Corporate Finance |University of Liverpool

Question 1

a)  In 1994, one subsidiary of Daimler-Benz, Daimler-Benz Aerospace, had an order book of DM20 billion, of which 80% was fixed in US dollars. In 1995, Daimler-Benz reported losses of DM1.56 billion, the largest in the company’s 109-year history. Briefly explain why Daimler-Benz failed to hedge its position [Hint: In your answer, you should refer to the primary goal of risk management as stated by Stulz (1996, Journal of Applied Corporate Finance)].

Answer –

The company uses both options and forwards to hedge. On December 31, 1994, DaimlerBenz group had DM23 billion in outstanding currency instruments on its books and DM15.7 billion of interest rate instruments. Despite these large outstanding positions, it had not hedged large portions of its order book. German accounting rules require the company to book all expected losses on existing orders, so that Daimler-Benz had to book losses due to the fall of the dollar. Had DaimlerBenz been hedged, it would have had no losses.

The explanation the company gave for not being hedged highlights the importance of costs of hedging as perceived by corporations. Some analysts explained the lack of hedging by their understanding that Daimler-Benz had a view that the dollar would not fall below DM1.55. This view turned out to be wrong since the dollar fell to SFR1.38. However, the company blamed its losses on its bankers.

If a company simply minimizes the volatility of its hedged cash flow, it is completely indifferent to forecasts of the exchange rate. However, to the extent that it has a forecast of the exchange rate that differs from the forward exchange rate, it bears a cost for hedging if it sells the foreign currency forward at a price below what it expects the spot exchange rate to be. Nevertheless, one would think that if forecasts differ too much across forecasters, this means that there is a great deal of uncertainty about the future spot exchange rate and that, therefore, the benefits of hedging are greater. This was obviously not the reasoning of Daimler-Benz. It is unclear whether the company thought that it could hedge a forecasted depreciation or whether it was concerned about its inability to pin down the costs of hedging.

Primary goal of risk management as stated by Stulzthat will suffice the above explanation –

A key goal of risk management then is to keep the probability of losses above a critical size from traded financial instruments low. To insure that this is the case, the firm can specify this critical loss size and the probability that it will be exceeded that it can tolerate.  Its main objective is not to dampen swings at corporate cash flows but provide protection against the possibility of costly lower?tail outcomes.

 

b) ABC Bank has the following balance sheet:

Required

1. Calculate the maturity gap for ABC Bank
2. Explain whether ABC Bank is more exposed to an increase or decrease in interest rates

Answer –

1. Maturity GAP

Maturity GAP is calculated as difference between average maturity period of assets and liabilities of financial institutions.

Formula to calculate maturity GAP –

MGAP = M(A) – M(L)

MGAP is a maturity gap.

MA is average maturity of assets

ML is average maturity of liabilities

Calculate maturity Gap of ABC Bank as shown below –

MGAP = ((0*20 + 5*60 + 200*30) / 320) – ((0*140 + 1*160) /300)

= ((0 + 300 + 6000) / 320) – ((0 + 160) / 300)

= 19.6875 – 0.53333

= 19.16 years

Thus, maturity Gap is 19.16 years. 

2. In this case ABC Bank is exposed to increase in interest rates. This is because it has positive maturity Gap and thus increase in interest rates would lead to decline in value of assets more than decline in value of liabilities.

 

c)  Bank of Southern America holds a $1 million position in a stock with beta=1.3. It has been estimated that over the past year, the standard deviation of the daily returns on the stock market index was 300 basis points. By assuming normality, calculate the 95% and 99?AR for this portfolio.

Answer

At 99% Confidence Level :

Probability factor for 99% Confidence Level= 2.33

Price volatility= Probability factor for 99% Confidence Level * Standard Deviation

Price volatility= 2.33 * 300bp

Price volatility= 699bp = 6.99%

 

DEAR= Amount * Price Volatility

DEAR= $1m * 6.99%

DEAR=$69900

 

At 95% Confidence Level

Probability factor for 99% Confidence Level= 1.65

Price volatility= Probability factor for 99% Confidence Level * Standard Deviation

Price volatility= 1.65 * 300bp

Price volatility= 495bp = 4.95%

DEAR= Amount * Price Volatility

DEAR= $1m * 4.95%

DEAR=$49500

 

d)  Using appropriate models, discuss the three factors that affect changes in the net worth of a financial institution when interest rates change. Assume that only duration is used for portfolio immunization purposes.

Answer –

INTEREST RATE CHANGE AND ITS EFFECTS ON NET WORTH OF A FINANCIAL INSTITUTION.

In the case of financial institutions they have Interest expenses as well as Interest Incomes .Like :

1. Interest to be paid on loans, deposits, bonds etc. taken . Here the increase in interest rate will reduce their profit or increase their losses. This will reduce its net worth. Similarly, a reduction in the market lending rates will reduce the financial institutions interest outflow, resulting in increase in the profits ar reduction in their losses. This will increase their net worth.

