ul mal’),
while the management and work is an exclusive responsibility of the other (who is called ‘mudarib’).

The Mudaraba (profit sharing) is a contract, with one party providing 100% of the capital and the
other party providing its specialist knowledge to invest the capital and manage the investment
project. Profits generated are shared between the parties according to a pre-agreed ratio. In a
Mudaraba only the lender of the money has to take losses.

This arrangement is therefore most closely aligned with equity finance.

(b) Musharaka
Musharaka is a relationship between two or more parties that contribute capital to a business, and
divide the net profit and loss pro rata. It is most closely aligned with the concept of venture capital.
All providers of capital are entitled to participate in management, but are not required to do so. The
profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner
strictly in proportion to their respective capital.

59
B10 – Conditional Probability

Management decision making in both financial and performance management involves making
choices based upon what may happen in the future. Such future events can be predicted but
decision makers can rarely be 100% certain that these future events will actually occur or will occur
in the way in which they are forecast.

There are a variety of ways of dealing with such uncertainty in forecast outcomes. In this article, we
shall look at how to consider all of the possible outcomes that may arise, together with their
associated chances of occurring. This is referred to as a situation where we are evaluating risk, since
there is past information or experience which can provide statistical evidence in order to assist in
determining the possibility of each event occurring.

Expected values, decision trees and combined probabilities

A commonly used way of evaluating decisions is via the use of expected values.

An expected value summarises all the different possible outcomes by weighting the possible
outcomes by their probabilities and then summing the result.

Problems where one or more decisions have to be taken can become more complex and may require
the use of a decision tree, with expected values being used to evaluate each of the decisions.

A decision tree is a diagrammatic representation of a problem, where the decision maker needs to
consider the logical sequence of events.

Since one event may depend upon another, we may get situations where event one has a certain
probability of occurring and event two, which depends on event one occurring, has another
probability of occurring. In such circumstances, we have a situation of combined probabilities

For example, if event one has a 0.6 chance of occurring and subsequent event two a 0.75 chance of
occurring, then overall the probability of both events occurring is:

0.6 x 0.75 = 0.45

ie a 45% chance of occurring.

We shall look at such concepts in the following example, which demonstrates how techniques
acquired from the Applied Skills exams can be used in the Strategic Professional exams.

Scenario

Brisport Master Motor Co (Brisport) designs, manufactures and sells a range of components for the
motor car industry. The design team has recently designed a new component for inclusion into
hybrid cars. The component greatly enhances the battery ‘road time’ and therefore reduces the
frequency with which the battery has to be recharged.

The company can either sell the design now, for its initial market value of $400,000, or attempt to
develop the design into a marketable product, which can be supplied to the motor industry. This
development would have an initial outlay of $300,000 now and the component would take one year
to be developed. In such a fast moving market, the component is likely to have a market life as a

60
saleable product of just five years after development.

If the company decides to develop the component, the chances of succeeding in developing the
design into the marketable product are 80%. If the attempt to develop fails, the design can only be
sold, in one year’s time, for half of its earlier market value.

If the attempt to develop the design succeeds the company has a choice of either selling both the
design and the rights to sell the developed component, or marketing the component themselves.

Selling the design would yield $300,000 in one year’s time and $160,000 in royalty payments for each
of the five years thereafter (years 2 to 6).

If the component is marketed by Brisport then there is a 75% probability that the product will be
popular and will generate cash inflows of $440,000 per annum but there is a 25% probability that it
will be unpopular and it will generate cash outflows of $55,000 per annum. Both cash flow figures
are also for each of years 2 to 6.

Brisport uses a weighted average cost of capital of 7% to discount its future cash flows.

The management of Brisport Master Motor Co seeks your advice as to their best course of action.

Solution

There are two decisions which need to be taken by the company:

1. sell the design or develop it

2. if it is developed, then whether to sell the design and the rights to sell the developed
component, or market it themselves

61
In order to evaluate decision 1, decision 2 needs to be evaluated first. In other words, the values we
use in decision 1 need to be determined by the decision we take in decision 2.

Decision 2

The net present value ($000s) on the 75% path is

1,686 – 300 = 1,386.

Taken together with the net present value ($000s) on the 25% path of

(211) – 300 = (511)

62
there is an expected net present value of choosing to market the component of ($000s):

[0.75 x 1,386] + [0.25 x (511)]

= 1,040 – 128
= 912

This is a higher value than the option of selling the design and the rights to sell the developed
component for a net present value of $594,000 ($894,000 – $300,000). Therefore, if the
development goes ahead, it will be more beneficial to market the product.

Of course, we still need to evaluate decision 1, whether to develop at all. The ‘success’ of the
expected present value of $912,000 in decision 2 has an 80% chance of arising, but there is a 20%
chance of the development not succeeding and recouping just half of the initial market value, that
being $187,000 in present value terms, resulting in the company being worse off by $113,000 in
present value terms after taking the development costs into account.

Hence, the expected net present value of the development option of decision 1 can be calculated
($000s):

= [0.80 x 912] + [0.20 x (113)]

= 730 – 23
= 707

Since this is higher than the option to sell the design at time 0, $400,000, on an expected value basis,
the component should be developed and marketed.

Attitude to risk

The expected value approach assumes risk neutrality, but not all management decision makers are
risk neutral. A risk averse management would, in this scenario, be concerned with the 20%
probability of being $113,000 worse off in present value terms should the development decision go
on to fail.

Furthermore, having taken the decision (at node 2) that marketing the component is preferred to
selling both the design and developed component there is a further risk of losses, since there is a
25% chance of the component being unpopular leaving the company worse off by $511,000 in
present value terms.

Combined with the 80% probability of the development being successful, there is an overall 20%
chance of this $511,000 loss. This 20% is known as a conditional probability since it depends upon
the 80% (0.80) success rate firstly and then depends on the 25% (0.25) unpopularity chance.

63
Hence,

0.80 x 0.25 = 0.20 ie 20%

For completeness, there is of course a 75% chance of the component being popular if marketed, and
hence the overall combined probability of a successful development together with a marketing
campaign which results in popularity is:

0.80 x 0.75 = 0.60

ie 60%

Summary

Outcome Probability Net present value ($000s)

Development succeeds and component is popular 60% 1,386

Development succeeds but component is unpopular 20% (511)

Development fails 20% (113)

Therefore, be aware that expected values can lead to a false sense of security. The expected NPV of
$707,000 is an average. In other words, it is the average NPV if the decision is repeated over and over
again. But is that useful in this situation? This is a one-off development of a product and therefore
only one of the outcomes listed in the table above will actually occur. (This is analogous to tossing a
coin once. We know that the outcome will either be a head or a tail, not the expected value of ‘half a
head’ or ‘half a tail’). As can be seen above, there is a 40% chance that the NPV will be negative, and
that is maybe a risk that the company is not prepared to take.

Furthermore, be aware that the analysis largely depends upon the values of the probabilities
prescribed. Often these are subjective estimates made by the decision makers and it would only take
relatively small changes in these to alter one of the decisions.

For example, in decision 2, if the probability of successful marketing falls to 55%, then the expected
NPV of ‘marketing’ falls to:

[0.55 x 1,386] + [0.45 x (511)]

= 762 – 230
= 532

This is now a lower value than the option of selling the design and the rights to sell the developed
component for a net present value of $594,000.

Such sensitivity analysis can be performed on other variables within the model.

64
Of course, decision models such as this are only as good as the information used. In reality there
would probably be a much wider range of possible outcomes than the discrete outcomes described
above. In other words, the problems in examination questions are a simpler version of what is
usually found in reality, but nonetheless are very useful techniques of which you should be aware.

Written by a member of the Advanced Financial Management examining team

B11 - Topic explainer video: Cost of capital

B12 - Topic explainer video: Black-Scholes Options Pricing (BSOP) model

B13 - Topic explainer video: Adjusted Present Value

B14 - How to use the AFM Modigliani and Miller formula

Assess and plan acquisitions and mergers as an alternative growth strategy (C)

C1 - Business valuations

Business valuation is ‘an art not a science’. These are the words used by many ACCA financial
management tutors (including myself) when introducing this topic to students preparing
for Advanced Financial Management. The words imply that when trying to value the equity capital of
a business, there is range of possible correct answers, all of which can be justified as being the most
appropriate. To a certain extent this is true but, as I like to put it, ‘there are different degrees of
correctness’.

Questions on Business Valuations are included in every Financial Management exam. The questions
have typically tested the ‘basic’ equity valuation methods of:

• net assets

• dividend valuation model (or dividend growth model)

• earnings model using P/E ratio or earnings yield

The Advanced Financial Management syllabus builds on those methods tested at the lower level
paper. The concept is the same – to find the value of equity. However, the techniques and methods
are more sophisticated. As I stated above, ‘there are different degrees of correctness’.

The primary purpose of this article is to demonstrate how to tackle an Advanced Financial
Management business valuation question. The detailed understanding of this topic will be gained
from your studies, whichever mode you choose to use. My aim is to show you how to successfully
apply this knowledge under exam conditions.

Equity valuation – categorising the methods

As stated above, there are more methods and models that can be used to find an equity share price
in Advanced Financial Management. The official textbooks explain these in detail and choose
different ways of categorising them within their material. I prefer to take a simple view of equity
valuation by allocating the methods into two main categories:

65
 • Pre-acquisition

• Post-acquisition

Under the first category, the question will be asking the students to ascertain an equity value for a
company. The entity may be a private company and, hence, no stock market price exists or that even
if the company is listed, the market price may not be appropriate for the relevant situation. The
valuation methods appropriate here are:

• net assets

• dividend valuation model (or dividend growth model)

• earnings model using P/E ratio or earnings yield

• net assets + calculated intangible value (CIV)

• free cash flows (FCF)

Past questions have, in my view, clearly indicated which method should be used to arrive at the share
price. However, it is fair to say that the free cash flow model has been tested more than any other
method.

Post-acquisition valuation requires a different mindset and series of methods. Here, students will
need to ascertain the value of the combined companies after acquisition. More importantly, past
exam requirements have requested students to ascertain the percentage gain or loss to both groups
of shareholders – those of both the buying and selling companies.

The post-acquisition valuation methods are:

• bootstrapping – applying the price earnings ratio of the buyer to the combined expected
earnings of the two entities

• combining the pre-acquisition values of the two companies and appending these with the
fair value of the synergies

• free cash flows (FCF) – present value of the combined companies FCF using the relevant
discount rate.

As I have stated above, your preparation should include ample time to study and understand the
equity valuation methods above, allowing you to apply your knowledge successfully in the exam
room.

Below is a worked sample question illustrating how I would tackle a 25-mark exam style question,
based broadly on previous exam content.

Borgonni and Venitra

Borgonni Co is a very successful entity. The company has consistently followed a business strategy of
aggressive acquisitions, looking to buy companies that it believes were poorly managed and hence
undervalued. Borgonni can be described as a modern day conglomerate and its business interests
stretch far and wide.

Its board of directors has chosen the takeover targets with care. Always looking for companies with
potential, but which were poorly managed and having a below par market value, Borgonni has
maintained its price earnings (P/E) ratio on the stock market at 12.2.

66
Borgonni’s 20X3 figures show a profit after tax of $886m and it has 375m shares in issue.

Venitra Pvt is a well-established owner-managed business. In financial terms it has a rather

chequered history with its up and downs corresponding directly with the state of the global economy.
Over the past five years, its profits have fallen each year with the 20X3 values standing at:

$m

Revenue 1,500

Operating profit 480

Interest (137)

Profit before tax 343

Taxation @ 25% (86)

Profit after tax 257

Number of shares in issue 150m

EPS $1.72

However, with economists predicting an upturn in the Western economies, Venitra’s management
team feel that revenue will increase by 6% per annum up to and including 20X7. The company’s
operating profit margin is not expected to change for the foreseeable future.

67
Operating profits are shown after deducting non-cash expenses (including tax allowable depreciation)
of $125m. This is expected to increase in line with sales. However, the company has recently spent
$210m on purchase of non-current assets. Venitra’s management believes this value will have to
increase by 10% per annum until 20X7 to enable the company to remain competitive. Venitra has
estimated its overall cost of capital to be approximately 12%, but this assumes it will maintain its
debt to equity ratio at 40:60.

Some of Venitra’s major shareholders are not so confident about the future and would like to sell the
business as a going concern. The minimum price they would consider would be the fair value of the
shares, plus a 10% premium. Venitra’s CFO believes the best way to find the fair value of the shares is
to discount the forecasted free cash flows of the firm, assuming that beyond 20X7 these will grow at
a rate of 3% per annum indefinitely.

Requirement
(a) As at 1 January 20X4, prepare a schedule of Venitra’s forecast free cash flows for the firm.
Ascertain the fair value of the Venitra’s equity on a per share basis.
(10 marks)

(b) Borgonni intends to make an offer to Venitra based upon a share for share swap. Borgonni will
exchange one of its shares for every two Venitra shares. Assuming that Borgonni can maintain its
earnings rating at 12.2, calculate the percentage gain in equity value that will earned by both groups
of shareholders?
(8 marks)

(c) What factors should the Venitra shareholders consider before deciding whether to accept or
reject the offer made by Borgonni?
(7 marks)
(25 marks)

Solution

At this stage, you can choose one of two ways to follow my approach to answering this question.
My solution to each part along with the relevant explanation is shown below.

(a) Venitra – Forecast Free Cash Flows and Value of Equity

Notes and explanations:

68
 1. As we are preparing a valuation as at 1 January 20X4, I have set up columns for each future
period. I need to prepare a detailed forecast for the first four years only. After 20X7, the FCF
of the firm will increase at the rate of 3% per annum. I have started with a 20X3 column just
as a reference point.

2. Revenue has been increased by 6% per annum using the 20X3 sales as a base point.

3. The operating margin in 20X3 was 32% (480/1,500). This will be maintained for the
foreseeable future.

4. One key factor is to ignore the interest payment. FCF for the firm must EXCLUDE interest.
This is because the cost of capital used to discount these flows is the company WACC. The
WACC takes into account the interest element and its tax benefit.

5. Income tax on company profits is charged at 25%. In this case, it is to be paid in the same
year as the profits are earned.

6. The operating profit is after deducting non-cash expenses, which are allowable for taxation.
These include tax allowable depreciation. In this question, these expenses will increase in
line with sales and they have to be added back after the tax charge has been computed.

7. Venitra needs to set aside cash each year to maintain its non-current asset (NCA) base. The
amount of capital expenditure will increase by 10% per annum for the next four years.
Please note that in some past questions, it has been assumed that the non-cash expenses
equal the required investment in NCAs. Hence, the add back and deduction will cancel out.

