Finance

14-1. What are financial markets What function do they perform How would an economy be worse off without them

Financial market is a place where buyer and seller easily interact with each other by trading different stocks, bonds and securities. The role of financial market is very pivotal in building the economy of any country and it is the barometer of the economy. The functions of financial markets are stated below
It provides a hub where investors buy and sell their securities.

Financial market helps in transfer of funds from one place to other and transfer the risk associated with.
Without financial market it is not possible for and financial analyst to assess the performance of any countrys economy. If financial market not exists than it is not feasible for an investor to evaluate the risk, inflation, prices of any commodity, etc.

14-3. Distinguish between the money and capital markets.
Money market is a place where short term liquid securities are transact. The life of those securities is less than a year such as CDs, T-Bills, Commercial Paper, etc. In money market the role of banks, mutual funds, etc is very significant.

Capital market is a place where long term liquid securities are transacts in form of bonds, stocks, etc. In addition, capital market is a place where either the corporate firms or government raises its long term funds.

c. 14-4. What major benefits do corporations and investors enjoy because of the existence of organized security exchanges

Some of the major benefits that the corporations and investors enjoy due to the existence of organized security exchanges are stated below

It provides a guarantee that over the investment of the potential investor.

It provides a space where to the businesses where they motivate the potential investors to invest in any particular security.
 
Where new companies raises its capital through an IPO.
15-12A.

COMPUTATION OF BREAKEVEN IS STATED BELOW

STEP 1 COMPUTE MARGIN
Margin x Operating asset turnover  Return on operating assets
Margin x 5  0.25
Margin  0.05

STEP 2 COMPUTE SALES
Sales  Operating assets  Operating asset turnover
Sales  20,000,000  5
Sales  20,000,000 x 5
Sales  100,000,000

STEP 3 COMPUTE EBIT
EBIT  Margin x Sales
EBIT  0.05 x 100,000,000
EBIT  5,000,000

STEP 4 COMPUTE REVENUE BEFORE FIXED COSTS
Revenue before fixed costs  Degree of operating leverage x EBIT
Revenue before fixed costs  4 x 5,000,000
Revenue before fixed costs  20,000,000

STEP 5 COMPUTE TOTAL VARIABLE COST (TVC)
 Sales  TVC  20,000,000
100,000,000  TVC  20,000,000
TVC  80,000,000

STEP 6 COMPUTE FIXED COSTS
Revenue before fixed costs  Fixed costs  5,000,000
20,000,000  Fixed Costs  5,000,000
Fixed Costs  15,000,000

STEP 7 COMPUTE SALES PER UNIT  VARAIBLE COST PER UNIT
Price per unit  Sales  Units
Price per unit  100,000,000  10,000,000
Price per unit  10
Variable cost per unit  TVC  Units
Variable cost per unit  80,000,000  10,000,000
Variable cost per unit  8

STEP 8 COMPUTE BREAKEVEN
Sales  Variable expenses  Fixed expenses  Profits
10Q  8Q  15,000,000  0
2Q  15,000,000
Q  15,000,000  2 per unit
Q  7,500,000 Units
e.      15-13A.

A. BREAK-EVEN POINT (In Units)
Sales  Variable expenses  Fixed expenses  Profits
180Q  126Q  540,000  0
54Q  540,000
Q  540,000  54 per unit
Q  10,000 units

B. BREAK-EVEN POINT (In Dollars)
Breakeven units x Selling Price per Unit
10,000 Units x 180
1,800,000

C.
UNITS12,00015,00020,000Sales  1802,160,0002,700,0003,600,000Less Variable Cost  1261,512,0001,890,0002,520,000Contribution Margin648,000810,0001,080,000Less Fixed Costs540,000540,000540,000EBIT108,000270,000540,000

D.
UNITS12,00015,00020,000Contribution Margin (a)648,000810,0001,080,000EBIT(b)108,000270,000540,000Degree of Operating Leverage (a b)6 times3 times2 times

Q.1    hat is the capital market How is the primary market different from the secondary market In your opinion, are these markets efficient Why or why not

The term Capital Market refers to those markets where only broad and long term range of financial products and services like Mortgages, Treasury Notes and government Bonds and Corporate Bonds etc. are traded. This is the place where companies and government raise their funds by issuing long term bonds where any potential investor or company buys a bond for certain time period and issuing bond authority promised to pay higher return to that person.