2. An increase in interest rates will increase their income on investments, loans, advances etc. . This will have an effect of increasing their profits or reducing their losses resulting an increase in net worth. Similarly, a reduction in interest rates will reduce their income receipts resulting in reducing profits or increase in losses. This will result in decreasing the Net worth.

Portfolio immunization is an investment strategy used to minimize the interest rate risk of bond investments by adjusting the portfolio duration to match the investor's investment time horizon.

 

e) Discuss whether interest rate risk is a big concern for investors given today’s economic environment.

INTERST RATE RISK AND INVESTMENTS

Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk on bond are depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on two things, the bond's time of maturity and the coupon rate of the bond.

Similarly, in all investment instruments this risk factor is present. In a sluggish economic condition like this where the economy is not showing any sign of positivity the investors will be put in deep uncertainty.

 

Question no. 3

a) Briefly discuss the problems associated with using modern portfolio theory for measuring a FI’s aggregate credit risk exposure.

Answer –

Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance. He was later awarded a Nobel prize for developing the MPT.

THE PROBLEMS OF USING MODERN PORTFOLIO THEORY

Critics contend MPT doesn't deal with the real world, because all the measures used by MPT are based on projected values, or mathematical statements about what is expected rather than real or existing. Investors have to use predictions based on historical measurements of asset returns and volatility in the equations, which means they are subject to be changed by variables currently not known or considered at the time of the equation.

Investors have to estimate from past market data because MPT tries to model risk in terms of the likelihood of losses, without a rationale for why those losses could occur. That makes the risk assessment probabilistic, but not structural.

In simple words, the mathematical model of MPT makes investing appear orderly when its reality is far less so.

 

b)  Consider the coefficients of Altman’s Z-score. Comment on the size of the coefficients and explain which ratios appear to be the most important in assessing the creditworthiness of a loan applicant. Also, comment upon the key limitation of this method.

Answer –

The Altman Z-score is a combination of five financial ratios weighted by coefficients that is used to estimate the likelihood of financial distress. The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by industry and approximate size (assets).

The original Altman Z-Sore was developed for US manufacturing companies and the formula is was as follows:

X1 = Working Capital (Current Assets less Liabilities) / Total Assets. Measures liquid assets in relation to the size of the company.

X2 = Retained Earnings / Total Assets. Measures profitability that reflects the company's age and earning power.

X3 = Earnings Before Interest and Taxes / Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.

X4 = Market Value of Equity / Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.

X5 = Sales / Total Assets. Standard measure for total asset turnover (varies greatly from industry to industry).

The five variables are then weighted together according to the following formula:

Altman Z-Score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5.

A Z-Score above 2.99 suggests that a company is in the Safe Zone based on the financial figures only. A Z-Score between 1.8 and 2.99 is in the Grey Zone which suggests there is a good chance of the company going bankrupt within the next two years of operations. Meanwhile, a Z-Score below 1.80 is in the Distress Zone which indicates a high probability of distress within this time period.

 

c) State Bank has the following year-end balance sheet (in millions):

The loans primarily are fixed-rate, medium-term loans, while the deposits are either short-term or variable-rate deposits. Rising interest rates have caused the failure of a key industrial company, and as a result, 3 percent of the loans are considered uncollectable and thus have no economic value. One-third of these uncollectable loans will be charged off.

Required:

1. What is the impact on the balance sheet after the necessary adjustments are made according to market value accounting?
2. Explain the main arguments against market value accounting
3. Explain the main argument that supports the use of market value accounting
4. What is the difference between the economic definition of capital and the book value definition of capital?

Solution

(i)

In market value of accounting the assets and liabilities of the company are represented on the basis of market value. The market value refers to the price which is currently quoted in the market.

The market value of the assets and liabilities and change in the market value of the assets and liabilities are taken into consideration in the market value of accounting. It does not consider the historical value.

There is a increase in the interest rate due to which 3% of the loans will not be collected by the Company as there is no economic value for such loans. The market value of loan remaining has decreased by 5?ter uncollectible loans.

The decline in the 3% of the loans which is considered as uncollectible and 5?cline in the remaining loans will be charged off.

So, the amount of loans to be charged off and decline in the value of equity is

= ($90*3%) + ($90*0.97*5%)=  $7.065 million.

So, the value of equity after deducting $7.065 million from $ 10 million will be ($10 - $7.065) = $2.935 millions.

(ii) Arguments against market value accounting

A financial institution has a different type of loans given to different people in different region which cannot be easily valued and that too regularly. If all the data are not available, then the Balance Sheet shall not give a true picture.

There is one more issue with the adoption of market value accounting is that all the changes in the value of the assets or liabilities are considered as income and passed to income statement, but they are not actually realized.

Moreover, if a long-term assets is revalued again and again, it might show its performance in a different way while it was constant over the long term. Because of all these reasons as mentioned above, this method of accounting is criticized all over the world.

