Topic: Financial Risk Management

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  • 7 Marks

FM – May 2016 – L3 – Q6a – Financial Risk Management

Calculating the number of call options needed to delta-hedge the position of a bank's investment in shares.

You work in the corporate finance department of a major bank. The bank has invested in 20,000,000 shares of Ode Oil Plc. You are concerned about the recent volatility in Ode Oil Plc’s share price due to the recent instability in the global oil market. You plan to protect the bank’s investment from a possible fall in Ode Oil Plc’s share price for the next three months and do not plan to sell the shares at present.

You have the following additional information:

  • Ode Oil Plc’s current share price: N10
  • Call option’s current share price: N11
  • Option expiry: 3 months
  • Interest rate (annual): 8%
  • Ode Oil Plc’s share annual standard deviation: 64%

You are required to calculate:
How many call options you need to buy or sell in order to delta-hedge the bank’s position. Please be specific.

Note: Delta may be estimated using N(d1).

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  • 15 Marks

FM – May 2017 – L3 – Q6 – Financial Risk Management

Analyze the use of an interest rate swap between two companies for mutual benefit.

Large Plc. (LP) wishes to borrow N200 million for five years to finance the purchase of new non-current assets. The preference of the company’s Directors is that these funds are borrowed at a fixed rate of interest. The company’s long-term debt is currently rated BBB, meaning LP would have to pay 6.5% p.a. for fixed rate borrowing. Alternatively, LP could borrow at a floating rate, i.e. the prime lending rate (PLR) + 2.25% at the present time.

The Directors of LP have recently been informed by its bank that TK Plc. is also currently looking to borrow N200 million for five years at a floating rate of interest, and its AA rating gives it access to floating rate borrowing at PLR + 1.50% per annum. TK Plc. would pay 5.50% per annum for fixed rate borrowing at the present time.

Required:

a. State FIVE reasons that a company might have for entering into an interest rate swap. (5 Marks)

b. Show how an interest rate swap could be used to the equal benefit of both companies, assuming that the terms of the swap agreement are such that LP’s swap payment to TK Plc. is to be 5.5% fixed per annum. (7 Marks)

c. Identify, with a supporting brief explanation, which of the two companies would be disadvantaged if the PLR were to fall consistently within the five-year term of the interest rate swap. (1 Mark)

d. Identify TWO risks that both companies will face, should they decide to enter into the interest rate swap agreement. (2 Marks)

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  • 5 Marks

FM – Nov 2014 – L3 – SC – Q5b – Financial Risk Management

Examine financial objectives, strategic changes, and risks during privatization of a state-owned enterprise.

What are the associated risks that the company may be exposed to as a result of privatization? (5 Marks)

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  • 3 Marks

FM – May 2022 – L3 – Q6b – Financial Risk Management

Calculate the number of put options needed to delta-hedge a short position.

In your personal investment portfolio, you have gone short (i.e., you have sold) 110,000 units of Big Bank plc. Call and put options exist on the bank’s shares. You decide to hedge your position using put options on the bank’s shares. For the relevant option, you know that:
N(d1) = 0.45

You are required to calculate how many put options you will need to buy or sell to delta-hedge. Be specific.

 

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  • 15 Marks

FM – May 2018 – L3 – SC – Q5 – Financial Risk Management

Use of forward rate agreements and interest rate management tools for borrowing concerns in Katangwa Limited.

Katangwa Limited will need to borrow ₦50 million in three months’ time for a period of six months. The company is concerned that interest rates are expected to rise over the next few months.

Interest rates and forward rate agreements (FRAs) are currently quoted as follows:

  • Spot 5.75 – 5.50
  • 3 – 6 FRA 5.82 – 5.59
  • 3 – 9 FRA 5.94 – 5.64

Required:

a. Explain how a forward rate agreement (FRA) may be useful to the company. Illustrate this on the basis that interest rates: i. Rise to 6.50% ii. Fall to 4.50%

(8 Marks)

b. Compare the use of interest rate futures with FRA in this instance. (4 Marks)

c. Explain how interest rate guarantees or a short-term interest rate cap could be used. (3 Marks)

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  • 20 Marks

FM – Nov 2023 – L3 – SB – Q4 – Financial Risk Management

Assess whether debt or equity financing is more suitable for a business expansion and discuss related financial concepts.

Xeco is considering a N15 million expansion to increase profit before interest and tax by 20%. Financial details for Xeco are as follows:

Item Amount (N’000)
Profit before interest 13,040
Finance charges (interest) (240)
Profit before tax 12,800
Taxation (3,840)
Profit for the year 8,960

Financing Options:

  1. Debt: Issue N15m in 8% loan notes, with each note at a nominal value of N100.
  2. Equity: 1-for-4 rights issue at a 20% discount to current share price (N6.25/share). Xeco has 12 million shares outstanding.
  3. Corporate tax rate: 30%.

Required:

  • a. Evaluate whether Xeco should finance the expansion with debt or equity. (10 Marks)
  • b. Explain the relationship between systematic and unsystematic risk. (5 Marks)
  • c. Discuss the assumptions made by the Capital Asset Pricing Model (CAPM). (5 Marks)

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  • 7 Marks

FM – May 2016 – L3 – Q6a – Financial Risk Management

Calculating the number of call options needed to delta-hedge the position of a bank's investment in shares.

