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Corporate Finance

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Corporate Finance ­FIN 622
Lesson 41
We shall cover following topics in this hand out:
Interest rate future
Prices in futures
Hedging ­ short term interest rate (STIR)
Scenario ­ Borrowing in ST and risk of rising interest
Scenario ­ deposit and risk of lowering interest rates on deposits
Options and Swaps
Features of options
Option terminology
Interest Rate Future:
Interest rate futures are also contracts, which have following features:
These contracts are similar to currency futures.
These are traded in standardized form on future exchanges.
Settlement dates on future exchanges are calendar quarters.
Each future contract is for standardized quantity of underlying security.
Price of the future is expressed in terms of underlying item.
Interest rate future, like currency futures may be settled before the maturity date.
Short Term Interest Rate futures ­ STIRs are cash settled.
Long-term interest rate futures are settled through physical delivery of bonds.
STIRs: is a type of standardized interest rate future on a notional deposit (for 3 months) of standard
amount of principal.
Bond futures: these are based on standard quantity of notional bonds. If buyer or seller does not close his
position before the final settlement date, then the contract is settled through physical delivery.
Prices of interest rate future are determined as follows:
Bond futures: these are priced exactly the same way as normal bonds.
For example, an interest rate future may be priced at 109.50 per 100 nominal value of underlying notional
Short-term interest rate futures are price in unusual way: the price is calculated by deducting interest rate
from 100. For example, if the interest rate is 6%, price will be 94. If 8%, price is 92. It means that if interest
rate rises, the price will fall and vice versa.
Hedging with Short Term Interest Rates:
A company intends to borrow short term in future may be concerned about the rising short-term interest
A company planning to place an amount in a short-term deposit may anticipate drop in deposit interest
The hedge is to establish a notional position to fix the interest rate in short term.
Scenario: a firm plans to borrow in short term and risk of rising short-term interest rates
A notional position is established with future. If the interest rate goes up, it will earn profit.
This profit will be used to offset the higher interest rate on loan when it is taken.
On the other side, if interest rates go down, it will result in loss with stirs, and this will be added to the
interest on loan cost when loan will actually be taken out.
The hedge will be to sell short-term interest rate future.
If interest rates go up, it will result in profit. Price of future will fall. The future will be closed by selling at
higher prices and then buying at lower price.
Corporate Finance ­FIN 622
If interest rates move down, it will result in loss. Price of future will increase. The future will be closed by
buying at higher price and selling at lower price.
Risk of fall in short term interest and firm plans to invest
If the short term interest rates fall the firm will make profit and this profit will be added to the interest
earned by deposit to arrive at net return on deposit.
The loss of return on deposit due to fall in short term interest rates is off set by the profit on futures.
If interest rates go up, there will be loss on future contract but the same will be off set by higher interest
rate on deposit.
The hedge can be created by buying short-term interest future.
Future position should be closed when actual deposit period begins by selling the same number of interest
rate futures.
If interest rate rise, price will fall, loss will incur.
If interest rate fall, price will rise, profit will be generated.
We can now note two important issues while deciding to hedge using STIRs:
A hedge can be created by buying and selling the exact number of contract but in real life this is not the case
and the hedge is not perfect. If the number of contracts needed to buy or sell is not a whole number then
the company has to buy or sell to the nearest whole number. This hedge is not perfect. For example, a
hedge would need 7.6 contracts to be bought or sold, and you cannot trade this number because contracts
are available in whole number. The firm will be buying or selling seven or eight contracts.
If the intended loan or deposit period is less than three months or longer than three months, a different
situation will arise. In these situations, where STIR contract is less than three months interest rate, the
hedge will be created by adjusting the number of futures contracts required by a factor of X/3, where X, is
the planned borrowing or investment period.
An option is a contract that confers a right to buy or sell a specific quantity or asset ­ but not the obligation,
at agreed price on or before the specified future date.
Options are available for commodities (like wheat, coffee, sugar, etc) and financial assets like currency or
bank deposits.
Features of Options:
It is a contractual agreement.
The holder of option exercises his/her right only if it is in his/her favours.
Option writer is seller and must honor his side of contract. (Sell or buy at agreed price).
Options like futures are standardized transaction in terms of size & duration.
Options are Exchange traded
These agreements are easy to buy & sell
Options either are call options or put options.
The option purchase price is called option premium.
Call option gives its holder a right (not obligation) to buy underlying item at the specified price.
Put option gives its holder a right (not obligation) to sell underlying item at specified price.
Expiry date:
Each option has expiry date and the holder must exercise his/her right before this date otherwise, it will
Strike or exercise price:
The price mentioned in option at which the holder exercises his right is known as exercise or strike price.
Options pricing
The strike price may be higher, lower or equal to the current market price of underlying item.
For example, a call option gives the right to its holder to buy x number of shares of y company at Rs 10 per
share and the current price could be greater than Rs. 10/-, less than Rs. 10/- or exactly Rs 10/- per share.
If the strike price is more favorable than the current market price of underlying asset or item, the option is
termed as "in-the-money."
Corporate Finance ­FIN 622
If the strike price is not favorable than the current market price of underlying asset or item, the option is
called "out-of-money."
If the strike price and current market price are equal, then it is known as "at-the-money."
An option holder will only exercise his option if it is "in-the-money".
Table of Contents:
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk