Derivatives, and risk management, left hand financing

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  • It gets complicated in a hurry.
  • Derivatives, and risk management, left hand financing

    1. 1. DERIVATIVES, AND RISK MANAGEMENT, LEFT-HAND FINANCING, AND LEVERAGED BUYOUT Group 1 Jerold Saddi Pamela Bernabe Juliet delos Santos Jenelle Canonizado Elvin Lee
    2. 2. Learning Objectives: After this session the FINMAN students would be able to:  Know all necessary concepts regarding derivatives  Know all various left-hand financing schemes, including their advantages and disadvantages  Know the mechanics of Leveraged buyout, its use, it’s advantages and disadvantagesJune 30, 2012
    3. 3. What are derivatives? Are financial instrument that “derive” their value from contractually required cash flows from some other security or index.June 30, 2012
    4. 4. Examplehttp://www.youtube.com/watch?v= FLGRPYAtReoJune 30, 2012
    5. 5. What are the essential features of aderivative? A derivative is a financial instrument  Values changes in response to the changes in UNDERLYING variables. No or minimum initial net investment Settled at a future date by a net cash payment / settlementJune 30, 2012
    6. 6. What are the kinds/examples ofderivatives? Option Contract Forward Contract Futures Contract Foreign Currency Exchange Contract Interest Rate SwapJune 30, 2012
    7. 7. Accounting for Derivatives Are to be considered as either assets or liabilities and should be reported in the balance sheet at fair value. Unrealized gain or loss from fedging transactions is presented depending on the type of hedging.  Under the Fair Value hedge method – part of income  Under Cash Flow Hedge Method – part of EQUITYJune 30, 2012
    8. 8. For foreign entity investment: Changes in fair Value determined to be an effective hedge are recognized in EQUITY. The ineffective portion of the changes in fair value are recognized in EARNINGS IMMEDIATELY if the hedging instrument is a derivative.June 30, 2012
    9. 9. Why do derivatives exist? Hedging - Pertains to designating one or more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item.http://www.youtube.com/watch?v =kBtrxAjtG04June 30, 2012
    10. 10. FORWARD CONTRACT A transaction in which a seller agrees to deliver a specific commodity to a buyer at some point in the future. Read more: http://www.investorwords.com/2060/forward_June 30, 2012
    11. 11. ExampleJune 30, 2012
    12. 12. Call/ put OptionsFinancial FuturesJune 30, 2012 Pamela Bernabe
    13. 13. OPTIONS  A derivatives financial instrument that specifies a contract giving its owner the right to buy or sell an asset at a fixed price on or before a given date.  Its also a unique type of financial contract because they give the buyer the right, but not the obligation, to do something.  The buyer uses the option only if it is adventageous to do so; otherwise the option can be thrown away  Give the marketplace opportunities to adjust risk or alter income streams that would otherwiseJune 30, not be available 2012
    14. 14. LOW STRIKEThales – ancient OLIVE SEASON –Greek philosopher HIGHJune 30, 2012
    15. 15. EXAMPLE Supposedly the first option buyer in the world was the ancient Greek mathematician and philosopher Thales of Miletus. On a certain occasion, it was predicted that the seasons olive harvest would be larger than usual, and during the off-season he acquired the right to use a number of olive presses the following spring. When spring came and the olive harvest was larger than expected he exercised his options and then rented theJune 30, 2012 presses out at much higher price than he
    16. 16. OPTION TERMINOLOGY• Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.• Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.• Call Option - Option to buy.• Put Option - Option to sell. Call Option Put Option Option Buyer Buys the right to buy the Buys the right to sell the underlying asset at the underlying asset at the Strike Strike Price Price Option Seller Has the obligation to sell Has the obligation to buy the the underlying asset to the underlying asset from the option holder at the Strike option holder at the Strike Price PriceJune 30, 2012
    17. 17. OPTION TERMINOLOGY• American Option - An option which can be exercised anytime on or before the expiry date.• Strike Price/ Exercise Price - Price at which the option is to be exercised.• Expiration Date - Date on which the option expires.• European Option - An option which can be exercised only on expiry date.JuneExercise• 30, 2012 Date - Date on which the option gets
    18. 18. CALL OPTIONSA call option gives you the right to buy within a specified time period at a specified price The owner of the option pays a cash premium to the option seller in exchange for the right to buyJune 30, 2012
    19. 19. PRACTICAL EXAMPLE OF A CALL OPTIONJune 30, 2012
    20. 20. CALL OPTIONS - ILLUSTRATION An investor buys one European Call option on one share of Neyveli Lignite at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity. On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium paymentJune 30, 2012 by the buyer.
    21. 21. June 30, 2012
    22. 22. PUT OPTIONS A put option gives you the right to sell within a specified time period at a specified price  It is not necessary to own the asset before acquiring the right to sell itJune 30, 2012
    23. 23.  An investor buys one European Put Option on one share of Neyveli Lignite at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The adjoining graph shows the fluctuations of net profit with a change in the spot price.June 30, 2012
    24. 24. June 30, 2012
    25. 25. CALL/PUT OPTIONS Call Option Put Option Option Buyer Buys the right to buy the Buys the right to sell the underlying asset at the Strike underlying asset at the Strike Price Price Option Seller Has the obligation to sell the Has the obligation to buy the underlying asset to the option underlying asset from the option holder at the Strike Price holder at the Strike PriceJune 30, 2012
    26. 26. STANDARDIZEDOPTION CHARACTERISTICS  All exchange-traded options have standardized expiration dates  The Saturday following the third Friday of designated months for most options  Investors typically view the third Friday of the month as the expiration date  The striking price of an option is the predetermined transaction price In multiples of $2.50 (for stocks priced $25.00 or below) or $5.00 (for stocks priced higher than $25.00)  There is usually at least one striking price above and one below the current stock priceJune 30, 2012
    27. 27. STANDARDIZEDOPTION CHARACTERISTICS Puts and calls are based on 100 shares of the underlying security  The underlying security is the security that the option gives you the right to buy or sell  It is not possible to buy or sell odd lots of optionsJune 30, 2012
    28. 28. FINANCIAL FUTURESForwards – a contract that is customized between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed priceFutures – an agreement between two parties to buy or sell an asset to a certain time in the future at a certain price. - it is also a special types of forward contracts in the sense that the former standardized exchange-traded contracts.June 30, 2012
    29. 29. SIMPLE EXAMPLE If you agree in April with your Aunt Sue that you will buy two pounds of tomatoes from her garden for $5, to be delivered to you when theyre ripe in July, you and Sue just entered into a futures contract.June 30, 2012
    30. 30. FINANCIAL FUTURES A financial future is a futures contract on a short term interest rate (STIR). Contracts vary, but are often defined on an interest rate index such as 3-month sterling or US dollar LIBOR. They are traded across a wide range of currencies, including the G12 country currencies and many others. The assets often traded in futures contracts include commodities, stocks, and bonds. Grain, precious metals, electricity, oil, beef, orange juice, and natural gas are traditional examples of commodities, but foreign currencies, emissions credits, bandwidth, and certain financial instruments are also part of todays commodity markets.June 30, 2012
