Foundations of Finance and Investment - Assignment Example

FOUNDATIONS OF FINANCE & INVESTSMENT TABLE OF CONTENTS PAGE NO The impact of the rise in the UK Base Interest Rate on the UK Sterling Exchange Rate with the US$ and Euro 2 2. A review of the UK Inter-Bank Money Markets from April 1 2005 to March 31, 2010, highlighting the LIBOR fixation process. 5 3. The Royal Dutch Shell Plc 9 4. Annex 12 5. References 17 FOUNDATIONS OF FINANCE & INVESTSMENT 1. The impact of the rise in the UK Base Interest Rate on the UK Sterling Exchange Rate with the US$ and Euro The situation states that the Monetary Policy Committee of the Bank of England decides to increase the present UK Base Interest Rate of 0.50% to 1.50%. In this context, will there be negative or positive impact with this policy in the financial community? The government is empowered to control the money supply in the society. When the interest is high, the tendency of people is to control spending and cuts on borrowing so the movement of money is slowed down. The effect is different when the government lowers the interest to attract people to borrow money, spend on things like houses and cars and invest on projects. The monetary policy is like a wheel, that when it gets heated, or the economy is overheating, it puts on a break to level down and put it back to normalcy. Thus, in order to do this, Russell (2010) said the government uses interest rate as a tool to control the money supply. Russell described that in UK, Monetary Policy involves using interest rates and other monetary tools to influence the levels of consumer spending and Aggregate Demand. Following this criteria, the UK base interest rate has been set at 0.50% since March of 2009. This interest rate is reflective of the UK monetary policy to bring down interest rates in response to the worldwide economic crisis. The interest rate has remained at this level for the rest of 2009 in order to reshape the banking industry and is expected to remain so until 2011. Our scenario now is towards increasing interest rate to 1.50% level, which could be construed that inflation, supply and demand for money are getting to be heated up. What can be gleaned from this average rate of interest? The contrast of contraction is expansion, so in 2009 and up to 2010, there is expansion in monetary policy. UK base interest rate is set at 0.5% and is expected to remain at this level for quite a while. This is an indication that now; the government has adopted expansionary monetary policy that had reduced interest rates in order to stimulate the economy. An expansionary policy means the government funds rate has been lowered to increase money supply. This will result to the decline in the mortgage rates, allow consumers to borrow and spend, and business to grow, and be able to hire more workers who will have more disposable income. (Amadeo, Kimberly, n.d.) What happens now when this scenario is implemented? As we have learned, interest rates influence exchange rates because it affects the demand and supply of currencies in the exchange market. To illustrate, Bizled.com in an article “The impact of….” wrote that when there are interest rates movements – speculative investors move funds from one currency to another to take advantage of price movements and better returns in different countries. If for example, when the rate of interest in U.S. is 0.50%, and we raise the interest rate in UK to 1.5%, there will be profit advantages in moving funds in dollar based securities to those dominated by Sterling. This situation will result in selling dollars to buy Sterling, thus the demand for Sterling will be going up and supply of dollars also rising up. This situation would put pressure on the Sterling and put its value up against the dollar thus creating an “Appreciation” of the currency. This means, the Pound would be more in terms of the dollars, (e.g. rising £1 = $1.60 to £1 = $1.70), thus, we see that the US consumer will have to pay more for the same amount of Sterling; that is, the US consumer will have to pay more for the good from UK. Thus, when the base interest rate is increased, there