THE BASIC DIFFERENCE BETWEEN THE PRIMARY AND SECONDARY MARKET
Newly issued securities firstly offer in the primary market to the investors. In this type of transaction investments banks are engaged and settle all the arrangements of IPOS (Initial Public Offering). Secondary market is quite different from primary market because in this market existing and outstanding securities are traded in stock exchange.

Yes, these markets are efficient and investors shown great deal of interest in it. Basically, these markets provides information to the potential investors about the stocks, bonds etc. of the companies and importantly allows them to trade securities under the one roof.

Q.2    What is three primary roles of the SEC How does the Sarbanes Oxley Act augment the SECs role in managing financial governance Do you think that businesses are more ethical after the passing of the Sarbanes Oxley Act What examples are there to support you answer.
   
The three objectives of Sarbanes Oxley Act are to provide a guarantee that securities market is functioning in a comfortable and organized manner. Securities industry specialists are dealing clearly with their customers. Corporations provide all material information to public so that investors made sound and accurate decisions about investments. Sarbanes Oxley Act enhanced the role of financial governance by mandating companies to disclose the financial information in front of investors. The act contains 11 sections ranging form additional corporate board responsibilities to criminal penalties. These all sections empowered and ensured the finance governance. After the implementation of this act companies are more ethical about the facts and figures. Because all financial information must be disclosed in front of the investors and if there is any sort of manipulation occurred in the financial information which in the lead towards penalties. For instance, investors are more relying on this act and if company manipulates their financial information that leads the investors to make a wrong decision. In the end, potential investor sues over the company in the court of law.

Q3    Which ratios measure a corporations liquidity What are some of the problems associated with using financial ratios How would the DuPont analysis overcome some of these problems

The following are the below ratios measure the Liquidity of the company
Current Ratio
Quick Ratio Net
Working Capital Ratio
Some problems associated with using financial ratios
Ratio analysis just deals with numeric values printed on financial statements and dont examine the other factors that affected the performance of the company.

It is difficult to predict whether certain ratio is good or bad. Like, the high current ratio of the company that showed an excellent liquidity position but on the other hand this shows that company is holding excessive amount of cash.

Different accounting procedures may affect the analysis of the ratio. Currently there are four commonly used methods to measuring the inventory. (1) Specific identification (2) FIFO (3) LIFO (4) Weighted Average. Different Depreciation methods to calculate depreciation like (1) Straight line (2) Diminishing Method etc.

The affect of inflation is not properly proposed in financial statements and figures based on historical numbers.

The differences in approaches to analyze the ratio also create the hurdle in elaborating the clear and fair finding of the ratio.

DuPont analysis means assets are measured on the basis of gross book value instead of net book value in order to show the higher return on equity (ROE). This analysis gives a plat form to resolve the some problems regarding the interpretation of the ratio like taken the assets on gross book value provide a higher return on equity. It avoids the effect of accounting depreciation method that resulting in higher ROE.

The acquisition of YouTube by Google came as a no surprise to many analysts in the technology industry. Google has developed a habit of buying companies that are based on a great idea and have a potential of becoming cash cows in the future once their development costs are recovered. Or in Googles case once the acquisition costs are covered these companies stand to benefit Google immensely.

On a strategic level Google has been successful because they know that re-inventing the wheel is a far more difficult and expensive task than just buying the whole idea from another creator. It has few basic advantages firstly it reduces competition and secondly it is a quick way of getting into a market. The 1.65 billion dollar move to buy YouTube might look expensive for the year 2006 but what Google knew about YouTube was more then what others could eve think about.

Lets see what YouTube offered Google when it might have thought of acquiring the company. In our opinion YouTube had a lot in common with what Google did a few years back when it was starting up. YouTubes simple and powerful idea of video-sharing allowed customers to challenge norms and interact with the world in an absolute new way such that just a click on upload will let their videos be seen by anyone else in the world. Just like Google the simple concept of video-sharing and giving power to the customers led to a phenomenal growth in the customer base of YouTube secondly because of the potential of the service we saw that a number of brands were attracted to sponsor YouTube.

Although this basic understanding of how Google and YouTube have similar business models is good for both the companies in terms of compatibility and direction but one wonders that to keep the creativity juices going how the working arrangements will be developed between these two companies Luckily for both the firms when Google was buying YouTube the deal was measured in Google stock and the Google management also announced that YouTube will continue working just as a separate company though Google will provide technological support to improve YouTubes ability to handle more powerful camera videos and other technological challenges.