    31. 31. FINANCIAL FUTURES Some representative financial futures contracts are:United States 90-day Eurodollar *(IMM) 1 mo LIBOR (IMM) Fed Funds 30 day (CBOT)Europe 3 mo Euribor (Euronext.liffe) 90-day Sterling LIBOR (Euronext.liffe) Euro Sfr (Euronext.liffe)Asia 3 mo Euro yen (TIF) 90-day Bank Bill (SFE)where IMM is the International Money Market of the Chicago Mercantile Exchange CBOT is the Chicago Board of Trade TOCOM is the Tokyo Commodity Exchange SFE is the Sydney futures exchangeJune 30, 2012
    32. 32. COMPARISON OF FUTURESAND FORWARD Futures Forward Amount Standardized Negotiated Delivery Date Standardized Negotiated Counter-party Clearinghouse Bank Collateral Margin Acct. Negotiated Market Auction Market Dealer Market Costs Brokerage and Bid-ask spread exchange fees Liquidity Very liquid Highly illiquid Regulation Government Self-regulatedJune Location 30, 2012 Central Worldwide exchange
    33. 33. ADVANTAGE AND DISADVANTAGEOF FINANCIAL FUTURES Advantages  Small Contract Size  Easy liquidation  Well organized and stable market (no risk of default) Disadvantages  Limited number of currencies (but think about how one futures might be a close hedge against another currency)  Rigid contract size  Fixed expiration dates (but if you can get close, it doesn’t matter all that much).June 30, 2012
    34. 34. THERE ARE TWO TYPES OFORGANIZATIONS THAT FACILITATEFUTURES TRADING:ExchangeExchanges are non-profit or for-profitorganizations that offer standardized futurescontracts for physical commodities, foreigncurrency and financial products.ClearinghouseA clearinghouse is agency associated with anexchange, which settles trades and regulatesdelivery. Clearinghouses guarantee thefulfillment of futures contract obligations by allparties involved.June 30, 2012
    35. 35. AN EXAMPLE:90-DAY EURODOLLAR TIME DEPOSITFUTURES Eurodollar futures contracts are traded on the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange. The underlying asset is a Eurodollar time deposit with a 3-month maturity.  Eurodollar rates are quoted on an interest-bearing basis, assuming a 360-day year.  Each Eurodollar futures contract represents $1 million of initial face value of Eurodollar deposits maturing three months after contract expiration.  Forty separate contracts are traded at any point in time, as contracts expire in March, June, September and DecemberJune 30, 2012
    36. 36. AN EXAMPLE:90-DAY EURODOLLAR TIME DEPOSIT FUTURES Eurodollar futures contracts trade according to an index that equals 100 percent minus the futures interest rate expressed in percentage terms.  An index of 91.50 indicates a futures rate of 8.5 percent.  Each basis point change in the futures rate equals a $25 change in value of the contract (0.0001 x $1 million x 90/360).June 30, 2012
    37. 37. 3 -M O . E U R O D O L L A R (C M E )-$ 1 M IL L IO N ; P T S O F 1 0 0 %EURODOLLAR Y ie ld O p en O p e n H ig h L o w S e ttle C h g S e ttle C h g I n te r e s t J u ly 9 4 .3 0 9 4 .3 1 9 4 .3 0 9 4 .3 1 ..... 5 .6 9 ..... 3 1 ,1 8 2FUTURES A ug S ept O c t 9 4 .3 1 9 4 .3 1 9 4 .3 1 9 4 .3 1 9 4 .3 1 9 4 .3 1 9 4 .3 0 9 4 .3 1 ..... ..... ..... 9 4 .2 7 ..... ..... ..... 5 .6 9 5 .6 9 5 .7 3 ..... ..... 5 1 0 ,6 0 6 ..... 9 ,3 8 0 2 ,1 9 2 N ov ..... ..... ..... 9 4 .2 7 ..... 5 .7 3 ..... 672 D ec 9 4 .2 6 9 4 .2 7 9 4 .2 4 9 4 .2 6 ..... 5 .7 4 ..... 3 8 7 ,5 3 1 M r9 9 9 4 .3 1 9 4 .3 1 9 4 .2 8 9 4 .3 1 ..... 5 .6 9 ..... 3 2 5 .3 4 2 J une 9 4 .3 0 9 4 .3 0 9 4 .2 8 9 4 .2 8 ..... 5 .7 2 ..... 2 6 9 ,6 4 1 The first column indicates the S ept 9 4 .2 6 9 4 .2 7 9 4 .2 6 9 4 .2 6 ..... 5 .7 4 ..... 2 2 9 ,0 7 5 settlement month and year. D ec M r0 0 9 4 .1 7 9 4 .1 7 9 4 .1 5 9 4 .1 6 9 4 .2 1 9 4 .2 1 9 4 .2 0 9 4 .2 1 ..... ..... 5 .8 4 5 .7 9 ..... 1 9 0 ,8 3 2 ..... 1 5 9 ,1 3 9 J une 9 4 .1 8 9 4 .1 8 9 4 .1 7 9 4 .1 8 ..... 5 .8 2 ..... 1 4 3 ,0 0 7 Each row lists price and yield S ept 9 4 .1 7 9 4 .1 7 9 4 .1 5 9 4 .1 6 ..... 5 .8 4 ..... 8 7 ,2 5 1 data for a distinct futures D ec M r0 1 9 4 .0 9 9 4 .0 9 9 4 .0 8 9 4 .0 9 9 4 .1 2 9 4 .1 3 9 4 .1 2 9 4 .1 2 ..... ..... 5 .9 1 5 .8 8 ..... ..... 7 3 ,2 0 5 6 7 ,2 2 2 contract that expires J une S ept 9 4 .1 1 9 4 .1 1 9 4 .1 0 9 4 .1 1 9 4 .1 0 9 4 .1 0 9 4 .0 9 9 4 .1 0 ..... ..... 5 .8 9 5 .9 0 ..... ..... 5 8 ,3 4 1 4 7 ,3 6 2 sequentially every three D ec 9 4 .0 3 9 4 .0 4 9 4 .0 2 9 4 .0 3 ..... 5 .9 7 ..... 4 1 ,4 1 5 months. M r0 2 J une 9 4 .0 7 9 4 .0 7 9 4 .0 6 9 4 .0 7 9 4 .0 5 9 4 .0 6 9 4 .0 4 9 4 .0 5 ..... ..... 5 .9 3 5 .9 5 ..... ..... 4 6 ,0 1 2 4 5 ,8 1 5 The next four columns report S ept D ec 9 4 .0 4 9 4 .0 5 9 4 .0 4 9 4 .0 4 9 3 .9 7 9 3 .9 8 9 3 .9 6 9 3 .9 7 ..... ..... 5 .9 6 6 .0 3 ..... ..... 4 3 ,1 8 4 3 2 ,7 3 6 the opening price, high and low M r0 3 J une 9 4 .0 1 9 4 .0 1 9 4 .0 0 9 4 .0 1 9 3 .9 9 9 3 .9 9 9 3 .9 8 9 3 .9 9 ..... ..... 5 .9 9 6 .0 1 ..... ..... 2 8 ,8 1 2 2 0 ,3 7 3 price, and closing settlement S ept 9 3 .9 8 9 3 .9 8 9 3 .9 8 9 3 .9 8 ..... 6 .0 2 ..... 1 5 ,8 6 4 price. D ec M r0 4 9 3 .9 1 9 3 .9 1 9 3 .9 1 9 3 .9 1 9 3 .9 4 9 3 .9 4 9 3 .9 4 9 3 .9 4 ..... ..... 6 .0 9 6 .0 6 ..... ..... 8 ,7 4 4 7 ,5 0 5 The next column, headed Chg, J une S ept ..... ..... ..... 9 3 .9 1 9 3 .9 1 9 3 .9 1 9 3 .9 1 9 3 .8 9 ..... ..... 6 .0 9 6 .1 1 ..... ..... 8 ,5 5 3 6 ,9 3 8 states the change in settlement D ec M r0 5 ..... ..... ..... ..... ..... 9 3 .8 2 ..... 9 3 .8 5 ..... ..... 6 .1 8 6 .1 5 ..... ..... 7 ,3 9 7 5 ,5 7 6 price from the previous day. J une ..... ..... ..... 9 3 .8 3 ..... 6 .1 7 ..... 5 ,3 2 3 S ept ..... ..... ..... 9 3 .8 1 ..... 6 .1 9 ..... 4 ,2 5 0 The two columns under Yield D ec ..... ..... ..... 9 3 .7 4 ..... 6 .2 6 ..... 3 ,7 3 5 convert the settlement price to M r0 6 J une ..... ..... ..... ..... ..... 9 3 .7 7 ..... 9 3 .7 4 ..... ..... 6 .2 3 6 .2 6 ..... ..... 5 ,8 1 6 3 ,6 4 8 a Eurodollar futures rate as: S ept D ec ..... ..... ..... ..... ..... 9 3 .7 2 ..... 9 3 .6 5 ..... ..... 6 .2 8 6 .3 5 ..... ..... 4 ,7 0 9 5 ,3 3 1 100 - settlement price = futures M r0 7 J une ..... ..... ..... 9 3 .6 8 ..... 9 3 .6 9 9 3 .6 9 9 3 .6 9 9 3 .6 6 1 .0 1 6 .3 4 2 .0 1 6 .3 2 ..... 4 ,0 7 5 4 ,2 0 5 rate S ept ..... ..... ..... 9 3 .6 4 1 .0 1 6 .3 6 2 .0 1 4 ,6 1 9 June 30, 2012 D ec ..... ..... ..... 9 3 .5 7 1 .0 1 6 .4 3 2 .0 1 3 ,6 8 0 M r0 8 ..... ..... ..... 9 3 .6 0 1 .0 1 6 .4 0 2 .0 1 3 ,4 0 6 J une ..... ..... ..... 9 3 .5 7 1 .0 1 6 .4 3 2 .0 1 295 E s t v o l 1 3 6 , 1 8 2 ; v o l F r i 2 2 7 , 5 8 8 ; o p e n i n t 2 , 9 6 31 ,19 19 , 66 ,4 5 .
