Student assignment: Finance assignment 1

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1.1           (a) Considering the effect of a surprise increase rates, such that the yields rise by 50 basis points (i.e., the yield curve is now flat at 6%)……………………………………………………………….. 3

1.1.1     What would happen to the value of the assets in the Citrix Fund? What would happen to the value of the liabilities? What can you conclude about the change in the value of the equity under these conditions?……………………………………………………………………………………….. 3

1.2           (b) What is the initial duration of the Citrix Fund (i.e., the duration of the equity)?  3

1.3           (c) How many dollars do you need to liquidate and reinvest to minimize the fund’s interest rate sensitivity?………………………………………………………………………………………………. 4

1.4           What is the notational amount of the swap you should enter into? Should you receive or pay the fixed rate portion of the swap?…………………………………………………………………………… 4

  1. Question 2 (20 marks) (Calculation)…………………………………………………………….. 4

2.1           (a) Suggest a strategy for borrowing the $100 million. What is your effective borrowing rate?     4

2.2           (b) How would you lock in your new credit quality for the next seven years? What is your effective borrowing rate now?…………………………………………………………………………………. 4

  1. Question 3 (30 Marks) (Approx. 3,000 words)………………………………………………. 5

3.1           (A) Financial risks management………………………………………………………. 5

3.1.1     Briefly comment on the various types of financial risks to be managed.      5

3.1.1.1Credit risk……………………………………………………………………….. 5

3.1.1.2Liquidity risk…………………………………………………………………… 5

3.1.1.3Interest rate risk……………………………………………………………….. 6

3.1.2     The CFO can manage risk exposure in a number of ways. List and comment on each of them.     6

3.1.2.1Credit risk management…………………………………………………….. 6

3.1.2.2Liquidity risk management………………………………………………… 7

3.1.2.3Interest rate risk management…………………………………………….. 7

3.2           (B) What are the lessons learned to avoid derivatives-related losses?…… 8

3.2.1     Balancing liquidity, safety and high yield………………………………….. 8

3.2.2     Price risk and costly trading……………………………………………………… 8

3.2.3     Underdevelopment of derivative related legislation…………………….. 9

3.3           (C) Mine development project in Nord Resource’s Ramu River property in Papua New Guinea   9

3.3.1     Describe three major risks in undertaking this project………………….. 9

3.3.1.1Foreign investment risk: Political Risk………………………………… 9

3.3.1.2Risks caused by pricing volatility……………………………………… 10

3.3.2     How can Nord structure its financing so as to reduce these risks?.. 10

3.3.2.1Recommended strategies to cope with political risk……………. 10

3.3.2.2Strategies to cope with risks caused by pricing and economic volatility      11

3.3.3     How can Nord use financing to add value to this project?………….. 11

3.3.3.1Applying international financial reporting standard in financial reporting to enhance investor relationship………………………………………………………………………………. 11

3.3.3.2Measuring the return on CSR (corporate social responsibility) investment for long term investment activities………………………………………………………………….. 12

Reference list………………………………………………………………………………………………… 13
Question 1 (20 marks) (Calculation)

 

1.1    (a) Considering the effect of a surprise increase rates, such that the yields rise by 50 basis points (i.e., the yield curve is now flat at 6%).

 

1.1.1            What would happen to the value of the assets in the Citrix Fund? What would happen to the value of the liabilities? What can you conclude about the change in the value of the equity under these conditions?

 

Because the change in rates is 0.5%, therefore:-

 

PercentageDollar
The change calculated in Asset value(6.40%)*(2,866,350.71)
The change calculated in Liability value(1.90%)*(743,127.96)
The change calculated in equity value(37.91%)(2,123,222.75)*

* Percentage change = -Duration* ε/ (1+r) = (6.40%)

* Percentage change = -Duration* ε/ (1+r) = (1.90%)

* The value of equity will be reduced by 2,866,350.71-743,127.96=2,123,222.75

 

1.2    (b) What is the initial duration of the Citrix Fund (i.e., the duration of the equity)?