Such an arrangement is of great help and strength for the YouTube management as they keep the all important product development and idea creation departments in their control the subsequent advantage of such a move is that Google is spared the need for hiring and nurturing a brand new team for YouTube. All Google needs to do is to keep the current YouTube employees happy and give them enough control and autonomy that are interested in staying with both the brands.

Another important aspect that justifies the price tag for YouTube is the similarity between Google and YouTubes revenue models. Both the companies rely on their large and growing customer bases and their potential ability of viewing in-text advertisements. By acquiring YouTube, Google gave a huge boost to its already massive customer base. This fundamental reason will ensure that the Google and YouTube relationship will bear great fruit for both the companies in the near future.

It must be understood here that certain industries have a unique growth model compared to other industries. The technology sector requires firms to grow at a phenomenal pace in order to survive competition and continue making revenues. The birth of Google was one of the greatest inventions of our time though we can not expect another similar product from the creators therefore to keep the company liquid and moving the firm has to expand its product base and either buy new ideas or create further ones.

The advantage that Google has is the huge clout over the internet market and its massive financial backing therefore buying a reasonably successful idea in its early years is a very good way of expanding Googles business interests. Just look at how an acquisition by Google of YouTube in 2006 will lead to future cash inflows that will cover all costs and result in profits as well. According to one analyst revenues from YouTube will come at a 7.5 million per month after the acquisition. Another independent analyst puts these revenue forecast figures at 150 million annually.

The benefits that Google has achieved from the buyout of YouTube more than compensate for the costs this is because a company like Google is dependent on customer base for revenue generation and YouTube has exactly been the product lately which has attracted large amounts of customer and fan base. The revenue sharing model between customers uploading videos and YouTube has given the companys revenue generation ability a completely new dimension.

We also must understand why YouTube has a long-term sustainability factor such that revenues will increase in the next few years. Firstly, YouTube offers customers the ability to watch what they like and search using filters and other options. Secondly with the stepping in of Google we see that YouTube has become more users friendly and accessible from a number of different sources. YouTube videos have become more searchable and through search engine optimization and other related technologies Google has strengthened the technology side of YouTube.

What we gather from the Google strategy here is that acquisition is the next big way in the technology sector for expanding and diversifying customer base. But a worrying aspect is that will companies like Google, Yahoo and Microsoft eventually become the big three of the industry and stifle competition and start on aggressive buyouts and increase barriers to entry. This can be detrimental to the technology industry since it thrives on the inventions and product-led approaches of many of the start-up entrepreneurs.

Analysis
Googles buyout of YouTube has set a major pattern in the technology sector. Companies like Yahoo, Microsoft, and Google are all vying up to buy successful startups and extremely good prices. This is an encouraging sign for many of the developers and investors who see the emergence of a potential exit strategy though we must ask crucial questions about the aggressive nature of these takeovers and is this acquisition model sustainable in the long-run

On a strategic level a company like Google wants to buy a company like YouTube, even at a higher than expected price tag, because the benefits in the future are so large that todays cost would look very small after a few years. In the technology sector it is all about the market share and how much money one can gain from each increasing customer. The media involvement and the entertainment aspect to the internet have increased so rapidly in recent times that we might see forums like YouTube take over the television market as well. This is because YouTube plans to launch major sporting and other events on YouTube which will not only give people the liberty of watching whenever they want to but also the ability to select different versions and quality offerings.

Another crucial aspect of the Google-YouTube deal was the way control and management would be run and organized. We believe that Google took a great step by deciding on only acting as a technology supplier and back-stage actor for YouTube and allowed its management the right to product development and other aspects that control creativity of YouTube. By adapting such a methodology both the companies have led the path to a new sort of partnership and understanding of how to solve each others problems and cater to each others needs. The strategy would have long-lasting impact on the motivation levels of the management as well as the specialization of both the companies as providers of certain specific services to each other. Google stated after the acquisition that it would want YouTube to continue working as an independent organization this was a great boost to a company like YouTube which is far smaller in size and financial strength than Google.

