ACCA AFM Syllabus E. Treasury And Advanced Risk Management Techniques - Risks - Past Papers ^{5 / 5}

Furlion Co manufactures heavy agricultural equipment and machinery which can be used in difficult farming conditions. Furlion Co’s chief executive has been investigating a significant opportunity in the country of Naswa, where Furlion Co has not previously sold any products. The government of Naswa has been undertaking a major land reclamation programme and Furlion Co’s equipment is particularly suitable for use on the reclaimed land. Because of the costs and other problems involved in transporting its products, Furlion Co’s chief executive proposes that Furlion Co should establish a plant for manufacturing machinery in Naswa. He knows that the Naswan government is keen to encourage the development of sustainable businesses within the country.

Initial calculations suggest that the proposed investment in Naswa would have a negative net present value of $1·01 million. However, Furlion Co’s chief executive believes that there may be opportunities for greater cash flows in future if the Naswan government expands its land reclamation programme. The government at present is struggling to fund expansion of the programme out of its own resources and is looking for other funding. If the Naswan government obtains this funding, the chief executive has forecast that the increased demand for Furlion Co’s products would justify $15 million additional expenditure at the site of the factory in three years’ time. The expected net present value for this expansion is currently estimated to be $0.

It can be assumed that all costs and revenues include inflation. The relevant cost of capital is 12% and the risk free rate is 4%. The chief executive has estimated the likely volatility of cash flows at a standard deviation of 30%.

One of Furlion Co’s non-executive directors has read about possible changes in interest rates and wonders how these might affect the investment appraisal.

Required:
(b) Explain what is meant by an option’s rho and discuss the impact of changes in interest rates on the appraisal of the investment. (5 marks)

The chief executive officer (CEO) of Faoilean Co has just returned from a discussion at a leading university on the ‘application of options to investment decisions and corporate value’. She wants to understand how some of the ideas which were discussed can be applied to decisions made at Faoilean Co. She is still a little unclear about some of the discussion on options and their application, and wants further clarification on the following:

(i) Faoilean Co is involved in the exploration and extraction of oil and gas. Recently there have been indications that there could be significant deposits of oil and gas just off the shores of Ireland. The government of Ireland has invited companies to submit bids for the rights to commence the initial exploration of the area to assess the likelihood and amount of oil and gas deposits, with further extraction rights to follow. Faoilean Co is considering putting in a bid for the rights. The speaker leading the discussion suggested that using options as an investment assessment tool would be particularly useful to Faoilean Co in this respect.

(ii) The speaker further suggested that options were useful in determining the value of equity and default risk, and suggested that this was why companies facing severe financial distress could still have a positive equity value.

(iii) Towards the end of the discussion, the speaker suggested that changes in the values of options can be measured in terms of a number of risk factors known as the ‘greeks’, such as the ‘vega’. The CEO is unclear why option values are affected by so many different risk factors.

Required:

(c) With regard to (iii) above, explain why changes in option values are determined by numerous different risk factors and what ‘vega’ determines.(5 marks)

Awan Co is expecting to receive $48,000,000 on 1 February 2014, which will be invested until it is required for a large project on 1 June 2014. Due to uncertainty in the markets, the company is of the opinion that it is likely that interest rates will fluctuate significantly over the coming months, although it is difficult to predict whether they will increase or decrease.

Awan Co’s treasury team want to hedge the company against adverse movements in interest rates using one of the following derivative products:

Forward rate agreements (FRAs); 
Interest rate futures; or
Options on interest rate futures.

Awan Co can invest funds at the relevant inter-bank rate less 20 basis points. The current inter-bank rate is 4•09%. However, Awan Co is of the opinion that interest rates could increase or decrease by as much as 0•9% over the coming months.

The following information and quotes are provided from an appropriate exchange on $ futures and options. Margin requirements can be ignored.

Three-month $ futures, $2,000,000 contract size
Prices are quoted in basis points at 100 – annual % yield

December 2013: 94•80
March 2014: 94•76
June 2014: 94•69

Options on three-month $ futures, $2,000,000 contract size, option premiums are in annual %

Voblaka Bank has offered the following FRA rates to Awan Co:

1–7: 4•37%
3–4: 4•78%
3–7: 4•82%
4–7: 4•87%

It can be assumed that settlement for the futures and options contracts is at the end of the month and that basis diminishes to zero at contract maturity at a constant rate, based on monthly time intervals. Assume that it is 1 November 2013 now and that there is no basis risk.

A member of Awan Co’s treasury team has suggested that if option contracts are purchased to hedge against the interest rate movements, then the number of contracts purchased should be determined by a hedge ratio based on the delta value of the option.

Required:

Discuss how the delta value of an option could be used in determining the number of contracts purchased. (6 marks)

Kenduri Co is a large multinational company based in the UK with a number of subsidiary companies around the world. Currently, foreign exchange exposure as a result of transactions between Kenduri Co and its subsidiary companies is managed by each company individually.

Kenduri Co is considering whether or not to manage the foreign exchange exposure using multilateral netting from the UK, with the Sterling Pound (£) as the base currency. If multilateral netting is undertaken, spot mid-rates would be used.

The following cash flows are due in three months between Kenduri Co and three of its subsidiary companies. The subsidiary companies are Lakama Co, based in the United States (currency US$), Jaia Co, based in Canada (currency CAD) and Gochiso Co, based in Japan (currency JPY).

Exchange rates available to Kenduri Co

Currency options available to Kenduri Co

Contract size £62,500, Exercise price quotation: US$/£1, Premium: cents per £1

It can be assumed that option contracts expire at the end of the relevant month

Annual interest rates available to Kenduri Co and subsidiaries

Required:

When examining different currency options and their risk factors, it was noticed that a long call option had a high gamma value. Explain the possible characteristics of a long call option with a high gamma value. (3 marks)