Solutions Manual

to accompany

Introducing
Corporate Finance 2e
Diana Beal, Michelle Goyen
Abul Shamsuddin

Prepared by

Diana Beal
© John Wiley & Sons Australia, Ltd 2008

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Chapter Fifteen: Risk Management

Questions

15.1 Think of a business with no market power such as a pumpkin grower. In what
areas does such a business face risk?

Prices of output; prices of all inputs.

15.2 Compare the business in 15.1 with Woolworths Ltd. How is the risk structure
facing the two businesses different?

Woolworths has market power and can control the prices of inputs to a much greater extent (it
contracts with conventional suppliers and also packs under its own labels); it also has
discretion in the prices of goods for sale, subject to the competitive pressure of Coles and
IGA.

15.3 What is the most common method for business to manage risk?

Insurance cover

15.4 Discuss the role of speculators in a futures market. Give a numerical example of
a successful speculation.

Speculators give markets depth and liquidity by providing more buying and selling pressure.
A successful speculation involves either buying low and selling high or selling high and
buying low to satisfy the selling contract. A speculator might buy 1000 shares at $20 and sell
those shares for $25 to make a gain of $5000. Conversely, a speculator who thinks the market
will fall might sell 1000 shares at $25 for later delivery and buy the shares after the market
has fallen at $20 to satisfy the sale, thus making a gain of $5000.

15.5 Speculators generally have a bad name. Is this justified?

No; speculators make markets deeper and also can only react to market forces. The only
exception to this rule is that occasionally a speculator ‘corners’ the market by taking such a
large position that the market fails. Hardliners would argue that this is acceptable; others
argue that it is not acceptable.

15.6 Explain how an arbitrageur would profit from a deal in the forex markets.

An arbitrageur might profit from noting that exchange rates were slightly out of alignment.
For example, if AUD/NZD 1.07, USD/NZD 1.70 and AUD/USD 0.58, an arbitrageur could
profit. How? Assume the arbitrageur starts with $A1 million. And ignore transaction costs.

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Introducing Corporate Finance 2e Solutions Manual

$A1 million → $NZ1 070 000 → USD 629 412 → $A1 085 193. Thus a gain of $A85 193.

15.7 Joseph Cotter and Co. hedges in the cotton futures market. In what business does
the firm trade?

Selling hedge — Cotter is a grower; buying hedge — Cotter is a spinner.

15.8 What is meant by the term ‘contract unit’ in relation to a futures contract? Give
three examples.

The contract unit is the standard quantity of the product that is the subject of each contract.
AUD $100 000; BABs $1 million; $100 000 3- and 10-year bonds.

15.9 Explain how margin requirements work in the futures markets.

Using the BAB contract, the initial margin is $600. Suppose a contract is traded at 95.00.
Prices are quoted with variations in terms of 0.01% (i.e. 95.01, 95.02, etc). Each variation is
equivalent to about $24. Thus, the margin will cover the risk of variation of about 0.25% or
25 basis points. Marking to market is undertaken each afternoon at close of business. Margin
calls will be made for more funds to be deposited into margin accounts as soon as the balance
falls below $300. This system allows a movement against a position to extend only about
12 basis points before a margin call is made. In this way, the risk of the clearing house as
counter-party is reduced.

15.10 What are mandatory-settled futures contracts? Are not they all mandatorily-
settled? Why do you think there are the so-called mandatory-settled contracts?

Contracts settled not by delivery but by a cash settlement price. Yes. Mandatorily-settled
contracts are those where it is easier to settle by cash rather than try to deliver, e.g. cattle,
electricity.

15.11 Why would a hedger take an option on a futures contract?

To gain the right not to settle the contract if the price moves against the hedger.

15.12 A 90-day BAB is traded at 93.3. What does this mean?

The yield is 6.7% (100 – 93.3).

15.13 Explain with a worked example how an FRA is settled.

$1 million borrowing; 6% contract and 6.25% market; 90 days.

