Examination Paper 2.1:

Transcription

1 CHARTERED INSTITUTE OF STOCKBROKERS March 2015 Professional Examination Level 2 Examination Paper 2.1: Financial Accounting and Financial Statement Analysis Economics and Financial Markets Quantitative Analysis and Statistics Level 2 Page 1 of 11

2 Question 2 - Financial Accounting and Financial Statement Analysis The Conceptual Framework for Financial Reporting identifies faithful representation as a fundamental qualitative characteristic of useful financial information. Distinguish between fundamental and enhancing qualitative characteristics and explain why faithful representation is important. Section B - Financial Accounting and Financial Statement Analysis Solution to Question 2 (Section B): The Conceptual Framework for Financial Reporting implies that the two fundamental qualitative characteristics (relevance and faithful representation) are vital as, without them, financial statements would not be useful, in fact they may be misleading. As the name suggests, the four enhancing qualitative characteristics (comparability, verifiability, timeliness and understandability) improve the usefulness of the financial information. Thus financial information which is not relevant or does not give a faithful representation is not useful (and worse, it may possibly be misleading); however, financial information which does not possess the enhancing characteristics can still be useful, but not as useful as if it did possess them. In order for financial statements to be useful to users (such as investors or loan providers), they must present financial information faithfully, i.e. financial information must faithfully represent the economic phenomena which it purports to represent (e.g. in some cases it may be necessary to treat a sale and repurchase agreement as an in-substance (secured) loan rather than as a sale and subsequent repurchase). Faithfully represented information should be complete, neutral and free from error. Substance is not identified as a separate characteristic because the IASB says it is implied in faithful representation such that faithful representation is only possible if transactions and economic phenomena are accounted for according to their substance and economic reality. Page 2 of 11

3 Question 5 - Financial Accounting and Financial Statement Analysis 5(a) You have been hired as an analyst for Main Bank and your team is working on an independent assessment of DDF Plc, a firm that specializes in the production of freshly imported farm products from France. Your assistant has provided you with the following data for DDF Plc and their industry. Ratio Industry Average Long-term debt Inventory Turnover Depreciation/Total Assets Days sales in receivables Debt to Equity Profit Margin Total Asset Turnover Quick Ratio Current Ratio Times Interest Earned Equity Multiplier (a1) In the annual report to the shareholders, the CEO of DDF Plc wrote, 2014 was a good year for the firm with respect to our ability to meet our short-term obligations. We had higher liquidity largely due to an increase in highly liquid current assets (cash, account receivables and short-term marketable securities). Is the CEO correct? Explain and use only relevant information in your analysis. 5(a2) What can you say about the firm's asset management? Be as complete as possible given the above information, but do not use any irrelevant information. 5(a3) You are asked to provide the shareholders with an assessment of the firm's gearing/leverage. Be as complete as possible given the above information, but do not use any irrelevant information. 5(b) On 1 January 2014, company A had an authorized share capital of 4 million shares and an issued share capital of 2 million shares. The nominal value of each share is 25k. During 2014, the company undertook the transactions below: January 8 March 30 A successful rights issue of 1 new share for 5 at N2.12 per share. A bonus issue of 1 share for every 2 held. How many authorized and issued shares will the company have at the end of its 2014 financial year? Ignoring transaction costs, how much money has company A raised? Page 3 of 11

4 5(c) A director of a manufacturing company was heard to say, Non-current asset turnover attracts too much analyst attention margin improvement has to be our key objective. Briefly state why improving non-current asset turnover may be important for such a company. Section C - Financial Accounting and Financial Statement Analysis Solution to Question 5 (Section C): 5 a1 Note: The answer should be focused on using the current and quick ratios. While the current ratio has steadily increased, it is to be noted that the liquidity has not resulted from the most liquid assets as the CEO proposes. Instead, from the quick ratio one could note that the increase in liquidity is caused by an increase in inventories. For a fresh food firm one could argue that inventories are relatively liquid when compared to other industries. Also, given the information, the industry-benchmark can be used to derive that the firm's quick ratio is very similar to the industry level and that the current ratio is indeed slightly higher - again, this seems to come from inventories. 5 a2 Note: Inventory turnover, days sales in receivables, and the total asset turnover ratio are to be mentioned here. a) Inventory turnover has increased over time and is now above the industry average. This is good - especially given the fresh food nature of the firm's industry. In 1999 it means for example that every 365/62.65 = 5.9 days the firm is able to sell its inventories as opposed to the industry average of 6.9 days. Days' sale in receivables has gone down over time, but is still better than the industry average. So, while they are able to turn inventories around quickly, they seem to have more trouble collecting on these sales, although they are doing better than the industry. Finally, total asset turnover went down over time, but it is still higher than the industry average. It does tell us something about a potential problem in the firm's long term investments, but again, they are still doing better than the industry. 5 a3 b) Solvency and leverage is captured by an analysis of the capital structure of the firm and the firm's ability to pay interest. Capital structure: Both the equity multiplier and the debt-to-equity ratio tell us that the firm has become less levered. To get a better idea about the proportion of debt in the firm, we can turn the D/E ratio into the D/V ratio: 1999: 43%, 1998: 46%, 1997:47%, and the industry-average is 47%. So based on this, we would like to know why this is happening and whether this is good or bad. From the numbers it is hard to give a qualitative judgement beyond observing the drop in leverage. In terms of the firm's ability to pay interest, 2014 looks pretty bad. However, remember that times interest earned uses EBIT as a proxy for the ability to pay for interest, while we know that we should probably consider cash flow instead of earnings. Based on a relatively large amount of depreciation in 2014 (see info), it seems that the firm is doing just fine. Page 4 of 11