We also see that Google has understood the strategic importance of acquiring reasonably successful start-ups which have been regarded as acceptable by the market. Google buys such companies for a premium price although this strategy will work for the company but it also needs to focus on its core competencies and develop powerful products that could counter some of its rivals such as Yahoo and Microsoft. Product development is considered extremely crucial in the long-run since that would determine the rate at which the company has successfully generated returns from retained or invested profits. Another important aspect to product development is that fact that most technology products have a short life span which leads to the need for greater development of products and services.

From the standpoint of finances this was a good move because even forecasted revenues are such that the return would be eminent within 5-7 years. This total return of investment also highlights an important factor during this time Google has lessened an important competitor for the all important customer base that is so dear to companies like Google. Essentially, what Google has achieved is a way of going forward which has its pros and cons but so far it has been an effective way of staying ahead of competitors such as Microsoft and Yahoo.

In the near future what we can expect from these stalwarts of the technology sector is a trend toward more aggressive buyout strategies and a possibility of synergies across different industries which might require technological products offered by some of these companies. Partnerships and strategic alliances across industries and within industries seem to be the future way forward for companies in the hi-tech sector.

This is because in the technology sector the need for higher profits means that better products are produced at lower prices so that more and more people leave older products in favor of these new products. This is a crucial factor in the technology sector that companies must defeat the market of their own products with the inventions and development of new products. We also must realize that mergers and acquisitions in the technology sector are important way of providing exit strategy for entrepreneurs and start-up owners.

Google has given a lot of product developers and entrepreneurs a new reason to develop a business that Google might buy and they subsequently will become billionaires such a dream is well worth the try for most entrepreneurs. This is precisely the reason why we might see a large number of start-ups in the near future that stands to benefit the technology sector and increase the ability of new ideas to be given an opportunity to develop.

Another important question that one must ask is the fact that Google will continue to grow by acquisitions but does that mean that a decade later we have monopoly like situation in the internet arena. Well for some this might not be a problem but for the others this means that the revolutionary path of improvement and better products might just fade away as a result of a shift from total competition in an industry to a form where Google dominates everything in the technology sector.

Whichever way we look at it Google is moving from strength to strength and it will continue doing so as more new businesses are up for grabs which offer better customer base and product idea that is much like that of Google.

Large organizations with a complicated hierarchical system are difficult to manage and not all the authority can be given to a single person. Therefore, the application of responsibility accounting is used where departments or segments of the organization needs to be separated in manageable parts with respect to revenues, costs, profits and investments (maaw.info). We will apply the concept on Tyson Food Company where operations are done at larger scale, from breeding stock and feed production to transporting and marketing finished goods. The company sells one of the finest forms of chicken, beef and pork in more than 90 countries. We will now be analyzing how the responsibility is divided in a particular segment of a company that has 26.9 Billion of revenues per year (indeed.com).

Activity and Time Period
Throughout the report, we will take a management function which is recruitment and hiring in Tyson. The main reason being that no company can be successful if the workforce is not successful and promising and to ensure that, one should hire the best candidates. Tyson has been ranked as Americas top 50 Employers by Equal Opportunity magazine and Tyson was ranked as the 3oth most preferred company in which employees will like to work (tyson.com). There have been employee motivation, management and training activities which reflect the duties and efficiency of the recruitment manager. The time period used for the activity totals to 6-7 hours in which we extracted the information about the company and its recruiting functions online and the account responsibility taken which is the management function is one of the most important and crucial function for an organization.

Inputs
The data is secondary but reliable as most of it is from the official website of Tyson. Other inputs are about the basic concepts of the report such as accounting responsibility. To verify the argument, data has also been gathered from Equal Opportunity magazine.

Results
The story revolves around the Account Manager of Recruitment, Rashad Delph. He says to Equal Opportunity magazine that he looks for Bachelors degree in food or meat science when he hires for quality control, similarly, Bachelor or Masters in finance if applying for finance department. This means that selecting the specialized people from the crowd as the recruitment managers are later responsible for the performance of the employees and hisher capabilities (tyson.com). The story doesnt stop here. After the selection and hiring, the workers go through the learning processes and compensations. The organization promotes diversity and equal opportunity to minorities as a service to people. As we can see, Business Resource Groups (BRGs) in the company help the employees to get in line with Tysons business strategy. Executive Diversity Business Council (EDBC) held in 2005 was a major step for promoting the diverse hiring nature of the company where people can work with different backgrounds and opinions but same goals.

