Copyright 2009 Pearson Education Canada

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1 Taking the financial incentives from the governments into account, the NPV of the plant in the Ontario location will be: $ million + $9.93 million + $67.53 million $ million As $ million > $ million, AA should choose the Ontario location. CHAPTER SEVEN Qualitative Questions 1. What types of interest rate risk may a treasury risk manager face? The risk that interest on a planned investment or loan deviates from the expected rate The risk that realized net income deviates from expected income because of changes in interest rates The risk that the value of an asset or liability changes adversely because of changes in interest rates 2. What other types of risk can a treasury risk manager face? The risk that net income deviates from expected income because of changes in the prices of key commodities The risk that net income deviates from expected income because of changes in foreign exchange rates 3. How is duration used to measure risk? The volatility of a security s value depends upon the security s duration. The longer the duration of a security, the more volatile its value will be in response to changes in interest rates. The duration of a portfolio is a weighted average of the durations of the assets and liabilities that make up the portfolio. The duration of a portfolio measures the sensitivity of the portfolio s value to changes in interest rates. 4. How is gap analysis used to measure interest-rate risk in financial institutions? Gap analysis attempts to identify gaps between assets and liabilities that expose the institution to interest-rate risk. An asset is interest rate sensitive if the asset is repriced when rates change. The gap is equal to rate-sensitive assets less rate-sensitive liabilities. If the gap is negative, net income decreases if rates rise and increases if rates drop. The magnitude of the potential decrease or increase in net income is proportional to the size of the gap. 5. How are gap analysis and duration calculations used to create basic hedges? Determining the gap between rate-sensitive assets and rate-sensitive liabilities allows management to create a basic hedge by narrowing the gap. Gap analysis will not eliminate risk because a true matching of asset rates and terms with liability rates and terms is unlikely. The duration calculation allows management to match asset duration to liability duration. Matching durations is a form of hedging known as portfolio immunization. 6. What are the general approaches to risk management? The opportunistic approach relies on management to have a superior ability to forecast financial or commodity prices, which will enable the firm to benefit from the changes. The passive approach ignores risk and relies on the company riding out changes, assuming that gains or losses will balance out. 68 Solutions to Self-Test Questions

2 The defensive approach occurs when the manager takes some action in the financial markets to insure against major risks. The compromise approach is a complete hedging strategy to minimize risk followed with the exception of the occasional opportunistic position. 7. International trade may expose a firm to risks other than foreign-exchange risk. What are these other risks? Credit risk: The importer s ability to make payment may be questionable, and information is not available to evaluate risk. Political risk: Government-imposed exchange and monetary controls may prevent payment to the exporter. Commercial risk: The importer may unlawfully reject a shipment, terminate a contract, or declare a product unfit. Other risks: There may be arrival time delays as a result of government-imposed trade barriers or time lags in international transportation. 8. What financing arrangements can be used to manage risks in international trade? Draft arrangements or bills of exchange Import/export letters of credit Bankers acceptances Pledging and factoring Forfeiting Foreign trade insurance services provided by the Export Development Corporation Qualitative Multiple Choice Questions Question 1 iv) Bill of lading Question 2 ii) A financing agreement in which the risk of customer default on the accounts receivable remains with the borrower Question 3 iv) The exporter receives funds immediately to be used for other purposes. Question 4 iv) Forfeiting is similar to factoring, except that the receivables are longer term and have higher values. Question 5 i) A letter of credit effectively commits a bank to the creditworthiness of its client in order to substantiate the client s future business dealings with a third party. Quantitative Multiple Choice Questions 1. iii) Bond market value is calculated first, as follows: Time Cash flow PV factor at 4% PV 1 $ $ , Market value of bond $1, Solutions to Self-Test Questions 69

3 2. iii) Duration [76.92(1) (2) (3) (4)] 1, , years 1, Portfolio duration D P 1 ( ) V P -D P * V P * r 1 + dw -$325, ($10 million)(0.01) i) Market value $50 PVIFA (4%, 4 periods) + $1,000 PVIF (4%, 4 periods) $1, Duration $50(1) * PVIF (4%, 1) + $50(2) * PVIF (4%,2) + $50(3) * PVIF (4%,3) + $1,050 * PVIF (4%,4) $1, $3, periods $1, Duration in years iii) The Canadian dollar value of the receivable falls from $14 million to $13.5 million, so there is a loss of C$500,000, or $10 million ( ) $500,000. Quantitative Problems Problem 1 a) The obvious alternative is that Susan can invest in the four-year bond. This way, she pays for the bond now, and at maturity she will receive her investment back plus interest. Alternatively, Susan can invest now in a one-year bond. At the end of one year, Susan will receive the principal plus interest. At that time, Susan can reinvest the proceeds in another one-year bond. This one will mature two years from now. Again, she can invest the proceeds in a third one-year bond maturing at the end of the third year. A fourth oneyear bond investment will accomplish Susan s investment objective. Now suppose that after the first one-year investment, Susan decides to buy a threeyear bond instead of a one-year bond. Also after one year, she has the choice of choosing a two-year investment. In this case, she will have to reinvest the proceeds in a one-year bond. She can also invest in a two-year bond and then reinvest in the same term at maturity. When all the possible scenarios are considered, Susan has five alternatives from which to choose. b) Assuming that there is no change in the yield curve during the period, then the returns on the various alternatives are as follows: Alternative 1: Susan invests in one four-year bond compounding annually. Year 4: $100, $121,088 Alternative 2: One-year bond reinvested into one-year terms. Year 1: $100, $104,000 Year 2: $104, $108,160 Year 3: $108, $112,486 Year 4: $112, $116, Solutions to Self-Test Questions

4 Alternative 3: Susan invests in one one-year bond and then one three-year bond. Year 1: $100, $104,000 Year 2: $104, $119,193 Alternative 4: Susan invests in two one-year bonds and one two-year bond. Year 1: $100, $108,160 Year 3: $108, $117,774 Alternative 5: Susan invests in two two-year bonds. Year 1-2: $100, $108,889 Year 2-4: $108, $118,568 Although the order in which Susan does her investing may change, the basic amounts she will earn are as previously displayed. c) None of the above alternatives give Susan the return that she requires. However, if she purchases the five-year bond and sells it at the end of four years, she should be able to arrive at the amount she requires. Years 1 to 5: $100, $128, But Susan wants to sell the bond at the end of year four. The bonds compound annually but pay out at maturity; therefore the purchaser will own a bond that is worth $128, at the end of one year. At the one-year rate of 4%, the bond should sell at the end of year 4 for: Bond value $128, thus satisfying Susan s requirements. $123,895 Problem 2 In this question, an investor holds bonds from two different issues in his portfolio. Candidates must calculate bond values, duration, and volatility, as well as assessing what interest rate change will be needed in order to result in a particular change in bond value for one of the issues. a) Issue A value per bond: coupon rate is 3% each half year, 2 years remaining market rate is 2% each half year Value (0.03)(1,000) PVIFA (2%, 4 semi-annual periods) + 1,000 PVIF (2%, 4 semi-annual periods) , $1, Issue B value per bond: coupon rate is 8% per annum, 4 years remaining market rate is 10% per annum Value (0.08) (1,000) PVIFA (10%, 4 years) + 1,000 PVIF (10%, 4 years) 80(3.170) + 1,000(0.683) $ Portfolio value 200(1,038.04) + 150(936.60) 207, ,490 $348,098 b) Duration of Issue A Bond: [30(1) * PVIF (1,2%) + 30(2)PVIF (2,2%) + 30(3)PVIF (3, 2%) + 1,030(4)PVIF (4, 2%) ] 1, [30(0.9804) + 60(0.9612) + 90(0.9423) + 4,210(0.9238)] 1, Solutions to Self-Test Questions 71

5 Duration of Issue B Bond: [80(1) * PVIF (1, 10%) + 80(2)PVIF (2,10%) + 80(3)PVIF (3,10%) + 1,080(4)PVIF (4,10%) ] [80(0.9091) + 160(0.8264) + 240(0.7513) + 4,320(0.683)] [ ,950.56] , [ , ] 1, , ,832 half years or years 1, years Duration of bond portfolio 207, ,490 * * years 348, , (1.915) (3.562) years c) Volatility of each bond and of the bond portfolio: Bond A volatility Bond B volatility ( ) d) If interest rates rise, bond B will have a larger drop in value because it has a higher duration. Bond B is therefore more sensitive to market interest rate changes. Company B also has higher business risk because of the nature of the industry in which it operates. Both factors contribute to the Issue B bonds being riskier and requiring higher investor returns than the Issue A bonds. Problem 3 a) The table summarizes the required calculation: Duration Calculation PV(CF t ) at a PV discount Time t CF t (factor) rate of 2% t PV(CF t ) (1) (2) (3) (4) (5) (1) (4) 1 $ 20, $19, $ 19, , , , , , , , , , , , , , , , , , , Continued > 72 Solutions to Self-Test Questions