5 5 b The issued share capital is the key number here. Jan 2nd 400,000 new shares (2.4 million total) and raising N848,000. March 3rd 1,12,0000,00 new shares (2.5 million total). No money raised. So 2.5 million shares and N2.4,000 raised. Authorised capital stays the same. 5 c Manufacturing assets are expensive and mean a great deal of capital is tied up and a return needs to be made on this investment. The return can only be achieved in two ways - charging a mark-up on cost or by getting more sales out of the assets. Asset turnover measures the latter of the two. Page 5 of 11

6 Question 3 - Economics and Financial Markets State why the long-run average total cost curve is expected to be U-shaped. Section B - Economics and Financial Markets Solution to Question 3 (Section B): The long-run average total cost curve is U-shaped showing that it falls at first and then rises Cost per unit LATC Output per period The falling average total cost curve at first is as a result of the possibility of economies of scale accruable to a growing firm while the rising portion reflects the diseconomies of scale that could result later. Page 6 of 11

7 Section C - Economics and Financial Markets 6(a) Discuss how money supply could be affected by the following: 6(a1) Increased cash reserve requirements. 6(a2) Sale of government issued bonds. 6(b) Analysts have always monitored changes in money supply with regard to its effects on inflation and the exchange rate. What do you forsee as the possible effects of money supply on these variables? Solution to Question 6 (Section C): Money Supply 6(a1): The cash reserve requirement is the minimum amount of money that banks must hold in reserve, usually given as a percentage of customer deposits. The requirement is set by each country s Central Bank. Raising or lowering the reserve requirement will subsequently influence the money supply in the economy. In a situation of increased cash reserve requirements banks will have less money to loan out and this effectively reduces the amount of monetary base, therefore lowering the money supply. 6(a2): 6(b): The sale of government issued bonds is an aspect of open market operations aimed at raising fund for government in the open market. The buyers of these bonds will draw cheques on their account to pay for them and the Bank s excess reserves will be reduced. This means the Bank s ability to increase credit is reduced and, with this credit reduction, money supply is also reduced. The money supply exercises significant influence on price level and price stability in the economy. As predicted by the quantity theory of money, the general price level varies directly and proportionately with money supply. An excessive money supply could bring about inflationary situation, especially when it is not accompanied by increased economic activities or in a situation of near full employment. This implies that to check inflation, a cut back in money supply becomes necessary. As for exchange rate, increases in money supply could lead to a higher demand for exchange and hence a depreciation of the exchange rate. Higher liquidity tends to bring about an increase in the ability of banks to purchase foreign exchange as well as provide loans to the public to buy foreign exchange thereby depreciating the exchange rate in terms of local currency. It therefore follows that decreases in money supply could limit ability of banks to purchase foreign exchange and hence an appreciation of exchange rate Page 7 of 11

8 Section B - Quantitative Analysis and Statistics Explain the following concepts as they relate to Linear Programming: 4(a1) Shadow Price. 4(a2) Feasible region. (4b) Outline two practical limitations of a linear programming model. Solution to Question 4 (Section B): 4(a1): A shadow price is the incremental change in the objective function for a one-unit change in the value of a constraint. It is also referred to as the benefit or the marginal revenue of an additional resource. 4(a2): The feasible region is the area that yields all possible production combinations given the constraints. It is a set of all possible points that satisfy the model s constraints. 4(b): Limitations of Linear Programming model (i) The objective function and constraints may not be directly specified by linear inequality equations. (ii) The values or the coefficients of the objective function as well as the constraint equations must be completely known and assumed to be constant over a period of time. However, in real life practical situations often it is not possible to determine the coefficients of objective function and the constraints equations with absolute certainty. (iii) Once a problem has been properly quantified in terms of objective function and the constraint equations and the tools of Linear Programming are applied to it, it becomes very difficult to incorporate any changes in the system arising on account of any change in the decision parameter. Hence, it lacks the desired operational flexibility. (iv) No Scope for Fractional Value Solutions. There is absolutely no certainty that the solution to a LP problem can always be quantified as an integer. Page 8 of 11

9 Section C - Quantitative Analysis and Statistics Question 7 - Quantitative Analysis and Statistics The historical daily exchange rates for of an emerging market economy are given in the table below: Exchange Rate 14-March March March March March March March March March March March March March March March Kenneth, a trainee analyst believes that a 10-day moving average can be used to forecast exchange rate using the historical data above Victor, a senior analyst thinks reliable estimates of exchange rate can best be obtained using an autoregressive time series model of other one (1). His model yields: Y t =1.06 t Abubakar supervises both analysts. He decides to fit a linear trend model as he believes this would yield the best forecasts for exchange rate in the coming days. His model is given as Y t =0.72t Page 9 of 11