8. The forecast FCF for the firm is a simple totalling up process for the first four years. After
20X7, the FCF are expected to grow at a rate of 3% per annum indefinitely. Therefore, the
20X8 value is calculated as $305m x 1.03.

9. As stated in point 4, the relevant discount rate to apply to the FCF of the firm is Venitra’s
WACC. This has been estimated as 12%. The first four discount factors have been copied
from the discount tables provided at the end of the exam paper. The discount factor for 20X8
and beyond must take into account both a 3% per annum growth rate as well as a cost of
capital of 12%. The financial mathematics for a delayed perpetuity with an annual growth
rate is (1/(0.12 – 0.03) x 0.636).

10. The value of the entity is the total of the present value of the forecast FCF. However, this
amount represents a combination of the debt and equity together. Venitra’s equity is equal
to 60% of the value of the firm.

11. The question requirement is to ascertain the equity value per share. Therefore, $1,866m
/150m = $12.44. This is the fair value of one share of Venitra.

12. Finally, I have computed the P/E ratio for Venitra. Although this was not specifically asked for,
this value will be needed for part (b).

(b) Percentage gain in equity value – both groups of shareholders

The first stage is to compute the current market price per share for Borgonni:

69
 $m

20X3 – Earnings 886

P/E ratio 12.2

Value of equity $10,809m

No of issued shares 375m

Value per share (Po) $28.82

Borgonni expects to maintain its P/E ratio after acquiring Venitra. Therefore, the post-acquisition
value of the two entities combined together can be ascertained by applying Borgonni’s P/E ratio to
the sum of the latest earnings of each company. As the P/E ratio of Borgonni (12.2) exceeds that of
Venitra (7.23) this is known as ‘bootstrapping’.

$m

Borgonni – 20X3 PAT 886

Venitra – 20X3 PAT 257

70
 $m

1,143

P/E ratio – Borgonni 12.2

Post-acquisition value $13,945m

The purchase is to be funded via a share for share exchange. Borgonni will issue one new share in its
company in return for every two shares in Venitra.

Borgonni issued share capital 375m

Additional shares issued (150m/2) 75m

New total issued share capital 450m

The new equity value for a Borgonni share is now $13,945m/450m = $30.99.

However, although many candidates may stop at this point (believing they have reached Utopia!) the
requirement has not been addressed. The question asks candidates to ascertain the gain that will be
made on the equity value to each group of shareholders. Looking at each in turn:

Borgonni shareholders’ gain (($30.99 – $28.82)/$28.82) x 100 = 7.53%

To compute the gain for the Venitra shareholders, the candidate must first compute the post-
acquisition value of a Venitra share. Venitra shareholders gave up two shares in their company to
receive one new Borgonni share. Therefore, the equivalent post-acquisition value of a Venitra share
will be $30.99/2 = $15.50.

The fair value of a Venitra share, per part (a), was $12.44. Therefore, the Venitra shareholders
gain 24.60%.

(c) Factors to consider – for the Venitra shareholders

There is no one correct answer to this part. As long as the candidate produces a reasonable number
of valid points, they will earn decent marks.

71
My answer would read as follows:

• Venitra shareholders wanted a gain of at least 10% on the fair value of the shares. Based
upon the figures, they are gaining nearly 25%, which is likely to encourage them to accept
the offer.

• The share for share exchange may be beneficial for tax planning. Any capital gain earned on
the sale of the shares will be rolled over until the gain is realised in cash.

• Venitra may decide to reject this bid believing that Borgonni will make a more lucrative offer
in the future.

• The fair value of the Venitra shares has been based upon forecasts and estimates. Some
sensitivity analysis needs to be carried out to ensure the value is robust.

• There is no guarantee that Borgonni can maintain its P/E ratio at 12.2. There may well be an
element of dilution given the much lower P/E of Venitra. Hence, the post-acquisition value is
then uncertain.

• Not all Venitra shareholders want to sell the company. The constitution of the company may
allow the takeover to be blocked unless a certain percentage majority of the shareholders
agree.

• Venitra shareholders may also feel that as the economic conditions are improving, their
business prospects and value will get better. They may reject Borgonni’s approach and stay as
an independent company.

As you can see, business valuation questions require you to have a disciplined approach and to
demonstrate that you have studied and understand this key area of the syllabus. Although equity
valuations are an ‘art not a science’, you have to produce an answer that is pleasing to the eyes of
the examining and marking team.

Sunil Bhandari, freelance tutor

www.SunilBhandari.com

C2 – Alternative methods of Listing

The Advanced Financial Management (AFM) syllabus now includes alternative methods which can be
used to obtain a stock market listing and introduces the following new topics, which are examinable
from September 2023 onwards:

• Dutch auctions

• special purpose acquisition companies

• direct listings.

This article begins with a brief summary of the method which companies have traditionally used to
achieve a stock market listing, ie an initial public offering (IPO), and then discusses each of the
alternative approaches highlighted above, including their advantages and disadvantages.

IPO

72
This topic is included in the Financial Management syllabus and is assumed knowledge for the AFM
exam.

An IPO is the most common route for a private company to obtain a listing. These are often highly
publicised events and the publicity can help attract new investors. An IPO will allow a company to
access a much wider pool of capital and raise the funds required to take advantage of future growth
opportunities.

An IPO is typically underwritten by one or more investment banks. The underwriter evaluates the
risks associated with the IPO and effectively guarantees the share issue. This concept of underwriting
a share issue is a critical component of the initial public offering process but it can be expensive,
typically 2% to 7% of the issue proceeds.

In periods of economic uncertainty, an IPO may not be successful in attracting potential investors and
may even have to be abandoned mid-way through the process. Market sentiment can change quite
quickly and if an IPO is cancelled, it means a lot of time and money will have been wasted without
anything to show for it.

An IPO can also take a long time, typically between one and two years, mainly due to the legal
requirements associated with a listing and the need to build interest amongst potential investors. An
underwriter which provides bookbuilding services will determine the price at which shares must be
sold after estimating investor appetite but this can be time consuming because it will involve a series
of sales pitches to various institutional investors in the form of a roadshow. This price discovery
process can also sometimes be unreliable. For example, LinkedIn shares were priced at $45 for its
IPO but closed at $94.25 at the end of the first day of trading. Such an increase implies the IPO was
significantly underpriced and when this happens, it means the issuing company loses out because it
ends up raising less capital.

Dutch auction

A Dutch auction is a price discovery process which is used to minimise the potential for mispricing in
an IPO. Once a company has decided on the number of shares it wishes to sell, interested investors
will submit a bid stating the quantity and price at which they are willing to purchase those shares.
The final share price for the IPO is based on the highest price at which all the shares can be sold.
Since all bidders will pay the same share price it means some bidders may end up paying less than
the amount they were initially willing to pay. However, at least in theory, the price is set at the
maximum level which ensures demand equals supply and the entire share offering is sold.

Advantages of a Dutch auction

There is evidence to suggest that Dutch auctions may result in a premium being paid to the issuing
company compared to the proceeds from a more traditional IPO. This reduces the spread between
the final offer price and the actual market price on the first day of trading.

For bidders, there is a trade-off between price and certainty in a way that favours the issuing
company. If a bid is too low, the bidder may lose out but the nature of a Dutch auction means it is
protected if it bids too high since all bidders ultimately pay the same market clearing share price. A
Dutch auction therefore incentivises more aggressive bids, which benefits the company being listed.

A Dutch auction reduces the involvement of the underwriters which results in lower transaction fees
for the issuing company.

73
Often in a traditional IPO, the underwriter will market the offer to institutional investors first and
retail investors are only allowed to participate after the company is admitted to trading. However,
Dutch auctions allow retail investors to compete against the institutional investors because shares
are sold to the highest bidder, effectively democratising public offerings.

Disadvantages of a Dutch auction

As previously discussed, the share offer price in a traditional IPO is determined by the issuing
company and its underwriter, typically following a roadshow where the shares are marketed to
institutional investors. In a Dutch auction, the underwriter loses this ability to direct the share price
because ultimately it is the potential investors who determine the final price since this is fixed by the
market at a level which maintains the balance between supply and demand.

In exactly the same way that a traditional IPO can be undersubscribed, the possibility remains that
the listing based on a Dutch auction will also be unsuccessful if demand is weaker than anticipated.

Retail investors are less sophisticated than institutional investors and may not conduct sufficient due
diligence on the issuing company. There is therefore a risk they might pay an excessively high price.
As a result, they may attempt to liquidate their holdings as soon as trading commences and cause
the share price to plummet.

Special purpose acquisition company (SPAC)

Another way for a private company to become publicly traded is by merging with an already listed
SPAC. A SPAC starts off as a private shell company which undergoes an IPO to become listed. The
SPAC is usually formed by people with relevant industry experience who provide the initial capital
prior to the SPAC being listed. These people are known as the SPAC sponsors. The purpose of the
listing is to raise sufficient funds from other investors to acquire a controlling stake or purchase
outright an existing private company in a target industry, although at the time of the IPO, the target
company is often unknown to investors. Even though there is usually a target industry in mind when
the SPAC is formed, there is typically enough flexibility built into the agreement to allow
opportunities in other sectors to be pursued too. After the SPAC has obtained a listing, it normally
has up to two years to identify a suitable target or it is closed down and the funds are returned to the
investors.

Advantages of a SPAC listing

One of the main advantages of a SPAC transaction is that it can take significantly less time to
complete compared to an IPO, typically completing within three to six months. There is also a
significant cost advantage. Once acquired, the target company becomes a publicly traded company
without paying the fees and underwriting costs associated with an IPO since these are covered
before the target company is ever involved. The target company also sidesteps the legal and
regulatory obstacles associated with an IPO and the need to generate interest amongst potential
investors since the SPAC is already listed when the deal is executed, which saves further time and
expenditure.

With an IPO, the share price depends on the market conditions at the time of the listing whereas
with a SPAC transaction the target company is in a position to negotiate before the deal is executed.
This provides greater certainty about the pricing of the shares. In theory, the target company will
therefore not have to worry about the funds raised being insufficient. In a volatile market, this can be
a key advantage compared to an IPO and might explain the significant growth in SPAC transactions
during the early stages of the pandemic.

74
The SPAC sponsors typically include individuals with relevant financial and industrial experience, who
can draw on their expertise and even take on a role themselves on the board. The SPAC sponsors
may also have experience of listing requirements and therefore in theory may be in a position to
guide the target company through the process, including any post-admission compliance issues.

Disadvantages of a SPAC listing

The terms of a SPAC transaction are negotiated between the SPAC sponsors and the target company.
Depending on the outcome of those negotiations, there may be changes made to the target
company’s management team. This contrasts with a traditional IPO, where an offering is typically
built on the reputation and success of the historical management team. Any change in the
composition of the management team may result in cultural or strategic dissonance which could lead
to a failure in execution.

Although there have been SPAC transactions that seem to have added value to shareholders, there is
evidence to suggest that many SPAC transactions underperform relative to initial expectations. One
of the possible reasons suggested for the mixed track record is that the knowledge and expertise
attributed to the SPAC sponsors is sometimes overstated and of limited benefit to the target
company post-execution.

Although one of the main advantages of a SPAC is to be able to achieve a listing within a compressed
timeline, a company going public must meet the same regulatory requirements as any other public
company, regardless of the route to market. For a SPAC this task must be accomplished in a matter of
months rather than the year or two that a traditional IPO can take. In theory, the SPAC sponsor may
help with the regulatory and compliance issues but in practice the target company often takes on
most of the burden and within a much shorter timeline.

The target company will need to do thorough due diligence on the SPAC sponsors and advisors. This
will involve investigating the sponsors’ track record and the source of the funds raised and ensuring
the merger agreement does not contain any terms and conditions which are detrimental to the
target company. It will also be important to ensure the shell company was set up properly and is
compliant with regulatory requirements.

The SPAC is obligated to put the potential merger to a shareholder vote. The SPAC shareholders
normally have a right to redeem their shares and have their funds returned if they do not approve of
the final business combination. The SPAC may then have to turn to the debt markets or raise
additional equity to make up the shortfall, which will cost further time and money.

Direct listing

In a direct listing a private company’s shares are admitted to trading on a public market, allowing its
existing shareholders to sell their shares directly to the public. The end result is essentially the same
as the outcome of an IPO in the sense that a formerly private company becomes traded on a public
exchange. However, the route a direct listing takes to get there is different from a traditional IPO
since a direct listing involves listing only the company’s existing shares rather than issuing new ones.
And since no new shares are issued, there is no need for an underwriter. Once listed, however, it is
worth noting that all companies enjoy the same liquidity benefits of being publicly traded, regardless
of their route to market.

A direct listing therefore provides an exit route for the private company’s early investors, potentially
including its directors and employees, but unlike an IPO, no new capital is raised since no new shares
are issued.

75
Advantages of a direct listing

A direct listing provides a much more cost-effective route to market since it bypasses the need for an
underwriter and the transaction fees associated with a traditional IPO. Companies that do not need
to raise capital may prefer this method since it also avoids the time delays associated with an IPO.
This also minimises the risk of the listing being abandoned since it sidesteps the need for a
bookbuilding process and the potential for the sort of unforeseen economic events which can trigger
a sudden shift in investor appetite.

A direct listing allows companies to access a broader shareholder base, including institutional and
retail investors, without the restrictions on trading which are associated with IPOs. This feature may
be particularly attractive to early investors who may want to sell their shares on the first day of
trading which is typically not possible with an IPO due to the requirement for a lockup period. Since
no new shares are issued, this method can also help avoid a dilution of the existing shareholders.

There is a lower risk of mispricing with a direct listing since the process of price discovery is
determined by the opening auction on the first day of trading.

Disadvantages of a direct listing

A direct listing is not the most suitable option for a company that needs capital to finance its future
growth plans. Without an underwriter, there is also no guarantee the shares will sell. If the listing is
to be successful, any company using a direct listing will therefore need to be confident that there is
sufficient investor appetite to allow a market to develop for its shares. This explains why companies
that use this route to market typically have strong brand recognition eg Spotify. The availability of
shares also depends on early investors and employees wanting to sell their shares. Without an
underwriter, it can also be difficult to protect against volatility and uncertainty in the early days of
trading after a direct listing.

Written by a member of the AFM examining team

C3 – Reverse Takeovers

Reverse takeovers is a topic that is examinable in Advanced Financial Management. This article aims
to provide an explanation of reverse takeovers and to discuss the potential benefits and drawbacks
associated with reverse takeovers (RTO).

Reverse takeovers – an explanation

An RTO involves a smaller quoted company taking over a larger unquoted company by a share-for-
share exchange. In order to acquire the larger unquoted company, a large number of shares in the
quoted company will have to be issued to the shareholders of the larger unquoted company. Hence,
after the takeover the current shareholders in the larger unquoted company will hold the majority of
the shares in the quoted company and will therefore have control of the quoted company.