will be a rise in the value of the Sterling against other currencies, and a decrease in the base interest rate will lead to the fall of the value of the Sterling against other currencies (Depreciation). In so doing, there would be a related effect to export and imports, such that “the demand for export fall as export prices rise; and conversely, the demand for import rises as import prices fall”. (“The impact…”.) The impact of the rise of UK base interest rate on the UK Sterling Exchange Rate with the US$ and Euro can be felt in many far different ways as illustrated herein. For instance, due to the promised higher interest rates, the value of £ increases, an article (Effects of Rising Interest….n.d.) finds that the “stronger Pound makes UK exports less competitive – thus reducing exports and increasing imports” that in effect reduces the aggregate demand in the economy. This source also argues that in increasing interest rates, the real interest rates should be considered. Real interest rate is arrived at by getting the nominal rates minus inflation. In our scenario, if we increase the nominal rate from 0.5% to 1.5% and inflation is 3.1%, the real interest rate is 2.1% in which case, results to an expansionary monetary policy. The 3.1% inflation rate is the UK government’s target inflation measure as of July, 2010. (Inflation. 2010) Let us now relate our scenario to the UK monetary policy. The monetary policy in UK is set by the MPC of the Bank of England that is independent in setting interest rates. In both cases, when the bank feels that the economy is going below target inflation rate, or vice versa, the bank cuts or raises interest rates to correct the inflationary pressures. (UK Monetary Policy…n.d.) As interest rate increases, so are the negative impacts that accrue to the economy. A rising interest rate affects the consumer, firms and the government. First, it increases the interest on loan payments. People will have less disposable income because of higher interest payments on personal loans, and then with 1.5% increase on interest, consumer will have to pay more on their mortgages. Second, higher interest will lead to higher taxes to people because government will have to spend more in paying its national debt that has been reported to be £23bn. The propensity to save becomes higher because of higher interest, it discourages investment and makes consumers and investors less willing to buy and take risky investments. (“Effects of Rising Interest…”) So, we found out that the increase of 1.5% is still below the inflation target of UK and could not be considered belonging to the contraction monetary policy. Therefore, the 1.5% rate of interest increase will not bring negative effects to the economy as has been spelled out in the discussion. 2. A review of the UK Inter-Bank Money Markets from 1st April 2005 to 31st March 2010, highlighting the LIBOR fixation process. The British Bank Association explains LIBOR as the benchmark used for short term interest rates worldwide. Contracts on major futures and options exchanges in the world apply this rate as the basis for settlement. Recently BBA said that the media draws on this as a barometer to measure the financial condition of the money markets (BBA Libor, n.d.) LIBOR is the international rate which is applied by international banks when they lend to each other. It is calculated every business day in 10 currencies and 15 time spans with maturities ranging from overnight to one year, based also on the levels of lending agreement of each other. LIBOR is set and announced at around 11 am to midday. According to Oxlade (2010) the LIBOR rate is found to be marginally higher than the central bank rate. As compared to previous years, the Libor rate was a decline on March 2005 at 2.85% then climbed up to 3.69%+ for the rest part of the year. It was lower than the UK bank rate of 4.50%at that time. It steadily climbed higher and reached to a peak of 5.47% in September 2007, the height of the credit crunch that is almost at par with the banking rate of 5.5%. Under normal conditions, the three-month LIBOR rate should be about 