10 7(a) Prepare a table of moving average exchange rates consistent with Kenneth s method. 7(b) Prepare a table showing the values of the dependent and independent variables that Victor must have used to estimate his model. 7(c) Using Victor s model, what is the forecast exchange rate for 29 th March 2013? 7(d) Using Abubakar s model, what is the forecast exchange rate for 30 th March 2013? (assume that origin is =14-March-2013). Solution to Question 7 (Section C): 7(a) Using a 10-day moving average: At every point in time, the 10-day moving average is the simple average of exchange rates in the preceding 10 days. Date Exchange Rate Moving average 14-March March March March March March March March March March March March March March March (b) Since the time series model is autoregressive (order 1), the dependent variable is a one-day lagged value of the exchange rate. Date Dependent (t) Independent (t-1) 14-March March March March March March March March March Page 10 of 11

11 23-March March March March March March (c) 7(d) Victor s model Y t =1.06 t t = 29th March 2013 t- 1 = 28th March 2013 Y t = 1.06(130.0)-6.58 = =131.2 Abubakar s model Y t =0.72t For 30-March-2013, t=15 Y t =0.72 (15) Y t = Page 11 of 11

12 CHARTERED INSTITUTE OF STOCKBROKERS March 2015 Professional Examination Level 2 Examination Paper 2.2: Corporate Finance Equity Valuation and Analysis Fixed Income Valuation and Analysis Level 2 Page 1 of 12

13 Section B - Corporate Finance Question 2 Corporate Finance Give justifications why some firms decide to grow through mergers and acquisitions rather than organically. Solution to Question 2 (Section B): 1) Synergy: The most used word in M&A is synergy, which is the idea that by combining business activities, performance will increase and costs will decrease. 2) Diversification: A company could merge to diversify its operations thereby reducing risk 3) Quick growth: Mergers can give the acquiring company an opportunity to grow faster that organic growth. 4) Increase Supply-Chain Pricing Power: By buying out one of its suppliers or one of the distributors, a business can eliminate a level of costs. If a company buys out one of its suppliers, it is able to save on the margins that the supplier was previously adding to its costs; this is known as a vertical merger if a company buys out a distributor, it may be able to ship its products at a lower cost. 5) Eliminate Competition: Many M&A deals allow the acquirer to eliminate future competition and gain a larger market share in its product's market. Section C Corporate Finance Question 5 Corporate Finance ContinentalCom Limited operates in the telecommunications industry and is planning to make a new capital investment of 300 billion Naira at the end of 2014 for the purpose of strengthening its wireless communications network. However, ContinentalCom has no cash or deposits that it has retained for new investments and must therefore raise new funding. ContinentalCom has a targeted liability ratio = (Liability/(Liability + Equity)) on a market value basis of (a) The current long-term government bond yield is 5%; economists estimate the market risk premium at 5%; and ContinentalCom's beta is estimated at 1.2. ContinentalCom's default risk is close to zero and its effective corporate income tax rate is 40%. What is the ContinentalCom's weighted average cost of capital (WACC) using CAPM? 5(b) ContinentalCom's free cash flow forecast (if new equity issued) (billion Naira) Sales 1,500 1,575 1,650 1,740 1,820 1,910 EBIT Interest payable NOPAT Depreciation Increase in working capital Capital expenditure FCF The table above contains the results of an estimation of ContinentalCom's free cash flow for the next 5 years if it makes the investment in the wireless communications network. Page 2 of 12

14 It was prepared by Mr. A, the company's financial officer. The calculations assume that funds for the capital investment are raised with an issue of new shares. Both the liabilities and shareholders' equity presented are after the new share issue. Assuming that after 2019 ContinentalCom's free cash flow will have a long-term growth rate of 3% and ContinentalCom's WACC is 8%, what is the value of the company as at the end of 2014? 5(c) Consider the case where ContinentalCom does not issue the new shares but, instead, relies on bank borrowings for the capital investment. What are ContinentalCom's unlevered beta and its cost of equity if it were to raise all of the capital with equity (take the additional information from question 5(a) above as necessary)? What is also the ContinentalCom s levered beta assuming a new targeted liability ratio as defined above of 0.45? Solution to Question 5 (Section C): 5a (Section C) Cost of equity of ContinetalCom Limited k X % ContinetalCom Limited default risk is close to zero, so it can be assumed that the cost of debt is the same as the long-term government bond yield, 5%. Company X's liability ratio is targeted at 35%. Therefore WACC X (1 0.4) % 5b (Section C) Capital structure is constant, so value of ContinetalCom Limited can be derived as the aggregate of the present value of FCF between 2015 and 2019 and the present value of the terminal value. ( ) TV 3,582 ( ) V , c (Section C) Unlevered beta is U D (1 (1 ) ) E 1 (1 0.6 (0.35/0.65)) L 3, From these results, unlevered cost of equity is = 9.535%. Then, levered beta is New D L ( 1 (1 ) ) U (1 0.6 (0.45/ 0.55)) E Page 3 of 12

15 Section B Equity Valuation and Analysis Question 3 Equity Valuation and Analysis What is Market Value Added (MVA)? Briefly explain its application in equity valuation. Solution to Question 3 (Section B): - Market Value Added (MVA) is the difference between the equity market valuation of a listed company and the sum of the adjusted book value of debt and equity invested in the company. - MVA represents the wealth generated by a company for its shareholders since inception. It equals the amount by which the market value of the company s stock exceeds the total capital invested in a company (including capital retained in the form of undistributed earnings) - In other words, it is the sum of all capital claims held against the company; the market value of debt and the market value of equity - When debt is the same (market or book value) on both sides of the difference, the MVA is just the difference between the market capitalization and the book value of equity. - MVA = Company s Market Value Invested Capital (Market Capitalisation Total Common Shareholders Equity) = Total Shares Outstanding x Current Market Price - Total Common Equity Market Value Added for all Investors = Market Value of the Company - (Book Value of Equity + Book Value of Debt) Market Value Added is an important measure to analyse how much value a company has added to the wealth of its shareholders. Analyst used MVA to determine if value has been added by management of the company relative to the amount invested into the company by the stakeholders. It can be used to compare MVA of a company, year on year and appraise the management. The higher the MVA, the better. A high MVA indicates the company has created substantial wealth for the shareholder. Page 4 of 12

16 Section C Equity Valuation and Analysis Question 6 Equity Valuation and Analysis Tunji Johnson a securities analyst prefers to use the price-to-earnings multiple (P/E multiple, P/E ratio) to value and compare stocks. He believes that the P/E ratio method makes the equity valuation a relatively easy and straight forward task. 6(a) Discuss two factors that make the P/E ratio an attractive and widely used method for valuing stocks. 6(b) Discuss three potential problems associated with using P/E ratios for comparing stocks and making investment decisions. (3 marks) 6(c) Tunji has collected the following information about Zenzen Auto, an automotive parts retailer which is rapidly expanding in Nigeria. Zenzen Auto Historical and expected return on equity (ROE) 12% Historical and expected dividend payout ratio 40% Beta 1.25 Expected return on NSE All share Index 8.5% Expected risk-free return 2.5% 6(c1) What is the required rate of return for Zenzen Auto based on CAPM? 6(c2) What is the Zenzen Auto s P 0 /E 0 and P 0 /E 1 ratios using the data provided? Let: P 0 : Price at the end of year 0 E 0 : Earnings during year 0 E 1 : Earnings during year 1 6(c3) Zenzen Auto is currently trading at 22 times its forecasted earnings. What is the long-term growth rate implied in Zenzen Auto s P 0 /E 1 ratio? Solution to Question 6 (Section C): 6a (Section C) A number of factors make the P/E ratio method a widely used method for stock valuation by analysts. 1. The P/E ratio is intuitively understandable and easy to explain as the relative cost of a stock. It represents the price of a share per dollar of expected earnings (P 0 /E 1 ) or per dollar of the current (or most recent) period s earnings (P 0 /E 0 ). The P/E ratio method of equity valuation is similar to valuation of a residential property based on its covered area or the number of bedrooms. 2. The P/E ratio method of valuing or comparing stocks eliminates the need for computing financial ratios and making assumptions about risk, payout ratios, and growth, all of which are needed for estimating the value of a stock in the discounted cash flow techniques. Page 5 of 12

17 3. The P/E ratio is easy to compute for most stocks because most firms report earnings (per share) in their income statements. Readily available market price data makes comparisons across firms easy. 4. The P/E ratios provide quick basis for determining whether a stock is cheap or expensive. Stocks with low P/Es are cheaper than stocks with high P/Es. If the stocks are in the same industry, have the same annual earnings, but have different P/Es, the stock with the lower P/E is cheaper. 5. The P/E ratio has different variants, the trailing and forward PE s. 6. The P/E ratio is used as proxy for a number of stock/firm characteristics such as relative risk, investor required rate of return, and expected growth in earnings. 6b There are a number of potential problems of using of P/E ratios for comparing the relative values of stocks that make its use perilous. 1. The P/E ratio calculation is meaningless when the earnings of a firm are negative. While using the normalized or average earnings per share in the recent past as a proxy for current earnings can reduce this problem, it cannot be eliminated. 2. The volatility of a firm s earnings can cause wild swings in the P/E ratio estimates from period to period. The P/E ratio of a cyclical firm may be unusually high during recession and low during economic expansion. 3. While a firm s earnings are generally influenced by the current economic environment, the price of the stock reflects the expected long-term performance of the firm. Often, the P/E ratio calculated using unusually high or low earnings result in meaningless P/E ratios. 4. P/E ratios vary across industries and firms. Comparing P/E ratios across firms, ignoring differences in risks, payout ratios, and growth rates can result in incorrect conclusions about the relative attractiveness of different stocks. 5. Often investors compare P/E ratios over time. P/E ratios rise as interest rates decline (because the required rate of return declines.) P/E ratios also rise as equity risk premium declines (again, because the required rate of return declines.) Comparing the P/E ratios across different periods without adjusting for differences in inflation rates, interest rates, and equity risk premiums can render the P/E ratio comparisons erroneous. 6. Earnings per share of a firm depend on the accounting principles used. Differences in accounting for inventories, depreciation, and research and development may lead to vastly difference values for earnings (and therefore, their P/E ratios) for two firms that may actually be exactly alike. 7. Remember that accountants can do some creative things with reported earnings. Whileone company may report a largely honest number, another may be manipulating earnings per share to meet market expectations. 8. The P/E ratio usually looks backwards. If one company is able to double its earnings in a few short years while another remains stagnant, the former could be a much better value despite a higher multiple. Yet you wouldn t know it from the single-snapshot picture the P/E provides. Page 6 of 12