(iii) Explain the main argument that supports the use of market value accounting

Market value accounting:- refers to accounting for the fair value of an asset or a liability based on the current market price. Market value accounting changes the values of the balance sheet as the market conditions change. It provides a realistic appraisal of the company's current financial position.

True Income. As fair value accounting limits the company’s ability for potentially manipulate its reported amount of net income. Sometimes the management might purposely arrange certain class of asset sales, example, To use gains or the losses from sales for increasing or decreasing net income reported.

Market values accounting reflect the most current and complete expectation and estimation of the value of assets or obligations, including the amounts, timing, and riskiness of the future cash flows attributable to assets or obligations. As such expectations lie at the heart of all transactions, market efficiency would be enhanced if the information upon which such decisions are made is reported in the financial statements at fair value.

(iv) Difference between the economic definition of capital and the book value definition of capital?

Financial system is composed of net lenders, financial intermediaries and net borrowers. The financial intermediaries helps in facilitation of transactions between the net lender and net borrower. The financial institution areregarded as the type fo the financial intermediaries.

There are many definitions of capital such as economic definition of capital and book value (accounting) definition of capital. The economist definition on capital of the financial institution is termed as the difference between the market value of liabilities and market value of assets.

However, the accountant or regulator definition of capital is termed as the difference of the assets as per book value and the book value of liabilities. The book value si regarded as the value of the assets and liabilities on the basis of historical costs.

For example, suppose the financial institution has a 20 million in the portfolio of loan, Suppose there is financial crisis, it would cause borrower to default the payment on loan issued to them and this lowers the market value of the loan that are part of the asset base of the financial institutions. Therefore, the financialinstructionshas to report with loan portfolio value with immediate descending adjustment on the portfolio of the loan.

However, for a similar situation as described above, as per the accounting method, the financial institution record asset base and corresponding losses on loans on their Balance Sheet at the opportune time with more discretion and hence are bale to handle the impact of the loan losses on the capital or the net worth of the financial institutions.

 

d) Define each of the following four measures of liquidity risk. Explain how each measure would be implemented and utilised by a depository institution. 

Required

1. Financing gap and financing requirement.
2. Sources and uses of liquidity.
3. Peer group ratio comparisons.
4. Liquidity index.

Answer –

(i)  Financing gap and financing requirement: The financing gap can be defined as average loans minus average deposits or, alternatively, as negative liquid assets plus borrowed funds. A negative financing gap implies that the bank must borrow funds or rely on liquid assets to fund the bank. Thus, the financing requirement can be expressed as financing gap plus liquid assets. This relationship implies that some level of loans and core deposits as well as some amount of liquid assets determine the need for the bank to borrow or purchase funds.

(ii) Sources and uses of liquidity: This statement identifies the total sources of liquidity as the amount of cash-type assets that can be sold with little price risk and at low cost, the amount of funds the bank can borrow in the money/purchased funds market, and any excess cash reserves over the necessary reserve requirements. The statement also identifies the amount of each category the bank has utilized. The difference is the amount of liquidity available for the bank. This amount can be tracked on a day-to-day basis.

(iii) Peer group ratio comparisons: Banks can easily compare their liquidity with peer group banks by looking at several easy to calculate ratios. High levels of loan to deposit and borrowed funds to total asset ratios will identify reliance on borrowed funds markets, while heavy amounts of loan commitments to assets may reflect a heavy amount of potential liquidity need in the future.

(iv) Liquidity index: The liquidity index measures the amount of potential losses suffered by an FI from a fire-sale of assets compared to a fair market value established under the conditions of normal sale. The lower the index, the less liquidity the FI has on its balance sheet. The index should always be a value between 0 and 1.

Explanation:

(i)  Financing gap and financing requirement: The financing gap can be defined as average loans minus average deposits or, alternatively, as negative liquid

assets plus borrowed funds. A negative financing gap implies that the bank must borrow funds or rely on liquid assets to fund the bank. Thus, the financing requirement can be expressed as financing gap plus liquid assets. This relationship implies that some level of loans and core deposits as well as some amount of liquid assets determine the need for the bank to borrow or purchase funds.

(ii) Sources and uses of liquidity: This statement identifies the total sources of liquidity as the amount of cash-type assets that can be sold with little price risk and at low cost, the amount of funds the bank can borrow in the money/purchased funds market, and any excess cash reserves over the necessary reserve requirements. The statement also identifies the amount of each category the bank has utilized. The difference is the amount of liquidity available for the bank. This amount can be tracked on a day-to-day basis.

(iii) Peer group ratio comparisons: Banks can easily compare their liquidity with peer group banks by looking at several easy to calculate ratios. High levels of loan to deposit and borrowed funds to total asset ratios will identify reliance on borrowed funds markets, while heavy amounts of loan commitments to assets may reflect a heavy amount of potential liquidity need in the future.

(iv) Liquidity index: The liquidity index measures the amount of potential losses suffered by an FI from a fire-sale of assets compared to a fair market value established under the conditions of normal sale. The lower the index, the less liquidity the FI has on its balance sheet. The index should always be a value between 0 and 1.