On completion of an RTO, it is usual for the quoted company to be managed by the senior
management team from the previously unquoted company and to take the name of the previously
unquoted company.

Through the RTO, the previously unquoted company has effectively achieved a listing on the stock
exchange. Eddie Stobart, a road haulage company based in the UK, achieved a listing in this way in
2007 by combining with Westbury, a property and logistics company.

76
It is worth noting that in the USA, the term 'reverse merger' is often used as opposed to the term
reverse takeover.

As ever, there are many variations on the basic idea. For instance, an RTO may involve a quoted
company, which is actively trading, or a shell company, which is not actively trading.

RTOs have often been deemed to be the poor man’s initial public offering (IPO) perhaps due to US
studies showing that companies achieving a listing through a reverse merger generally have lower
survival rates and underperform compared to companies who have achieved their listing through a
traditional IPO.

However, studies in the UK have shown that this is not necessarily the case. Indeed, during the
period 1995 to 2012, RTOs seem to have survival rates similar to those for IPOs. The best results
seem to arise with RTOs, which involve a quoted company that is actively trading, as the takeover is
then able to benefit from synergy gains. Equally, small RTOs seem to perform better than larger ones.

Reverse takeovers – the potential benefits

As previously stated, an RTO is effectively a way that a currently unquoted company can achieve a
listing. Hence, just as with an IPO, the company obtains the benefits of the public trading of its
securities. These benefits include:

Easier access to capital markets

As a listed company, more finance is likely to be available and the cost of that finance is likely to be
lower than if the company was still unquoted.

Higher company valuation

As the shares in the company will be listed, potential investors will deem the shares to be less risky
as the company will have to abide by the relevant rules and regulations. Additionally, they will know
that the shares are liquid and that whenever they wish to sell there will be a willing buyer. As a result
of this, investors are likely to attribute a higher value to the shares.

Enhanced ability to carry out further takeovers

Once the shares in a company are listed, the company is able to acquire other companies through
further share-for-share exchanges.

Enhanced ability to use share based incentive plans

Once the shares of a company are listed, share based incentive plans can be used as a key tool to
attract and retain good quality employees.

In addition to the above, an RTO has a number of other potential benefits when compared to a
normal IPO. These include the following:

Speed
An IPO can often take between one and two years to complete whereas an RTO can be completed in
as little as 30 days. Furthermore, the work required to complete an IPO can mean that the managers
of a company have less time to run the company, which may prove detrimental to the growth
prospects of the company. The variability of market conditions can also make the speed of an RTO
attractive, as in the time taken to prepare for an IPO, the market may deteriorate such that the IPO is
not finally worth completing. Furthermore, particular circumstances in a market may make RTOs
attractive. For instance, in China the IPO process is notoriously slow and there is usually a significant
queue of companies waiting to carry out an IPO. An RTO allows a company to jump this queue.

77
Cost
Just as an IPO is a time-consuming process, it is also an expensive one due to the volume of work
required by investment banks, sponsors, accountants and other advisers. An RTO will usually, but not
always, cost less.

Availability
In a market downturn it is not easy to convince investors to support an IPO, whereas this does not
seem to be the case with RTOs. Studies have shown that the volume of RTO transactions is far more
resilient to market downturns. During the market correction that followed the bursting of the
dotcom bubble, the number of RTOs actually increased while the number of IPOs fell very
significantly.

Similarly, the fall in the number of RTOs was less than the fall in the number of IPOs following the
more recent financial crisis. This is probably because, with an RTO, the deal is fundamentally
between the shareholders of the quoted and unquoted companies involved and, hence, market
sentiment has much less import.

Furthermore, while an RTO is often accompanied by a concurrent secondary offering to raise new
finance, the amount of new finance being raised in both $ and % terms is usually less than that which
is raised during an IPO. Hence, even in a downturn, investors are often more willing to support an
RTO rather than an IPO.

Existing analyst coverage

A listed company subject to an RTO is likely to have existing analyst coverage and, after the RTO, this
analyst coverage usually continues. However, companies that use an IPO may struggle to get
significant analyst coverage especially if they are smaller. Without reasonable analyst coverage,
potential investors may not have much awareness of the company and, hence, are unlikely to want
to invest in the company.

Reverse takeovers – the potential drawbacks

RTOs do, however, have a number of potential drawbacks when compared to an IPO and any
company considering an RTO should be aware of these.

Lack of expertise
A company achieving a listing through an RTO may find that it does not have the expertise to
understand and deal with all the regulations and procedures that listed companies must comply
with. The long process of listing through an IPO can be viewed as a valuable training period and any
company that has been through the process is in a better position to deal with the requirements of
the exchange than a company catapulted onto the market through an RTO. Hence, any company
considering an RTO must consider the need to hire and/or retain staff from the existing listed
company who are able to keep the company compliant with all the relevant regulations.

Reputation
As previously discussed, an RTO has often been viewed as a poor man’s IPO. Hence, companies that
achieve their listing in this way may be viewed less favourably by investors than companies that have
completed an IPO. To some extent, the reasons for this lie in the recent past.

In 2011 and 2012, there were a number of accounting scandals involving Chinese firms that gained
access to the US markets through RTOs. Indeed, over 100 companies were suspended or delisted as a
result. A public bulletin issued by the US Securities and Exchange Commission in June 2011 warned
investors by stating that ‘many companies either fail or struggle to remain viable following a reverse

78
merger’ and that there have been ‘instances of fraud and other abuses involving reverse merger
companies’.

Since that time, the regulations and standards that apply to reverse mergers / RTOs on the US stock
exchanges and other exchanges around the word have been tightened up in order to prevent similar
problems arising in the future.

Risk
As a result of the lower level of scrutiny that is applied to an RTO compared to an IPO, investors must
be aware of the higher level of risk that is attached to companies achieving a listing in this way. In
particular, the unquoted company carrying out an RTO must ensure that there is a thorough
investigation of the listed company which they are taking over so that all potential problems and
liabilities are revealed.

Regulation
Although RTOs can generally be completed more quickly than an IPO as there is less regulation and
scrutiny involved, it must be recognised that there are still a significant amount of regulatory hurdles
to overcome. It should be understood that RTOs are, to some extent, combinations of acquisitions
and IPOs and, as such, are potentially complex and difficult deals to manage. By way of example, two
regulatory issues that may arise are now discussed:

• Suspension
The Financial Conduct Authority’s (FCA) standard view is that when an RTO is announced or
leaked, there will generally be insufficient information publicly available on the proposed
transaction. In particular, information on the unquoted company contemplating the takeover
could well be limited compared to the information that is available on listed companies. As a
result of this, the listed company will not be able to accurately assess its financial position
and inform the market. Hence, the FCA will often consider that a suspension of trading in the
shares is appropriate. This standard view can be rebutted, but there is significant work
required to achieve this. However, this work is essential as the listed company will not want
to contemplate a scenario where its listing is suspended and is quite likely to walk away from
the proposed transaction were this to occur.

• Mandatory offer
If, individually or with their closely connected persons or friends, any shareholder in the
unquoted company carrying out an RTO will on completion of the transaction hold shares
that carry 30% or more of the voting rights of the listed company, then that shareholder will
be required to make a general cash offer for the remaining shares in the listed company
under the mandatory bid rule. This would obviously undermine the reason for doing the RTO
in the first place. While the takeover panel will usually consent to a waiver of this
requirement as long as certain conditions are satisfied, it is another regulatory obstacle
which must be navigated around carefully.

Share price decrease

Many listed companies which could make potential RTO targets are in that position because of past
problems. Hence, they may have shareholders who are keen to exit from the company as soon as a
suitable opportunity arises and, hence, they may ‘dump’ their shares shortly after the RTO has
completed. To safeguard against the risk of a ‘dump’ occurring, the shareholders may need to

79
guarantee that they will not sell their shares until a certain period of time has elapsed since the deal
is completed. This is called a lock-up and/or a lock-up period.

Cost
While a reverse takeover is usually cheaper than an IPO, there are still significant direct and indirect
costs involved and, hence, the total cost can easily be far more than was originally anticipated. A
number of these costs are now considered:

• Regulatory costs
As mentioned previously, an RTO is a complex transaction and to ensure that the regulatory
hurdles are successfully overcome will incur significant cost.

• Acquisition cost
As a result of an RTO being seen as an easier and quicker option than an IPO, especially in
the Chinese market, the value of potential listed company targets are often at a significant
premium to their true value. Furthermore, the pressure to find a target has resulted in some
unusual combinations such as a mobile computer game developer getting listed through the
acquisition of a shoe company! It is hard to imagine there were any synergy gains available
here and, indeed, resolving cultural and other issues that may well have arisen would have
further added to the indirect cost of achieving the listing.

• Investor relations
Although an RTO may benefit from existing analyst coverage, RTO transactions only really
introduce liquidity to a previously private company if there is real investor interest in the
company. In many cases, in order to generate this interest, a comprehensive investor
relations and investor marketing programme will be required. This is another potential
indirect cost of an RTO.

Conclusion

As with anything that seems too good to be true, it must be recognised that an RTO is not without
significant complication and cost. Just as there is no such thing as a free lunch, there is also no easy
way to achieve a listing.

William Parrott, freelance tutor and senior FM tutor, MAT Uganda

References:

• BPP ACCA Approved Study Text

• Reverse takeovers: No longer the poor man’s IPO, M&A Research Centre at Cass Business
School

• Reverse Takeovers, Stepping through the looking glass, Karen Davies, Dominic Ross and
James Fletcher of Ashurst LLP

• Leapfrogging the IPO gridlock: Chinese companies get a taste for reverse takeovers, Elzio
Barreto

C4 - Topic explainer video: Valuations

C5 - Topic explainer video: Valuation of acquisitions

80
Evaluate and advise on alternative corporate re-organisation strategies (D)

D1 - Topic explainer video: Corporate restructuring

Apply and evaluate alternative advanced treasury and risk management techniques (E)

E1 - Foreign currency futures – step by step

This article highlights the different approaches which can be taken for foreign currency futures
hedging transactions in the AFM exam. There is the lock-in rate method which is most commonly
seen in published AFM answers, but there is also a future spot-rate method as well. You can use
either method in your AFM exam and receive full credit. To look at each method, we will consider an
example.

EXAMPLE 1
Norris Co is a company based in the eurozone which carries out trade in the country of Mengia,
whose currency is the dollar.

Today's date is 1 May. On 30 November Norris Co is due to pay $20 million to a Mengian supplier. Its
treasury function is reviewing how using futures to manage the foreign exchange risk on these
transactions would work compared to using the forward market.

The following information is available:

Exchange rates (quoted as $/€1)

Spot 1.2100 – 1.2116

7 months’ forward 1.2274 – 1.2308

Currency futures (Contract size €125,000, futures price quoted as $/€1)

June 1.2180

September 1.2225

December 1.2300

Futures contracts mature at the month’s end. Basis can be assumed to diminish to zero at contract
maturity at a constant rate, based on monthly time intervals.

81
The number of contracts to be used should be rounded to the nearest whole number. If the amount
cannot be hedged using an exact number of futures contracts the balance should be considered
immaterial.

SOLUTION

Forward market hedging

$20m/1.2274 = €16,294,606

This method has the advantage of being tailored to the exact timing and amount of Norris Co's
exposure. However there is counterparty risk and, once entered into, the contract is not flexible or
liquid.

Futures
As the transaction occurs in November, sell December euro futures now to hedge against a
weakening of the € relative to the dollar. Note – always follow the flow of the currency to set up the
hedge. We need to buy $ and sell € to pay the invoice. The futures contract is on the €, so the hedge
needs us to sell contracts. December contracts are used as the June and September contracts will
have expired before the actual transaction date.

To work out the number of contracts for this transaction, the transaction value has to be divided by
the size of the contract. Since the transaction is in $ it needs to be translated into the contract
currency using the current futures price of 1.2300.

Number of contracts = ($20m/1.2300)/€125,000 = 130.1

Therefore round to 130 contracts

Lock-in rate method

The basis within a futures hedge is calculated as follows:

Basis = spot price – futures price

Therefore, on 1 May: basis = 1.2100 – 1.2300 = -0.0200

The basis on the expiry date of the futures contract is always zero. Since Norris Co is selling
December contracts and futures contracts expire at the month’s end, the expiry date in this example
is 31 December.

Assuming that basis reduces to zero at contract maturity in a linear fashion, unexpired basis on the
transaction date (ie 30 November) can be calculated as follows:

Unexpired basis = ([1.2100 – 1.2300] × 1/8) = – 0.0025

'Lock in rate' = opening futures price + unexpired basis

'Lock in rate' = 1.2300 + -0.0025 = 1.2275

Expected € net cost = $20m/1.2275 = €16,293,279

This calculation is an approximation to the full hedging transaction as shown below. It ignores the
rounding of contracts and basis risk, both of which will lead to the actual outcome being slightly
different to the calculated outcome. However, the benefit is that it gives an idea of the likely
outcome and does not need actual or assumed spot rates in November to complete the calculation.

82
Future spot rate method

It is possible to calculate the futures outcome by making an assumption about the spot price in 7
months’ time ie on 30 November, and then working through the implications for the spot market and
futures market transactions. For example, if the spot price on 30 November is assumed to be 1.2265,
the following calculations would apply:

Expected futures price (to close out by buying futures) using assumed spot price of 1.2265 is 1.2265
– -0.0025 = 1.2290$/€1

Note - since the spot price on 1 May (ie 1.2100) is lower than the opening futures price (ie 1.2300),
the unexpired basis is subtracted from the assumed spot price on 30 November when calculating the
expected futures price.

Because the opening trade was to sell futures, we have a gain because the futures price has dropped.

Gain on futures market = (1.2300 – 1.2290)$/€1 x 130 x €125,000 = $16,250

Convert gain into euros at assumed spot price of 1.2265 = $16,250 / 1.2265 = €13,249

Convert $20m payment on spot market at assumed spot price of 1.2265 = $20m / 1.2265 =
€16,306,563

Therefore futures outcome = €16,306,563 – €13,249 = €16,293,314

This is effectively the same outcome as from using the lock-in rate method previously. Any assumed
spot rate could be used to get to a similar futures outcome.

In either method, the futures outcome is marginally cheaper than the forward market outcome, so
futures would be the recommended method of hedging for Norris Co on a financial basis.
Additionally, the futures contracts have the benefit of flexibility (can close out hedge any time up to
end of the contract’s life) and there is no counterparty risk through using the exchange. The
transaction has not been hedged exactly, because the number of contracts was rounded down to
130, meaning that the hedge efficiency would be less than 100%.

EXAMPLE 2
This example will use the original exchange rate data as the previous example, but looks at how a
Mengian customer would hedge a payment of €15m to Norris Co on the same date.

SOLUTION

Forward market hedging

€15m x 1.2308 = $18,462,000

Futures
Again, December contracts will be used but the Mengian company needs to buy € and sell $. The
futures contract is on the €, so the hedge needs the company to buy contracts. The number of
contracts will be

Number of contracts =€15,000,000/€125,000 = 120

Therefore buy 120 contracts

Lock-in rate method

The basis within a futures hedge is calculated as follows:

83
Basis = spot price – futures price

Therefore, on 1 May: basis = 1.2116 – 1.2300 = –0.0184

The basis on the expiry date of the futures contract is always zero. Since the Mengian company is
buying December contracts and futures contracts expire at the month’s end, the expiry date in this
example is 31 December.

Assuming that basis reduces to zero at contract maturity in a linear fashion, unexpired basis on the
tranasaction date (ie 30 November) can be calculated as follows:

Unexpired basis = ([1.2116– 1.2300] × 1/8) = –0.0023

'Lock in rate' = opening futures price + unexpired basis

Therefore, the 'lock in rate' = 1.2300 - 0.0023 = 1.2277

Expected $ net cost = €15m x 1.2277$/€1 = $18,415,500

Future spot rate method

If the spot price on 30 November is assumed to be 1.2310, the following calculations would apply:

Expected futures price (to close out by selling futures) using assumed spot price of 1.2310 = 1.2310 –
-0.0023 = 1.2333

Because the opening trade was to buy futures, we have a gain because the futures price has risen.

Gain on futures market = (1.2333 – 1.2300) x 120 x €125,000 = $49,500

Convert €15m payment on spot market at assumed spot price of 1.2310 = €15m x 1.2310 =
$18,465,000

Therefore futures outcome = $18,465,000 - $49,500 = $18,415,500

Once again, the futures outcome is cheaper than the forward market outcome so, on a financial
basis, futures would be the recommended method of hedging for the Mengian customer with the
same non-financial benefits as before. In this example, the outcome from using the lock-in rate
method and the future spot rate method are the same, because this transaction uses an exact
number of contracts to match the transaction amount, meaning the hedge efficiency is 100% in this
example.

If a different assumption is made about the spot price on 30 November, the outcome will be exactly
the same. For example, assume the spot price on 30 November is 1.2200 instead of 1.2310 as
follows:

Because the opening trade was to buy futures, we have a loss because the futures price has fallen.

Expected futures price (to sell futures) using assumed spot price of 1.2200 = 1.2200 – -0.0023 =
1.2223

Loss on futures market = (1.2223 – 1.2300) x 120 x €125,000 = $115,500

Convert €15m payment on spot market at assumed spot price of 1.2200 = €15m x 1.2200 =
$18,300,000

Therefore futures outcome = $18,300,000 + $115,500 = $18,415,500

84
This is exactly the same outcome as before. It does not matter if the assumed spot price on 30
November is not provided in an exam question because any assumption about the spot price on 30
November will result in the same outcome. In this case, although the spot price is more favourable to
the Mengian customer, resulting in a lower payment in dollars, any advantage is cancelled out by the
loss on the futures market.

Conclusion

This article has looked at different approaches which can be taken in the AFM exam for foreign
currency futures hedging transactions. As long as there is no basis risk, either method is eligible for
full credit, so the examining team recommends that you use the method which will best suit you
under exam conditions. This will enable you to maximise your marks on a question which looks at
foreign currency futures hedging transactions. If you are given an expected spot rate or closing
futures rate in the exam it may be easier to use the information provided to close out the hedge than
to use the lock-in rate.

Written by a member of the AFM examining team

E2 - How to answer a foreign exchange risk management question

The Advanced Financial Management syllabus states that there will be at least one question with a
focus on syllabus section E, Treasury and advanced risk management techniques. Within Section E,
foreign exchange risk management is frequently examined. This article will explain the significance of
the information you’ll be given in foreign exchange risk management questions and show you what
you’ll be asked to do.

The scenario is adapted from Nutourne Co, Question 2 in the December 2018 exam, which ACCA
published. Some of the numbers have been changed. In this question, the closing futures price and
spot rate are not given and so the predicted futures rate has to be calculated. (See the article
'Exchange traded foreign exchange derivatives' for an example of when the spot rate and futures
price on the day of settlement are given). There is also a spreadsheet provided showing how the
calculations could be set out in the spreadsheet tool in the exam.

Scenario

Nutourne Co is a company based in the USA, supplying medical equipment to the USA and Europe.
Nutourne Co’s treasury department hedges foreign exchange risk on transactions using forward
contracts, the money market, traded futures or traded options.

It is currently 30 November 20X8.

Nutourne Co’s treasury department is currently dealing with a sale to a Swiss customer of CHF12.3
million which has just been agreed, where the customer will pay for the equipment on 31 May 20X9.

Exchange rates (quoted as US$/CHF 1)

Spot 1.0292 – 1.0309

85
 Three months forward 1.0322 – 1.0341

Six months forward 1.0356 – 1.0378

Annual interest rates available to Nutourne Co

Investing rate Borrowing rate

Switzerland 3.2% 4.4%

USA 4.6% 5.8%

Currency futures (contract size CHF125,000, futures price quoted as US$ per $1)

Futures price

December 1.0306

March 1.0336

June 1.0369

Currency options (contract size CHF125,000, exercise price quotation US$ per CHF1, premium: US
cents per CHF1)

Calls Puts

86
 Exercise December March June December March June
price

1.0375 0.47 0.50 0.53 0.74 0.79 0.86

If futures or options are chosen, any amount not hedged by a futures or options contract will be
hedged on the forward market.

Futures and options contracts mature at the month’s end. Basis can be assumed to diminish to
zero at contract maturity at a constant rate, based on monthly time intervals.

Required:
Evaluate which of the possible methods of hedging being considered would give Nutourne Co the
highest receipt, assuming the options are exercised.

Approaching the question

Read the requirements carefully

You must read the requirements before reading the scenario in detail. Knowing what you have to do
will help you analyse the scenario and ensure that you answer the question fully.

Breaking down the requirements for Nutourne Co:

Evaluate which of the possible The answer needs to state which method gives the highest receipt, but it
methods of hedging being does not ask you to recommend a method. However, if there are
considered would give Nutourne uncertainties relating to the amounts received for any of the methods, it
Co the highest receipt would be legitimate to discuss them.

Assuming the options are This means that the amount hedged by the options contracts will be
exercised translated at the exercise price.

Identify the important data in the scenario

• Hedging methods to be used

• Transaction to be hedged

• Time period

• Spot and 6 month forward rates

Hedging methods to be used

The scenario states that the following methods should be considered:

87
 • Forward contracts

• The money market

• Traded futures

• Traded options

Transaction to be hedged
Nutourne Co is a company based in the USA … currently dealing with a sale to a Swiss customer of
CHF12.3 million which has just been agreed.

Nutourne Co needs to hedge against the USD strengthening (the CHF weakening).

Implications for hedging methods

Forward contract Money market Futures contracts Options contracts

SELL CHF to bank at BORROW in CHF – the SELL CHF futures now to BUY CHF PUT options
forward rate when amount borrowed will be hedge against sale of CHF now to hedge against
money received from repaid by the CHF receipt when money received sale of CHF when money
customer. from Swiss customer. from Swiss customer. received from Swiss
customer.

CONVERT amount
borrowed into USD.

INVEST translated
amount.

Time period
It is currently 30 November 20X8… the customer will pay for the equipment on 31 May 20X9.

Two things to note:

• The length of time between today’s date (30 November 20X8) and the date of settlement (31
May 20X9) – 6 months

• The date of settlement – 31 May

Implications for hedging methods

Forward contract Money market Futures contracts Options contracts

88
 6 month forward rate Annual interest rates will Date of futures will have Date of options will have
will need to be used. have to be divided by 2. to be after May. to be after May.

Spot rate

1.0292 – 1.0309 (quoted as US$/CHF 1)

Remember that the bank ‘always wins’ – so if there is a choice of two exchange rates, choose the one
that gives the lowest receipt.

Implications for hedging methods

Forward contract Money market Futures contracts Options contracts

Not relevant. Determines USD received Could be used in basis Could be used in basis
when translating CHF calculation. calculation.
amount borrowed.

Use lower of two rates Use lower of two rates

Use lower of two rates
(1.0292), as multiplying (1.0292), as multiplying
(1.0292), as multiplying
CHF receipt to obtain CHF receipt to obtain
CHF receipt to obtain
USD, and use of lower USD, and use of lower
USD, and use of lower
rate will mean fewer USD rate will mean fewer USD
rate will mean fewer USD
are received. are received.
are received.

Note that premium is

quoted in US$, so it will
not be translated.

6 month forward rate

1.0356 – 1.0378 (quoted as US$/CHF 1)

6 month rate is used, as it is 6 months between today‘s date (30 November) and date of settlement
(31 May).

Remember again that the bank ‘always wins’.

Implications for hedging methods

Forward contract Money market Futures contracts Options contracts

89
 Use lower of two rates Not relevant Could be used if there is Could be used if there is
(1.0356) as multiplying an amount not hedged. an amount not hedged.
CHF receipt to obtain
USD, and use of lower
If there is a under - If there is a under -
rate will mean fewer USD
hedge, use lower of two hedge, use lower of two
are received.
rates (1.0356) as rates (1.0356) as
multiplying CHF receipt multiplying CHF receipt
to obtain USD, and use of to obtain USD, and use of
lower rate will mean lower rate will mean
fewer USD are fewer USD are
received. received.

ANSWER
Let’s now review the answer:

Forward contract
Receipt = CHF12,300,000 × 1.0356 = $12,737,880

Three months 1.0322 – 1.0341 Use six months rate and lower of two rates (1.0356), as
multiplying CHF receipt to obtain USD, and use of lower
rate will mean fewer USD are received.
Six months 1.0356 – 1.0378

Money market hedging

• Borrow CHF

Amount borrowed = CHF12,300,000/(1 + [0.044/2]) = CHF12,035,225

CHF Investing 3.2% Borrowing 4.4% Borrow in CHF at 4.4%, as CHF receipt from
Swiss customer will pay back borrowing. Adjust
rate as borrowing is for 6 months.

• Convert into US$ at spot rate

Receipt = CHF12,035,225 × 1.0292 = US$12,386,654

Spot 1.0292 – 1.0309 Use lower of two rates (1.0292), as multiplying

CHF receipt to obtain USD, and use of lower rate
will mean fewer USD are received.

• Invest in US$

90
Receipt = US$12,386,654 × (1 + [0.046/2]) = US$12,671,547

US$ Investing 4.6% Borrowing 5.8% Invest translated receipt at 4.6%. Adjust rate as
investment is for 6 months.

Futures

• Sell CHF futures

Sell CHF futures now to hedge against sale of CHF when money received from Swiss customer.

• Use June CHF futures contracts

December 1.0306 Must be June (1.0369) as only date after 31

May.
March 1.0336

June 1.0369

• Number of contracts

Number of contracts = CHF12,300,000/125,000 = 98.4, say 98, hedging 98 × CHF 125,000 =

CHF12,250,000

Contract size is $125,000 Number of contracts =

Receipt/$125,000, rounded to the nearest

contract

• Remainder to be hedged on forward market

Remainder to be hedged on the forward market = CHF12,300,000 – CHF12,250,000 = CHF 50,000

Receipt = CHF50,000 × 1.0356 = $51,780

Number of contracts does not cover full amount of transaction, so need to hedge residual receipt of CHF.

Underhedge = Amount of transaction – Amount hedged

Use same rate as for forward contract above of 1.0356

• Futures price and expected receipt

Estimate from March and June futures rates

Predicted futures rate at the end of May = 1.0336 + ([1.0369 – 1.0336] × 2/3) = 1.0358

91
Expected receipt = CHF12,250,000 × 1.0358 = $12,688,550

Futures and options contracts mature at the 31 May is 2/3 of time between 31 March and 30
month’s end. Basis can be assumed to diminish June, so use 2/3 of the difference
to zero at contract maturity at a constant rate, between March futures price of 1.0336 and
based on monthly time intervals. June futures price of 1.0369.

This method is a shortcut, used to work out a

‘lock-in’ rate that will be the net result of the
underlying transaction and the hedge gains or
losses.

Or

Estimate from spot rate and June futures rate

Predicted futures rate at the end of May = 1.0292 + ([1.0369 – 1.0292] × 6/7) = 1.0358

Expected receipt = CHF12,250,000 × 1.0358 = $12,688,550

Futures and options contracts mature at the 31 May is 6/7 of time between 30 November
month’s end. Basis can be assumed to and 30 June, so use 6/7 of the
diminish to zero at contract maturity at a difference between spot rate of 1.0292 and
constant rate, based on monthly time June futures rate of 1.0369.
intervals.

This method is a shortcut, used to work out a

‘lock-in’ rate that will be the net result of the
underlying transaction and the hedge gains
or losses.

• Outcome

Futures 12,688,550

Remainder on forward market 51,780

92
 $

12,740,330

Options

• Buy CHF put options

Buy CHF put options to hedge against sale of CHF when money received from Swiss customer.

• Buy June options

Put: Must be June as only date after May.

December

March

June

• Number of contracts and receipt

Number of contracts = CHF12,300,000/125,000 = 98.4, say 98, hedging 98 × CHF 125,000 =

CHF12,250,000 (as for futures)

Receipt = CHF125,000 × 98 × 1.0375 = $12,709,375

Contract size is $125,000 Number of contracts =

Receipt/$125,000, rounded to the nearest

contract

• Remainder to be hedged on forward market

Remainder to be hedged on the forward market = CHF12,300,000 – CHF12,250,000 = CHF 50,000

Receipt = CHF50,000 × 1.0356 = $51,780 (as for futures)

Number of contracts does not cover full amount of transaction, so need to hedge residual receipt of CHF.

Underhedge = Amount of transaction – Amount hedged

Use same rate as for forward contract above of 1.0356.

• Premium

93
1.0375 options = 98 × 125,000 × 0.0086 = $105,350

Put June 0.86 US cents per CHF Multiply number of contracts × size of one contract
× 0.0086, as premium is quoted in US cents (not US
dollars) per CHF.

Receipt 12,709,375

Forward contract 51,780

Premium (105,350)

12,655,805

Comments

If the options are exercised, the futures would give the higher receipt. The options give a lower
receipt because of the premium that Nutourne Co has to pay. The futures will be subject to the risk
that basis (the difference between the futures price and the spot price) may not decrease linearly as
the futures approach maturity, as assumed in the above calculations. This will mean that the hedge
of the CHF12,250,000 is imperfect, and the receipt may be unpredictable despite a futures hedge
being taken out.