18 9. Doesn t account for growth- The price to earnings ratio doesn t account for any type of growth or the lack of growth. The fact that growth isn t factored in mean that older more mature stocks are typically going to appear cheaper even if they aren t growing if you use the P/E ratio. For many investrs growth is a variable they do not want to exclude. 10. The PE ratio doesn t consider debt- Companies with major debt issues are obviously higher risk investments, but the P in the P/E ratio only considers the equity price and does nothing with the debt that the business has to continue with operations. As we have found out over time, excess debt can be a real problem, and the market price of a stock isn t always a good gauge of fair value. 6(c1) The required rate of return can be calculated using the capital asset pricing model (CAPM): r R f R R % m f Where: r, the required rate of return Rm, the expected return on the market (NSE All Share Index) portfolio Rf, the risk-free rate of return 6(c2) We know that: P 0 DPS1, ( r g) DPS ( 1 EPS1 Payout ratio ), and EPS (1 1 EPS 0 g) Therefore, DPS (1 1 EPS 0 g)( Payout ratio ) So, P 0 EPS (1 0 g)( Payout ( r g) ratio) Rearranging, we get: P 0 EPS 1 Payout ratio ( r g) and Page 7 of 12

19 P 0 EPS 0 Payout ratio(1 g) ( r g) All-Things Auto Retention ratio = (1 - payout ratio) = (1 0.40) = 0.60 Expected growth rate, g = Retention rate x ROE = 12 x 0.60 = 7.20% = P 0 EPS 1 Payout ratio ( r g) = 0.40( ) ( ) 0.40 ( ) =15.31 = (c3) The implied growth rate in Zenzen Auto P/E ratio can be computed as follows: P EPS 1 Payout ratio 40% Required rate (from 1.C., above) 10.0% P 0 EPS 1 Payout ratio ( r g) By rearranging, implied growth rate, g = Payout ratio r = P0 EPS = = 8.18% 22 (3 marks) Page 8 of 12

20 Section B Fixed Income Valuation and Analysis Question 4 Fixed Income Valuation and Analysis You are building a bond portfolio comprising of two zero-coupon bonds (Bond A and Bond B). The bonds have the following characteristics: BOND A BOND B MATURITY (YEARS) YIELD TO MATURITY (%) 8 12 If you invest N25 million in Bond A and N15 million in Bond B, what is the convexity of your bond portfolio?{hint: Convexity formulae = n(n + } 1) (1 + y) 2 Solution to Question 4 (Section B): Convexity of zero-coupon bond is = n(n + 1) (1 + y) 2 Bond A = Bond B = Portfolio (weighted average): Page 9 of 12

21 Section C Fixed Income Valuation and Analysis 7(a) Tanko Plc is a major player in the road construction industry with a credit rating of AA. The company plans to raise N500 million from the bond market. The bond being considered has a coupon rate of 15% with maturity of four years. The current annual spot yield curve for government bonds is as follows: One-year 13.3% Two-year 13.8% Three-year 14.5% Four-year 15.3% The following table of spreads (in basis points) is given for the construction industry: RATING 1 YEAR 2 YEARS 3 YEARS 4 YEARS AAA AA A (a1) What is the price at which the bond can be issued? 7(a2) What is the yield to maturity? (a3) 7(b) What is the duration? Among the criteria used by credit agencies for establishing a company s credit rating are the following: I. Industry risk. II. Earning protection. III. Financial flexibility. IV. Company management. Explain any two of the criteria above and suggest factors that could be used to assess each of the selected criteria. (3 marks each = 6 marks) Page 10 of 12

22 Solution to Question 7 (Section C): 7(a1) The spot yield curve should be used to calculate a likely issue price. The government bond yield curve needs to be adjusted by the credit spread for an AA rate 1 year 2years 3 years 4years Govt. bond spot yield curve (%) Add AA spread (%) Applicable spot rate (%) To price the bond, the bond related cash flows are discounted at the above spot rates; P o 7(a2) The YTM is the value of y in the following equation: = = y (1 + y) 2 (1 + y) 3 (1 + y) 4 y = 15.60% You could also use your financial calculator: n= 4, PV = , PMT = 15 FV = 100, CPT 1 / y = 15.60% 7(a3) Duration Year CF PVF PV PV n (n) at Duration = / = 3.28 years. 7(b) Page 11 of 12

23 Industry risk measures the resilience of the company s industrial sector to changes in the economy. In order to measure or assess this, the following factors could be used: - Impact of economic changes on the industry in terms how successfully the firms in the industry operate under differing economic outcomes; - How cyclical the industry is and how large the peaks and troughs are; - How the demand shifts in the industry as the economy changes. Earnings protection measures how well the company will be able to maintain or protect its earnings in changing circumstances. In order to assess this, the following factors could be used: - Differing range of sources of earnings growth; - Diversity of customer base; - Profit margins and return on capital. Financial flexibility measures how easily the company is able to raise the finance it needs to pursue its investment goals. In order to assess this, the following factors could be used: - Evaluation of plans for financing needs and range of alternatives available; - Relationships with finance providers, e.g. banks; - Operating restrictions that currently exist in the form of debt covenants. Company s management considers how well the managers are managing and planning for the future of the company. In order to assess this, the following factors could be used: - The company s planning and control policies, and its financial strategies; - Management succession planning; - The qualifications and experience of the managers; - Performance in achieving financial and non-financial targets. Page 12 of 12