Time to time training is provided to the Tyson employees. The company offers PEER (Pause-Engage-Expand-Program) which is a workshop to expand the views of employees by making them realizes their capabilities and other peoples potential. The Pipeline Management Process identifies employees in the operation sector from the first level supervisors to the upper management and helps them improve and develop themselves (tyson.com).

Implications
Mentioned above are the situations in which Rashad Delph and other senior managers are responsible for the activities related to their own accounting responsibilities. These activities, in long term, also result in profits, therefore, the only implication for an efficient organization moving upwards in job recruitment policy is to hire internees rather than fresh people. This helps in reducing costs as the internees already know how the organization works through the tough times they faced. This procedure is also used by large multinationals such as PG, Unilever, Reckitt Benckiser, Philip Morris, etc. 

Introduction  Scope of Report
The Income Statement prepared, which encompasses a variance analysis between actual and budgeted figures is not appropriate for performance measurement.  This is due to the fact that a fixed budget is utilized to compute the respective variances.  A flexible budget ought to be prepared, where the budgeted figures a flexed in accordance with actual sales figures.  In addition, the variances resulting from the flexible budget will be examined in relation to qualitative features that shed light upon if the variance was within the operational manager control.  This will be conducted in the forthcoming sections.

Flexible Budget Statement
DetailsOriginalRevisedSales (note 1)900,000540,000ExpensesFood (note 2)300,000180,000Hourly Labor (note 2)180,000108,000Supplies (note 2)18,00010,800Supervisory Labor (note 3)90,00090,000Utilities (note 3)40,00040,000Rent (note 3)50,00050,000Corporate Overhead (note 4)90,00084,000Insurance  Taxes30,00032,000Total Expenditure798,000594,800Net Income(Loss)102,000(54,800)

Note 1 
Flexing Sales Revenue

There is a direct correlation between the level of advertising and sales revenue.  Hence, the 40 reduction in advertising in the San Diego area is envisaged to diminish sales revenue by such amount.  Thus the flexed sales amount to
900,000 x 60  540,000

Note 2  Variable Costs Dependent on Sales
Since the flexed sales revenue changed, the variable costs dependent on sales should also alter.  First one needs to compute the original proportion of such cost in relation to the budgeted sales, which is done below
 EMBED Equation.3 
 EMBED Equation.3 
 EMBED Equation.3 
Flexed Food Expenditure 540,000 x 33.33  180,000
Flexed Hourly Labor Costs 540,000 x 20  108,000
Flexed Supplies Expenses 540,000 x 2  10,800

Note 3  Unaltered Costs The costs that fall within this category are unaffected when flexed, because they encompass fixed costs, which are not influenced by fluctuations in sales. 

Note 4  Corporate Overhead
 EMBED Equation.3 
Flexed Corporate Overhead 540,000 x 10  54,000
Increase due to New Computer System       30,000
Corporate Overhead                   84,000

Performance Evaluation and Controllable Expenditure
Comparing the flexible budget statement with the actual results, one can note that the performance of the Restaurant Manager was positive.  This is highlighted in the Variance Analysis Statement Below
DetailsActualFlexedVarianceSales 800,000540,000260,000 FExpensesFood 250,000180,00070,000 (U)Hourly Labor 150,000108,00042,000 (U)Supplies 14,00010,8003,200 (U)Supervisory Labor 95,00090,0005,000 (U)Utilities 47,00040,0007,000 (U)Rent 60,00050,00010,000 (U)Corporate Overhead 120,00084,00036,000 (U)Insurance  Taxes32,00032,000Total Expenditure768,000594,800173,200 (U)Net Income(Loss)32,000(54,800)86,800 F

Further more, a number of expenditure items are outside the control of the operational manager, where he cannot be held accountable for such rise.  For instance, corporate overheads and rent increased due to decisions taken by top management and sales were lower than the original budget due to decreased advertisement decided by executive management.  Utility rates were also the result of a general increase enacted by the Public Utility Commission, which falls outside the control of the operational manager.  Therefore, the performance of Gregory was a positive one and Harry should take into account the aforesaid elements, before evaluating the applicability for performance bonus.