 

Equity duration = 44.8 / 5.6 * 13.5 yrs – (39.2/5.6 * 4 yrs) = 80 yrs

 

Therefore, the initial duration of the Citrix Fund (i.e., the duration of the equity) will be 80 years.

 

1.3    (c) How many dollars do you need to liquidate and reinvest to minimize the fund’s interest rate sensitivity?

 

Replacement asset duration2 Years
Exchange amount38.96 million*
New asset duration3.50
New equity duration0

* Amount needed to liquidate and reinvest to minimize the fund’s interest rate sensitivity = 80 yrs * 5.6 / 11.5 yrs = $ 38.96 million

 

1.4    What is the notational amount of the swap you should enter into? Should you receive or pay the fixed rate portion of the swap?

Replacement asset duration7 Years
Exchange amount68.92 million*
New asset duration3.50
New equity duration0

* Notational amount of the swap = 80 yrs * 5.6 / (7 – 0.5 yrs) = 68.92 million

 

2.        Question 2 (20 marks) (Calculation)

 

2.1    (a) Suggest a strategy for borrowing the $100 million. What is your effective borrowing rate?

 

By borrowing short term at a spread of 1% over LIBOR, the $100 million notional swap will receive LIBOR with 8.0 percentage fixed paid. Therefore,

 

The effective borrowing rate = (LIBOR + 1%) – LIBOR + 8% = 9 %

 

2.2    (b) How would you lock in your new credit quality for the next seven years? What is your effective borrowing rate now?

 

By refinancing $100million short term loan with long-term loan:-

9.10% + 0.50% = 9.60%.

 

It will be getting new swap to pay LIBOR and therefore receive a percentage of 9.50. And the effective borrowing cost now will be following:-

9.60% + (–LIBOR + 8.0%) + (LIBOR – 9.50%) = 8.10%

 

3.        Question 3 (30 Marks) (Approx. 3,000 words)

 

3.1    (A) Financial risks management

 

3.1.1            Briefly comment on the various types of financial risks to be managed.

 

3.1.1.1      Credit risk

 

Credit risk refers to the risk of loss of principal or loss of a pecuniary reward stemming from a borrower’s failure in repaying a loan or else wise meet a contractual debt. Credit risk arises every time a borrower is looking ahead to use future cash flows through the payment of a current obligation. The investors are rewarded for presuming credit risk through the way of interest payments from the issuer or borrower of a debt contract (readyratios.com 2011). In my understanding, a higher credit risk reflects a higher interest rate demanded by the investors for lending their capital. And therefore, to some extent credit risk level indicates the nature of the investment as well as the demand of the investors.

 

3.1.1.2      Liquidity risk

 

The liquidity risk stems from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Liquidity risk is typically reflected in unusually wide bid-ask spreads or large price movements (especially to the downside) (investopedia.com 2011). Beside the market liquidity risk, there could be funding risk as well which is the risk that an entity can not meet its payment obligations on settlement date, or meet margin calls due to mismatches of inflows and outflows of funds (Schwartz & Smith 1997, p. 319). There are methods that a company could take to control or reduce such risks which will be elaborated later.

 

3.1.1.3      Interest rate risk

 

Interest rate risk refers to the possibility of a reduction in the value of a security, especially a bond, resulting from a rise in interest rates. For instance, bonds with elevated interest rate risk tend to perform well when rates are falling, but they will underperform when interest rates are rising. As a result, rate-sensitive securities tend to perform best when the economy is slowing, since slower growth is likely to lead to falling rates (investorwords.com 2011). Therefore, investments such as bonds with seemingly lower risks can still bear risks if they are rate sensitive. Companies need to adjust their financial strategies to control such risks.

 

3.1.2            The CFO can manage risk exposure in a number of ways. List and comment on each of them.

 

3.1.2.1      Credit risk management

 

According to Morton Glantz and Johnathan Mun (2008, p. 12), one effective method and the CFO of a company could take to reduce the credit risk is to take into consideration of the potential future changes in economic conditions when assessing individual credits and their credit portfolios, and should assess their credit risk exposures under stressful conditions. In addition, it is the CFO’s responsibility to ensure that the company owns an effective system and is equipped with analytical techniques to enable the management to measure and monitor the credit risk inherent in all on and off balance sheet activities.

