explain Exposure to exchange rate risk

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BUACC5936 – FINANCIAL MANAGEMENT

Semester 2   2014

 (Due Date: 4.00pm Friday, Week 10)

This assignment consists of Three (3) questions. All three questions must be answered. Assignment is to be completed in groups of three. (Under unavoidable situations only, group of two will be considered). Students are advised to concentrate on the following for question 3:

  • Content
  • Introduction
  • Structure
  • Expression
  • Presentation
  • Conclusion and
  • Reference List

Note:        

  • The above items are attributes of a good assignment – they are not sections.
  • Work that fails to show adequate acknowledgement of sources will not receive a mark.
  • Questions two and three must have minimum of three academic references in the reference list and the referencing must follow good academic format. The link to the library website for more information is:   http://www.ballarat.edu.au/library/assignment-and-research-help/referencing
  • Penalty for late submissions: 10 per cent of your earned marks will be deducted for each day after the due date, unless prior arrangements are made with the lecturer and are consistent with the School rules and practices.

Students are strongly urged to read reviewed journal articles. Please note: understanding the notions in the articles is more important than an entanglement with the advance math in many of the articles.

Question 1   (1½ + 1 ½ + 2 = 5 marks)

You have invested a substantial amount of money in three different unlisted financial securities. These investments are not traded on the financial market and, as a result, they do not have observable market prices, but you have gathered the following information:

a)         Company bonds: $1, 000 face-value with 6 years to maturity, paying 11% p.a. in semi-annual coupons. Currently the yield on 6-year government bonds is 6% p.a. and you think that a risk premium of 4% p.a. is appropriate for these company bonds,

b)         Preference shares: Irredeemable, paying 8% annually on $10 par value and your estimate of the risk premium for these shares is 7% p.a., and

c)         Ordinary shares: Five years ago the annual dividend paid by the company was12¢/share and given this year’s dividend of 18.5¢/share you expect future dividends to grow at the same annual compound rate. From your analysis of the variability of the company’s earnings over the last five years, you deem a reasonable estimate of the company’s market risk (beta) to be 1.7. Also you know that the long-term historical average return from a market portfolio investment is 13 percent p.a.

On the basis of this information estimate the current value of the Company bonds, the Preference shares, and the Ordinary shares.

Question 2                                                                              (2 + 2+ 2+ 2 = 8 Marks)

You are the Chief Financial Officer of an Australia listed company which exports large amounts and values of commodities to overseas countries. Explain the following terms as they relate to your company. (Maximum word limit 150 words each)

i.          Exposure to exchange rate risk,

ii.         Translation exposure,

iii.        Transaction exposure, and

iv.        Economic exposure.

Students are encouraged to start with the textbook information and then move to other sources for extra information and examples.

Question 3                                                                              (12 marks)

“One of the big issues in the current crisis is how much the mortgage-backed securities and securitized assets more generally, are worth, since the market does did not seem to price them correctly for long period of time. If markets are efficient, market prices can be trusted as they reflect asset fundamentals correctly. The basic idea behind market efficiency is that if something becomes under-priced, there is a profit opportunity. Investors can buy the under-priced security and make a profit. That incentive provides the arbitrage mechanism to make sure that prices rise to the correct level. In the crisis this mechanism appears to have broken down. In particular, it seems that there were limits to arbitrage. A good example is what happened in the fall of 2007. The prices of the mortgage –backed securities went down. Some investment banks and hedge funds thought the securities were cheap and bought more. But the problem was that the prices kept on going down and this caused difficulties for many investors”.

Source:  Allen, F. and Carletti E. (2009, p.17), ‘An Overview of the Crisis: Causes, Consequences and Solutions’, paper presented at the Conference on Global Market Integration and Financial Crises at HKUST July, pp.1- 45.

(Another variant of this paper is available at: Allen, F. and E. Carletti, (2010), ‘An Overview of the Crisis: Causes, Consequences and Solutions’, International Review of Finance, 10 (1):  1-26).

Required:

Read, consider, and explain the key issues in the above paragraph in light of market efficiency and arbitrage (Maximum word limit 1000 words).

Students must cite at least three reviewed journal papers in their answers.