10 to 20 points higher than the bank rate. For example if the base rate is 2%, the LIBOR should be 2.1% or 2.2%. (Oxlade 2010) However, Oxlade, in his article, suspected that the widening Libor gap observed is attributed to the increasing bad debts in the banking sector and a result of the euro debt crisis. With a widening gap, it could be assumed that banks are unwilling to lend. The LIBOR rate started to drift down on January 2008 at 3.9 after a high of 5.01 in December 2007. It lingered for a while in the range of 2% + from March to October of 2008, and then dived to the 1%+ range for November and December. For 2009 and the rest of 2010, LIBOR maintained a rate of less than 0.5%. On July 2010, LIBOR rate is 0.3341 while UK base rate has stayed at 0.5% since March of 2009. A persistent gap between LIBOR and UK base rate of interest stayed on during the period of review after the final cut of interest rate in March. LIBOR has been on the lower side since November of 2008 up the recent time. (Libor chart attached as Annex 1) Chart and graph of UK Base interest rates for 2005 to 2009 are shown below UK Base interest rates Year Month Rate 2009 March 0.5% 2008 Dec. 2.0% 2007 Dec. 5.5% 2006 Nov. 5.0% 2005 Aug. 4 4.5% LIBOR has many rates that depend on maturities for different currencies. Usually, it has maturities ranging from overnight to 12 months. Chart below is an example of LIBOR rates for one month to a 12 month period and compared to the U.S. Feds Fund Rate for 2010. It will be observed that the FED target fund rate of 0-0.25% is lower than the UK’s Base rate of 0.5% Chart: U.S. Prime Rate vs. Fed Funds Target Rate vs. 1-Month LIBOR vs. 3-Month LIBOR Maturity Rate (%) One month LIBOR 0.27188 Three-month LIBOR 0.36938 Six-month LIBOR 0.59188 Twelve-Month LIBOR 0.96531 Current U.S. Prime Rate 3.25% The current target for the FED funds rate 0-0.25% Source: “The London Interbank Offered Rates, 2010 The difference may stem from the fact that LIBOR rates are fixed every UK business day by Thomson Reuters, a global media corporation in association with a nonprofit trade association, the British Bankers Association and not controlled by England’s central bank. On the other hand the Fed Funds Target Rate as well as the U.S Prime Rate is controlled by the U.S Federal Reserve, the America’s Central Bank. What is the significance of LIBOR to the futures market? LIBOR plays important role in financial derivates such as the Eurodollar futures and interest rate swap. Eurodollar futures are transactions wherein US dollars are deposited in banks outside the United States, primarily in Europe. By holding these deposits outside the country, the U.S. depositors have higher leverage of funds because they are exempted from the Federal Reserve margin requirements. The Eurodollars earn interest based on LIBOR, and Eurodollar futures provide a way of betting on or hedging against future interest rate changes. (“What is Libor”?) Another instance that depends on LIBOR is the interest swap. This is described as a situation wherein two parties exchange sets of interest payments on a given amount of capital. Here, the first party “will have a fixed interest payment, while the other will have a variable rate. The variable rate payment stream is often defined in terms of LIBOR.” (“What is Libor”?) LIBOR fixation process was adopted in 1980s when the world banking system needed a benchmark for short-term inter-bank loans. So now, LIBOR has been the internationally accepted indexes used as guide for many types of consumer and corporate loans, debt instruments, and debt securities across the globe. LIBOR rate is also applied to other currencies not only in Pound Sterling, but also to other major currencies such as US Dollar, Canadian Dollar, Swiss Franc, and Japanese Yen. The influence of the Libor rate system is observed on the rates on loans and amounts lender will lend. It is an agreed rate of each bank, and show the measure of confidence they have on each other. Therefore, there will be a lag when Libor changes to when bank lending rates are altered. 