    38. 38. SPECULATING WITHFUTURES, LONG Buying a futures contract (today) is often referred to as “going long,” or establishing a long position. Recall: Each futures contract has an expiration date.  Every day before expiration, a new futures price is established.  If this new price is higher than the previous day’s price, the holder of a long futures contract position profits from this futures price increase.  If this new price is lower than the previous day’s price, the holder of a long futures contract position loses from this futures price decrease.June 30, 2012
    39. 39. EXAMPLE I: SPECULATING INGOLD FUTURES You believe the price of gold will go up. So,  You go long 100 futures contract that expires in 3 months.  The futures price today is $400 per ounce.  There are 100 ounces of gold in each futures contract. Your "position value" is: $400 X 100 X 100 = $4,000,000 Suppose your belief is correct, and the price of gold is $420 when the futures contract expires. Your "position value" is now: $420 X 100 X 100 = $4,200,000 Your "long" speculation has resulted in a gain ofJune 30, 2012 $200,000
    40. 40. SPECULATING WITHFUTURES, SHORT Selling a futures contract (today) is often called “going short,” or establishing a short position. Recall: Each futures contract has an expiration date.  Every day before expiration, a new futures price is established.  If this new price is higher than the previous day’s price, the holder of a short futures contract position loses from this futures price increase.  If this new price is lower than the previous day’s price, the holder of a short futures contract position profits from this futures price decrease.June 30, 2012
    41. 41. EXAMPLE II: SPECULATING INGOLD FUTURES You believe the price of gold will go down. So,  You go short 100 futures contract that expires in 3 months.  The futures price today is $400 per ounce.  There are 100 ounces of gold in each futures contract. Your "position value" is: $400 X 100 X 100 = $4,000,000 Suppose your belief is correct, and the price of gold is $370 when the futures contract expires. Your “position value” is now: $370 X 100 X 100 = $3,700,000 Your "short" speculation has resulted in a gain of $300,000 What would have happened if the gold price was $420?June 30, 2012
    42. 42. INTEREST RATE SWAPSJune 30, 2012 Juliet Delos Santos
    43. 43. Swaps Contracts In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. There are two types of interest rate swaps:  Single currency interest rate swap  “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.  Cross-Currency interest rate swap  This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.June 30, 2012
    44. 44. Swap BankA swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. The swap bank can serve as either a broker or a dealer.  As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap.  As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.June 30, 2012
    45. 45. Example: Interest Rate Swap Consider this example of a “plain vanilla” interest rate swap. Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.  Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent.  It would make more sense to for the bank to issue floating-rate notes at LIBOR (London Interbank Offered Rate) to finance floating-rate Eurodollar loans.June 30, 2012
    46. 46. Example: Interest Rate Swap (cont.) Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five- year economic life.  Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent.  Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + ½ percent.  Firm B would prefer to borrow at a fixed rate.June 30, 2012
    47. 47. Example: Interest Rate Swap (cont.)The borrowing opportunities of the two firms are: COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBORJune 30, 2012