Conclusion

This question has demonstrated how to use the data given in the question in foreign exchange
hedging calculations. Hopefully, it will help you tackle this type of question systematically.

View an example of how the question could be attempted in the exam software

Written by a member of the AFM examining team

E3 - How to answer an interest rate risk management question

Questions on risk management feature regularly in the Advanced Financial

Management exam. Performance information from recent exams suggests students tend to do less
well on interest rate risk management questions than questions about foreign exchange risk

94
management. This article will therefore explain the significance of the information you’ll be given in
interest rate risk management questions and show you what you’ll be asked to do.

The scenario is adapted from Wardegul Co, Question 4 in the September/December 2017 sample
questions which ACCA has published.

Scenario

Assume Wardegul Co has a newly-acquired subsidiary in Euria, where the local currency is the dinar
(D). The subsidiary expects to receive D27,000,000 and wants to invest this D27,000,000. Assume it is
now 1 October 2017 and the subsidiary expects to receive the money on 31 January 2018. It wishes
the money to be invested for five months until 30 June 2018.

Currently the central bank base rate in Euria is 4·2%, but Wardegul Co’s treasury team has seen
predictions that the central bank base rate could increase by up to 1·1% or fall by up to 0·6%
between now and 31 January 2018. The treasury team believes that Wardegul Co can invest funds at
the central bank base rate less 30 basis points.

The treasury team normally hedge interest rate exposure by using whichever of the following
products is most appropriate:

• Forward rate agreements (FRAs)

• Interest rate futures

• Options on interest rate futures

Treasury function guidelines emphasise the importance of mitigating the impact of adverse
movements in interest rates. However, they also allow staff to take into consideration upside risks
associated with interest rate exposure when deciding which instrument to use.

A local bank in Euria, with which Wardegul Co has not dealt before, has offered the following FRA
rates:

• 4–9: 5·02%

• 5–10: 5·10%

The treasury team has also obtained the following information about exchange traded Dinar futures
and options:

Three-month D futures, D500,000 contract size

Prices are quoted in basis points at 100 – annual % yield

December 2017 94.84

March 2018 94.78

95
 June 2018 94.66

Options on three-month D futures, D500,000 contract size, option premiums are in annual %

Call Put

December March June December March June

0.417 0.545 0.678 94.25 0.071 0.094 0.155

0.078 0.098 0.160 95.25 0.393 0.529 0.664

It can be assumed that futures and options contracts are settled at the end of each month. Basis can
be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time
intervals. It can also be assumed that there is no basis risk and there are no margin requirements.

Requirements
Recommend a hedging strategy for the D27,000,000 investment, based on the hedging choices which
treasury staff are considering, if interest rates increase by 1·1% or decrease by 0·6%. Support your
answer with appropriate calculations and discussion. (18 marks)

Approaching the question

Read the requirements carefully

You should read the requirements first before reading the scenario in detail. Knowing what your
answer has to cover, and therefore what the key data will be, will help you analyse the scenario.

Breaking down the requirements for Wardegul Co:

Recommend a You’ll have to make a clear recommendation

hedging strategy based on your calculations. Anyone reading the
recommendation should be able to see:

• How much would be received under each

instrument

• The effective annual interest rate for each

instrument

96
 so that they can compare the results of the
hedging choices with the interest rate currently
available.

Based on the hedging You need to consider all the hedging

choices which instruments for which data is given, including
treasury staff are both the options.
considering

If interest rates You should assess, for all the hedging

increase by 1·1% or instruments, what will happen if interest rates
decrease by 0·6% rise or fall.

Support your answer You should make some comment on any

with appropriate calculation you carry out in the Advanced
calculations and Financial Management exam. However,
discussion mentioning discussion in the question
requirements here indicates that a number of
marks will be available for comments (four
marks maximum per the marking scheme).
Therefore, a single sentence comment won’t be
enough.

Identify the important data in the scenario

For interest rate hedging questions, you need to identify the information that will affect the
calculations for each instrument. Let’s have another look at the scenario, with the important data
highlighted and referenced to explanations below.

Assume Wardegul Co has a newly-acquired subsidiary in Euria, where the local currency is the dinar
(D). The subsidiary expects to receive D27,000,000 and wants to invest this D27,000,000.

Forward rate agreements Futures Options

Wants to invest this Possibilities are: Buy now (go long), sell Buy call option
D27,000,000 later

• Pay money to bank if

base rate exceeds FRA rate

97
 Forward rate agreements Futures Options

• Receive money from

bank if FRA rate is greater
than base rate

Assume it is now 1 October 2017 and the subsidiary expects to receive the money on 31 January
2018.

Forward rate Futures Options

agreements

It is now 1 Oct 2017 and A period of four Choose futures dated Choose options dated
the subsidiary expects months, so look for a 4– after January – March is after January – March is
to receive the money on x agreement closest date closest date
31 Jan 2018

It wishes the money to be invested for five months until 30 June 2018.

Forward rate Futures Options

agreements

The money to Four months Contracts are Contracts are

be invested to start of for three for three
for five investment + months, so months, so
months until five months to adjust adjust
30 June 2018 end of contracts contracts
investment = calculation, so calculation, so
nine months, that five that five
so select 4–9 month period month period
agreement is covered is covered

Calculate Calculate Calculate

investment investment investment

98
 Forward rate Futures Options
agreements

return for five return for five return for five

months months months

Calculate
transaction
with bank for
five months

Adjust Adjust Adjust

effective effective effective
annual annual annual
interest rate interest rate interest rate
calculation for calculation for calculation for
interest being interest being interest being
received for received for received for
five months five months five months

Currently the central bank base rate in Euria is 4·2%,

Forward rate Futures Options

agreements

Currently the Affects Affects Affects

central bank calculation of: calculations calculations
base rate in of: of:
Euria is • Future
currently interest rates • Future • Future
4.2% interest rates interest rates

• Basis • Basis

but Wardegul Co’s treasury team has seen predictions that the central bank base rate could increase
by up to 1·1% or fall by up to 0·6% between now and 31 January 2018.

99
 Forward rate Futures Options
agreements

The central Affects future Affects future Affects future

bank base interest rates interest rates interest rates
rate could and hence: and hence: and hence:
increase by
up to 1.1% or • Actual • Actual • Actual
fall by up to investment investment investment
0.6% return return return

• Transaction • Calculation • Calculation

with bank of expected of expected
futures price futures price
and hence and hence
result on whether
futures options are
market exercised or
not

• Calculation
of gain if
options are
exercised

The treasury team believes that Wardegul Co can invest funds at the central bank base rate less 30
basis points.

Forward rate agreements Futures Options

Wardegul Co can invest Affects actual investment Affects actual Affects actual
funds at the central return: investment return: investment return:
bank base rate less 30
basis points • If rate rises to 5.3%, • If rate rises to 5.3%, • If rate rises to 5.3%,
investment return will be investment return will investment return will
5.0% be 5.0% be 5.0%

• If rate falls to 3.6%, • If rate falls to 3.6%, • If rate falls to 3.6%,

investment return will be investment return will investment return will
3.3% be 3.3% be 3.3%

100
The treasury team normally hedges interest rate exposure by using whichever of the following
products is most appropriate:

• Forward rate agreements (FRAs)

• Interest rate futures

• Options on interest rate futures

Treasury function guidelines emphasise the importance of mitigating the impact of adverse
movements in interest rates. However, they also allow staff to take into consideration upside risks
associated with interest rate exposure when deciding which instrument to use.

A local bank in Euria, with which Wardegul Co has not dealt before, has offered the following FRA
rates:

• 4–9: 5·02%

• 5–10: 5·10%

The treasury team has also obtained the following information about exchange traded Dinar futures
and options:

Three-month D futures, D500,000 contract size

Forward rate agreements Futures Options

Three-month D500,000 Affects calculations of:

futures
• Number of futures
contracts

• Result on futures
contracts

Prices are quoted in basis points at 100 – annual % yield

December 2017 94.84

March 2018 94.78

101
 June 2018 94.66

Options on three-month futures, D500,000 contract size, option premiums are in annual %

Forward rate agreements Futures Options

Options on three-month Affects calculation is

futures, D500,000 of:
contract size
• Number of options
contracts

• Gain if options are

exercised

• Option premium

Call Put

December March June December March June

0.417 0.545 0.678 94.25 0.071 0.094 0.155

0.078 0.098 0.160 95.25 0.393 0.529 0.664

It can be assumed that futures and options contracts are settled at the end of each month. Basis can
be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time
intervals. It can also be assumed that there is no basis risk and there are no margin requirements.

102
 Forward rate Futures Options
agreements

Basis can be Use in basis Use in basis

assumed to calculation: calculation:
diminish to
zero at • Period • Period
contract between between
maturity at investment investment
a constant date (31 date (31
rate, based January) and January) and
on monthly contract contract
time maturity maturity
intervals date (31 date (31
March) (two March) (two
months) months)

• Period • Period
between between
today’s date today’s date
(1 October) (1 October)
and contract and contract
date (31 date (31
March) (six March) (six
months) months)

Let’s now review the answer:

Forward rate agreement

FRA 5.02% (4 – 9) since the investment will take place in four months’ time for a period of five
months.

If interest rates increase by 1.1% to 5.3%

Actual investment return 5.0% × 5/12 × D27,000,000 562,500

Payment to bank (5.3% – 5.02%) × 5/12 × D27,000,000 (31,500)

103
 Net receipt 531,000

Effective annual interest rate 531,000/27,000,000 × 12/5 4.72%

Actual investment return 3.3% × 5/12 × D27,000,000 371,250

Receipt from bank (5.02% – 3.6%) × 5/12 × D27,000,000 159,750

Net receipt 531,000

Effective annual interest rate as above 4.72%

531,000/27,000,000 × 12/5

Comment

The two calculations should give the same effective annual interest rate.

Futures

Buy futures now (go long in the futures market), as the hedge is against a fall in interest rates.

Use March contracts, as investment will be made on 31 January.

Number of contracts = D27,000,000 ÷ D500,000 × 5 months ÷ 3 months = 90 contracts

Basis

Current price (1 October) – futures price = basis

(100 – 4.20) – 94.78 = 1.02

Unexpired basis on 31 January = 2/6 × 1.02 = 0.34

If interest rates increase by 1.1% to 5.3%

104
 D

Actual investment return 5.0% × 5/12 × D27,000,000 562,500

Expected futures price: 100 – 5.3 – 0.34 = 94.36

Loss on the futures market: (0.9436 – 0.9478) × (47,250)

D500,000 × 3/12 × 90

Net return 515,250

Effective annual interest rate 515,250/27,000,000 × 12/5 4.58%

If interest rates fall by 0.6% to 3.6%

Actual investment return 3.3% × 5/12 × D27,000,000 371,250

Expected futures price: 100 – 3.6 – 0.34 = 96.06

Profit on the futures market: (0.9606 – 0.9478) × 144,000

D500,000 × 3 /12 × 90

Net receipt 515,250

Effective annual interest rate 515,250/27,000,000 × 12/5 4.58%

105
 Comment

The two calculations should give the same effective annual interest rate.

As we are buying futures now, then selling futures later:

• we make a PROFIT if the expected futures price is GREATER than the current futures price

• we make a LOSS if the expected futures price is LESS than the current futures price

Options

Buy call options as need to hedge against a fall in interest rates.

Use March contracts, as investment will be made on 31 January.

Number of contracts = D27,000,000 ÷ D500,000 × 5 months ÷ 3 months = 90 contracts

Basis

Current price (1 October) – futures price = basis

(100 – 4.20) – 94.78 = 1.02

Unexpired basis on 31 January = 2/6 × 1.02 = 0.34

If interest rates increase by 1.1% to 5.3%

Exercise price 94.25 95.25

Expected futures price: 94.36 94.36

100 – 5.3 – 0.34 = 94.36

Exercise? Yes No

Gain in basis points 11 0

D D

106
Actual investment 562,500 562,500
return 5.0% × 5/12 ×
D27,000,000

Gain from options 12,375 0

0.0011 × D500,000 ×
3/12 × 90

Premium

0.00545 × D500,000 × (61,313)

3/12 × 90

0.00098 × D500,000 × (11,025)

3/12 × 90

Net return 513,562 551,475

Effective interest rate

513,562/27,000,000 × 4.56%
12/5

551,475/27,000,000 × 4.90%
12/5

Exercise price 94.25 95.25

107
Expected futures 96.06 96.06
price: 100
– 3.6 – 0.34 = 96.06

Exercise? Yes Yes

Gain in basis points 181 81

Actual investment 371,250 371,250

return 3.3% × 5/12 ×
D27,000,000

Gain from options

0.0181 × D500,000 × 203,625

3/12 × 90

0.0081 × D500,000 × 91,125

3/12 × 90

Premium

0.00545 × D500,000 × (61,313)

3/12 × 90

0.00098 × D500,000 × (11,025)

3/12 × 90

Net return 513,562 451,350

108
 Effective interest rate

513,562/27,000,000 × 4.56%
12/5

451,350/27,000,000 × 4.01%
12/5

Comment

If one of the options is exercised for both interest rates, as the 94.25 is here, the calculations should give the
same result.

As these are CALL options, options to buy, choose the LOWER price and so:

• If the exercise price is LOWER than the expected futures price, EXERCISE

• If the exercise price is HIGHER than the expected futures price, DO NOT EXERCISE

Discussion
The forward rate agreement gives the highest guaranteed return. If Wardegul Co wishes to have a
certain cash flow and is primarily concerned with protecting itself against a fall in interest rates it will
most likely choose the forward rate agreement. The 95.25 option gives a better rate if interest rates
rise, but a significantly lower rate if interest rates fall, so if Wardegul Co is at all risk averse it will
choose the forward rate agreement.

This assumes that the bank with Wardegul Co deals with is reliable and there is no risk of default. If
Wardegul Co believes that the current economic uncertainty may result in a risk that the bank will
default, the choice will be between the futures and the options, as these are guaranteed by the
exchange. Again the 95.25 option may be ruled out because it gives a much worse result if interest
rates fall to 3.6%. The futures give a marginally better result than the 94.25 option in both scenarios
but the difference is small. If Wardegul Co feels there is a possibility that interest rates will be higher
than 5.41%, the point at which the 94.25 option would not be exercised, it may choose this option
rather than the future.

Comment
Identifying which of the possible strategies gives the highest value is only the start of the discussion and you
need to consider other factors that may influence the decision to obtain four marks:

• The level of risk aversion that Wardegul Co has. The treasury team appears to be weighing limiting downside

109
 against the possibility of taking advantage of upside.

• Other risk considerations are also important. There may be counterparty risk, as FRAs are over-the-counter
instruments.

