Financial Institution and Markets

Questions: 1. The National Australia Bank wants to obtain short-term funds on the money market and issues a 30 day Certificate of deposit (COD) to a wholesale investor. The amount of the deposit is $20,000,000 and the relevant rate is 4.5% p.a. a) What is the Face Value of one of the Certificates of Deposit? What does this value mean? b) What will be the dollar return to the investor if they hold the COD until maturity? c) If the bank wanted to raise $100,000,000 how many of these CODs would they issue? 2. The Commonwealth Bank issues bonds on the capital market to raise financing for its loans. a) How much financing will the Commonwealth Bank raise if it issues 500 5-year bonds today that pay an annual coupon of 6% and have a face value of $1000 if yields on bonds of similar risk and maturity are 4%? b) What will happen to the price of the bonds in a) if 1 year from now the credit rating of the Commonwealth Bank is increased from AA to AAA? Why? 3. The ANZ Bank (Share code: ANZ.AX) expects to pay a dividend of $0.91 today and dividends are expected to grow at 6% forever. The required return on ANZ shares is 9%. Based on this information would you buy the share today? Answers: (1). (a) In the given question, National Australian Bank has issued a Certificate Of Deposit to a wholesale investor for obtaining short-term fund. The question requires, calculation of Face value of deposit, it is shown as under Calculation Of Face Value Of Certificate Of Deposit Formula Face Value= Purchase Price X (1+ (daily Interest Rate X Term)) In the given Question, Amount Of Deposit $20,000,000.00 Rate Of Interest(p.a) 4.50% Term (Days) 30 Face Value 20073972.6 A Certificate of deposit may be defined as a saving certificate that entitles its holder to receive interest. Certificate of Deposits are issued by the bank as a saving certificate for a short term (Deegan 2013). The holder of the Certificate of Deposit is required to purchase the certificate and at the end of the maturity term is entitled to receive the Face Value. The difference between the Face value received and the purchase price is the return of the investor. Thus Face Value for certificate of deposit may be defined as the amount paid to the holder of certificate at the end of maturity. (b) The Return on certificate of Deposit is calculated by deducting Amount of deposit from the Face Value of the certificate. The investor is entitled to the full return if certificate is held till the date of maturity. In case of premature surrender of certificate, a penalty is usually deducted. In the given case, the investor holds the security till the date of maturity. So the return received by the investor is calculated below. Calculation of Return to the Investor Face Value $20,073,972.60 Amount Of Deposit $20,000,000.00 Return to the investor $73,972.60 (c) The number of Certificate Of Deposit to be issued is calculated by dividing the amount to be raised by issuing certificate with the amount of deposit that is to be made per certificate. Formula Formula Number Of COD= Amount to be raised/ Amount of Deposit In the given question bank is looking forward to raise funds of $1,000,000,000.00 by issuing Certificate of Deposit of value $ 20,000,000.00. The calculation is shown below: Calculation of number Of Certificate of Deposit Amount to be raised $1,000,000,000.00 Amount of Deposit $20,000,000.00 Number Of COD 50 (2). A bond is a debt instrument issued by the bank. The bank pays a fixed amount of interest on the Face value of bond until maturity. At the time of maturity, face value of bond is returned to the bondholders. A bond can be issued at par, discount and premium depending upon the interest rate offered by the bond and the prevailing market interest rate. If the interest rate offered by the bond is less than the prevailing market rate then bond shall be issued at discount. If the prevailing market interest rate is the same as that of bond then it can be issued at par. When the market interest rate is less and the interest rate of the bond is more in such case bond can be issued at premium (Rose and Hudgins 2014). In the given question Common Wealth Bank has issued 6% coupon interest bond of Face Value $1000.00. The prevailing market rate is 4% so the bonds will be issued at premium. The calculation showing the amount raised by the common wealth bank is given below. Formula Premium Bond Price= Face Value of Bond/prevailing market interest Rate X Bond Interest Rate Calculation showing financed raised by issue of Bond Face Value of Bond $1,000.00 Market Interest Rate 4% Bond Interest Rate 6% Bond Price $1,500.00 No. Of Bond Issued 500 Amount Raised by Bank $750,000.00 So the amount raised by the Common Wealth Bank is obtained by multiplying Bond Price with the