China Aviation Oil Corporation Ltd - Assignment Example

Finance and accounting Table of Contents Question 3 Question 3 7 Question 4 8 Question 5 12 Question 6 12 Question 7 14 Reference List 16 Question1 China Aviation Oil (CAO) (Singapore) Corporation Ltd is regarded as the largest jet fuel trader in Asia Pacific region. It is also the “main supplier of the imported jet fuel to PRC civil aviation” industry. The main business of CAO includes supplying jet fuel and trading of oil products, besides concentrating on making investment in oil-related assets (Deloitte, n.d). The company was established in on 26th May, 1993 (Reed Business Information Limited, 2014). It is listed in the main board in Singapore Exchange Securities Trading Limited, since 6th December, 2001. The parent company of CAO is China National Aviation Fuel Group Corporation (CNAF), which is the largest state owned enterprise in PRC region (Prima Professional, n.d). The parent company is a well-known aviation transportation and logistics service provider in PRC. CNAF owns 51% of total shares that are issued by CAO. The year, 2005, was not at all good for CAO, since it had to face a loss of $550 million (China Daily Information Company, 2007). The situation led to the collapse of the institution, until it was revived by its parent company. The facts that are learnt from performance of CAO, regarding valuation of derivative, are elaborated in this section (Ernst & Young Global Limited, 2014). The CAO, in the initial period of their business, “traded in over-the-counter (OTC) swaps and exchange-traded futures” for protecting their business from risks associated with procurement of oils. The company purchased and sold risk free options on behalf of airline companies, who are their clients. So, there is a good source of income for CAO from the bid-ask spread, without exposing the company to vitality of the oil markets. During the third quarter of 2003, the company started to conduct options trades as speculators for earning profit from constructive market movements, which was observed in the oil-related commodities market. The company had started trade on the belief that oil prices will move upward. The trading strategy indicated purchase of call option and sale of put option simultaneously (Amato and Gyntelberg, 2005). Thus, it created a synthetic long position in the oil market, without purchasing the commodity outright. When price of the oil increased, the calls, which were purchased earlier, exercised at a profitable rate. The puts were not exercised and the company profited from premiums, which were collected from the options at the time of sale (IBS Case Development Centre, 2010). The put that were sold in the security market were not exercised by the company and thus, it earned profit from premiums, which were collected from the option, when they were held for sale. The strategies were, however, not approved of or reviewed by the Board of Directors, before trading activities were initiated. There was also no risk committee for the purpose of reviewing the transactions daily (Takahash, 2004). Even so, the strategy performed successfully until fourth quarter of 2003, when the company estimated that prices of oil could fluctuate. The CEO of the company, Chen Jiulin, began to undertake trades, which had many counterparties. These counterparties undertook short position that earned profit as price of oil moved below $38.00/barrel (The Taipei Times, 2014). The activities were accomplished by buying puts and selling calls, which resulted in CAO going for short position, during end of 2003. Nonetheless, in 2004, the price of oil rose above $ D38.00, which resulted in CAO funding the margin calls at its short positions (The Sydney Morning Herald, 2004). The losses, incurred by the company, for exercising the short positions amounted to $390 million. Even more, the company had to encounter unrealized losses of $160 million for compensating a total derivative loss of $550 million. The company had concealed these losses. However, the international standard for accounting for derivatives IAS 39 requires the transactions, which are related to market, to be reflected as current earnings (Ockenden, 2004). Singapore companies required to adopt FRS 39 (that is equivalent to IAS 39) on 1 January, 2005 (Anderson and McKay, 2008). A review conducted by Price Water House Coopers (PWC) opined that specific techniques for evaluating derivatives trading were not present in FRS 39 (London Stock Exchange Plc, 2014). Therefore, the company should have concentrated on adopting the industry standards, instead of complaining about the absence of specific norms for the derivative trading under FRS39 (Times Interest Limited, 