• The decision may depend upon what is believed about future interest rates. Here, as rates are volatile, you
should consider whether the decision would change depending on what interest rates are expected.

The discussion should be in full sentences and use information relevant to the scenario. A bullet point list or
generic statements relating to hedging are unlikely to be awarded many marks.

Conclusion

This article has demonstrated how to use the data given in the question to calculate the impact of
interest rate hedging. Hopefully it will help you tackle interest rate risk management questions in a
structured way, which should mean that you score well.

Written by a member of the examining team for Advanced Financial Management

E4 – Basis Risk

In theory the futures market provides a fixed and stable outcome when hedging currency or interest
rate risk, but in practice futures contracts are exposed to basis risk.

Basis is the difference between the futures and spot prices and, for the purposes of recommending a
hedging strategy, it is often assumed to diminish at a constant rate. Basis risk arises when the price of
a futures contract does not have a predictable relationship with the spot price of the instrument
being hedged. When basis risk is introduced to a scenario, it may mean an alternative hedging
method would provide a better result.

In order to illustrate this point, we will use the information provided in a sample question from the
September/December 2017 exam sessions, Wardegul Co, and investigate the impact of basis risk on
the hedging recommendation. The company’s treasury department would like to hedge the following
transaction.

Transaction to be hedged

Today’s date is 1 October 2017. The treasury department plans to hedge a receipt, in Eurian Dinar
(D), of D27m. The receipt is expected on 31 January 2018 and will need to be invested until 30 June
2018.

The central bank base rate in Euria is currently 4·2% and the treasury team believes that it can invest
funds in Euria at the central bank base rate less 30 basis points. However, treasury staff have seen
predictions that the central bank base rate could increase by up to 1·1% or fall by up to 0·6%
between now and 31 January 2018.

For the purposes of this example we will consider the following possibilities to hedge the receipt:

• Interest rate futures

110
 • Exchange-traded options on interest rate futures

Three month D futures, D500,000 contract size

Prices are quoted in basis points at 100 – annual % yield:

December 2017: 94.84

March 2018: 94.78

June 2018: 94.66

Exchange-traded options on three month D futures, D500,000 contract size, option premiums are
in annual %

Calls Strike price Puts

December March June December March June

0.417 0.545 0.678 94.25 0.071 0.094 0.155

0.078 0.098 0.160 95.25 0.393 0.529 0.664

Assume futures and options contracts are settled at the end of each month.

In the first instance we will follow the approach used in the past exam question and assume there is
no basis risk and that basis diminishes at a constant rate, based on monthly time intervals. We will
then introduce basis risk and consider the impact on our recommended hedging strategy.

(1) Ignore basis risk (as per sample question)

Futures
Wardegul Co’s treasury department would buy March futures as the hedge is against a fall in interest
rates and the investment will be made on 31 January.

Number of contracts = D27,000,000 / D500,000 × 5 months / 3 months = 90 contracts

Unexpired basis
Spot price (1 October) – futures price = basis

111
(100 – 4.20) – 94.78 = 1.02
Unexpired basis on 31 January = 2/6 × 1.02 = 0.34

If central bank base rate increases to 5.3%

Investment return 5.0% x 5/12 x D27,000,000 562,500

Expected futures price: 100 – 5.3 – 0.34 = 94.36

Loss on the futures market: (0.9436 – 0.9478) × D500,000 × 3/12 × 90 (47,250)

Net receipt 515,250

Effective annual interest rate 515,250 / 27,000,000 x 12/5 4.58%

If central bank base rate falls to 3.6%

Investment return 3.3% x 5/12 x D27,000,000 371,250

Expected futures price: 100 – 3.6 – 0.34 = 96.06

Profit on the futures market: (0.9606 – 0.9478) × $500,000 × 3/12 × 90 144,000

Net receipt 515,250

112
 Effective annual interest rate 515,250 / 27,000,000 x 12/5 4.58%

Options on interest rate futures

The treasury department would buy March call options to hedge against a fall in interest rates. As
above, 90 contracts are required.

If central bank base rate increases to 5.3%

Exercise price 94.25 95.25

Expected futures price, as above 94.36 94.36

Exercise? Yes No

Gain in basis points 11 0

D D

Investment return as above 562,500 562,500

Profit on option 0

0.0011 × $500,000 × 3/12 × 90 12,375

Premium

0.00545 x D500,000 x 3/12 x 90 (61,313)

113
 0.00098 x D500,000 x 3/12 x 90 (11,025)

Net receipt 513,562 551,475

Effective annual interest rate

513,562 / 27,000,000 × 12/5 4.56%

551,475 / 27,000,000 × 12/5 4.90%

If central bank base rate falls to 3.6%

Exercise price 94.25 95.25

Expected futures price, as above 96.06 96.06

Exercise? Yes Yes

Gain in basis points 181 81

D D

Investment return as above 371,250 371,250

Profit on option 0

114
 0.0181 × $500,000 × 3/12 × 90 203,625

0.0081 × $500,000 × 3/12 × 90 91,125

Premium as above (61,313) (11,025)

Net receipt 513,562 451,350

Effective annual interest rate

513,562 / 27,000,000 × 12/5 4.56%

451,350 / 27,000,000 × 12/5 4.01%

Comments
As expected, the futures market provides a fixed return of 4.58% whether the central bank base rate
increases to 5.3% or reduces to 3.6%. The 95.25 option provides a better outcome as long as interest
rates rise but is significantly lower if interest rates fall. If the board is at all risk averse the futures
outcome would be preferable. The 94.25 option is marginally lower than the futures outcome under
both scenarios but may be preferable if the base rate rises higher than 5.41%, the point at which the
option would not be exercised.

(2) Impact of basis risk

Today’s date is 31 January. The prediction that the central bank base rate might increase by 1.1% to
5.3% turns out to be exactly correct. Based on our previous basis calculation we would have
expected today’s price for the March futures contracts to fall to 94.36.

However, futures contracts are exposed to basis risk, which means the closing March futures price on
31 January could be more or less than predicted. For the purposes of this example, we will assume
the closing futures price on 31 January is 94.16, only marginally less than our prediction from before.

Futures

Central bank rate increases to 5.3%

115
 D

Investment return as above 562,500

Loss on the futures market: (0.9416 – 0.9478) × $500,000 × 3/12 × 90 (69,750)

Net receipt 492,750

Effective annual interest rate 492,750 / 27,000,000 x 12/5 4.38%

Options on interest rate futures

If central bank base rate increases to 5.3%

Exercise price 94.25 95.25

Futures price, as above 94.16 94.16

Exercise? No No

D D

Investment return as above 562,500 562,500

Premium (61,313) (11,025)

Net receipt 501,187 551,475

116
 Effective annual interest rate

501,187 / 27,000,000 × 12/5 4.45%

551,475 / 27,000,000 × 12/5 4.90%

Implications for hedging strategy

The futures market provides a lower return than both option contracts although we have already
determined that a risk averse treasury manager would have ignored the 95.25 option. However, the
94.25 option now looks more attractive than the futures outcome even though the central bank base
rate increased exactly as predicted.

If the relationship between the futures and spot price is not predictable, there is no guarantee that
the closing futures price on 31 January will match the price predicted by our basis calculation. On 1
October the futures price prediction for 31 January is 94.36, assuming the base rate increases to
5.3%, but it could be either more or less even when the base rate increases exactly as predicted.

This exposure to basis risk means the actual futures price fell to 94.16 on 31 January instead of
94.36. An unexpected change in basis, even marginally, reduces the return on the futures hedge from
4.58% to 4.38% as opposed to a return of 4.45% using the 94.25 option. With the benefit of hindsight
the 94.25 option would have provided a better outcome. However, the treasury department have
limited visibility of the future when choosing an optimal strategy at the time the hedge is set up on 1
October. The treasury department’s best estimate of the closing futures price is based on a
simplifying assumption that basis diminishes at a constant rate, which may not hold true in practice.
Basis risk, therefore, introduces an element of unpredictability which the treasury staff need to be
aware of at the outset. Scenario analysis would be useful in determining the final strategy in
accordance with the company’s risk preferences.

Written by a member of the AFM examining team

E5 – Currency Swaps

A currency swap is an agreement in which two parties exchange the principal amount of a loan and
the interest in one currency for the principal and interest in another currency.

At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.

During the length of the swap each party pays the interest on the swapped principal loan amount.

At the end of the swap the principal amounts are swapped back at either the prevailing spot rate, or
at a pre-agreed rate such as the rate of the original exchange of principals. Using the original rate
would remove transaction risk on the swap.

117
Currency swaps are used to obtain foreign currency loans at a better interest rate than a company
could obtain by borrowing directly in a foreign market or as a method of hedging transaction risk on
foreign currency loans which it has already taken out.

We will consider how a fixed for fixed currency swap works by looking at an example.

An American company may be able to borrow in the United States at a rate of 6%, but requires a loan
in rand for an investment in South Africa, where the relevant borrowing rate is 9%. At the same time,
a South African company wishes to finance a project in the United States, where its direct borrowing
rate is 11%, compared to a borrowing rate of 8% in South Africa.

Each party can benefit from the other's interest rate through a fixed-for-fixed currency swap. In this
case, the American company can borrow U.S. dollars for 6%, and then it can lend the funds to the
South African company at 6%. The South African company can borrow South African rand at 8%, then
lend the funds to the U.S. company for the same amount.

Currency swaps can also involve exchanging two variable rate loans, or fixed rate borrowing for
variable rate borrowing. Let’s consider a case where a company exchanges fixed rate borrowing for
variable rate borrowing.

Barrow Co, a company based in the USA, wants to borrow €500m over five years to finance an
investment in the Eurozone.

Today’s spot exchange rate between the Euro and US $ is €1·1200 = $1.

Barrow Co’s bank can arrange a currency swap with Greening Co. The swap would be for the
principal amount of €500m, with a swap of principal immediately and in five years’ time, with both
these exchanges being at today’s spot rate.

Barrow Co’s bank would charge an annual fee of 0.4% in € for arranging the swap.

The benefit of the swap will be split equally between the two parties.

The relevant borrowing rates for each party are as follows:

Barrow Co Greening Co

USA 3.6% 4.5%

Eurozone ESTR + 1.5% ESTR + 0.8%

We will see what the gain on the swap for each party will be.

118
 Barrow Co Greening Co Benefit

USA 3.6% 4.5% 0.9%

Eurozone ESTR + 1.5% ESTR + 0.8% 0.7%

Gain on swap 0.8% 0.8% 1.6%

Bank fee (0.2%) (0.2%) (0.4%)

Final gain 0.6% 0.6% 1.2%

Using this gain to work out the overall result for each company, we can provide an illustration of how
the swap could work as follows:

Barrow Co Greening Co

Barrow Co borrows 3.6%

Greening Co borrows ESTR + 0.8%

Swap

Greening Co receives (ESTR)

Barrow Co pays ESTR

119
 Barrow Co Greening Co

Barrow Co receives (2.9%)

Greening Co pays 2.9%

Net result ESTR + 0.7% 3.7%

Bank fee 0.2% 0.2%

Overall result ESTR + 0.9% 3.9%

The overall result show each party paying 0.6% less than they would have paid in they had borrowed
directly in the foreign markets.

Barrow Co’s original principal amount of €500m would be exchanged at the inception of the swap for
$446,428,517. The principal would be swapped back five years later, at the end of the agreement, at
the original spot rate.

Written by a member of the examining team for Advanced Financial Management

E6 - Exchange traded foreign exchange derivatives

The aim of this article is to consider both foreign exchange futures and options using real market
data. The basics, which have been well examined in the recent past, will be quickly revisited. The
article will then consider areas which, in reality, are of significant importance but which, to date,
have not been examined to any great extent.

Foreign exchange futures – the basics

Scenario

Imagine it is 10 July. A UK company has a US$6.65m invoice to pay on 26 August. They are concerned
that exchange rate fluctuations could increase the £ cost and, hence, seek to effectively fix the £ cost
using exchange traded futures. The current spot rate is $1.71110/£1.

Research shows that £/$ futures, where the contract size is denominated in £, are available on the
CME Europe exchange at the following prices:

120
September expiry – 1.71035
December expiry – 1.70865

The contract size is £100,000 and the futures are quoted in US$ per £1.

Note:
CME Europe is a London based derivatives exchange. It is a wholly owned subsidiary of CME Group,
which is one of the world’s leading and most diverse derivatives marketplace, handling (on average)
three billion contracts worth about $1 quadrillion annually!

Setting up the hedge

1. Date? – September:
The first futures to mature after the expected payment date (transaction date) are chosen.
As the expected transaction date is 26 August, the September futures which mature at the
end of September will be chosen.

2. Buy/Sell? – Sell:
As the contract size is denominated in £ and the UK company will be selling £ to buy $ they
should sell the futures.

3. How many contracts? – 39

As the amount to be hedged is in $ it needs to be converted into £ as the contact size is
denominated in £. This conversion will be done using the chosen futures price. Hence, the
number of contracts required is: ($6.65m ÷ 1.71035)/£100,000 ≈ 39.

Summary

The company will sell 39 September futures at $1.71035/£1.

Outcome on 26 August:
On 26 August the following was true:
Spot rate – $1.65770/£1
September futures price – $1.65750/£1

Actual cost:
$6.65m/1.65770 = £4,011,582

Gain/loss on futures:
As the exchange rate has moved adversely for the UK company a gain should be expected on the
futures hedge.

$/£1

Sell – on 10 July 1.71035

Buy back – on 26 August (1.65750)

121
 $/£1

Gain 0.05285

This gain is in terms of $ per £ hedged. Hence, the total gain is:
0.05285 x 39 contracts x £100,000 = $206,115

Alternatively, the contract specification for the futures states that the tick size is 0.00001$ and that
the tick value is $1. Hence, the total gain could be calculated in the following way:

0.05285/0.00001 = 5,285 ticks

5,285 ticks x $1 x 39 contracts = $206,115

This gain is converted at the spot rate to give a £ gain of:

$206,115/1.65770 = £124,338

Total cost:
£4,011,582 – £124,338 = £3,887,244

This total cost is the actual cost less the gain on the futures. It is close to the receipt of £3,886,389
that the company was originally expecting given the spot rate on 10 July when the hedge was set up.
($6.65m/1.71110). This shows how the hedge has protected the company against an adverse
exchange rate move.

Summary

All of the above is essential basic knowledge. As the exam is set at a particular point in time you are
unlikely to be given the futures price and spot rate on the future transaction date. Hence, an
effective rate would need to be calculated using basis. Alternatively, the future spot rate can be
assumed to equal the forward rate and then an estimate of the futures price on the transaction date
can be calculated using basis. The calculations can then be completed as above.