This paper will explain and illustrate how each of component contributed to the change Cash from Financing Activities, which is a component of a regular cash flow statement prepared by companies.    Cash from financing activities should be distinguished from Cash from Operating Activities and Cash from Investing Activities, which are part of a regular cash flow statement.  This will be illustrated and explained using the cash flow figures of Wal-Mart Stores for the years 2009 and 2008.  See Appendix A. How each item contributed in the change Cash from Financing Activities is explained as follows  Basically changes in cash would come from cash receipts and cash payment arising from financing activities.  Cash receipts would come mainly from cash investments from owners or stockholders through issuance of stocks or sale of treasury stocks and proceeds from both short-term and long-term borrowing. Cash payments would come from payments to stockholders in the form of dividends or redemption or reacquisition of outstanding shares of stocks and repayment of amounts borrowed excluding interest payments related to such short-term and long-term borrowings.
            
These concepts could be better understood by looking at the cash flows of Wal-Mart Stores for the years 2009 and 2008.   It could be observed that net cash from financing activities amount to 9,918 million for 2009 broken down into Net Issuance of Stock at a negative amount of (3,521) Dividends at another negative amount of (3,746) and Other account with negative amount of (2,651). Compared with 2008 net cash from financing activities for 2008, Net Issuance of Stock at a negative amount of (7,691) Dividends at another negative amount of (3,586) are similarly expressed in the negative. However, Other account appeared with positive figure of 4,143.00 this time. See Appendix A.  Since 2009 and 2008 Net Issuance of Stock amount should have positive default amounts, the negative amounts should mean that the company has not issued but instead reacquired them as treasury shares or retired said stocks from stockholders during the last two years.   Since dividends involve payments or cash outflows, they should have negative amounts as default figures. 

As such, reflected dividend figures for both years should in fact represent dividend payments to stockholders.  The account Other during 2009 reflected a negative figure, which could only mean other payments to stockholders or creditors. Since dividends are already made and net issuance of stock represented reacquisition of stocks, the other payments should be applicable to creditors and which represent payments for borrowings made or retirement of some debts.  Compared with the account Other in 2008, the latter should be considered as proceeds of continuing borrowings since the amount was not reflected under net issuance of debt account.

Finance Essay Capital Market Practice
Explain in detail how an Interest Rate Cap could be used to manage the interest rate reset risk for the issuer of the FRN

Interest Rate Caps safeguard against the risks of rising interest rates. It is just one of the techniques of managing interest rates, used mainly when the customer follows a variable lending rate system. Perhaps one of the main functions of interest rate caps is to afford protection against the rise in base interest rates, but it does not offer any kind of safeguards against fluctuations of acceptance fees or margins. The only area where interest rate caps can be useful is when it becomes intrinsic to counter interest rate vicissitudes. Again, .. .interest rate movements might result in little or no need for cap protection in which case the premium cost will exceed the compensation benefit you receive over the life of the Cap.Taxation (Phelan  Beattie, n.d., p.7). There are several aspects that impact the interest rate cap and its usage as an interest rate management tool. The first factor is the Strike Rate, or the maximum interest rate that can be enforced. In this case study, this is 6.25. Another aspect is the notional amount on which calculations are made. In this case, it is 250,000,000. Another feature is Reference Rate, or base rate that is to be provided at the start of the transaction.

In case an investor wishes to take advantage of this interest rate caps, he will need to make a non-refundable premium towards gaining befit of the cap.

Salient Advantages of Interest Rate Cap
In the event that the Reference Rate is greater than the Strike Rate, the difference in rate will be reimbursed to the investor.

The Strike Rate is a flexible one, and can be adjusted to suit the degree of protection the investor wishes to gain. However, the non-refundable premium payment will again fluctuate according to the strike rate.
Again, the term of the cap is flexible and may not have any bearing on the underlying facility. During wide vicissitudes in interest rates, it is possible to use interest rates caps as protection against such fluctuations.

Caps are revocable and since these are not linked to any underlying facility, these can be used for a variety of purposes.

The only costs that caps incur are non refundable premiums

Main Disadvantages

1. These are useful only in cases of increases in interest rate and becomes insignificant during times when interest rates fall.

2. Premium is non refundable and will need to be paid even if the reference rate does not fall below strike rate.
Taking the example of calculation of interest cap
Strike rate  6.25
Reference rate  7.25 ( assumed)
Notional amount- 250,000,000
6 months LIBOR
(Notional Amount) x (Reference Rate  Strike Rate) x ( of days in period360)
Or 250,000,000 x 1.00  x 180360  12,50,000

Thus this sum will be reimbursed to investor, in the event reference rate is more than the strike rate. However, this figure would vary with differences between reference rate and strike rate, and will not be gained in the event that the reference rate is lower than the strike rate.

