If Mr. Lim wants a 9% rate of return on the investment, he had to sell the bond for $988.53. Mr. Lim had first paid $980.30 for the bond at a yield to maturity (YTM) of 8.5%, and with an YTM of 8.5%, he would only be able to get a bond price of $988.62 the following year. Hence, at a price of $988.53 the following year, the YTM would have fallen to 8.35%. Thus, it is realistic to sell his bong at $988.53.
Question 1 (c) i.
Conversion price = Material price of conversion bond
Conversion ratio
=
= $2.50
Conversion Premium = Bond price - (Stock price x conversion ratio)
= $100 - ($2.375 x 40)
= $100 - $95
= $5
Question 1 (c) ii.
Conversion value = Current market price of common stock received on conversion
x Conversion rate or ratio
= $2.375 x 40
= $95
Question 1 (c) iii.
Value of convertible bond = $60 million
Interest = $100 x 8.5%
= $8.50
Value of bond (Vb) in 15 years = INT (PVIFA int, N) + M (PVIF int, N)
= 8.5 (7.6061) + 100 (0.2394)
= $88.59
Total number of bonds = $60 million / $88.59
= 677,277.35
Value of bond (Vb) in 10 years = INT (PVIFA int, N) + M (PVIF int, N)
= 8.5 (6.1446) + 100 (0.3855)
= $90.78
Price of bond in 10 years = $90.78 x 677,277.35
= $61,483,237.83
Value of bond upon maturity = Conversion value x Price of bond in 10 years
= $64,341,348.25
Difference between value of bond upon maturity and price of bond in 10 years
= $64,341,348.25 - $61,483,237.83
= $2,858,110.42
As the value of the bond upon maturity is greater than the price of the bond, Mr. Lim can invest in the convertible bond as it gives him a profit of $2,858,110.42.
Question 2 (a).
Theoretical ex-rights price
= Current share price x Number of rights needed to subscribe for 1 new share + New share price
Number of rights needed to subscribe for 1 new share +1
=
=
= $2.75
Question 2 (b).
Number of new shares =
= 10 million
3 Old shares : 1 New share
Ratio is 1:3
Thus, number of ordinary shares before rights offering = 10 million x 3
= 30 million
Question 2 (c).
Number of shares after rights offering = 30 million + 10 million
= 40 million
Market value of shares after rights offering = 30 million x $3 + 10 million x $2
= $90 million + $20 million
= $110 million
Value of each share after rights offering =
= $2.75
Value of a right on one old share = Market value of each share after rights offering
- Value of each rights shares offered
= $2.75 - $2.00
= $0.75
Mr Lim's ownership of share in the company before rights offering =
= 0.03%
Amount of rights Mr. Lim is entitled = 10 million x 0.03%
= 3000
Amount that Mr. Lim will received from the company before rights offering
= 9000 x $3.00
= $27,000
Amount that Mr. Lim will received from the company after rights offering
= Value of Mr. Lim's ordinary shares + Value of Mr. Lim's right shares
= 9000 x $2.75 + 3000 x $0.75
= $24,750 + $2,250
= $27,000
Mr. Lim would have received $27,000 from the company. In addition, he would not lose value despite unable to afford the right shares because the value of his shares before rights offering ($27,000) is the same as the sum of the value of his shares after rights offering and the value of the rights he is entitled ($24,750 + $2,250 = $27,000).
Even though Mr. Lim may not be able to find the cash necessary for the purchase of the rights, he still can sell them to other investors at the price of $0.75 each. As a result, he will still end up $27,000, hence losing no value.
Question 2 (d).
Cum rights are shares held by holders of record that are qualified for rights offering by a company. They are offered for sale with their associated rights attached. [1]
On the other hand, ex-rights shares are shares that are being offered for sale, but without rights attached. This is due to share expiry, share being exercised or being transferred to other investors. Thus, the rights to the stockholders are no longer applicable to the stock or valid. [2]
In general, the share price of a stock with cum rights is higher than the share price of a stock with ex-rights.
Question 3 (a).
When the spot rate in 3 months time = R7.00/ US$,
Forward market hedge strategy
Mr. Lim had based the invoice at a three months forward rate of R7.50/ US$, however the spot rate in 3 months time is R7.00/ US$.
Invoice amount at a three months forward rate of R7.50/ US$ for R150 million
= US$20 million
Invoice amount at a spot rate in 3 months time of R7.00/ US$ for R150 million
= US$21.43 million
US$20.00 million - US$21.43 million = - US$1.43 million
Mr. Lim would have made a loss of US$1.43 million using the forward market hedge strategy.
Money market hedge strategy
Invoice amount at a current spot rate of R7.46/ US$ for R150million
= US$20.107 million
3% interest rate on US$20.11 million deposited for 3 months
= US$20.107 million x 3%
= US$0.603 million
2.5% interest rate on R150 million loaned for 3 months
= R150 million x 2.5%
= R3.75 million
At 3 months spot rate of R7.00/ US$, R3.75 million
= R3.75 million / R7.00
= US$0.5357 million
US$0.603 million - US$0.5357 million = US$0.0673 million
Mr. Lim would have made a profit of US$0.0673 million using the money market hedge strategy.