    48. 48. Example: Interest Rate Swap (cont.) Swap The swap bank makes this offer to Bank A: You pay Bank LIBOR – 1/8 % per year 10 3/8% on $10M for 5 yrs. and we LIBOR – 1/8% will pay you 10 3/8% on Bank $10M for 5 yrs. A COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBORJune 30, 2012
    49. 49. Example: Interest Rate Swap (cont.)½% of $10M = Here’s what’s in it for$50K. That’s quite Swap Bank A: They can borrowa cost savings per Bank externally at 10% fixedyr. for 5 yrs. 10 3/8% and have a net LIBOR – 1/8% borrowing position of Bank -10 3/8 + 10 + (LIBOR – 10% A 1/8) = LIBOR – ½ % which is ½ COMPANY B BANK A % better than they can Fixed rate 11.75% 10% borrow floating without a Floating rate LIBOR + .5% LIBOR swap. June 30, 2012
    50. 50. Example: Interest Rate Swap (cont.)The swap bankmakes this offer to Swapcompany B: You Bankpay us 10½% per 10 ½%year on $10 LIBOR – ¼%million for 5 years Companyand we will payyou LIBOR – ¼ % Bper year on $10million for 5 years. COMPANY B BANK A Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBORJune 30, 2012
    51. 51. Example: Interest Rate Swap (cont.)Here’s what’s in it ½ % of $10M =for B: Swap $50K that’s quite a cost savings per yr. forThey can borrow Bank 5 yrs.externally at 10 ½%LIBOR + ½ % and have LIBOR – ¼%a net borrowing position Company LIBOR + ½%of 10½ + (LIBOR + ½ ) B- (LIBOR - ¼ ) = 11.25%which is ½% better than COMPANY B BANK Athey can borrow floating. Fixed rate 11.75% 10% Floating rate LIBOR + .5% LIBOR June 30, 2012 25-51
    52. 52. Example: Interest Rate Swap (cont.)The swap bank makes money too. ¼% of $10M= Swap $25,000 per yr. for 5 yrs. Bank 10 3/8% 10 ½% LIBOR – 1/8% LIBOR – ¼% Bank Company A LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 B 10 ½ - 10 3/8 = 1/8 ¼ COMPANY B BANK A Fixed rate 11.75% 10% June 30, 2012 Floating rate LIBOR + .5% LIBOR 25-52
    53. 53. Example: Interest Rate Swap (cont.) The swap bank makes ¼% Swap Bank 10 3/8% 10 ½% LIBOR – 1/8% LIBOR – ¼% Bank Company A B A saves ½% B saves ½% COMPANY B BANK A Fixed rate 11.75% 10%June 30, 2012 Floating rate LIBOR + .5% LIBOR 25-53
    54. 54. Example: Currency Swap Suppose a U.S. MNC wants to finance a £10M expansion of a British plant. They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.  This will give them exchange rate risk: financing a sterling project with dollars. They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.June 30, 2012
    55. 55. Example: Currency Swap (cont.) If they can find a British MNC with a mirror-image financing need they may both benefit from a swap. If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16M.June 30, 2012
    56. 56. Example: Currency Swap (cont.)Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational.Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below. $ £ Company A 8.0% 11.6% Company B 10.0% 12.0%June 30, 2012
    57. 57. Example: Currency Swap (cont.)A’s net position is to borrow at £11% Swap Bank $8% $9.4% £11% £12% $8% Firm Firm £12% A B A savaes £.6% $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% June 30, 2012
    58. 58. Example: Currency Swap (cont.)B’s net position is to borrow at $9.4% Swap Bank $8% $9.4% £11% £12% $8% Firm Firm £12% A B B saves $.6% $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% June 30, 2012
    59. 59. Example: Currency Swap (cont.)The swap bank makes money too: 1.4% of $16 million Swap financed with 1% of £10 million per year Bank for 5 years. $8% $9.4% £11% £12% $8% Firm At S0($/£) = $1.60/£, Firm £12% A that is a gain of $64,000 B per year for 5 years. $ £ The swap bank faces Company A 8.0% 11.6% exchange rate risk, but Company B 10.0% 12.0% maybe they can lay it June 30, 2012 off (in another swap).