3. Royal Dutch Shell PLC. Company chosen is Royal Dutch Shell Plc. It has its primary listing on the London Stock Exchange and is a constituent of the FTSE 100 Index Shell operates in over 140 countries. Shell Oil Company, the companys subsidiary in the United States, is one of its largest businesses. (Hoovers’ Profile, 2010) For fiscal year 2009, the company has the following key figures (Hoovers’ Profile): Sales: $285,129.0M One year growth: (37.8%) Net income: $12,518.0M Income growth: (52.4%) EPS 3.41 P/E Ratio 15.59 Dividend 0.71 Yield 5.37 Stock quote as of August 24, 2010 : 53.17 Sales Volume:  2,123,402 The key figures of a company are vital information for an investor to know what is ahead when investing. Generally, an investor is interested to know basic information about the company, how does it operate its business and more importantly, the earnings per share, dividend and yield that he will get from his investment. Of equal importance also is when the data is compared to other companies that work in the same industry like BP and Exxon Mobil, Shell’s closest competition. Comparison will show the relative position and standing of the company as against its competitors. Historical stock chart covers September 2009 to August 2010 is shown below. (Earlier data is not available on line). As shown, the company had the highest stock bid on October 1, 2009 of 63.75, and lowest bid on July 1, 2010 of 49.16. Shell also had an average volume of stock sales of 1.7M during the period. Shown below is the daily average stock quote of Royal Dutch Shell PLC from the NYSE as of August 24, 2010, that shows last quote as 53.17. RDSA - Royal Dutch Shell PLC (NYSE)  4:01 PM ET, 08/24/2010   Last: 53.17  Change: -0.73  %Change: -1.35%  Volume: 2,123,402    Open: 53.00   High: 53.37   Low: 52.50   Previous Close: 53.90   Market Cap: 94.26B   Shares Outstanding: 1.77B   EPS: 3.41   52wk High (10/21/2009): 63.75   P/E Ratio: 15.59   52wk Low (7/1/2010): 49.16   Dividend: 0.71   Dividend Date: 8/4/2010   Yield: 5.37   Average Volume: 1.7M  Source: Hoovers’ Profile, 2010 Stock Chart: Royal Dutch Shell Source: Hoovers’ Profile, 2010 Why are there changes in the stock market? As shown from the chart, there are high and low bids in the stock prices and do not remain constant over the period of time. These changes are not only isolated in Shell, as other indexes in the stock market show changes. FTSE Index 100 as of August, 24, 2010 is 5,155.95 and has also reflected a negative 1.59% change from previous day’s report. (FTSE 100) Changes in stock pricing may be negative or positive that depends on the behavior of the market. According to McCoach, 2008, changes are brought about by the government’s policy to respond to the economic environment. Changes are the political stimulus such as monetary policies that serves as guides for interest rates movements. For instance, McCoach mentioned in his article the need to prime the stock market by the government so as not to create a selling panic that happened during the economic crisis. Annex: Libor Rates 1-Month 3-Month 6-Month 12-Month January of 2005 2.5892 2.7439 2.9582 3.271 February of 2005 2.6895 2.9101 3.1495 3.5114 March of 2005 2.8582 3.0995 3.3876 3.842 April of 2005 3.0826 3.2107 3.4151 3.7101 May of 2005 3.1126 3.3292 3.5314 3.7789 June of 2005 3.3401 3.5045 3.6914 3.8632 July of 2005 3.5107 3.6948 3.9235 4.1745 August of 2005 3.6942 3.872 4.0817 4.3123 September of 2005 3.8584 4.0551 4.2154 4.4067 October of 2005 4.0882 4.2523 4.4467 4.6765 November of 2005 4.2954 4.4139 4.5795 4.7379 December of 2005 4.3857 4.5298 4.6901 4.8226 1-Month 3-Month 6-Month 12-Month January of 2006 4.572 4.6795 4.8126 4.9412 February of 2006 4.631 4.8192 4.9907 5.1526 March of 2006 4.826 4.9898 5.1196 5.2476 April of 2006 5.0245 5.1479 5.2879 5.4217 May of 2006 5.1071 5.2335 5.3215 5.4139 June of 2006 5.3451 5.5085 5.6382 5.766 July of 2006 5.4045 5.4889 5.5473 5.591 August of 2006 5.3314 5.4014 5.4501 5.4501 September of 2006 5.3229 5.3725 5.3704 5.2985 October of 2006 5.3198 5.3729 5.3898 5.3348 November of 2006 5.3479 5.3685 5.3495 5.2439 December of 2006 5.3279 5.3601 5.3651 5.3139 1-Month 3-Month 6-Month 