At 6.25%, price = $984 822.93

At 6%, price = $985 421.17 Market has risen; lender pays borrower $598.24.

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 Chapter Fifteen: Risk Management

15.14 At settlement, the buyer of an FRA pays the seller. Explain what has happened
and how the buyer has fixed her interest rate.

The market has fallen, so potential borrower pays lender. The payment converts the market
rate to the fixed rate (yield).

15.15 How are interest rate swaps possible and able to benefit the parties?

The markets involved have mis-aligned the risk margins.

15.16 Explain why Cubbyhouse Partnership, a large Australian cotton-growing firm,

would enter a currency swap.

Cubbyhouse sells cotton normally in USD, so the currency swap (AUD: USD) manages the
currency risk.

15.17 Why would a company issue options instead of fully paid shares?

As low-cost benefits to employees to stay and also to try to increase the share price, as
sweeteners attached to finance issues and as planned enticements to assist future funds
raisings.

15.18 Explain one of the downside risks in a company issuing a large number of
options.

May impact on future funds raising in that investors may be able to exercise options at, say
$2, when the share price is $4 and an issue of shares might raise $3.50.

15.19 Why should firms dealing in the derivatives markets split the duties associated
with trading? What are the three tasks associated with each day’s trading?

Risk management — risky to have no checking mechanisms built into processes. Trading
operations, risk assessment, recording and settlement.

15.20 Grain Handlers Ltd regularly used the derivative markets to hedge grain prices
for its growers. If its derivatives traders exceeded their limits while on a profit-
making quest, is the firm still hedging?

No; once the firm trades above the volumes needed to hedge the crop, it is speculating.

© John Wiley and Sons Australia, Ltd 2008 15.4

Introducing Corporate Finance 2e Solutions Manual

Financial Problems

15.1 Hank Harnencort is a Brisbane forex dealer, lately arrived from Boston. Hank
sees these quotes on his screen and decides to use US$400  000 to make an
arbitrage deal. The quotes are:
AUD1 = USD 0.7484
AUD1 = JPY 85.22
USD1 = JPY 110.59
How much gain would Hank make at these rates, disregarding transaction costs?

$11 862 (USD1 = AUD 1.336 = JPY 113.869 = USD 1.0296)

15.2 A firm buys two SFE September 90-day BAB futures contracts at 93.15. At
settlement, the firm receives what and pays what?

Receives BABs to the value of $2 million; pays $1 966 780.27.

15.3 A small credit union sells an SFE June 90-day BAB futures contract at 92.85. At
settlement, what does it receive? When the bill matures, what happens?

$982 675.30 received; at maturity, pays $1 million.

15.4 An Australian exporter decides to hedge receivables in USD. Accordingly, it buys

10 SFE June AUD futures contracts at 0.6410. In early June, it decides to reverse
its position in the futures market by selling 10 contracts at 0.6620. How much has
the exporter gained or lost on the futures trade? Explain what these prices
indicate about the movement of the physical exchange rate.

Pays .6410 × 100 000 × 10 = $US641 000

Receives .6620 = $US662 000 Gain $US21 000
Value USD decreases; value AUD increases
Reduction in amount of AUD gained in physical exchange.
Loss on physical = gain on futures.

15.5 A New Zealand exporter, Kiwanis, does business with the USA and is to receive
about US$700 000 next September. Kiwanis decides to hedge the USD and does
so at the SFE at 0.6990. Kiwanis is happy to receive AUD as it buys a large
amount of goods from Australia.

(a) How many AUD contracts will Kiwanis buy or sell?

Buy 10 contracts.

(b) Kiwanis reverses its position at 0.6300. Has the futures trading brought a
loss or gain? Of how much?