number of Bond issued. (b) If in one year the credit rating of the bond is increased from AA rating to AAA rating then price of the bond will increase. The reason is that AAA rating means a very high quality bond. The credit rating agencies are engaged in assessing the worthiness of the borrower. After evaluating the worthiness it provides a grade to the security which determines the quality of the security. The higher grade represents a high quality security so the institution can charge more prices for the security. A low-grade security represents a high level of risk so the yield required by the investor is more. There is an inverse relationship between credit rating and yield of the security. Alternatively, it can also be derived that there is a positive relationship between the credit rating and price of the security. That is if the credit rating of a security improves then price of that security in the market will also improve. (3). The cost of capital may be defined as the cost for financing the business. The business may be financed by Equity Share Capital, Preference Share Capital, Debt Capital and from own fund (Hou et al. 2012). The cost of capital is the aggregate weighted average cost of the different sources of capital. The cost of capital is often used for computing the net present value of the investments and it is considered as the minimum rate of return that is required of any investment. The cost of capital serves as an overall basis for evaluating investment decision. The cost of debt is less expensive than cost of equity as interest is tax deductible but dividend is not. The cost of equity share capital includes that part of the cost of capital which are payable to the shareholders. There are various methods of calculating the cost of equity share capital. In dividend yield, method the cost of equity share is the present value of future dividend. It is calculated by dividing Dividend per share by market price per share. If it is expected that future dividend will grow then growth rate is also added with the above. From the viewpoint of the investor, the cost of equity is the amount that is received as income on investment made in the equity share of the company. In the given case, ANZ Bank is to pay dividend of $0.91, which is expected to grow at 6%. The calculation of cost of equity is given below: Formula Cost of Equity= Dividend/Market Price of share + Growth Rate The market price of the share is taken based on closing price of share on 25/05/16 on Australian Stock Exchange. Calculation showing Cost of Capital Dividend $0.91 growth Rate in % 6% Market Price Per share $25.25 Cost OF Equity 9.60% The cost of equity is 9.60% and the required rate of return from the investment is 9%. As the required rate of return is more than the cost of equity share cost so it is advisable to purchase this shares. References: Bekaert, G., Ehrmann, M., Fratzscher, M. and Mehl, A., 2014. The global crisis and equity market contagion.The Journal of Finance,69(6), pp.2597-2649. Deegan, C., 2013.Financial accounting theory. McGraw-Hill Education Australia. Hou, K., Van Dijk, M.A. and Zhang, Y., 2012. The implied cost of capital: A new approach.Journal of Accounting and Economics,53(3), pp.504-526. Rose, P. and Hudgins, S., 2014. Bank Management Financial Services, 9th. Financial Institution and Markets Question: Discuss about the Financial Institution and Markets. Answer: Introduction The aim of present study is to provide a dynamic introduction to the valuation of the financial option along with the viability of contractual conditions and its requirements. Certain aspects form the core of the report like the difference between naked and covered options. The benefits of both the option are described in the light of having a strong position in the market and anticipation of the market dynamics. Naked and Covered ptions An option is a contract which gives the buyer the right to buy or sell a financial stock depending on the form of the option at a specific strike price on a particular date. The trading options are not only limited to buying or selling these shares. They also involve other strategies. Figure 1: Types of Option Call (Source: (Nardon and Pianca, 2016)) Naked Call Options Writing call options contracts without owning the underlying shares, is known as a naked call option. Here, the writer has the flexibility to set the expiration date and strike price. If the writer gets the buyer for their options, then the buyer get eligible to acquire rights to own the stock before the expiration date at the predetermined strike price. Covered call Options In a covered call strategy, the writer not only writes call options but also owns the actual stock. In case the price of a particular stock rises the writer will be liable to provide the