The ability to do this would normally earn four marks in an exam. Equally, another one or two marks
could be earned for reasonable advice such as the fact that a futures hedge effectively fixes the
amount to be paid and that margins will be payable during the lifetime of the hedge. It is some of
these areas that we will now explore further.

Foreign exchange futures – other issues

Initial margin

When a futures hedge is set up the market is concerned that the party opening a position by buying
or selling futures will not be able to cover any losses that may arise. Hence, the market demands that
a deposit is placed into a margin account with the broker being used – this deposit is called the
‘initial margin’.

These funds still belong to the party setting up the hedge but are controlled by the broker and can be
used if a loss arises. Indeed, the party setting up the hedge will earn interest on the amount held in
their account with their broker. The broker in turn keeps a margin account with the exchange so that
the exchange is holding sufficient deposits for all the positions held by brokers’ clients.

122
In the scenario above the CME contract specification for the £/$ futures states that an initial margin
of $1,375 per contract is required.

Hence, when setting up the hedge on 10 July the company would have to pay an initial margin of
$1,375 x 39 contracts = $53,625 into their margin account. At the current spot rate the £ cost of this
would be $53,625/1.71110 = £31,339.

Marking to market

In the scenario given above, the gain was worked out in total on the transaction date. In reality, the
gain or loss is calculated on a daily basis and credited or debited to the margin account as
appropriate. This process is called ‘marking to market’.

Hence, having set up the hedge on 10 July a gain or loss will be calculated based on the futures
settlement price of $1.70925/£1 on 11 July. This can be calculated in the same way as the total gain
was calculated:

$/£1

Sell – on 10 July 1.71035

Settlement price – 11 July (1.70925)

Gain 0.00110

Gain in ticks – 0.00110/0.00001 = 110

Total gain – 110 ticks x $1 x 39 contracts = $4,290
This gain would be credited to the margin account taking the balance on this account to $53,625 +
$4,290 = $57,915.

At the end of the next trading day (Monday 14 July), a similar calculation would be performed:

$/£1

Settlement price – 11 July 1.70925

Settlement price – 14 July (1.70805)

123
 $/£1

Gain 0.00120

Gain in ticks – 0.00120/0.00001 = 120

Total gain – 120 ticks x $1 x 39 contracts = $4,680.
This gain would also be credited to the margin account taking the balance on this account to $57,915
+ $4,680 = $62,595.

Similarly, at the end of the next trading day (15 July), the calculation would be performed again:

$/£1

Settlement price – 14 July 1.70805

Settlement price – 15 July (1.71350)

Loss 0.00545

Loss in ticks – 0.00545/0.00001 = 545

Total loss – 545 ticks x $1 x 39 contracts = $21,255.
This loss would be debited to the margin account, reducing the balance on this account to $62,595 –
$21,255 = $41,340.

This process would continue at the end of each trading day until the company chose to close out
their position by buying back 39 September futures.

Maintenance margin, variation margin and margin calls

Having set up the hedge and paid the initial margin into their margin account with their broker, the
company may be required to pay in extra amounts to maintain a suitably large deposit to protect the
market from losses the company may incur. The balance on the margin account must not fall below
what is called the ‘maintenance margin’. In our scenario, the CME contract specification for the £/$
futures states that a maintenance margin of $1,250 per contract is required. Given that the company
is using 39 contracts, this means that the balance on the margin account must not fall below 39 x
$1,250 = $48,750.

As you can see, this does not present a problem on 11 July or 14 July as gains have been made and
the balance on the margin account has risen. However, on 15 July a significant loss is made and the
balance on the margin account has been reduced to $41,340, which is below the required minimum
level of $48,750.

124
Hence, the company must pay an extra $7,410 ($48,750 – $41,340) into their margin account in
order to maintain the hedge. This would have to be paid for at the spot rate prevailing at the time of
payment unless the company has sufficient $ available to fund it. When these extra funds are
demanded it is called a ‘margin call’. The necessary payment is called a ‘variation margin’.

If the company fails to make this payment, then the company no longer has sufficient deposit to
maintain the hedge and action will be taken to start closing down the hedge. In this scenario, if the
company failed to pay the variation margin the balance on the margin account would remain at
$41,340, and given the maintenance margin of $1,250 this is only sufficient to support a hedge of
$41,340/$1,250 ≈ 33 contracts. As 39 futures contracts were initially sold, six contracts would be
automatically bought back so that the markets exposure to the losses the company could make is
reduced to just 33 contracts. Equally, the company will now only have a hedge based on 33 contracts
and, given the underlying transaction’s need for 39 contracts, will now be underhedged.

Conversely, a company can draw funds from their margin account so long as the balance on the
account remains at, or above, the maintenance margin level, which, in this case, is the $48,750
calculated.

Foreign exchange options – the basics

Scenario

Imagine that today is the 30 July. A UK company has a €4.4m receipt expected on 26 August. The
current spot rate is £0.7915/€1. They are concerned that adverse exchange rate fluctuations could
reduce the £ receipt but are keen to benefit if favourable exchange rate fluctuations were to increase
the £ receipt. Hence, they have decided to use €/£ exchange traded options to hedge their position.

Research shows that €/£ options are available on the CME Europe exchange.

The contract size is €125,000 and the futures are quoted in £ per €1. The options are American
options and, hence, can be exercised at any time up to their maturity date.

Setting up the hedge

1. Date? – September:
The available options mature at the end of March, June, September and December. The
choice is made in the same way as relevant futures contracts are chosen.

2. Calls/Puts? – Puts:
As the contract size is denominated in € and the UK company will be selling € to buy £, they
should take the options to sell € for £ – put options.

3. Which exercise price? – £ 0.79250/€1

An extract from the available exercise prices showed the following:

Exercise price Put premiums

£/€1 £/€1

0.79000 0.00465

125
 Exercise price Put premiums
£/€1 £/€1

0.79250 0.00585

As the company is selling €, it wants the maximum net £ receipt for each € sold. The maximum net
receipt is the exercise price minus the premium cost.

This is calculated below:

Put
Exercise price
premiums Net receipt
£/€1
£/€1 £/€1

0.79000 0.00465 0.7900 – 0.00465 = 0.78535

0.79250 0.00585 0.79250 – 0.00585 = 0.78665

Hence, the company will choose the 0.79250 exercise price as it gives the maximum net receipt.
Alternatively, the outcome for all available exercise prices could be calculated.

In the exam, either both rates could be fully evaluated to show which is the better outcome for the
organisation or one exercise price could be evaluated, but with a justification for choosing that
exercise price over the other.

4. How many? – 35
This is calculated in a similar way to the calculation of the number of futures. Hence, the number of
options required is:
€4.4m/€0.125m ≈ 35

Summary

The company will buy 35 September put options with an exercise price of £0.79250 /€1

Premium to pay – £/€0.00585 x 35 contracts x €125,000 = £25,594

Outcome on 26 August:
On 26 August the following was true:
Spot rate – £ 0.79650/€1

As there has been a favourable exchange rate move, the option will be allowed to lapse, the funds
will be converted at the spot rate and the company will benefit from the favourable exchange rate
move.

126
Hence, €4.4m x 0.79650 = £3,504,600 will be received. The net receipt after deducting the premium
paid of £25,594 will be £3,479,006.

Note:
Strictly a finance charge should be added to the premium cost as it is paid when the hedge is set up.
However, the amount is rarely significant and, hence, it will be ignored in this article.

If we assume an adverse exchange rate move had occurred and the spot rate had moved to £
0.78000/€1, then the options could be exercised and the receipt arising would have been:

Receipt €4,400,000

Exercise option:

Pay – 35 x 125,000 (€4,375,000)

Receive –
4.375m x 0.79250 £3,467,188

Underhedged amount €25,000

Buy £ at spot (£0.78/€1) (€25,000) £19,500

0 £3,486,688

Deduct premium cost (£25,594)

Net receipt – see Note 1 £3,461,094

Notes:
1. This net receipt is effectively the minimum receipt as if the spot rate on 26 August is anything less
than the exercise price of £ 0.79250/€1, the options can be exercised and approximately £3,461,094
will be received. Small changes to this net receipt may occur as the €25,000 underhedged will be
converted at the spot rate prevailing on the 26 August transaction date. Alternatively, the

127
underhedged amount could be hedged on the forward market. This has not been considered here as
the underhedged amount is relatively small.

2. For simplicity it has been assumed that the options have been exercised. However, as the
transaction date is prior to the maturity date of the options the company would in reality sell the
options back to the market and thereby benefit from both the intrinsic and time value of the option.
By exercising they only benefit from the intrinsic value. Hence, the fact that American options can be
exercised at any time up to their maturity date gives them no real benefit over European options,
which can only be exercised on the maturity date, so long as the options are tradable in active
markets. The exception perhaps is traded equity options where exercising prior to maturity may give
the rights to upcoming dividends.

Summary

Much of the above is also essential basic knowledge. You are unlikely to be given the spot rate on the
transaction date. However, the future spot rate can be assumed to equal the forward rate which is
likely to be given in the exam. The ability to do this may earn up to six marks in the exam. Equally,
another one or two marks could be earned for reasonable advice.

Foreign exchange options – other terminology

This article will now focus on other terminology associated with foreign exchange options and
options and risk management generally. All too often students neglect these as they focus their
efforts on learning the basic computations required. However, knowledge of them would help
students understand the computations better and is essential knowledge if entering into a discussion
regarding options.

Long and short positions

A ‘long position’ is one held if you believe the value of the underlying asset will rise. For instance, if
you own shares in a company you have a long position as you presumably believe the shares will rise
in value in the future. You are said to be long in that company.

A ‘short position’ is one held if you believe the value of the underlying asset will fall. For instance, if
you buy options to sell a company’s shares, you have a short position as you would gain if the value
of the shares fell. You are said to be short in that company.

Underlying position

In our example above where a UK company was expecting a receipt in €, the company will gain if the
€ gains in value – hence the company is long in €. Equally the company would gain if the £ falls in
value – hence, the company is short in £. This is their ‘underlying position’.

To create an effective hedge, the company must create the opposite position. This has been achieved
as, within the hedge, put options were purchased. Each of these options gives the company the right
to sell €125,000 at the exercise price and buying these options means that the company will gain if
the € falls in value. Hence, they are short in €.

Therefore, the position taken in the hedge is opposite to the underlying position and, in this way, the
risk associated with the underlying position is largely eliminated. However, the premium payable can
make this strategy expensive.

It is easy to become confused with option terminology. For instance, you may have learnt that the
buyer of an option is in a long position and the seller of an option is in a short position. This seems at

128
variance with what has been stated above, where buying the put options makes the company short
in €. However, an option buyer is said to be long because they believe that the value of the option
itself will rise. The value of put options for € will rise if the € falls in value. Hence, by buying the €/£
put options the company is taking a short position in €, but is long the option.

Hedge ratio

The hedge ratio is the ratio between the change in an option’s theoretical value and the change in
the price of the underlying asset. The hedge ratio equals N(d1), which is known as delta. Students
should be familiar with N(d1) from their studies of the Black-Scholes option pricing model. What
students may not be aware of is that a variant of the Black-Scholes model (the Grabbe variant –
which is no longer examinable) can be used to value currency options and, hence, N(d1) or the hedge
ratio can also be calculated for currency options.

Hence, if we were to assume that the hedge ratio or N(d1) for the €/£ exchange traded options used
in the example was 0.95 this would mean that any change in the relative values of the underlying
currencies would only cause a change in the option value equivalent to 95% of the change in the
value of the underlying currencies. Hence, a €0.01 per £ change in the spot market would only cause
a €0.0095 per £1 change in the option value.

This information can be used to provide a better estimate of the number of options the company
should use to hedge their position, such that any loss in the spot market is more exactly matched by
the gain on the options:

Number of options required = amount to hedge/(contract size x hedge ratio)

In our example above, the result would be:

€4.4m/(€0.125m x 0.95) ≈ 37 options

Conclusion

This article has revisited some of the basic calculations required for foreign exchange futures and
options questions using real market data, and has additionally considered some other key issues and
terminology in order to further build knowledge and confidence in this area.

William Parrott, freelance tutor and senior FM tutor, MAT Uganda

E7 - Determining interest rate forwards and their application to swap valuation

The previous article on bonds (see 'Related links') considered the relationship between bond prices,
the yield curve and the yield to maturity. It demonstrated how bonds can be valued and how a yield
curve may be derived using bonds of the same risk class but of different maturities. It also showed
how individual company yield curves maybe estimated.

This article follows on from that, and will show how interest rate forwards may be determined from
the spot yield curve. It will then briefly discuss what they mean, before proceeding to show how they
may be used in determining the value of an interest rate swap. The second article addresses the
learning required in the E1 and E3 areas of the Advanced Financial Management Syllabus and Study
Guide.

Determination of interest rate forwards

129
Supposing that a bank assesses and quotes the following rates to a company, based on the annual
spot yield curve for that company’s risk class:

One-year: 3.50%
Two-year: 4.60%
Three-year: 5.40%
Four-year: 6.10%
Five-year: 6.30%

This indicates that the company would have to: pay interest at 3.50% if it wants to borrow a sum of
money for one year; pay interest at 4.60% per year if it wants to borrow a sum of money for two
years; pay interest at 5.40% per year if it wants borrow a sum of money for three years; and so on.

Alternatively, for a two-year loan, the company could opt to borrow a sum of money for only one
year, at an interest rate of 3.50%, and then again for another year, commencing in one year’s time,
instead of borrowing the money for a total of two years.

Although the company would be uncertain about the interest rate in one year’s time, it could request
a forward rate from the bank that is fixed today – for example, through a 12v24 forward rate
agreement (FRA). The question then arises: how may the value of the 12v24 FRA be determined?

A forward rate commencing in one year for a borrowed sum lasting a year can be calculated as
follows:

In summary:

130
Supposing the company wants to borrow a sum of money for three years on the basis of the above
rates:
i. it could pay annual interest at a rate of 5.40% in each of the three years, or
ii. it could pay interest at a rate 3.50% in the first year, 5.71% in the second year and 7.02% in the
third year, or
iii. it could pay annual interest at a rate of 4.60% in each of the first two years and 7.02% in the third
year.

Using interest rate forwards to value a simple interest rate swap contract

Supposing the above company has $100m borrowings in the form of variable interest rate loans
repayable in five years and pays interest based on the above yield curve. It expects interest rates to
increase in the future and is therefore keen to fix its interest rate payments.

The bank offers to swap the variable interest rate payments for a fixed rate, such that the company
pays a fixed rate of interest to the bank in exchange for receiving a variable rate of return from the
bank based on the above yield rates less 50 basis points. The variable rate receipts from the bank will
then be used to pay the interest on the loan.