24 CHARTERED INSTITUTE OF STOCKBROKERS March 2015 Professional Examination Level 2 Examination Paper 2.3: Derivatives Valuation Analysis Portfolio Management Commodity Trading and Futures Level 2 Page 1 of 9

25 Section B - Derivative Valuation and Analysis Question 2 Derivative Valuation and Analysis Your father-in-law, Daddy K, has retired with the free time necessary to follow the market closely, K has established large option position as stock investor. He tells you that his portfolio has a positive theta. Give an intuitive explanation of what this means. Daddy K plans to go on vacation for a month, leaving his option open while he is on vacation. Explain what will happen to the value of his portfolio while he is on vacation. (3 marks) Solution to Question 2 (Section B): THETA measures the exchange in the value of an option because of changes in the time until expiration for the option contract. That is, with the passage of time, the value of an option contract will change. In most cases, the option will experience a decrease in value with the passage of time. This is known as time decay. Formally, THETA is the negative of the first derivative of option pricing model with respect to changes in the time until expiration. Since your father-in-law has constructed a portfolio with a positive THETA, the passage of time should increase the value of his portfolio. Thus, he should, all things being equal, return from his vacation to find that the value of his portfolio has increased. Section C Derivative Valuation and Analysis Question 5 Derivative Valuation and Analysis 5(a) You have a client John P, who believes that the share price of KZ plc (currently N58 per share) could move substantially in either direction in reaction to an expected court decision involving the company. The client currently owns no KZ shares, but asks for your advice about implementing strangle strategy to capitalize on the possible stock price movement. You gather the KZ option pricing data shown in the table below: KZ Plc Option Pricing Data CHARACTERISTIC CALL OPTION PUT OPTION PRICE N5 N4 STRIKE PRICE N6O N55 TIME TO EXPIRATION 90 DAYS FROM NOW 90 DAYS FROM NOW Required: Recommend whether John should choose a long strangle or short strangle strategy to achieve his objective. Justify your recommendation with one reason. 5(b) Indicate, at expiration for the appropriate strategy in 5(a) above, the following: 5(b1) Maximum possible loss per share. 5(b2) Maximum possible gain per share. Page 2 of 9

26 5(b3) Breakeven stock price(s). 5(c) Support your answer in 5(b) above with an appropriate graph. 5(d) The delta of the call option in the table above is and the company does not pay any dividends. What is the approximate change in price for the call option if the company s stock price immediately increases to N59? 5(e) Define gamma and state whether gamma for the put option in the table above would decrease, stay the same, or increase if the company s stock price immediately decreases to N57. 5(f) Now assume that you have another client, Ms Fumi R. Fumi has gone short 1,500,000 units of the shares of KZ Plc. Fumi has decided to hedge her stock position using put option on KZ Plc having the same characteristics (strike price, expiration, etc) as the call options in the above table. What position in the put option will be required for delta hedging? 5(g) Briefly discuss the key practical problems with delta-neutral hedging strategies. Solution to Question 5: 5(a): John should choose the long strangle strategy. A long strangle strategy consists of buying a put and a call with the same expiration date and the same underlying asset. In a strangle strategy, the call has an exercise price above the stock price and the put has an exercise price below the stock price. An investor who buys (goes long) a strangle expects that the price of the underlying asset (KZ in this case) will either move substantially below the exercise price on the put or above the exercise price on the call. With respect to KZ, the long strangle investor buys both the put and call options for a total cost of N9.00, and will experience large profits it the stock price moves more than N9.00 above the call exercise price or 9.00 below the put exercise price. This strategy would enable John s client to profit from a large move in the stock price, either up or down, in reaction to the expected court decision. 5(b1): The maximum possible loss per share is 9.00, which is the total cost of the two options = (b2): The maximum possible gain is unlimited, if the stock price moves outside the breakeven range of prices. 5(b3): The breakeven prices are and The put will just cover costs if the stock price finishes 9.00 below the put exercise price ( = 46.00), and the call will just cover costs if the stock price finishes 9.00 above the call exercise price ( = 69.00). Page 3 of 9

27 5(c): The following diagram provides support for the answers above (d): The delta for a call option is always positive, so the value of the call option will increase if the stock price increases. Specifically, if the stock price increases by 1.00, the price of the call will increase by approximately 0.63: Price call = x 1.00) = increase 5(e): Gamma is the second derivative of the option price with respect to the stock price and measures how delta changes in the underlying stock price. The gamma for the put option would increase if the stock price decreases to Gamma is respectively small when an option is out-of-the-money but becomes larger as the option approaches near-the-money, which is the case as the underlying asset value moves down towards the put option s 55 exercise price. 5(f): Delta of call = Delta of put = = Current delta of short stock position = -1,500,000 Let represent the number of puts required. Total delta of puts = Total delta of stock and put = -1,500, For delta neutrality: -1,500, ,000,000 puts Page 4 of 9

