Corporate Finance – Creditrisk, enterprise maangemnt & Market risk

This EMA should be submitted by the cut-off date shown in Week 22 of the study planner.
The EMA contributes 50% towards the total marks available for the assessment for BB841. The total mark available for the EMA is 100.
The EMA asks questions relating to the subject matter covered in Weeks 14 to 21 of the study planner. This includes Book 3 (Sections 8–12) and Book 4.
The guideline maximum word count for this EMA, as a whole, is 3000 words.
Note that if the EMA guideline word limit is exceeded by more than 10%, any content over 3300 words is awarded no marks and any feedback is provided at the discretion of the tutor. Failure to indicate, or to indicate correctly, the overall word count (and the point at which 3300 words is reached if the guideline word limit is exceeded) will be penalised by the deduction of up to 5% (5 marks) from the total score awarded. Refer to Word count in the MBA Qualification Guide.
Question 1
35 marks
Klopp GmbH is a German company selling components for electrical vehicles.
Its manufacturing bases are all located in the eurozone and consequently virtually all its costs are denominated in Euros. By contrast its sales are worldwide and in the last financial year its receipts from these were sourced in the following currencies:
Table 1
Currency % of Total sales revenue
Euros 35%
US dollars 20%
UK sterling 15%
Chinese yuan 13%
Russian roubles 10%
Australian dollars 7%
Klopp has outstanding debts of €350m. Its debt comprises:
€250m fixed rate eurobond.
• Residual life 3 years.
• Annual coupon 4% p.a.
• Current yield-to-maturity (YTM) 5% p.a.
• The next coupon is payable in exactly 1 years’ time
€100m fixed rate bank loan.
• Residual life 1 year.
• Interest of 4% p.a. is payable on maturity in 1 years’ time
Klopp also has €100m of liquid assets (marketable financial investments) invested in the following two bonds.
€75m in a European Investment Bank (EIB) fixed rate eurobond:
• Residual life 7 years
• Annual coupon 5% p.a.
• The next coupon is payable in exactly 1 years’ time
• Current yield-to-maturity 5% p.a.
• S&P long-term credit rating AAA.
€25m in Flounder Autos fixed rate eurobond:
• Residual life 10 years
• Annual coupon 6% p.a.
• The next coupon is payable in exactly 1 years’ time
• Current yield-to-maturity 8% p.a.
• S&P long-term credit rating BB-
• Flounder Autos is on CreditWatch for a possible downgrade in its ratings.
The Euro zero-coupon yield curve is currently:
Table 2
Term to maturity 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y
3.4% 3.8% 4.2% 4.6% 5.0% 5.4% 5.8% 6.2% 6.6% 7.0%
(Note: depending on your screen size, you may need to use the scroll bar to view all of the cells in Table 2.)
The 7-year swap market quote provided to Klopp by its bank is:
• Receive 4.95% p.a. annual fixed rate versus paying 3 month Euribor, or
• Pay 5.05% p.a. annual fixed rate versus receiving 3 month Euribor.

Questions
• i.Use gap analysis to assess the impact on Klopp’s debts and investments of a parallel upward shift of 3% p.a. in the above zero-coupon yield curve.
(Since each cash flow is on a specific date you should use date-specific time slots (e.g. 1 year exactly) rather than period specific (e.g. 1–2 years).Use separate rows to display the principal and interest (coupon) flows for both the debts and investments)
(10 marks)
• ii.Explain how an interest rate swap transaction, combined with the EIB bond, could help manage the interest rate risks being run by Klopp if a rise in interest rates is expected by the company. Use a diagram to display the action you would recommend and the resultant ‘swap-plus-bond’ investment return.
(5 marks)
• iii.Comment on the economic risks Klopp is exposed to as a result of the foreign currency (FX) characteristics of its costs and revenues.
(5 marks)
• iv.Explain how these FX risks could be managed by the use of ‘operational’ techniques. Your answer should comment on the feasibility of using these risk management techniques.
