Corporate Finance - Assignment Example

Corporate Finance xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Lecturer xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Question 1: ii) What are the advantages and disadvantages of CFDs for a small (retail) investor compared to individual share futures contracts or Low exercise price options (LEPOs) Both CFDs and futures contracts have advantages and disadvantages to small investors. Firstly, CFD trading is model for small investors, as they do not necessarily need to outlay huge capital in order to get a potentially big return. Basically, an investor is only required to expend a fraction of capital required to directly invest in commodities or shares (Siganos 2010). Thirdly, CFD have lower margin requirement, access to global market is eased, no shorting or any day trading rules, as well as little or no fees for professional execution. All the benefits favor small investor investors who may not be tremendously funded. Trading with CFDs is better in the sense that dealing with a specific trader makes the dealing systematic, and hence a better model for small investors. In contrast, single stock futures contain an expiry date. There pricing therefore, constitutes a forward premium of interest as well as a discounted dividend that can be confusing, hence not very convenient for small investors. On the other hand CFDs can be disadvantageous to retail investors. Unlike futures that are transferable and standardized instruments, CFDs at times can be over the counter. Choice of broker becomes an issue to investors especially to retail ones. The potential to profit well in small moves is eliminated (Siganos 2010). Also, CFD industry is lowly regulated. The credibility of broker is mainly based on financial position, reputation and life span. Due to limited means and resources to investigate on eligibility, small investors may be at a risk of losing funds to fraud brokers. Moreover, the high leverage magnifies losses when a huge price movement fails to take place. These risks arises when the issuer fail to meet their required obligations to the investor (ASIC 2010). iii) What are the differences and similarities between Futures Contracts and LEPOs? Futures contracts constitute a contractual agreement to buy or sell a specific financial instrument of commodity in the future at a pre-determined price. This agreement is mainly prepared on the trading bases of a futures exchange futures contracts can necessitate physical delivery of asset, and others may be settled in cash (Tanlapco et al. 2002). Low exercise price options (LEPOs) are call options which have a one cent exercise price, and an agreement of purchase of 1 cent, purchasing 100 shares. Until expiry, they are not be exercised. The paid premium is mainly the price that purchases the entire share, though the only percentage as margin is posted by the purchaser (ASX 2011). Another major difference between LEPOs and futures contract is that the holder of options has a right sell or buys the basic asset at expiration, while futures contract holder is required to execute the terms of contract. The primary similarity between LEPOs and futures contract is that both have an expiry date (McGill & Winston 2008). iv) Some CFDs are exchange traded whereas others are traded over the counter. What are the advantages and disadvantages of exchange traded CFDs vs over the counter CFDs Exchange traded CFDs have various disadvantages. To begin with, CFD traders may deal with the fact that only a restricted range of CFDs may be available on the place of exchange. That is, unlike in over the counter CFDs, traders with exchange traded CFDs, securities that a trader deals with may simply not available. Secondly, there are numerous costs linked to exchange traded CFDs. On the other hand, exchange trade derivatives are not subject to many risks associated with trading over the counter. Secondly, exchange traded derivatives is that each deal is not a private one. Thus, trader is protected when things go wrong, unlike in OTC where this protection is not guaranteed. Trading over the counter CFDs Unlike CFDs traded on the exchange, CFDs traded over the counter can be traded even after the regular exchange hours. This advantage offers investors control in regard to when a position is to be closed. in addition, over the counter traded CFDs are generally cheap. Their cost is much lower due to less exposure to the set government taxes and lower fee structures as compared to exchange traded CFDs. OTC derivatives may be bilaterally negotiated and that advantage that the set transactions tailored according to both parties needs (Kristiansen 2004). Over the counter CFDs also are subject to extensive risks unlike the exchange traded derivatives. The main risk involved is the counter party risk where one party in the transaction may default prior to the closing of trade, and that it does not ensure the present or even the future payments indebted by the contract. Under OTC system, the trader must ensure to close out CFD trade with the same broker they placed it with, and also at their price (Brown et al. 2010). Question 2 i) Payment from X to Y = (8% X $20,000,000)/2 = $800,000 Payment from Y to X = (0.47786 % X $20,000,000)/2 = $47786 Value of the Swap Swaps can be valued: Difference of two bonds: Let, V- Value of swap B1 - value of fixed rate underlying the swap B2 – value of floating rate bond underlying the swap Q – Notional principal in the swap agreement C – Fixed cash flow U – First cash flow on variable It follows that: V = B1 – B2 Value fixed = (4.5/1.05) + (4.5/1.05)2 + (104.5/1.05)3 = 4.29 + 4.08 + 90.27 = 98.64 Value variable = (104.7786/1.05) = 99.79 Value of the swap = fixed – variable = 98.64 - 99.79 = -1.15 Long position in a fixed rate bond in one currency and a short position in a fixed rate bond in another currency 6% x $12,500,000 = $750,000/2 = $375,000 5% x $10,000,000 = $500,000/2 = $250,000 = $$250,000 - $375,000 = ($125,000) x 0.80 USD = ($100,000) Portfolio of forward exchange rate contracts =(6% - 5%) x ($12,500,000 x 0.80AUD) = 1% X $10,000,000 = $100,000 C) i) By getting the returns of the contracts By factoring the contracts ii) $100 X 5% X 0.3 = $1.5 = $1.5 X $11.04 = $16.56 $1.5 X $4.60 = $6.9 iii) $1000/ $110 = 9.09 Question 3 i) $0.75 x (6% - 5%) = $0.75 x 1% = $0.0075 $0.80 x (6% - 5%) = $0.80 x 1% = $0.008 $0.85 x (6% - 5%) = $0.85 x 1% = $0.0085 The exchange rate of AUD is profitable at $0.0085 ii) 0 Read More