 

3.1.2.2      Liquidity risk management

 

In order to control or reduce the liquidity risks, liquidity report could be of great assistance. As a matter of fact, liquidity report that reflects a company’s trend of developing in the sources and uses of liquidity can be helpful if presented to the management in a regular basis to assist better understanding of the liquidity of the company to eliminate the possibility of company based liquidity risks. In addition, according to Leonard Matz and Peter Neu (2007, p. 291), contingency plans which exist for situations when projections made on the liquidity funding report turn out to be wrong could also help to minimize the liquidity risk because of such wrong decisions made.

 

3.1.2.3      Interest rate risk management

 

As known to us, bond’s duration will determine how its price is affected by interest rate changes. In another word, duration is the tool that helps investors to gauge these price fluctuations that are due to interest rate risk. The CFO of a company can diversify the investment of bonds in term of different durations in order to lower the general level of interest rate related risk. In addition, interest rate sensitivity analysis can also be adopted which refers to a measurement of the volatility of the value of a fixed-income asset in response to changes in the prevalent interest rate (mysmp.com 2011) to control the interest risks.

 

3.2    (B) What are the lessons learned to avoid derivatives-related losses?

 

3.2.1            Balancing liquidity, safety and high yield

 

The first lesson to be learned from many cases of derivatives-related losses many of which tended to involve great loss is that liquidity, safety and high yield can not be achieved at the same time. A complex investment strategy involving large investment in derivatives could lead to more risks than the costs it saves or the profits it creates (Oldani 2008, p. 41). According to Dennis W. Cox (2007, p. 83), the exposure of option-based derivatives to market risk factors results in greater complexity, because option-based derivatives are subject to convexity risk, the relationship between the option price and underlying asset price is not constant. Options are also subject to volatility risk and time decay risk. Therefore investors firstly need to learn that they need to consider liquidity, safety and yielding rate but high yield will not necessarily come with high degree of liquidity and safety, they need to balance these three dimensions and prepare for more loss if they choose the high risks investment choices such as the derivatives such as futures and options. What’s more because of the time decay risk, treating the derivative as long term investment will also suffer great risks.

 

3.2.2            Price risk and costly trading

 

The modern analysis of financial derivatives is unified by the successful application of absence of arbitrage pricing arguments. Because of the nature of derivatives, the composition of the replicating portfolios can vary considerably over time and maintaining these portfolios can involve extensive and costly trading (Hentschel & Smith 1995). The price of a derivative product may not match its theoretical price due to outside influences such as market supply and demand factors. As a result, actual traded prices can be higher or lower than the theoretical price, and this is also known as extraordinary price movements for Exchange Traded Derivative Products (cpy.com.hk 2011).

 

3.2.3            Underdevelopment of derivative related legislation

 

For legislators and committees responsible for financial reform related to derivatives in the United States and elsewhere, distinguishing between hedging and speculative derivatives activities has been a nontrivial challenge. The distinction is critical because regulation should help to isolate and curtail speculation with derivatives, especially for “systemically significant” institutions whose default could be large enough to threaten the entire financial system. At the same time, the legislation should allow for responsible parties to hedge risk without underlying tying up working capital as collateral that firms may better employ elsewhere in their operations and investment (Zubrod & Luke 2011). For this reason, the underdevelopment of derivative related legislation is common even in the most developed nations; therefore the risk of the derivatives is increased because of the lack of enough regulation and legislation.

 

3.3    (C) Mine development project in Nord Resource’s Ramu River property in Papua New Guinea

 

3.3.1            Describe three major risks in undertaking this project

 

3.3.1.1      Foreign investment risk: Political Risk

 

According to Arthur J. Keown (2004, p. 521), political risks arises because the foreign subsidiary conducts its business in a political system different from that of the home country. Many foreign governments, especially those in the less developed countries, are less stable than those of the home country government. Therefore a change in the country’s political setup frequently brings a change in policies with respect to businesses- and especially with respect to foreign businesses. An extreme change in policy might involve nationalization or even outright expropriation of certain businesses.