Explain in detail how to use interest rate swaps to hedge the reset risk in the FRNLower credit rated firms need to pay high premium in order to participate in bonds. Interest rate swaps are intended to reduce such premiums and interests and thus bringing down overall costs. The main idea is borrowing initially on short term floating rates and then swapping the same for fixed interest rates. This is of special significance during times of rising interest rates, when loanees will be obliged to pay higher interest rates on their current loans and then if they possibly will have to pay under a fixed interest regime. This may create a mismatch between availability of income from assets and payment of liabilities. The idea is that the incomes generated from the assets stream should be more than the payment due to be paid on the liabilities. This is the underlying principle behind interest swaps. The aspect of the use of interest rate swaps to hedge reset risk can be further explained by way of an illustration. Let us assume two entirely different corporate enterprises, Ms ABC Irons Limited, and Ms Ever Alert Banking Corpn LLC. ABC happens to be a non-financial low credit rating company who needs to rely on fixed interest rate loans for their long term investment projects. But considering the fact that their financial credit rating is not very impressive, they will need to pay high premiums to gain such kind of funds. Conversely, Ever Alert Bank can easily draw forth funds through floating rates at lower interests because they enjoy a better credit rating.

The financial portfolios of these two entities are as follows
Serial ABC Irons LimitedEver Alert Banking Corpn.1.Could borrow  14 fixed interest in market Could borrow  12 variable rates in market 2.LIBOR  1LIBOR 0.5 3.Low credit rating  Very high credit rating
Thus the main factor that emerges from this comparison is that ABC Limited presently will have to pay 2 more than Ever Alert Bank.  In case ABCIL borrows using LIBOR, they become obliged to pay a premium of 1 loan amount where as the bank needs to pay only 0.5.

Both these entities would like to get into a swap transaction to lower interest burden and gain competitive and strategic advantages. As part of the swap arrangement, ABC Irons obtains floating rate bank loan on which it will initially pay LIBOR  1. Simultaneously, the bank will issue 12 fixed Seven-Year Bonds at LIBOR  0.1. As a result of this swap, the following scenario emerges

The bank takes over the loan of ABC Irons along with the LIBOR. The balance 1 is to be paid by the latter.
 ABC takes over the bonds at 12 fixed interest rate and intermediatory fees of 0.1, in addition to 1 interest that is has to pay.

The benefits that would accrue to both ABC Irons and Ever alert bank are as follows

Benefits to ABC
They are able to get a fixed rate loan thus creating less cash flow problems for themselves
Their total commitment results in cost savings of 0.9 percentage points in that they need not have to pay 14 interest now.14  ( 12  1.0  0.1)

In the event of the swap, the bank would save the extra 0.5 LIBOR charge which they otherwise would have to bear.

The benefits that accrue from interest swaps are quite substantial in FRN. But what needs to be kept in mind is that these provide advantage when the interests rates are increasing. During times of constant falling rates of interests, they may serve little purpose, except perhaps in terms of exercising choice between fixed or floating rates. During regimes of interest rates, floating rates would be more beneficial, since the promoters would not need to be saddled with fixed interest rates, especially when such rates are higher than floating ones. 

3. Explain in detail how you would calculate the price of a three-year swap that will hedge reset risk for your company. You should illustrate your explanation with an appropriate numerical example

The value of the price of a three year swap could be ascertained by calculating the PVs of each of the cash flows generated through the use of discount factors

In the above case, therefore, the values could be derived as follows
Serial PeriodDaysRate (Libor  40 points)Notional
CF1. 1.1  30.6.091805.4250,000,000         6,875,0002.1.7  31.12.091805.9250,000,000         7,375,0003.1.1  30.6.101806.1250,000,000         7,625,0004.1.7  31.12.101806.4250,000,000         8,000,0005.1.1. 2011  30.6.111806.5250,000,000         8,125,0006.1.7- 31.12.111806.65 250,000,0008,312,500
The discounted cash flows of the above are
Cash Flows ()Discounted cash flows Amounts ()6,875,0005,871,5247,375,0006,390,3127,625,0006,773,4378,000,0007,289,1618,125,0007,629,1078,312,5008,049,172Total  42,002,713