    60. 60. Variations of Basic Swaps Currency Swaps  fixed for fixed  fixed for floating  floating for floating  amortizing Interest Rate Swaps  zero-for floating  floating for floating Exotica  For a swap to be possible, two humans must like the idea. Beyond that, creativity is the only limit. June 30, 2012
    61. 61. Risks of Interest Rate and Currency Swaps Interest Rate Risk  Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position. Basis Risk  If the floating rates of the two counterparties are not pegged to the same index. Exchange Rate Risk  In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated. June 30, 2012 25-61
    62. 62. Risks of Interest Rate and Currency Swaps Credit Risk  This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap. Mismatch Risk  It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time. Sovereign Risk  The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap. June 30, 2012
    63. 63. Pricing a SwapA swap is a derivative security so it can be priced in terms of the underlying assets: How to:  Plain vanilla fixed for floating swap gets valued just like a bond.  Currency swap gets valued just like a nest of currency futures.June 30, 2012
    64. 64. Derivatives Prevailing in the PhilippineMarket Forward Swap (Interest or Asset) Options Credit-Linked Notes Structured Product –Structured Yield DepositSource: BSP Circular 594June 30, 2012
    65. 65. What is corporate risk management, and whyis it important to all firms? Corporate risk management relates to the management of unpredictable events that would have adverse consequences for the firm. All firms face risks, but the lower those risks can be made, the more valuable the firm, other things held constant. Of course, risk reduction has a cost.June 30, 2012
    66. 66. Definitions of different types ofrisk  Speculative risks – offer the chance of a gain as well as a loss.  Pure risks – offer only the prospect of a loss.  Demand risks – risks associated with the demand for a firm’s products or services.  Input risks – risks associated with a firm’s input costs.  Financial risks – result from financial transactions.June 30, 2012
    67. 67. Definitions of different types of risk  Property risks – risks associated with loss of a firm’s productive assets.  Personnel risk – result from human actions.  Environmental risk – risk associated with polluting the environment.  Liability risks – connected with product, service, or employee liability.  Insurable risks – risks that typically can be covered by insurance.June 30, 2012
    68. 68. What are the three steps ofcorporate risk management?1. Identify the risks faced by the firm.2. Measure the potential impact of the identified risks.3. Decide how each relevant risk should be handled.June 30, 2012
    69. 69. What can companies do to minimize orreduce risk exposure?  Transfer risk to an insurance company by paying periodic premiums.  Transfer functions that produce risk to third parties.  Purchase derivative contracts to reduce input and financial risks.  Take actions to reduce the probability of occurrence of adverse events and the magnitude associated with such adverse events.  Avoid the activities that give rise to risk.June 30, 2012
    70. 70. Leasing and Other Asset-Based Financing Corporate Financial Management 3e Emery Finnerty Stowe Modified for course use by Arnold R. CowanJune 30, 2012
    71. 71. Lease Financing A lease is a rental agreement that extends for one year or longer. The owner of the asset (the lessor) grants exclusive use of the asset to the lessee for a fixed period of time.  In return, the lessee makes fixed periodic payments to the lessor. At termination, the lessee may have the option to either renew the lease or purchase the asset.June 30, 2012 71
    72. 72. Types of Leases Full-service lease  Lessor responsible for maintenance, insurance, and property taxes. Net lease  Lessee responsible for maintenance, insurance, and property taxes.June 30, 2012 72
    73. 73. Types of Leases Operating lease  short-term  may be cancelable Financial lease  long-term  similar to a loan agreementJune 30, 2012 73
    74. 74. Types of Lease Financing Direct leases Sale-and-lease-back agreements Leveraged leasesJune 30, 2012 74
    75. 75. Direct Lease Manufacturer Lessee Lease / Lessor or ManufacturerLessee Lease Lessor Sale of Asset / LessorJune 30, 2012 75
    76. 76. Sale-and-Lease-Back Sale of Asset Lessee Lessor LeaseJune 30, 2012 76
    77. 77. Leveraged Lease Manufacturer Sale of Asset Single Lien Lender Purpose LoanLessee Lease Leasing Equity Company Equity InvestorJune 30, 2012 77
    78. 78. Synthetic Leases  Firms have used synthetic leases to get the use of assets but keep debt off their balance sheets.  An unrelated financial institution invests some equity and sets up a special- purpose-entity that buys the assets and leases it to the firm under an operating lease.  Since the Enron bankruptcy, firms have been reluctant to use synthetic leases.June 30, 2012 78