 

And obviously, as given the new project of property development will be in Papua New Guinea. According to the internet reports, since Aug-2011, there was a political crisis between the parliament-elect Prime Minister, Peter O’Neill (voted into office by a large majority of MPs) and Sir Michael Somare, who was deemed by the Supreme Court (in a December Opinion, 3:2) to retain office. The stand-off between Parliament and the Supreme Court continued until the July 2012 National Elections, with legislation passed effectively removing the Chief Justice and subjecting the Supreme Court members to greater control by the Legislature, as well as a series of other laws passed. Therefore, with the political instability, the new mining project in this less developed country will be exposed with great political instability (pnglng.com 2012).

 

3.3.1.2      Risks caused by pricing volatility

 

The mining industry encompasses a wide range of companies involved in the exploration, development, extraction, processing, refining and sale of minerals plus coal. Because of the large scale of investment, in case of a lack of earnings and cash flow stability can be caused by volatile product pricing and responsiveness to economic cycles (dbrs.com 2011), there will be high degree of finance risk therein.

 

3.3.2            How can Nord structure its financing so as to reduce these risks?

 

3.3.2.1      Recommended strategies to cope with political risk

 

As above mentioned, considering the high degree of political instability in the target country, there are several major strategies that the company can take better understand and control the political risks. First of all, the company must be full learnt about the ownership requirement in the target country according to the most updated legal requirements as well as constrains that could be found by studying the relevant legislation and government policies. And in order to reduce to ownership related risks, it is strongly recommended that the company set up partnership with some local company to utilize the local ownership advantages to some degree as well as making use of the networking enjoyed by the local players. Another key strategy involved is hiring local legal agency in handling the contractual matters that could arise in doing business in the target country.

 

3.3.2.2      Strategies to cope with risks caused by pricing and economic volatility

 

The first recommended strategy is to utilize the commercial and widely accepted effective financial risk assessing software to perform a wide range of financial risk assessment including geological, financial, economic and operational risks. In addition, as in mining investment business sector mining investment decisions often have to be made based on many estimated / predicated variables and generally there is significant uncertainty associated with these estimation and predictions (ecms.adelaide.edu.au 2012), hiring finance consultancy that has actual experience in the mining investment in the target country to further understand the uncertainties and the relevant effects on the financial performance of the mining project will be of great significance.

 

3.3.3            How can Nord use financing to add value to this project?

 

3.3.3.1      Applying international financial reporting standard in financial reporting to enhance investor relationship

 

With many countries now require companies to prepare their financial statements in accordance with International Financial Reporting Standards (IFRS). Regulatory bodies in many other countries are converging national standards with IFRS. The move to adopt or harmonise with IFRS has advanced the transparency and comparability of financial statements around the world (pwc.com 2007). It is believed that adopting the international financial reporting standard in financial reporting can be helpful to enhance investor relationship in particular it can attract international investors who can get easy access and checking with the needed finance information through the standardized finance reporting.

 

3.3.3.2      Measuring the return on CSR (corporate social responsibility) investment for long term investment activities

 

Corporate social responsibility (CSR) activities have the potential to create several distinct forms of value for customers. It is the customer perception of this value that mediates the relationship between CSR activities and subsequent financial performance. By categorizing major CSR activities and the different types of value each can create, this report offers a number of practical recommendations to business leaders embarking in CSR programs for their companies. Investments in CSR activities are under scrutiny. Boards and shareholders are increasingly demanding that outcomes from these investments be measured to understand if and how they positively impact the profitability of the firm (law.harvard.edu 2011). Therefore, The field of measuring return on corporate social responsibility (CSR)) initiatives is growing. There is a growing demand from investors, shareholders and corporate management to determine the value of CSR initiatives (commdev.org 2010). Measuring return on these types of investments requires a multidisciplinary approach bringing experience from financial valuation, political risk and environmental and social impact assessment. By measuring the return on CSR (corporate social responsibility) investment, it is expected that long term investment activities on CSR will be able to enhance the company investment in a cost effective perspective.