Futures loss = $699 000 – $630 000 = $69 000

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 Chapter Fifteen: Risk Management

15.6 Comet Mines NL wants to lock in the price of some of it future gold production.
Rather than enter the futures market directly, it decides to purchase some
December 850 gold put options. Each option gives Comet the right to sell one
100-ounce gold futures contract for $850 per ounce; each option costs $1200. The
price of gold in the physical market increases to $925. What will Comet do?
What are its gains and losses?

Let the option lapse. Sell on the physical market at $925 per ounce. The premium of $1200 is
a sunk cost and of no relevance to the decision.

15.7 CGT Ltd wants to fix the interest rate of some future borrowings. Accordingly it
makes a deal with its financier to buy a 5:8 FRA for a notional principal of
$10 million at 5.9%. At settlement, the market rate for 90-day funds has risen to
6.4%. Who pays what to whom?

Market rate has risen, so financier pays the borrower $11 963 ($9 856 606 – 9 844 643).

15.8 Given the circumstances in problem 15.7, what payments would be made if the
market price of 90-day funds at settlement had fallen to 5.65%?

Market rate has fallen, so borrower pays the financier $5993 ($9 862 599 – 9 856 606)

15.9 GS Trading Co Ltd’s financial manager thinks interest rates will rise. Hence, he
wants to lock in the cost of future borrowings. He arranges to buy a 6:9 FRA for
a notional $10 million at 6.2%. At settlement the market has risen to 6.45%. How
much does the firm pay or receive?

Market rate has risen, so financier pays the borrower $5976 ($9 849 425 – 9 843 449)

15.10 Given the circumstances in problem 15.9, what payments would be made if the
market had fallen to 6.05%?

Market rate has fallen, so borrower pays the financier $3590 ($9 853 015 – $9 849 425)

15.11 GS Trading is so pleased with its FRA deal that it decides to extend the fixing of
its interest rate. If settlement in 15.11 took place in September, how would you
describe another FRA deal which locked in the notional $10 million for another
three months after the maturity of the current deal?

This is really no longer a FRA because the deal for the funds is struck for the period starting
immediately.

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Introducing Corporate Finance 2e Solutions Manual

15.12 Australian Avocados (AAV) can borrow at 8.2% and BBSW +3.5%; Ptero
Traders (PT) can borrow at 9.8% and BBSW +4.1%. The managers of the two
firms know each and decide to arrange a swap. AAV borrows fixed and really
wants floating, and PT is happy to borrow floating and swap to fixed. Arrange a
swap with any benefit shared equally and AAV paying PT no more than BBSW.

AAV PT Difference
Fixed 8.2% 9.8% 1.6
Floating BBSW + 3.5% BBSW + 4.1% 0.6
1.0
Pay to market –8.2% –(BBSW + 4.1%)
Pay to other –BBSW –5.2%
Receive from other +5.2% +BBSW
Outcome BBSW + 3.0% 9.3%

15.13 Allen’s Autos (AA) can borrow at 7.2% and BBSW +2.8%; Davidson Fruits (DF)
can borrow at 8.8% and BBSW +3.2%. The managers of the two firms decide to
arrange an interest rate swap. AA borrows fixed and really wants floating, and
DF is happy to borrow floating and swap to fixed. Arrange a swap with any
benefit shared equally and AA paying DF no more than BBSW.

AA DF Difference
Fixed 7.2% 8.8% 1.6
Floating BBSW + 2.8% BBSW + 3.2% 0.4
1.2
Pay to market –7.2% –(BBSW + 3.2%)
Pay to other –BBSW –5.0%
Receive from other +5.0% +BBSW
Outcome BBSW + 2.2% 8.2%

15.14 Build a table such as table 15.4 (in the chapter) showing the actual payments for
your swap solution in problem 15.12 during one year with four reset periods, a
nominal loan amount of $40 million, and BBSW increasing by 100 basis points
each reset period from a start of 5%.