    79. 79. Advantages of Leases Efficient use of tax deductions and tax credits of ownership Reduced risk Reduced cost of borrowing Bankruptcy considerations Tapping new sources of funds Circumventing restrictions  debt covenants  off-balance sheet financingJune 30, 2012 79
    80. 80. Disadvantages of Leasing Lessee forfeits tax deductions associated with asset ownership. Lessee usually forgoes residual asset value.June 30, 2012 80
    81. 81. Valuing Financial Leases Basic approach is similar to debt refunding. Lease displaces debt. Missed lease payments can result in the lessor  claiming the asset.  filing lawsuits.  forcing firm into bankruptcy. Risk of a firm’s lease payments are similar to those of its interest and principal payments.June 30, 2012 81
    82. 82. Project Financing Desirable when  Project can stand alone as an economic unit.  Project will generate enough revenue (net of operating costs) to service project debt. Examples:  Mines & mineral processing facilities  Pipelines  Oil refineries  Paper millsJune 30, 2012 82
    83. 83. Project Financing Arrangements Completion undertaking Purchase, throughput, or tolling agreements Cash deficiency agreementsJune 30, 2012 83
    84. 84. Advantages and Disadvantages ofProject Financing  Advantages  Risk sharing  Expanded debt capacity  Lower cost of debt  Disadvantages  Significant transaction costs and legal fees  Complex contractual agreements  Lenders require a higher yield premiumJune 30, 2012 84
    85. 85. Limited Partnership Financing  Another form of tax-oriented financing.  Allows the firm to “sell” the tax deductions and credits associated with asset ownership to the limited partners.  Income (or loss) for tax purposes flows through to the partners.  Limited partners are passive investors.  General partner operates the limited partnership and has unlimited liability.June 30, 2012 85
    86. 86. June 30, 2012
    87. 87. 87 Leveraged Buyouts (LBO) • LBOs are a way to take a public company private, or put a company in the hands of the current management, MBO. • LBOs are financed with large amounts of borrowing (leverage), hence its name. • LBOs use the assets or cash flows of the company to secure debt financing, bonds or bank loans, to purchase the outstanding equity of the company. • After the buyout, control of the company is concentrated in the hands of the LBO firm and management, and there is no public stock outstanding.
    88. 88. 88 History: LBO • Leveraged buyouts were a relatively obscure means of financing large corporate acquisitions in the post WWII period. The practice positively boomed in the 1980s, with a combined $188 billion in acquisitions taking place in 1988 alone. The term “hostile takeover” coined during this period, it reflects the mixed feelings towards LBO.
    89. 89. 89 Successful LBO Strategies • Finding cheap assets – buying low and selling high (value arbitrage or multiple expansion) • Unlocking value through restructuring: – Financial restructuring of balance sheet – improved combination of debt and equity – Operational restructuring – improving operations to increase cash flows
    90. 90. Key Terms and concepts regarding LBOs: Transaction fee amortization. This reflects the capitalization and • amortization of financing, legal, and accounting fees associated with the transaction. - its like depreciation, is a tax-deductible noncash expense. Interest Expense- For simplicity, interest expense for each tranche of • debt financing is calculated based on the yearly beginning balance of each tranche. • Capitalization. Most leveraged buyouts make use of multiple tranches of debt to finance the transaction. A simple transaction may have only two tranches of debt, senior and junior. A large leveraged buyout will likely be financed with multiple tranches of debt that could include some or all of the following: • Revolving credit facility (revolver). This is a source of funds that the bought-out firm can draw upon as its working capital needs dictate.
    91. 91. • Bank debt. Often secured by the assets of the bought-ought firm, this is the most senior claim against thecash flows of the business.• Mezzanine Debt – exists in the middle of the capitalstructure and is junior to the bank debt incurred infinancing the leveraged buyout.• Subordinated or high yield notes (junk bonds) –most junior source of debt financing and as such hasthe highest interest rates.• Cash Sweep - is a provision of certain debt covenantsthat stipulates that any excess cash generated by thebought out business will be used to pay downprincipal.• Exit Scenario – usually involves either a sale ofportfolio company or recapitalization.

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