6 8 20, , , , , , , , , , , , ,020, , ,651, Sum $1,000, $10,786, The price of the bond sum of column 4 $1,000, The duration of the bond sum of column 5, price 107,786, , 1,000, quarterly periods The duration of the bond in years , years. b) The volatility of the bond , ( , 4) , c) Using Equation 7-3 and solving for Δ r yields: ΔV $1,000, $10,000 Therefore: * $1,000,000 -$10, , 4 -$10,000-2,696,700 r 1.02 r $10,000 2,643, Therefore, if the annual non-compounded rate rises by 37.8 basis points above the coupon rate of the bonds, Kim should sell. Problem 4 a) There are three steps that a firm must follow: Canvass the market to collect information regarding the current forecast. This step includes checking to see what other people think. Institutions with good track records of forecasting may be consulted. Identify and evaluate the underlying assumptions. This step involves questioning some of the assumptions used by the institutions consulted in the first step. Integrate forecasts received from institutions and formulate an internal view regarding the future. b) According to the article by Wally Hassenrueck, developing the internal view is fundamental to developing a successful strategy. The following reasons support such a strategy. The internal view of the nature, magnitude, and probability of risk requires a company to take the time to analyze the present and future environment. The internal view ensures an increased level of comfort, especially if the company is committing significant dollars to a hedging program. The internal view increases commitment by involving members from the treasury team and senior management. r Solutions to Self-Test Questions 73

7 Problem 5 a) Bond A value: Bond B value: $1,000, ( ) 5 $ $ $40 (1.033) + $40 2 (1.033) + $40 3 (1.033) + $40 4 (1.033) + $1,040 5 (1.033) $1, Bond C value: $ $70 (1.062) 2 + $70 (1.062) 3 + $70 (1.062) 4 + $1,000 (1.062) 4 $1, b) The duration of a zero coupon bond (strip) is always equal to its maturity. Thus, the duration of bond A is 5 years. Using Equation 7-1, the duration of bond B is 2.73 years, and the duration of bond C is 3.63 years. The calculations are: For bond B: D $40 * years + $40 * 1 $40 * $40 * 2 $1,040 * $40 * 3 2 (1.033) (1.033) 3 4 (1.033) (1.033) 5 (1.033) 6 $1, For bond C: D $70 * $70 * 2 (1.062) + $70 * 3 2 (1.062) + $70 * 4 3 (1.062) + $1,000 * 4 4 (1.062) 4 $1, years The denominator is the market value of the bond, which was calculated in part a). c) The table shows the duration of Adam s bond portfolio. Duration Calculations Value Total Duration Bond Number per bond value (V) (D) D V A 10 $ $ 7, , B 5 1, , , C 8 1, , , Sum $20, , Duration of the portfolio 81, $20, years d) For the purposes of using Equation 7-7 to calculate the volatility of a portfolio, the current weighted average discount rate of Adam s bond portfolio is: [(0.06 $7,472.60) + (0.033 $5,187.75) + (0.062 $8,220.72)], $20, % e) The volatility of the portfolio is: v -3.90, ( ) Solutions to Self-Test Questions

8 f) The value of the portfolio would increase. The magnitude of the increase can be measured using Equation 7-7: V P -3.9 * $20, * (-0.01) $ Cases Case 1: The Baywater Soup Company a) Expected interest income ($5,125, %) + ($50,000, %) $166, $2,500,000 $2,666, $2.67 million b) Expected interest cost ($23,000, %) + ($121,500, %) $690,000 + $5,771,250 $6,461,250 $6.46 million c) Expected net income (loss) $2.67 million - $6.46 million ($3.79 million) d) Net return on assets ($3.79), $ % e) The gap $ $23.0 -$ f) Using Equation 7-5, the change in net interest income (loss) is calculated as: ΔNII Δr gap $ $ million or ($178,750) CHAPTER EIGHT Qualitative Questions 1. What is a financial futures contract? An agreement is made between a buyer and a seller. A specific financial asset or commodity underlies the trade. The agreement sets the specific delivery date in the future and the amount of the asset to be delivered. No cash is exchanged at the time of signing the agreement, although margin requirements must be met. 2. How do forwards differ from futures? Forwards have no margin requirements. Forwards have no standard features because they are negotiated directly between buyer and seller. Forwards do not have a clearing house to cover and guarantee contracts. Forwards lack the liquidity associated with futures. Forwards trade in the over-the-counter market, whereas futures trade on an organized exchange. Forwards are not usually marked to market daily. 3. What is the role of the clearing house in futures trading? Intermediates between sellers and buyers of futures contracts Acts as a seller to the buyer and as a buyer to the seller Guarantees futures contracts against default Keeps a record of sellers and buyers Solutions to Self-Test Questions 75