BBSW AA PT
Period (%) Pay to mkt Swap Net cost Pay to mkt Swap Net cost
1 5 –820 +20 800 910 –20 930
2 6 –820 –80 900 1010 +80 930
3 7 –820 –180 1000 1110 +180 930
4 8 –820 –280 1100 1210 +280 930

15.15 Build a table such as table 15.4 (in the chapter) showing the actual payments for
your swap solution in problem 15.13 during one year with four reset periods, a
nominal loan amount of $40 million, and BBSW increasing by 100 basis points
each reset period from a start of 5%.

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 Chapter Fifteen: Risk Management

BBSW AA PT
Period (%) Pay to mkt Swap Net cost Pay to mkt Swap Net cost
1 5 –720 0 720 820 0 820
2 6 –720 –100 820 920 +100 820
3 7 –720 –200 920 1020 +200 820
4 8 –720 –300 1020 1120 +300 820

15.16 Austra Global can borrow at fixed rates in Australia at 8.2% and in the USA at
6.2%. New Texas, a US firm, has a better credit rating and can borrow at 7.2%
in Australia and 4.8% in the USA. Austra borrows in Australia and New Texas in
the USA; they want loans denominated in the other currency so arrange a
currency swap for principal and interest. They decide to share the benefits
equally. Structure a swap and calculate the quarterly payments on a
A$10 million and the equivalent USD loan with the AUD:USD exchange rate
at 0.6000.

AG NT Difference
AUD 8.2% 7.2% 1.0
USD 6.2% 4.8% 1.4
0.4
Pay to market –8.2%AUD –4.8%USD
Pay to other –4.8%USD –7.0%AUD
Receive from other +7.0%AUD +4.8%USD
Outcome 4.8%USD and 1.2%AUD 7.0%AUD

USD loan is $6 million.

AG pays $US90 000 / qtr; NT pays $A175 000 / qtr

15.17 Design a currency swap for the following situation with a financial institution
earning 50 basis points and assuming all foreign exchange risk.

AA BB Difference
AUD 9.6% 10.0% 0.4
USD 5.0% 6.5% 1.5
1.1 – 0.5 = 0.3% each
Pay to market –5.0%USD –10.0%AUD
Pay to intermediary –9.3%AUD –6.2%USD
Receive from intermediary +5.0%USD +10.0.%AUD
Outcome 9.3%AUD 6.2%USD

The intermediary gains 1.2%USD and losses 0.7%AUD, thereby making 0.5% on the deal.

© John Wiley and Sons Australia, Ltd 2008 15.8

Introducing Corporate Finance 2e Solutions Manual

15.18 Directors in ABG Ltd granted themselves two million options exercisable at
$2 each as part of their remuneration packages. The options will lapse in
December 2012, if not exercised before this time. When the market price of the
fully-paid ordinary shares is $6.30 and the company has recently issued rights at
$5, how much do you believe the company has forgone in granting the options?

The forgone amount depends on the share price at the time of exercising the rights. If the
rights can be exercised at $5 (as a discount to the current share price), the forgone amount is
at least $3 per share or $6 million.

15.19 Fanta Ltd is a software company looking to increase its capital. Its adviser
reports that it can raise the $100 million in funds needed by issuing shares at
$2.50 each. This issue, according to the adviser, should be underwritten at a fee
cost of 4%. Alternatively, the adviser suggests directors should consider
attaching a free option to the issue. The option should be exercisable by investors
at $2 anytime before 30 September 2011. The adviser notes that the issue will
now be more attractive and the underwriting fee will drop to 3%. Advise the
directors of the issues and costs involved here.

The fee cost is $4 million which drops to $3 million if the option is attached, thus saving
$1 million. If the option is issued, there will be 40 million options supplied. The directors
have to consider whether they want a large number of options available for trading; whether
they will need the extra $80 in equity represented by the options; whether the capital forgone
will become significant by 2011 if the share price rises sharply. Overall, it would appear the
$1 million drop in fee may not be enough to attract the directors to attach the option.

© John Wiley and Sons Australia, Ltd 2008 15.9