The fixed equivalent rate of interest the company will pay the bank for the swap can be calculated as
follows:

The current expected amounts of interest the company expects to receive from the bank, based on
year 1 spot rate and years 2, 3, 4 and 5 forward rates are:

Year 1 0.0300 x $100m = $3.00m

Year 2 0.0521 x $100m = $5.21m
Year 3 0.0652 x $100m = $6.52m
Year 4 0.0773 x $100m = $7.73m
Year 5 0.0660 x $100m = $6.60m

Note: The rates used to calculate the annual amounts are reduced by 50 basis points or 0.5%.

At the start of the swap, the net present value of the swap receipts based on the variable rates from
the bank will be the same as the costs based on the fixed amount paid to the bank.

Let’s say R is the fixed amount of interest the company will pay the bank, then

131
Removing the brackets, the above expands to:
2.90m – 0.966R + 4.76m – 0.914R + 5.57m – 0.854R +
6.10m – 0.789R + 4.86m – 0.737R= 0

Simplifying this, adding all the $ flows together and R-flows together, gives:
24.19m – 4.26R = 0
$5.68m = R

In percentage = $5.68m/$100m = 5.68%

In practice the receipts and payments of the swap would be netted off such that the company will
expect to pay $2.68m ($5.68m – $3.00m) to the bank in year one, and expect to receive $0.84m
($6.52m – $5.68m) from the bank in year three, and so on for the other years. The present values of
these n et annual flows, discounted at the yield curve rates, will be zero. The fixed rate of 5.68% is
lower than the five-year spot rate of 6.30% because some of the receipts and payments related to
the swap contract occur in earlier years when the spot yield curve rate is lower.

Although at the commencement of the contract, the present value of the swap is zero, as interest
rates fluctuate, the value of the swap will change. For example, if interest rates increase and the
company pays interest at a fixed rate, then the swap’s value to the company will increase. The value
of the swap contract will also change as the swap approaches maturity, and the number of receipts
and payments reduce.

Conclusion

The previous article and this article considered the relationship between bonds, interest rates, spot
and forward yield curves, culminating with how the forwards rates can be used to determine the
equivalent fixed rate of a simple swap contract. The examples used were simplified into annual cash
flows and rates, and students undertaking Advanced Financial Management should be able to
demonstrate their knowledge and understanding of these areas to this extent.

In practice, valuation of bonds and related products is more complicated because of factors such as:
cash flows occurring more frequently than once a year, early redemption of products, change in
product values, and so on. However, these aspects are beyond the scope of the Advanced Financial
Management syllabus.

Written by a member of the Advanced Financial Management examining team

E8 – Risk Management

The management of risk is a key area within a number of ACCA exams, and exam questions related
to this area are common. It is vital that students are able to apply risk management techniques,
such as using derivative instruments to hedge against risk, and offer advice and recommendations
as required by the scenario in the question. It is also equally important that students understand

132
why corporations manage risk in theory and in practice, because risk management costs money
but does it actually add more value to a corporation? This article explores the circumstances where
the management of risk may lead to an increase in the value of a corporation.

Risk, in this context, refers to the volatility of returns (both positive and negative) that can be
quantified through statistical measures such as probabilities, standard deviations and correlations
between different returns. Its management is about decisions made to change the volatility of
returns a corporation is exposed to, for example changing a company’s exposure to floating interest
rates by swapping them to fixed rates for a fee. Since business is about generating higher returns by
undertaking risky projects, important management decisions revolve around which projects to
undertake, how they should be financed and whether the volatility of a project’s returns (its risk)
should be managed.

The volatility of returns of a project should be managed if it results in increasing the value to a
corporation. Given that the market value of a corporation is the net present value (NPV) of its future
cash flows discounted by the return required by its investors, then higher market value can either be
generated by increasing the future cash flows or by reducing investors’ required rate of return (or
both). A risk management strategy that increases the NPV at a lower comparative cost would benefit
the corporation.

The return required by investors is the sum of the risk free rate and a premium for the risk they
undertake. If investors hold well-diversified portfolios of investments then they are only exposed to
systematic risk as their exposure to firm-specific risk has been diversified away. Therefore, the risk
premium of their required return is based on the capital asset pricing model (CAPM). Research
suggests companies with diverse equity holdings do not increase value by diversifying company
specific risk, as their equity holders have already achieved this level of risk diversification. Moreover,
risk management activity designed to transfer systematic risk would not provide additional benefits
to a corporation because, in perfect markets, the benefits achieved from risk management activity
would at most equal the costs of undertaking such activity. Therefore, in a situation of perfect
markets, it may be argued that risk management activity is at best neutral or at worst detrimental
because costs would either equal or be more than the benefits accrued.

Such an argument would not apply to smaller companies which have concentrated, non-diversified
equity holdings. In this case the equity holders, because they are exposed to both specific and
systematic risk, would benefit from risk diversification by the company. Therefore, whereas larger
companies may not create value from risk management activity, smaller companies can and should
undertake risk management. However, empirical research studies have found that risk management
is undertaken mostly by larger companies with diverse equity holdings and not by the smaller
companies. The accepted reason for this is that the costs related to risk management are large and
mostly fixed. Small companies simply cannot afford these costs nor can they benefit from the
economies of scale that large companies can.

In addition to the ability of larger companies to undertake risk management, market imperfections
may provide the motivation for them to do so. Market imperfections that exist in the real world, as
opposed to the perfect world conditions assumed by finance or economic theory, may provide
opportunities to reduce volatility in cash flows and thereby reduce the costs imposed on a
corporation. The following discussion considers the circumstances which may result in providing such
opportunities.

Taxation

133
Risk management may help in reducing the amount of tax that a corporation pays by reducing the
volatility of the corporation’s earnings. Where a corporation faces taxation schedules that are
progressive (that is the corporation pays proportionally higher amounts of tax as its profits increase),
by reducing the variability of that corporation’s earnings and thereby staying in the same low tax
bracket will reduce the tax payable.

According to academics, corporations could often find themselves in situations where they face
progressive tax functions, for example, when they have previous losses which are not written off or,
in the case of multinational corporations, due to the taxation treaties which exist between different
countries. The amount of taxation that can be saved depends upon the corporation’s individual
circumstances.

Insolvency and financial distress

A corporation may find itself in a situation of being insolvent when it cannot meet its financial
obligations as they fall due. Financial distress is a situation that is less severe than insolvency in that a
corporation can operate on a day-to-day basis, but it finds that these operations are difficult to
conduct because the parties dealing with it are concerned that it may become insolvent in the
future. When facing financial distress a corporation will incur additional costs, both direct and
indirect, due to the situation it is facing.

The main indirect costs of financial distress relate to the higher costs of contracting with the
corporation’s stakeholders, such as customers, employees and suppliers. For example, customers
may demand better warranty schemes or may be reluctant to buy a product due to concerns about
the corporation’s ability to fulfil its warranty; employees may demand higher salaries; senior
management may ask for golden hellos before agreeing to work for the corporation; and suppliers
may be unwilling to offer favourable credit terms.

Academics exploring this area postulate that because stakeholders are subject to the corporation’s
full risk, as opposed to only systematic risk, which is faced by the corporation’s equity holders, the
stakeholders would demand greater compensation for their participation. Where an organisation
actively manages its risk and prevents (or reduces the possibility of) situations of financial distress, it
will find it easier to contract with its stakeholders and at a lower cost. Hence, the more volatile the
cash flows of a corporation, the more likely the need to manage its risk in order to reduce the costs
related to financial distress.

External funding and agency costs

Another consequence of financial distress is the impact this may have on the corporation’s ability to
undertake profitable future investment. Financial distress may make the cost of external debt and
equity funding so expensive that a corporation and its management may be forced reject profitable
projects. Academics refer to this as the under investment problem.

Equity holders in effect hold a call option on a corporation’s assets and debt holders can be
considered to have written the option. In cases of low financial distress the company may be
considered to be similar to an at-the-money option for its equity holders, and, therefore, they would
be more willing to undertake risky projects as they would benefit from any increase in profitability,
but the impact of any loss is limited. In the case of substantial financial distress, the option could be
considered to be well out-of-money. In this situation there is little (or no) benefit to equity holders of
undertaking new projects, as the benefits of these will pass to the debt holders initially. However,
debt holders would be reluctant to lend to a severely distressed company in any case.

134
Therefore, when raising debt capital, a corporation that is subject to low levels of financial distress
would face higher agency costs, with lenders imposing higher borrowing costs and more restrictive
covenants. Whereas debt holders get a fixed return on their investment, any additional benefit due
to higher profits would go to the equity holders. This would make the debt holders reluctant to allow
the corporation to undertake risky projects or to lend more finance to the corporation because they
would not gain any benefit from the risky projects.

A corporation that faces high levels of financial distress would find it difficult to raise equity capital in
order to undertake new investments. If corporations try to raise equity finance for relatively less risky
projects then the profits earned from such projects would initially go to the debt holders and the
equity holders will gain only residual profits. Therefore equity holders would put pressure on the
corporation and its management to reject good, low risk projects, which may have been acceptable
to the bondholders.

Therefore, risk management in reducing financial distress by reducing the volatility of the
corporation’s cash inflows may help the management to obtain an optimal mix of debt and equity,
and to undertake profitable projects.

Capital structure and information asymmetry

Risk management can help a corporation obtain an optimal capital structure of debt and equity to
maximise its value. Since risk management stabilises the variability of cash inflows, this would enable
a corporation to take more debt finance in its capital structure. Stable cash flows indicate less risk
and therefore debt holders would become more willing to lend to the corporation. Since debt is
cheaper to finance than equity because of lower required rates of return and the tax shield, taking
on more debt should increase the value of the corporation. Risk management can help achieve this.

Academics have observed that managers would prefer to use internally generated funds rather than
going to the external markets for funds because it is cheaper and less intrusive on the corporation.
They suggest that borrowing money from the external markets, whether equity or debt, would
involve parties who do not have the complete information about the corporation. This information
asymmetry would make the external sources of funds more expensive. If risk management stabilises
the cash flows that the corporation receives from year to year, then this would enable managers to
plan when the necessary internal funds will become available for future investments with greater
accuracy. They will then be able to align their investment policies with the availability of funding.

Manager behaviour towards risk management

In his seminal paper, Rene Stulz suggests that managers, whose performance reward structure
includes large equity stakes in a corporation, are more likely to reduce the corporation’s risk, as
opposed to managers whose performance reward structure is based primarily on equity options.
Managers who hold concentrated equity stakes in a corporation face increased levels of risk when
compared to other equity holders. As discussed previously, investors hold well-diversified portfolios
and face exposure to systematic risk only. But managers with concentrated equity stakes would face
both systematic and unsystematic risk. Therefore, they have a greater propensity to reduce the
unsystematic risk.

However, if investors do not reward corporations that are reducing unsystematic risk, because they
have diversified this risk away themselves. And if a corporation’s managers use the corporation’s
resources to reduce unsystematic risk, thereby reducing the corporation’s value. Then it is worth
exploring under what circumstances would equity investors allow managers to act to reduce

135
unsystematic risk and whether such actions could actually result in the value of the corporation
increasing.

Stulz argues that encouraging managers to hold concentrated equity positions but allowing them to
reduce unsystematic risk at the same time, may enable them to act in the best interests of the
corporation and the result may be an increase in the corporate value. He explains that managers,
who do not have to worry about risks that are not under their control (because they have hedged
them away), would be able to focus their time, expertise and experience on the strategies and
operations that they can control. This focus may result in the increase in the value of the corporation,
although the impact of this increase in value is not easily measurable or directly attributable to risk
management activity.

As an aside, one could pose the question, why don’t managers, who are rewarded by equity, diversify
the risk of concentrated equity investments themselves? They could sell equity in their own
corporation and replace it by buying equity in other corporations. In this way they do not have to
hold concentrated equity positions and then would be like the normal equity holders facing only
systematic risk. A research study on wealth management, which looked at concentrated equity
positions and risk management, found that senior managers are reluctant to reduce their
concentrated equity positions because any attempt to sell the equity would send negative signals to
the markets, and cause their corporation’s value to decrease unnecessarily.

Contrary to the behaviour of managers who hold concentrated equity stakes, managers who own
equity options, which will be converted into equity at a future date, will actively seek to increase the
risk of a corporation rather than reduce it. Managers who hold equity options are interested in
maximising the future price of the equity. Therefore in order to maximise future profits and the price
of the equity, they will be more inclined to undertake risky projects (and less inclined to manage
risk). Equity options, as a form of reward, have been often criticised because they do not necessarily
make managers behave in the best interests of the corporation or its equity investors, but encourage
them to act in an overly risky manner.

A number of empirical studies looking at manager behaviour support the above discussion (see for
example Tufano’s study published in 1996 in the Journal of Finance).

Testing the impact of risk management

In addition to the above, empirical research studies have looked at the risk management policies and
actions pursued by corporations and their impact on corporate value. Although the studies have
provided varying results when studying each area of market imperfections and their impact, the
overarching conclusion from these studies is that: corporations manage their risks in the belief that
this would create or increase corporate value, although a direct link between risk management and a
corresponding increase in corporate value has not been established.

Hence the belief held among managers is that the management of risk does create value, and
certainly corporations and their senior managers seem to believe and act in a manner that it does.
However, the jury is still out on whether risk management actually does lead to increased corporate
value. There seem to be strong theoretical reasons for managing risk, but empirical research has not
proven the impact of risk management activity on corporate value.

Written by a member of the examining team for Advanced Financial Management

Further reading

136
I would suggest that students read the following academic books and papers to supplement their
knowledge and understanding.

• Arnold, G, 2008. Corporate Financial Management. 4th ed. Harlow: Pearson.

• Culp, C, 2002. The Revolution in Corporate Risk Management: A Decade of Innovations in

Process and Products. Journal of Applied Corporate Finance, 14(4), 8–26.

• Jensen, M, and Meckling, W, 1976. Theory of the Firm: Managerial Behaviour, Agency Costs
and Ownership Structure. Journal of Financial Economics, 3, 305–360.

• Myers, S, and Majluf, N, 1984. Corporate Financing and Investment Decisions when Firms
have Information that Investors do not have. Journal of Financial Economics, 13, 187–221.

• Smithson, C, 1998. Managing Financial Risk: A Guide to Derivative Products, Financial

Engineering and Value Maximization. New York: McGraw-Hill, pp492–517.

• Stulz, R, 1996. Rethinking Risk Management. Journal of Applied Corporate Finance, 9, 8–24.

• Tufano, P, 1996. Who Manages Risk? An Empirical Examination of Risk Management

Practices in the Gold Mining Industry. Journal of Finance, 51, 1097–1137.

E9 - Topic explainer video: Risk management

E10 - Topic explainer video: Marking to market

E11 - Topic explainer video: Basis risk

137