28 Ms Funmi will therefore need to sell 4,000,000 puts. 5(g): Practical problems with delta-neutral hedging strategy include: i. The delta of an option changes even when the stock price does not change. For example, as time to expiration changes, delta of an option changes. Therefore, the delta hedge has to be adjusted periodically thereby incurring regular transaction costs. ii. Although delta-neutral positions are hedge against changes in the price of the underlying asset, they still are subject to volatility risk, the incurred from unpredictable changes in volatility. iii. Delta hedging is only effective for a very small change in the price of the underlying asset. For a large change in price a delta-gamma-hedge will be required. Section B Portfolio Management Question 3 Portfolio Management Given below is the graph of the Capital Allocation Line (CAL) which is made up of four segments: E(B) CAL B 1 B A δ 1 δ Capital Allocation Line Required: Name and briefly describe the four segments. 3 (Section B): The CAL has four segments. The four segments are: i. A is the point where the investor only hold the risk-free asst (X 1 =0), hence the standard deviation is zero. ii. The segment from A to B is the locus of all portfolios, which are at the same time long in risky and the risk-free asset ( x 1 ). iii. In B all the portfolio is invested in the risky asset (x 1 =1). iv. Beyond B, the share of the risky asset is of over 100% of wealth of the portfolio(that is, x 1 x 2 assets. 0). This means that the investor borrows at the risk-free arte in order to buy risky Page 5 of 9

29 Section C Portfolio Management Question 6 Portfolio Management 6(a) List and explain the major risks involved in investing in the equities of foreign countries. 6(b) A well-known Nigerian investor is comparing an investment in a Nigerian equity mutual fund with a Ghanaian equity fund. Suppose that Ghanaian cedi is currently at an historical low against the naira (0.020 cedi per naira). Assume also, that interest rates in Ghana are flat at 10% p.a. while the interest rates are flat at 8% in Nigeria (both rates are discrete returns). 6(b1) You forecast that the fall of the cedi is over and that a rebound is likely in the near future. Should you hedge the currency exposure of the cedi? 6(b2) You decide to buy 5,000 shares of BB Plc in Ghana at 10 cedi per share. What 6(b3) Assume that the price of the share increases by 8% and the cedi appreciates by 10% against the naira, what is your percentage gain or loss on this position? 6(b4) The volatility of the BB stock in cedi is 15% p.a. The exchange rate volatility is 12% p.a. The correlation between the BB return in cedi and the exchange rate between the cedi and naira is Assuming that the investor does not hedge his investment in naira, what would be the approximate volatility of the stock in naira? Why is this result only an approximation? 6(c) A fund manager starts to manage a fund and loses 35% of his assets in the first year. The investors retain their faith in the manager and inject liquidity to bring back the portfolio to its initial value to attempt to reduce the losses. The same scenario is repeated in the second year, albeit with 20% losses, i.e., the investors inject liquidity to bring back the portfolio to its initial investment. At the end of the third year, the faith of the investors in the fund manager is not undermined as he is able to generate an IRR of 6.09% on their investment p.a. What is the return generated by the fund in the third year? Solution to Question 6 (Section C): 6(a): The major risks include: Political risk. Political actions, changes in governments, events or instability, changes of tax law, currency or market regulations, all these can affect the value or liquidity of an investment. Liquidity risk. Liquidity is the case with which one can sell an investment without any loss of value. In smaller foreign stock exchange, liquidity risk increases for thinly traded shares. Information risk. The information released by foreign companies to their shareholders may also be more difficult to access by non-local investors, and may not always be available in English. Thus, investors may find it difficult to obtain timely information Page 6 of 9

30 needed to locate and invest in the under-valued stocks of foreign companies offering the greatest discount to their long-term values, or to adequately monitor their investments in such companies. Trading costs. Traditional brokerage cost as well as exchange fees, custodial fees, taxes, and other charges considerably increase the cost of buying and selling foreign securities. Investing in foreign markets also involves higher portfolio management costs (greater cost of research, etc). This can have a negatively impact on returns. Currency risk. International diversification automatically brings with it currency risk and requires expertise to manage this risk. 6(b1): Hedging is not necessary a rebounding cedi is a positive event for the investor. 6(b2): Total value in cedi = 5,00 10 = 50,000 Exchange rate (cedi/naira) = 0.02 Total cost in naira = 50,000/0.02 = N2, 500,000 6(b3): Revised stock value in cedi = 50, = 54,000 Current Value of 1 cedi =1/0.02 = N50 Revised value of 1 cedi = N = N55 Current value of investment in naira = 54,000 = N2, 970, 000 N55 Percentage gain Note: A faster approach is simply: ( ) 1 = 18.80% (3 marks) 6(b4): The variance is: 6(c): Standard Deviation This is only an approximation because we are not using continuously compound return. (3 marks) Assume the initial investment = 100 CF 0 = CF 1 + CF 2 + CF 3 = 0 1+IRR (1+IRR) 2 (1+IRR) = CF 3 (1.0609) 1 ( ) 2 (1.0609) CF 3 = 0 (1.0609) 3 CF 3 = (1.0609) 3 X = The return in third year is Note: Any assumed initial investment should generate the above result. (4 marks) Page 7 of 9