12-Month January of 2007 5.3201 5.3601 5.4014 5.4414 February of 2007 5.3214 5.3598 5.3723 5.3328 March of 2007 5.3195 5.3479 5.3212 5.2009 April of 2007 5.3201 5.3555 5.3581 5.2967 May of 2007 5.321 5.3595 5.3844 5.3885 June of 2007 5.3195 5.3593 5.3817 5.4048 July of 2007 5.32 5.3597 5.3743 5.3832 August of 2007 5.4975 5.4837 5.3773 5.1860 September of 2007 5.4927 5.4939 5.3538 5.0618 October of 2007 4.9814 5.1465 5.0513 4.8771 November of 2007 4.7672 4.9621 4.8324 4.5219 December of 2007 5.0172 4.9794 4.825 4.4227   1-Month 3-Month 6-Month 12-Month January of 2008 3.9091 3.9176 3.7795 3.4415 February of 2008 3.1368 3.0876 3.0039 2.8046 March of 2008 2.8066 2.7825 2.6798 2.5133 April of 2008 2.7854 2.7947 2.8386 2.8288 May of 2008 2.5065 2.6924 2.8544 3.0306 June of 2008 2.4704 2.7654 3.1035 3.4176 July of 2008 2.46 2.7921 3.1157 3.2796 August of 2008 2.4682 2.8063 3.1116 3.2364 September of 2008 2.927 3.1217 3.3369 3.3709 October of 2008 3.8096 4.0586 3.8784 3.7893 November of 2008 1.621 2.2791 2.6578 2.8231 December of 2008 1.0826 1.8294 2.1778 2.3845   1-Month 3-Month 6-Month 12-Month January of 2009 0.3834 1.2108 1.6211 1.9024 February of 2009 0.4628 1.2426 1.7569 2.0644 March of 2009 0.5325 1.2667 1.8273 2.1173 April of 2009 0.45 1.1062 1.6519 1.9351 May of 2009 0.3423 0.8166 1.357 1.6791 June of 2009 0.3162 0.6207 1.1796 1.6776 July of 2009 0.2907 0.5153 0.9814 1.5 August of 2009 0.2704 0.4245 0.8428 1.4231 September of 2009 0.2473 0.298 0.6774 1.2691 October of 2009 0.2443 0.2831 0.5897 1.2275 November of 2009 0.2378 0.2681 0.5168 1.0844 December of 2009 0.2329 0.2531 0.4529 0.9993   1-Month 3-Month 6-Month 12-Month January of 2010 0.2317 0.2501 0.3993 0.8979 February of 2010 0.2291 0.2505 0.3878 0.8516 March of 2010 0.2373 0.2684 0.4106 0.8733 April of 2010 0.2598 0.3116 0.4759 0.9598 May of 2010 0.3355 0.4585 0.6593 1.13 June of 2010 0.3487 0.5369 0.7518 1.188 July of 2010 0.3341 0.5103 0.7185 1.1178 References BBA Libor. Welcome to BBA Libor. Viewed 25 August 2010 from http://www.bbalibor.com/bbalibor-explained Effects of rising interest in UK. (n.d.) Economics Help. Viewed 24 August 2010 from http://www.economicshelp.org/macroeconomics/monetary-policy/effect-raising-interest-rates.html FTSE 100, 2010. Yahoo Finance. Viewed 24 August 2010 from http://finance.yahoo.com/echarts?s=^FTSE#chart1:symbol=^ftse;range=1y;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=off;source=undefined Inflation. 2010. Office for National Statistics. Viewed 24 August 2010 from http://www.statistics.gov.uk/cci/nugget.asp?id=19 Hoover’s Profile: Royal Dutch Shell Plc. (n.d.) Britannica Concise Encyclopedia. Viewed 24 August 2010 from http://www.answers.com/topic/royal-dutch-shell-plc-adr Kimberly, Amadeo, n.d... Expansionary Monetary Policy. About.com. US Economy. Viewed 24 August 2010 from http://useconomy.about.com/od/glossary/g/Expansionary.htm McCoach, Greg. 2010. Changes in the stock market. Bush, Bernanke & the Legion of Doom... An Investors Guide for the Short and Long Term. Viewed 24 August 2010 http://www.goldworld.com/articles/changes-stock-market/211 Michael Russell, 2010. Monetary Policy and Interest Rates. In Ezine Articles. Viewed 24 August 2010 from http://ezinearticles.com/?Monetary-Policy-and-Interest-Rates&id=389183 Oxlade, Andrew. 2010. Libor rate latest. This is money.uk.com. Viewed 25 August 2010 from http://www.thisismoney.co.uk/libor UK Interest rates. (2010). Houseweb. Viewed 25 August, 2010 from http://www.houseweb.co.uk/house/market/irfig.html The Impact of a Rise in Interest Rates on UK Sterling Exchange Rate (n.d.) The Interest Rate Transmission Mechanism. Viewed 24 August 2010 from http://www.bized.co.uk/learn/economics/govpol/macropolicies/interest/exchange/interest_rate_3.htm The London Interbank Offered Rates, 2010. Fed Prime Rate. Viewed 24 August 2010 from http://www.wsjprimerate.us/libor/index.html UK Monetary Policy. (n.d.) Economics Help. Viewed 24 August 2010 from http://www.economicshelp.org/macroeconomics/monetary-policy/index.html What is Libor? (n.d.). In Wise Geek. Viewed 24 August 2010 from http://www.wisegeek.com/what-is-libor.htm Read More