buyer with the physical shares (Jahncke and Kallsen, 2016). The writer can do this by simply providing the option holder with the shares contained in the portfolio of the writer. Figure 2: Graphical Representation of Covered Call Option (Source: Zerenner, Segal and Zerenner, 2014) Difference between Covered Call options and Naked Call Options Basis of Differentiation Naked Call Covered Call POSSESSION OF SHARES The writer does not possess shares in physical. The writer has possession of shares in real. INVESTOR OUTLOOK The writer of such call may get buyers only if the buyer believes that the stocks of a particular company may rise in the future and therefore the buyer may want to lock their shares in a lower price A covered call is perfect for writers who are optimistic and confident about their estimation of companys pricing. AMOUNT OF GAIN The amount of gain is unlimited in such an option as the writer gains from trading in the form of speculation. The writer of such call must possess sufficient shares to have additional income to protect him from the losses. The amount of gain is limited. [(Strike Price - Stock Price) + Credit Received] AMOUNT OF LOSS A Huge amount of losses can also be accrued to the writer in such a call. The purchase price of the new stock is the loss of the writer. With this strategy, the writer can eliminate the risk of buying the stocks at a new and higher price. (Stock Price - Credit Received) BREAK EVEN POINT Strike Price + Purchase Price Stock Price - Credit Received Requirement for Contract Obligations The Query of contract obligations applied by an options exchange in order to ensure that the writer meets their obligations is explained. Any financial option is said to be a contract between two parties. The terms of the contract are mentioned in a term sheet (Israelov and Nielsen, 2014). Option contracts are quite complicated. It is mandatory for the option holder to specify the following in the contract: The rights held by the writer to buy or sell the stocks. The class and quantity of the basic asset(s) possessed. The strike price of the option at which the deal will occur upon exercise. The expiration date of the option. The settlement terms of the transaction. The total amount to be paid by the holder to the writer. Figure 3: Graphical representation of Pay off for writing a short call. (Source: Patel and et.al. 2016) Other requirement applied by option exchange (ASX) According to (Hirsa and Neftci, 2013), it is compulsory for the writer to hold shares till the options contract expires. The writer can also buy back the contract before its expiration. The value of the contract is determined on the basis of the volatility of the stock, the expectation of the future price and expiration of the contract. A minimum level of cover is required for options (margins), which is the value of option contracts at the time of liquidation. When the option no longer exists in the market, all the amount of margin is credited back into the account of the writer (Jarrow and Chatterjea, 2013). The writer has obligations under the option contract to buy shares for delivering them at the contracted price. Cash is considered as the only medium for settlement of the transaction. The value of buy options must offset the value of sell options. Conclusion Owning shares of a public company can increase the number of investing strategies available. Hence, it can be concluded from the report that a variety of call and put options exist for writers from which they can select their option depending upon the level of risk and the profit from them. Contract obligations of the writer are also to be considered so as to minimise the loss a writer sustains. The writers must wisely select from the options of naked and covered so that their income stream remains unaffected from the losses occurring through speculations in the stock market. References Books and Journal Hirsa, A. and Neftci, S.N. 2013.An introduction to the mathematics of financial derivatives. Academic Press. Israelov, R. and Nielsen, L.N. 2014. Covered Call Strategies: One Fact and Eight Myths. Jahncke, G. and Kallsen, J. 2016. Approximate Pricing of Call Options on the Quadratic Variation in Lvy Models. InAdvanced Modelling in Mathematical Finance.(Pp. 241-256). Springer International Publishing. Jarrow, R.A. and Chatterjea, A. 2013.An introduction to derivative securities, financial markets, and risk management. WW Norton Company. Nardon, M. and Pianca, P. 2016. A covered call is writing in a cumulative prospect theory framework. Patel, V. and et.al. 2016. Price discovery in stock and options markets. Zerenner, E.H., Segal, G.A. and Zerenner, G.J. 2014. Power Financial Group, Inc.System and method for analysing and searching financial instrument data. Patent 8,630,937.