31 Section B Commodity Trading and Futures Question 4 Commodity Trading and Futures Consider the classic hedging problems of the farmer who sells wheat in the futures market in anticipation of a harvest. Would the farmer be likely to deliver his harvested wheat against the futures? Explain. If he is unlikely to deliver, explain how he manages his futures position instead. Solution to Question 4 (Section B): Most farmers who hedge would not deliver against the futures. Often the wheat would not be deliverable due to difference in grade or type of wheat. Also, wheat is probably distant from an approved delivery point, and trying to deliver the wheat would involve prohibitively high transportation cost. Instead of actually delivering, the farmer would be much more likely to sell to the harvested wheat to the local grain elevator and offset the futures position. Section C Commodity Trading and Futures Question 7 Commodity Trading and Futures 7(a) In the context of commodity futures, list and explain the three key participants in the market (Note: your answers should be specific to commodity futures market). 7(b) The beta of gold relative to the market portfolio is 0.3. The risk-free rate is 7 percent, and the market risk premium is 4 percent. 7(b1) What is the expected return on gold based on the capital asset pricing model (CAPM)? 7(b2) Give an intuitive explanation for the magnitude of the expected return on gold. Solution to Question 7 (Section C): 7(a): i. Hedgers Commodity prices can be volatile and are difficult to forecast, which is a problem for any firm that produces or uses commodities. Such companies may wish to take on an opposite position in the futures markets in order to protect the firm from the impact of commodity price changes. An entity that has an exposure to commodity prices and takes on an offsetting position in the futures market to lower risk is called a hedger. Commodity producers have a natural long position in the commodity that they produce. A wheat farmer may wish to lock in the selling price of wheat using a short hedge (known as forward selling ). This allows a farmer to fix the selling price (and profit) at the beginning of the growing season. Commodity consumers (e.g., manufacturers) have a natural short position in the commodities that they use. Such users of commodity may wish to fix the purchase price of their inputs with a long hedge. An airline faces this situation: fuel costs are a major Page 8 of 9

32 component of operating costs, so an airline may want to take a long futures position in crude oil to offset potential rising fuel prices. ii. iii. Speculators When commodity hedgers use futures to lower risk, it is generally the speculators that accept the risk by taking the opposite. Because they do not have an offsetting physical commodity position, speculators are exposed to significant risk of loss (or gain). In exchange for providing liquidity to hedgers and for taking on this risk, speculators will on average demand a premium. Arbitrageurs Commodity arbitrageurs try to create riskless profits from price difference over time, between locations, or from difference between futures and spot prices. Riskless profits are possible when price difference exceed the frictions such as shipping costs, insurance premiums, and interest rates. The actions of arbitrageurs act to keep the relationship between spot and futures prices in line. One example of a potential arbitrage trade is cash and carry arbitrage, which is possible when the future price for a commodity is too high relative to the spot price. An arbitrageur will buy the physical commodity at the spot price, store it, and simultaneously enter into a futures contract to sell the same commodity at a higher price in the future price and the spot price (after subtracting storage, financing, and other costs). 7(b1): The expected return on gold, as theoretically derived by the CAPM, is: E(R gold ) = 7% + β gold + 4% = 7% (4%) = 5.8% 7(b2): Given its negative beta, gold is likely to perform well when the overall market performs poorly. Thus, our investment in gold is likely to offset some of the loss on the rest of the portfolio. Investors should be willing to accept an overall lower expected return on gold because, in periods of financial distress, gold tends to do well. Page 9 of 9

33 CHARTERED INSTITUTE OF STOCKBROKERS March 2015 Professional Examination Level 2 EXAMINATION PAPER 2.4: Ethics and Professional Standards Law relating to Securities and Investments Regulations of Securities and Corporate Finance

34 Question 2 Ethics and Professional Standards Somebody once said that in looking for people to hire, you look for certain qualities: integrity,... And if you don t have integrity, the other qualities will kill you. You think about it; it s true. If you hire somebody without [integrity], you really want them to be dumb and lazy. Warren Buffet. 2(a) What is integrity in the context of the securities and investment business? 2(b) Apart from integrity, enumerate four other personal qualities that a CIS member should exhibit in dealing with clients, prospective clients, employers, employees, peers, colleagues in the securities and investment profession as enshrined in the CIS Code and Standards. Solution to Question 2(a): Integrity stems from the Latin adjective integer (whole, complete). In this context, integrity is the inner sense of wholeness deriving from qualities such as honesty and consistency of character. In ethics, integrity is regarded as the honesty and truthfulness or accuracy of one s actions. Solution to Question 2(b): I. High standards of honesty. II. Fairness. Question 3 Law Relating to Securities and Investments Explain the term agency by necessity and give a relevant example. Solution to Question 3: The term agency by necessity is a type of agency which is created in a situation where a person acts on behalf of another person in an emergency situation without the opportunity to obtain instructions from that other person. Action taken must be for the benefit of the principal. Question 4 Regulations of Securities and Corporate Finance Securities & Exchange Commission Rule 20 defines the basic qualifications of a sponsored individual. What are they? Solution to Question 4: Sponsored individuals and Compliance Officers are required to have any of the following qualifications and job experience: (a) A first or higher degree or its equivalent in a relevant field including banking, finance, accounting, business management, law, economic and company secretarial studies with a minimum of 4 year relevant post-qualification experience (excluding the National Youth Service Corps year); or