Q 4 Explain the difference between Hedging and Insurance, and how using a futures contract or an option will enable you to manage the equity market risk in the pension fund portfolio

A hedge is an investment made to condense the unfavorable cost incurred in a security by equalizing the security related aspects or a technique to eliminate the financial risk. The hedging process is the process of nullifying the financial risk caused by the price fluctuation. It is depended on the factors like the sale and the purchase of commodities in the market. It is a frequent term in the securities and the foreign exchange markets. In commerce the hedging method is the one by which the traders counterbalance the strategies of investments by price fluctuations, it involves the buying and selling the goods at the time of the contract and buying or selling the things at the later stage. Despite the contracts the only aim of them is to discard the unwanted risk by the different agents like the forward contracts, swap, options, insurance policies and the derivatives. There are different categories of hedgeable risk, which have the value of the accounting amount which can be unfavorable to the value of the import market. The different risk associated are the interest rate risk, equity, volatility and lending of securities.

The insurance is a guaranteed reimbursement of certain probable future losses as a token of exchange for the investment on a periodic basis. Insurance is planned in such a manner as to shield the financial assets of the individual or the company in the catastrophic loss.

According to law and economics it is a kind of risk management basically used as a hedge against the unexpected loss. It is a kind of the exchange of the finance for a secured premium. There are many misconcepts of insurance, some consider insurance as a type gambling over a period of time. The future contract and the option are rapidly emerging gadgets for the pension funds they are also the strategic tool for the risk management.The quick growth of them is due to the vast outcome for the portfolio management. Options hold quite a lot of significant attractions for pension-fund portfolios. Once the initial policy and procedural hurdles is defeated, they give faster and inexpensive ways to implement strategies. The market risks are those risks that the markets fail in obtaining the expected results. The pensions are the long term of investment and the occupying some kind of asset allocation method to expand their assets.

Market risk is built-in to the assets themselves in fact, it is implicit that all asset classes will diverge from performance prospect over time. Pension systems can alleviate market risk by factoring probable correlation to portfolio diversification. The futures and option can affect the risk associated with the portfolio in terms of price variations in underlying security, price of the future contracts etc. These are used to hedge positions in the pension equity portfolios. There are different criteria when pension funds invest in the options, they are the tactic view, dynamic strategies, loss limitation and the profit limitations (Equity option for pension fund, 2007, para.3). The option term is quite an insubstantial issue a strategy of short-dated options, are insufficient as it has too much considerations against equity risk. But when options are too long the liquidity (price) becomes an issue. To carry out the appropriate evaluation, implied volatilities and correlations between indices are to be incorporated in spite of the market variables which are complicated to obtain. As the market risk for foreign equity portfolio investments is hedged, this should be included in the options value by means of a quanto adjustment. Performance shows that pension funds tend to lack the required trading and financial engineering expertise and experience. The keen focus on the pension portfolio industry will broaden the interest rate risk and inflation risk to equity exposure, the equity premium are responsible for the low interest rates and the viability of the pension premium.

5) Using the data given above, explain and demonstrate how you would calculate arbitrage free price of a six-month futures contract on the FTSE 100 index

Arbitrage refers to the financial transaction which helps in gaining instant profit without any involvement of risk factor. It is the process of purchasing commodity in one market for the purpose of selling it immediately to the other market. The frequent use of the term has increased its popularity and has expanded its meaning to, the process whereby underpriced securities are purchased and are sold at higher price, with the objective to earn more profit. The opportunity for the arbitrage exists when there is change in the future price from its fair value. Fair value is derived by adding spot price plus holding cost. A future contract is a contract, whereby the commodities and securities which posses standard quality are bought and sold on a particular date in a market place and for particular price.

Thus, in simple terms, arbitrage essentially means buying and selling simultaneously the same commodity or security in two different markets at two different prices, and pocketing a risk free return. A simple example of a arbitrage would be in the event of Wal-Mart selling CDs for 5piece, and in the other places such CDs being sold for 25piece.

An enterprising person could buy CDs from Wal-Mart at such low prices, sell the same at higher prices and pocket the difference. This is a typical example of a arbitrage profits.

However, arbitrage contracts could be of different characteristics and genres from sports activities, forward contracts, etc., wherever, the aspect of transacting or buying in one place and  rendering sales at another place, perhaps at different prices.