2014). The main fault identified by PWC was that derivatives valuation was totally wrong. The company considered the intrinsic value as the fair value of the options. The company could have taken into consideration the time value as well as intrinsic value. This indicated that length of maturity date of option, interest rates, volatility of the spot price of the commodity and other elements should have been taken into account by the company for valuation of the derivative (Finance Train, 2014 : Thomsett, 2010). Question 2 a) A call option provides the owner with the right, but not obligation to buy the underlying asset at predetermined price, during a specific time period. The put option provides owner with the right and not the obligation to sell at a predetermined price during a specific period of time. In this question, it is observed that the put is selling for $ 3.75 and the call for $ 8.00, when the exercise price is $45 and will expire in 115 days. The risk free rate of the stock is 4.5%. There is mispricing of the call option, since no option is sold for an amount that is less than the exercise price. The call option is sold at $ 8.00, which is less than the exercise price, $45. The actual call price is miscalculated (Ansi and Ouda, 2009). The actual value of the call is calculated below: Present value of strike price = $ 45/1.45 = $ 31.03. The lower bound on the call value = $ 48 - $ 31.03 = $ 16.97. The call option has to be sold for more than $ 16.97, but not less than this (this value can be regarded as actual call price of the option). Nonetheless, it is selling at $8.00, which is not correct and thus, there is mispricing of call option (Chance and Brooks, 2010). b) Option arbitrage is common for traders in the option market, since it allows them to earn profit, which is associated with zero or very little risk. The traders prefer conversion of the options, when price is more than the purchased stock and sell the equivalent amount. When the options are underpriced (i.e. value is less than actual price of the stock), then the trader prefers to reverse conversion. Precisely speaking, the trader favours to go long, when the stock is underpriced and short, when the same is overpriced (European banking Authority, 2014: Siddiqi, 2012). If the puts options are overpriced than the calls, traders sell a put and offset the risk by purchasing a synthetic put. Similarly, if a call is overpriced than the put, then the trader will sell a call and purchase a synthetic call option to offset the risk. In this case, the arbitrage can be executed in the following ways: 1) The call option should be purchased in less than $ 8.00 and make profit by exercising the right to sell it later in an amount more than $8.00. 2) If the call option is traded for less than $ 16.97, then the call is purchased at that rate. Later, the stock is sold short for $ 45 and the net proceeds ($ 45 – $ 16.97) = $ 28.03 is invested at a risk free rate of 4.5%. Now, if the stock price is greater than $48, the trader will first collect the proceeds from the riskless investment ($ 28.03*1.45) = $ 40.67. Then, he will exercise the option or purchase the share at $ 48 and go for a short sale. The difference ($ 48- $ 40.67) = $ 7.33 will be his profit. Since, it is non-dividend paying stock and the option is European that is exercised at expiration, the arbitrage will be carried out with ease (Economy Watch, 2014). Question 3 The call price and put price of a stock is $6.64 and $ 2.75, respectively. The exercise price of the same is $30 and that of the stock price is $ 33.19. The risk free rate is 4%. The put call parity refers to equivalence of call and protective put option. The parity exists between prices of European call and put option. It basically identifies the relation between put price and call price on a same underlying stock, with same date of expiry (Bielecki and Rutkowski, 2010). There are several ways to express the put–call option. The following relation is used to illustrate the put-call parity, when stock price at expiration is $ 20: c + PV(x) = p +s or, $ 6.64 + ($ 30*1.04) = $ 2.75 + $ 20 or, $ 37.84 = $ 22.75 Therefore, it is observed that there is put-call parity of ($ 37.84 - $22.75) = $ 15.09, when stock price at expiration is $20. b) When the stock price at expiration is $40, the calculation for put call parity is as follows: c + PV(x) = p +s or, $ 6.64 + ($ 30*1.04) = $ 2.75 + $ 40 or, - $4.91 Thus, it is observed that there is put-call parity of - $ 4.91, when the stock price at expiration is $40. Question 4 a) A pay off diagram indicates a graph, which shows the cash value at any point of time, during life of the option. It reflects exact profit earned from the purchase of the