Financial Management

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Financial Management

© All Rights Reserved

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Question 1

Consider a company A with zero earnings retention ratio and a real growth rate in

earnings of percent. In an inflation environment, the company can only pass inflation

through its earnings at a flow-through rate of percent. So if I is the inflation rate, its

earnings will growth at a rate of g I . The real rate of return required for this

company is , so the nominal rate of return required is r I .

Use a discounted dividend model and assume that dividends will grow indefinitely at a

constant compounded annual growth rate, g I .

(a) Suppose earning in the current period is denoted

0

E . State an expression for

earnings in the next period

1

E .

(b) Using an appropriate formula, show clearly with workings how you arrive at an

expression for the intrinsic P/E using the prospective earnings. (Hint: Obtain an

expression for

0 1

/ P E ).

(c) Using the expression for the intrinsic P/E you obtained in part (b), explain the

relationships between

(i) inflation pass through rate and the price of the company (or stock price).

(ii) the real growth rate in earnings and the P/E ratio.

(d) Calculate the P/E ratio on company As prospective earnings given

2%, I= 4% and =100% .

(e) What is the implication on company As P/E ratio if the inflation pass through

rate is only 80%? Explain.

(f) Suppose the inflation pass through rate is 100% and the inflation rate is exactly

equal to the real growth rate in earnings. What can you infer about the intrinsic

P/E? Explain.

2

Question 2

An American investor holds a British bond portfolio worth 100 million. The portfolio

has a duration of seven. She fears a temporary depreciation of the pound but wishes to

retain the bonds. To cover this risk, she decides to sell pounds forward. She has observed

that the British government tends to adopt a leaning-against-the-wind policy. When the

pound depreciates, British interest rates tend to rise to defend the currency.

(a) The investor runs a regression of variations in long-term British yields on

percentage $/ exchange rate movements and found that it has a slope coefficient of

0.2. Interpret this regression result.

(b) The investor uses only forward currency contracts to hedge this risk and not bond

futures contracts. What should be the optimal hedge ratio used by the investor if she

wishes to reduce the uncertainty caused by exchange risk?

(c) List 3 factors that could make this hedge imperfect if the depreciation of the pound

materialises. Elaborate on these factors.

3

Question 3

In this question sigma ( ) is used to denote the standard deviation of asset or portfolio

returns. It is also a measure of volatility. The Japanese stock market has a sigma of 18%,

when computed in yen. The U.S. stock market has a sigma of 17% in US$ and the

US$/Yen exchange rate has a sigma of 6%. The correlation between the Japanese stock

market and US$/Yen currency movements is 0.1. The correlation between the Japanese

and U.S. stock market is equal to 0.4, measured either in local currency or in dollars.

(a) What is the sigma of the Japanese market when expressed in dollars?

(b) Using this number, calculate the sigma (in dollars) of a portfolio made up of 50%

of Japanese stocks and 50% of US stocks.

(c) Suppose the dollar volatility of the Japanese stock market is 18.97%, what can

you conclude about the correlation between the Japanese stock market movements and

exchange rate movements?

Assume that the domestic volatility (standard deviation in yen) of the Japanese bond

market is 8%. The volatility of the yen against the U.S. dollar is 6%.

(d) Suppose the dollar volatility of the bond market is 11.35%, what can you

conclude about the correlation between the Japanese bond market movements and

exchange rate movements?

(e) Assume that you have a portfolio made up of 50% of Japanese stocks, 20% of

Japanese bonds, and 30% of U.S. stocks. Formulate an expression for the sigma (in

dollars) of your portfolio in terms of

2 2 2

_ _ _

, , , , ,

JS USS JB USS JS USS JB JS JB

where the

subscripts JS, USS and JB denote Japanese stocks, US stocks and Japanese bonds

respectively.

Question 6

Amazon is completing construction on a new mega-warehouse outside of London,

England. The final construction payment is due in three months in the amount of

525,000. The current spot rate is 1.6500 $/, and the bid-ask quotes for the three month

forward rate are 1.66001.6800 $/.

(a) If Amazon hedges in the forward market, what will be its dollar cost for the

construction payment three months from now? Be specific about how they would hedge?

(Buy (Sell) dollars (pounds) forward)?

b) Amazon may also choose to hedge using an option. The rates available on options to

buy and sell pounds are as follows:

Type of Option Strike Price Premium Cost

Three month call on $1.65/ $0.040/

Three month put on $1.65/ $0.030/

Which option should Amazon consider? Why?

c) Suppose Amazon chose to buy the option. Three months have passed and the spot

exchange rate is now 1.58$/. What is the hedged dollar value of the payment? What is the

hedged dollar value of the payment if the exchange rate is now 1.68$/?

d) Suppose you are given prevailing interest rates in the US and UK, how would you

structure a money market hedge (i.e. resorting to borrowing/lending)?

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