Currency option hedge strategy
Strike price gives the buyer the right to buy at a prespecified price by paying an additional premium. In this case, with a strike price of R7.50/ US$ and a premium of US$400,000, Mr. Lim would receive:
R150 million at R7.50/ US$ - premium = US$20 million - US$400,000
= US$19.6 million
Mr. Lim would have made a profit of US$19.6 million using the currency option hedge.
When the spot rate in 3 months time = R7.00/ US$,
= R150 million / R7.00
= US$21.43 million
Mr. Lim could have received US$21.43 million based on a spot rate of R7.00/ US$ in 3 months time.
US$19.6 million - US$21.43 million = - US$1.83 million
Mr. Lim would have made a loss of US$1.83 million using the currency option hedge strategy.
Question 3 (b).
When the spot rate in 3 months time = R8.00/ US$,
Forward market hedge strategy
Mr. Lim had based the invoice at a three months forward rate of R7.50/ US$, however the spot rate in 3 months time is R8.00/ US$.
Invoice amount at a three months forward rate of R7.50/ US$ for R150 million
= US$20 million
Invoice amount at a spot rate in 3 months time of R8.00/ US$ for R150 million
= US$18.75 million
US$ 20.00 million - US$18.75 million = US$1.25 million
Mr. Lim would have made a profit of US$1.25 million using the forward market hedge strategy.
Money market hedge strategy
Invoice amount at a current spot rate of R7.46/ US$ for R150million
= US$20.107 million
3% interest rate on US$20.11 million deposited for 3 months
= US$20.107 million x 3%
= US$0.603 million
2.5% interest rate on R150 million loaned for 3 months
= R150 million x 2.5%
= R3.75 million
At 3 months spot rate of R8.00/ US$, R3.75 million
= R3.75 million / R8.00
= US$0.4688 million
US$0.603 million - US$0.4688 million = US$0.1342 million
Mr. Lim would have made a profit of US$0.1342 million using the money market hedge strategy.
Currency option hedge strategy
Strike price gives the buyer the right to buy at a prespecified price by paying an additional premium. In this case, with a strike price of R7.50/ US$ and a premium of US$400,000, Mr. Lim would receive:
R150 million at R7.50/ US$ - premium = US$20 million - US$400,000
= US$19.6 million
Mr. Lim would have made a profit of US$19.6 million using the currency option hedge.
When the spot rate in 3 months time = R7.00/ US$,
= R150 million / R8.00
= US$18.75 million
Mr. Lim could have received US$18.75 million based on a spot rate of R8.00/ US$ in 3 months time.
US$19.6 million - US$18.75 million = US$0.85 million
Mr. Lim would have made a profit of US$0.85 million using the currency option hedge strategy.
Question 3 (c).
Foreign exchange risks are risks that usually affect business that do import and or export, as well as investors involved with international investments. They are risks of the investment's value that changes because of currency exchange rates changes. [3] This fluctuation in price is a double-edged sword as agreeing on a price beforehand could work for or against the investor. Hence, it is only safer and sensible that foreign exchange risks are hedged to reduce risks.
Question 4 (a).
Under a swap arrangement, Black & Co. will be borrowing from Bank A at a 9% fixed rate while White & Co. will borrow from Bank B at a floating rate of LIBOR + 150 basis points (bps).
The interest rate payment flow chart is as below:
Question 4 (b).
The drawbacks of the swap arrangement for Black & Co. are interest rate risk and credit risk.
Interest rate risk comes from changes in the floating rate. The party (White & Co.) whom pays the floating rate, benefits when rates fall. On the other hand, Black & Co. whom has locked at a fixed rate of 9% payment from the beginning would not have benefit from the decrease in interest rates. This means that Black & Co. would have to pay more than the market rate, which might cause a potential loss in its business operations.
Credit risk may happen when Black & Co. faces default by either White & Co. or Bank B as there was a note stating that due to credit standing, White & Co. can only borrow at Libor + 200 basis points. This shows that White & Co. has a low credit rating which again could be a potential risk to Black & Co.
Question 4 (c).
An interest rate cap is an option contract which imposes an upper limit on a floating exchange rate. [4] When the reference rate is breached, the writer of the cap has to pay the cap's holder the difference between the reference rate and the floating rate. In order to gain certainty of a maximum payout, there is a premium payable for such contract.
If Libor rate cap is 8.5%, 4% of 40 million covered = $50 million x 4%
= $2 million
If Libor rate rises to 10% in the 4th year, the bank will have to compensate Black & Co.
= (10% - 8.5%) x $2 million
= 1.5% x $2 million
= $30,000
If the 4th year Libor rises to 10%, the payment will be $30,000
Question 4 (d).
Caps and floors are derivative securities that help to hedge interest rate risk. A 'floor' is a put option on interest rates and are often with multiple exercise dates whereas a 'cap' is a call option on interest rate and similarly often with multiple exercise dates. [5] Firms would buy a 'cap' if interest rate rise would lead to a loss and hence financial institutes purchase interest rate caps when they are exposed to losses causes by it. Financial institutes purchase 'floor' when they have fixed costs on debts and floating rates on assets or net short in bonds.
To alleviate the cost of a 'cap', a 'floor' can be used in the form of a collar option whereby a firm can simultaneously be in a 'cap' and a 'floor' by selling a 'floor' and buying a 'cap'. [6] Thus, the firm can hedge itself against rising interest rates and is still able to finance the cost of the 'cap'.