option. The pay off graph is shifted downward to form the new pay off diagram, after adding the premium (Financial Services Authority, 2011). The call option with exercise price is $80 and $5.00. The payoff diagram is given below. The above green line indicates the pay off line for the diagram. b) The following diagram identifies the pay diagram of put option. c) The combined put and call option is indicated in the following figure: Straddle d) If the stock price at expiration is $ 80, then there will be no profit and loss since the exercise price is $ 80. e) At $ 80, the stock will earn no profit. Question 5 The price of the stock is $120 and is expected to rise by 10% or fall by 20%. The risk free interest rate is 6%. The exercise price of the stock is $130. If price of the stock increases by 10%, the following is the calculation: a) The price of the stock = $120 + (0.10*120) = $ 132. Hence, price of the call option becomes = $132*1.04 = $137.2. When there is a fall in price of the stock by 20%, the following is the calculation: The price of the stock = $ 120 - (0.20*120) = $ 96. The price of the call option = $ 96 *1.04 = $ 99.84. b) The probability, that the stock will rise, depends on the risk free interest rate. The risk free interest rate is 4%. So, it can be said that probability of rise is 0.04. c) If the option expires in two years time and there is 10% rise in price of the stock: The price of the call option after two years = $ 132*2.04 = $269.28. If the option expires in two years time and 20% fall in the price of stock: The price of call option after two years = $ 96 * 2.04 = $195.84. Question 6 The Black Scholes model is regarded as the mathematical model, which has its application in financial market. It comprises the derivative investment instrument, which estimates price of the European style option. It reflects variations in price of the financial instruments that are used to determine price of the European call option (Skipton Financial Services Limited, 2014). The model takes into account the price of heavily traded assets, which follows the geometric model of Brownian motion with the drift in volatility. When the model is applied to options associated with the stocks, the model considers the constant price variation of stocks, time value of money and the strike price of the option as well as time of expiry (Helium Inc., 2013). The formulae that is required to calculate Black schools formula is as follows: C(S,t) = N (d1)S – N(d2) Ke-r(T-t) Where, C(S,t) = price of the European call option S = price of the stock K = Strike price of the stock r = risk free interest rate a) The stock sells at $110 and the call option on the stock has an exercise price of $105 and the days of expiry is 43 days. The risk frees interest rate is 11% and the risk is 25%. Therefore, price of the call option, according to the Black-Scholes model, is = d1 = 1/ 0.25 (√ 43 ) [ ln (110/105) + (0.11 – (0.252/ 2)) (43)] = 3.733 d2 = d1 – σ √ T-t = 3.73 – 0.25* (43)1/2 = 3.32 Hence, C(S,t) = N (d1)S – N(d2) Ke-r(T-t) C(S,t) = 3.73 * 110 – 3.32 * 105-0.11*43 = $401 b) The value of the put option can be obtained from Black-Scholes model. P(S,T) = Ke-r(T-t) – S + C(S,T) = 105-0.11*43 – 110 + $ 401 = $ 305 Question 7 There are two investors, Mike and Sheila. In August, the cash of S&P Index is 1007 and in December, the future is 1000. The initial margin of the contract is kept at 50 points (50 points amounts to $ 12,500). Mike Mike is quite sure that the cash S&P Index will be higher in the next three months and will range between 1007 and 1200. He also expects it to cross the futures price of December i.e. 1000. Mike longs to go for futures contract at 1000 i.e. he involves into a future contract that promises to pay back 1000 S&P points in future. Movement from 700 to 1300 Profit and Loss on S&P500 Points =700 Points = 1300 Total amount = 700* $ 250 = $175000 Total amount = 1300*250= $ 325000 Sheila Sheila is anticipating that the market is overvalued and is heading towards fall and the cash market will crash to 800. Sheila sells the future as she feels that the market will move downward. Sheila sells the future as she feels that the market will move downward. The initial margin on the contract is kept at 50 points (50 points amounts to $ 12,500). Movement from 1300 to 700 Profit and Loss on S&P500 Points =700 Points = 1300 Total amount = 700* $ 250 = $175000 Total amount = 1300*250= $ 325000 From the above two tables, it can be observed that if the prediction of Mike is correct, then he will earn a profit of ($ 325000 - $ 175000) = $ 150000. Nevertheless, if Sheila’s prediction is right, then Mike will lose the same amount. 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