You work in the corporate finance department of a major bank. The bank has invested in 20,000,000 shares of Ode Oil Plc. You are concerned about the recent volatility in Ode Oil Plc’s share price due to the recent instability in the global oil market. You plan to protect the bank’s investment from a possible fall in Ode Oil Plc’s share price for the next three months and do not plan to sell the shares at present.

You have the following additional information:

  • Ode Oil Plc’s current share price: N10
  • Call option’s current share price: N11
  • Option expiry: 3 months
  • Interest rate (annual): 8%
  • Ode Oil Plc’s share annual standard deviation: 64%

You are required to calculate:
How many call options you need to buy or sell in order to delta-hedge the bank’s position. Please be specific.

Note: Delta may be estimated using N(d1).

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  • 15 Marks

FM – May 2017 – L3 – Q6 – Financial Risk Management

Analyze the use of an interest rate swap between two companies for mutual benefit.

Large Plc. (LP) wishes to borrow N200 million for five years to finance the purchase of new non-current assets. The preference of the company’s Directors is that these funds are borrowed at a fixed rate of interest. The company’s long-term debt is currently rated BBB, meaning LP would have to pay 6.5% p.a. for fixed rate borrowing. Alternatively, LP could borrow at a floating rate, i.e. the prime lending rate (PLR) + 2.25% at the present time.

The Directors of LP have recently been informed by its bank that TK Plc. is also currently looking to borrow N200 million for five years at a floating rate of interest, and its AA rating gives it access to floating rate borrowing at PLR + 1.50% per annum. TK Plc. would pay 5.50% per annum for fixed rate borrowing at the present time.

Required:

a. State FIVE reasons that a company might have for entering into an interest rate swap. (5 Marks)

b. Show how an interest rate swap could be used to the equal benefit of both companies, assuming that the terms of the swap agreement are such that LP’s swap payment to TK Plc. is to be 5.5% fixed per annum. (7 Marks)

c. Identify, with a supporting brief explanation, which of the two companies would be disadvantaged if the PLR were to fall consistently within the five-year term of the interest rate swap. (1 Mark)

d. Identify TWO risks that both companies will face, should they decide to enter into the interest rate swap agreement. (2 Marks)

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  • 5 Marks

FM – Nov 2014 – L3 – SC – Q5b – Financial Risk Management

Examine financial objectives, strategic changes, and risks during privatization of a state-owned enterprise.

What are the associated risks that the company may be exposed to as a result of privatization? (5 Marks)

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  • 3 Marks

FM – May 2022 – L3 – Q6b – Financial Risk Management

Calculate the number of put options needed to delta-hedge a short position.

In your personal investment portfolio, you have gone short (i.e., you have sold) 110,000 units of Big Bank plc. Call and put options exist on the bank’s shares. You decide to hedge your position using put options on the bank’s shares. For the relevant option, you know that:
N(d1) = 0.45

You are required to calculate how many put options you will need to buy or sell to delta-hedge. Be specific.

 

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  • 15 Marks

FM – May 2018 – L3 – SC – Q5 – Financial Risk Management

Use of forward rate agreements and interest rate management tools for borrowing concerns in Katangwa Limited.

Katangwa Limited will need to borrow ₦50 million in three months’ time for a period of six months. The company is concerned that interest rates are expected to rise over the next few months.

Interest rates and forward rate agreements (FRAs) are currently quoted as follows:

  • Spot 5.75 – 5.50
  • 3 – 6 FRA 5.82 – 5.59
  • 3 – 9 FRA 5.94 – 5.64

Required:

a. Explain how a forward rate agreement (FRA) may be useful to the company. Illustrate this on the basis that interest rates: i. Rise to 6.50% ii. Fall to 4.50%

(8 Marks)

b. Compare the use of interest rate futures with FRA in this instance. (4 Marks)

c. Explain how interest rate guarantees or a short-term interest rate cap could be used. (3 Marks)

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  • 20 Marks

FM – Nov 2023 – L3 – SB – Q4 – Financial Risk Management

Assess whether debt or equity financing is more suitable for a business expansion and discuss related financial concepts.

Xeco is considering a N15 million expansion to increase profit before interest and tax by 20%. Financial details for Xeco are as follows:

Item Amount (N’000)
Profit before interest 13,040
Finance charges (interest) (240)
Profit before tax 12,800
Taxation (3,840)
Profit for the year 8,960

Financing Options:

  1. Debt: Issue N15m in 8% loan notes, with each note at a nominal value of N100.
  2. Equity: 1-for-4 rights issue at a 20% discount to current share price (N6.25/share). Xeco has 12 million shares outstanding.
  3. Corporate tax rate: 30%.

Required:

  • a. Evaluate whether Xeco should finance the expansion with debt or equity. (10 Marks)
  • b. Explain the relationship between systematic and unsystematic risk. (5 Marks)
  • c. Discuss the assumptions made by the Capital Asset Pricing Model (CAPM). (5 Marks)

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