Reference list

 

Cox, D. W. 2007, Frontiers of Risk Management: Key Issues and Solutions. London: Euromoney Books. p. 83

 

commdev.org 2010. Measuring returns on community investments in mining. Accessed on 17 Jan 2012 [online] available: http://commdev.org/userfiles/SRMining%20Veronica%20Nyhan%20Jones,%20Jelena%20Lukic,%20Arjun%20Bhalla,%20Dafna%20Tapiero%20-%20July%2015.pdf

 

cpy.com.hk 2011. Risks of Exchange Traded Derivative Products. Accessed on 17 Jan 2012 [online] available: http://www.cpy.com.hk/CPY/derivatives/derivatives_risk_en.htm

 

dbrs.com 2011. Stage 1: Industry Business Risk Rating for the Mining Industry. Accessed on 17 Jan 2012 [online] available: http://www.dbrs.com/research/240365/rating-companies-in-the-mining-industry.pdf

 

ecms.adelaide.edu.au 2012. Managing the risks of mining investment. Accessed on 17 Jan 2012 [online] available: http://www.ecms.adelaide.edu.au/civeng/research/mining/MINVESTCase_Study_v.03.pdf

 

Glantz, M. & Mun, J. 2008, The Banker’s Handbook on Credit Risk: Implementing Basel II. California: Elsevier Academic Press. p. 12

 

Hentschel, L. & Smith, C. W. 1995 “Controlling Risks in Derivatives Markets,” Journal of Financial Engineering, (Vol. 4, No. 2, pp. 101-125).

 

investopedia.com 2011. Definition of ‘Liquidity Risk’. Accessed on 17 Jan 2012 [online] available: http://www.investopedia.com/terms/l/liquidityrisk.asp#axzz2I9rpBCSL

 

investorwords.com 2011. Definitions of interest rate risk. Accessed on 17 Jan 2012 [online] available: http://www.investorwords.com/2546/interest_rate_risk.html

 

Keown, A. J. 2004, Foundation of Finance. Beijing: Pearson Education Asia Limited and Tsinghua University Press. p. 521

 

law.harvard.edu 2011. Investing in Corporate Social Responsibility to Enhance Customer Value. Accessed on 17 Jan 2012 [online] http://blogs.law.harvard.edu/corpgov/2011/02/28/investing-in-corporate-social-responsibility-to-enhance-customer-value/

 

Matz, L. & Neu, P. 2007, Liquidity Risk Measurement and Management. Singapore: John Wiley & Sons (Asia) Pte Ltd. p. 291

 

mysmp.com 2011. Interest Rate Sensitivity. Accessed on 17 Jan 2012 [online] available: http://www.mysmp.com/bonds/interest-rate-sensitivity.html

 

pnglng.com 2012. Project Overview. Accessed on 17 Jan 2012 [online] available:  http://www.pnglng.com/project/index.htm

 

Oldani, C. 2008, Governing Global Derivatives: Challenges and Risks. Burlington: Ashgate Publishing, Ltd, p. 41

 

readyratios.com 2011. Credit Risk. Accessed on 17 Jan 2012 [online] available: http://www.readyratios.com/reference/analysis/credit_risk.html

 

pwc.com 2007. Financial reporting in the mining industry. Accessed on 17 Jan 2012 [online] available: http://www.pwc.com/en_GX/gx/energy-utilities-mining/pdf/ifrs-mining.pdf

 

Schwartz, R. J. & Smith, C. W. 1997, Derivatives Handbook: Risk Management and Control. New Jersey: John Wiley & Sons, Inc. p. 319

 

Zubrod & Luke 2011 The Atlantic. “Will the ‘Cure’ for Systemic Risk Kill the Economy?” Accessed on 17 Jan 2012 [online] available: http://www.theatlantic.com/business/archive/2011/06/will-the-cure-for-systemic-risk-kill-the-economy/240600/