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Cfm 306 Financial Risk Management (D+E) Question Paper
Cfm 306 Financial Risk Management (D+E)
Course:Bachelor Of Commerce
Institution: Kca University question papers
Exam Year:2011
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UNIVERSITY EXAMINATIONS: 2010/2011
THIRD YEAR EXAMINATION FOR THE DEGREE OF BACHELOR OF
COMMERCE
CFM 306 FINANCIAL RISK MANAGEMENT (D+E)
DATE: DECEMBER2011 TIME: 2 HOURS
INSTRUCTIONS: Answer Question One and Any Other Two Questions
Question One
SARBANES: “Warren Buffett has warned us that derivatives are time bombs, both for the parties
that deal in them and the economic system. The Financial Times has said so far, there has been no
explosion, but the risks of this fast growing market remain real. How do you respond to these
concerns?”
BERNANKE: “I am more sanguine about derivatives than the position you have just suggested. I
think, generally speaking, they are very valuable. They provide methods by which risks can be
shared, sliced, and diced, and given to those most willing to bear
them. They add, I believe, to the flexibility of the financial system in many different ways. With
respect to their safety, derivatives, for the most part, are traded among very sophisticated financial
institutions and individuals who have considerable incentive to
understand them and to use them properly. The Federal Reserve’s responsibility is to make sure
that the institutions it regulates have good systems and good procedures for ensuring that their
derivatives portfolios are well managed and do not create excessive
risk in their institutions.”
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—Interchange between Senator Paul Sarbanes and Federal Reserve Bank Chairman Ben Bernanke,
Senate Banking Committee hearing, November 2005
Required:
a) What are derivatives instruments and why are they useful? (4 Marks)
b) How are futures liquidated? (3 Marks)
c) What are the differences between futures contracts and forward contracts? (4 Marks)
d) What are the differences between options and futures contracts? (3 Marks)
e) Explain how futures are used to manage risk for a farmer who grows corn and a canning
company who buys the corn for processing and selling in grocery stores. (6 Marks)
f) Assume that you are a bond portfolio manager and that you anticipate an infusion of investable
funds in three months. How could you use the futures market to hedge against unexpected
changes in interest rates? (5 Marks)
g) For the most part, the price of oil is denominated in dollars. Assume that you are a French firm
that expects to import 420,000 barrels of crude oil in six months. What risks do you face in this
transaction? Explain how you could transact to hedge the currency portion of those risks.
(5 Marks)
(TOTAL 30 MARKS)
Question Two
a) Assume the following: A stock is selling for $100, a call option with an exercise price of $90 is
trading for $6 and matures in one month, and the interest rate is 1 percent per month. What
should you do? Explain your transactions. (6 Marks)
b) Digunder, a property development company, has gained planning permission for the
development of a housing complex at Newtown which will be developed over a three year
period. The resulting property sales less building costs have an expected net present value of
$4 million at a cost of capital of 10% per annum. Digunder has an option to acquire the land in
Newtown, at an agreed price of $24 million, which must be exercised within the next two
years.
Immediate building of the housing complex would be risky as the project has a volatility attaching
to its net present value of 25%.
One source of risk is the potential for development of Newtown as a regional commercial centre
for the large number of professional firms leaving the capital, Bigcity, because of high rents and
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local business taxes. Within the next two years, an announcement by the government will be made
about the development of transport links into Newtown
from outlying districts including the area where Digunder hold the land option concerned. The risk
free rate of interest is 5% per annum.
Required:
i) Estimate the value of the option to delay the start of the project for two years using the Black
and Scholes option pricing model and comment upon your findings. Assume that the
government will make its announcement about the potential transport link at the end of the
two-year period. (10 Marks)
ii) On the basis of your valuation of the option to delay, estimate the overall value of the project,
giving a concise rationale for the valuation method you have used. (4 Marks)
(20 Marks)
Question Three
Expo plc is an importer/exporter of textiles and textile machinery. It is based in the UK but trades
extensively with countries throughout Europe. It has a small subsidiary based in Switzerland. The
company is about to invoice a customer in Switzerland 750,000 Swiss francs, payable in three
months' time. Expo plc's treasurer is considering two methods of hedging the exchange risk. These
are:
Method 1: Borrow Swiss Francs now, converting the loan into sterling and repaying the Swiss
Franc loan from the expected receipt in three months' time.
Method 2: Enter into a 3-month forward exchange contract with the company's bank to sell Fr
750,000.
The spot rate of exchange is Fr 2.3834 to £1. The 3-month forward rate of exchange is Fr 2.3688 to
£1.
Annual interest rates for 3 months' borrowing in: Switzerland is 3% for investing in UK, 5%.
Required
a) Advise the treasurer on:
i) Which of the two methods is the most financially advantageous for Expo plc, and
ii) The factors to consider before deciding whether to hedge the risk using the foreign
currency markets Include relevant calculations in your advice. (10 Marks)
b) Explain three causes of exchange rate fluctuations. (3 Marks)
c) Advise the treasurer on other methods to hedge exchange rate risk. (7 Marks)
(20 Marks)
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Question Four
(a) (a) Describe what a yield curve is. (5 Marks)
(b) Explain the extent to which the shape of the yield curve depends on expectations about the
future. (10 Marks)
(c) Explain the likely implications for a typical company of lower interest rates. (5 Marks)
(20 Marks)
Question Five
There are five basic kinds of swaps: interest rate swaps, currency swaps, equity swaps, commodity
swaps, and credit swaps. Swaps can also be classified as plain vanilla or flavored.
a) Explain the differences between a plain vanilla interest rate swap and a plain vanilla currency
swap. (5 Marks)
b) What features of swaps can be customized? (5 Marks)
c) What is mismatch risk? Why is mismatch risk an important concern of swap dealers?
(10 Marks)
(20 Marks)
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