(8 marks)
• v.Briefly explain how the price of a credit default swap (CDS) is determined and comment on whether CDSs would be of use to Klopp.
(7 marks)
Question 2
15 marks
On 1 June 20XX LeBlanc anticipated a need to borrow €4m in 6 months’ (180 days’) time to cover a 6-month (180-day) cash shortfall and was concerned that interest rates might rise in the interim causing higher interest payments on this debt. It considered various means of managing this risk and decided to use the forward rate agreement (FRA) market.
The company’s bank sold LeBlanc an FRA for 360 days against 180 days (180/360) at 2.5% for a €4,000,000 notional amount. On 1 December the actual 6-month Euro interest rate (Euribor) for 180 days was 4.40%.
LeBlanc could alternatively have entered into short-term interest rate futures agreements (STIRs). On 1 June the index price for the December 3-month interest-rate contract was 97.85 and the price for the (following) March 3-month interest-rate contract was 97.35.
On 17 December – the maturity date of the December contract – the 3-month (90-day) Euro interest rate (Euribor) was 4.45%. The maturity date of the March contract was on 17 March in the following year.
(Notes: the notional contract size for Euro STIRs is €1m. Assume all dates are working dates and not weekends or holidays.)
Questions
• i.How much would be paid out under the terms of the FRA contract and to which party?
(2 marks)
• ii.How could LeBlanc have hedged its interest-rate risk using the December and March STIRs? You should comment on whether it would have needed to buy or sell the STIR contracts, and the number of contracts that would have been needed to hedge the exposure fully.
(2 marks)
• iii.If STIRs were used to hedge the exposure, what action would LeBlanc needed to have taken on 1 December? You should explain how this action could hedge the 6-month exposure.
(2 marks)
• iv.What risks are involved in using STIRs in this way to manage LeBlanc’s 6-month interest-rate risk?
(3 marks)
• v.What was the price of the December STIR contract on its maturity?
(1 mark)
• vi.Explain how ‘clearing houses’ minimise the credit risks in using STIRs and other exchange-traded financial contracts.
(5 marks)
Question 3
25 marks
ABC Enterprises (ABC) is a US-based company. Over the past two years, it has worked on a Spanish construction project. As a result of this project, it now knows it will receive a payment of €10,000,000 in three months’ (90 days’) time. Profitability for ABC has been poor in recent years so this payment is vital to the company. Given recent events in the Eurozone, ABC is considering hedging this exposure and seeks help from its bank who provides the following information:
The spot rate is USD1.25/EUR1.
Forecasts for the exchange rate in 90 days’ time are:
Table 3
Exchange rate for EUR1 Probability
USD 1.20 25%
USD 1.25 60%
USD 1.30 15%
The bank also advises that the 90-day interest rate for USD deposits is 0.5% p.a. and for EUR deposits it is 1.5%. There are no bid–offer spreads. ABC’s bank provides the following prices for EUR calls and puts for exercise in 90 days’ time:
Table 4
Exercise price Call EUR1.00 Put EUR1.00
USD 1.25 1.0 US cents (USD 0.01) 1.5 US cents (USD 0.015)
Questions
• i.What would be the expected outcomes if:
o a.ABC leaves the foreign exchange exposure unhedged.
o b.ABC hedges the foreign exchange exposure using the forward exchange market. Use the forward margin approach when answering this question.
o c.ABC uses options to insure itself against adverse movements in the exchange rate. Assume the cost of the option is paid on the exercise date.
In each case show all your calculations.
You are advised to complete Activity 15.2 (in Week 16) before attempting this question.
(10 marks)
• ii.What advice would you give ABC in the choice of the courses of action set out in Part (i)?
(5 marks)
• iii.How does ‘technical’ analysis attempt to predict future movements in foreign exchange (FX) rates? How does this differ from ‘fundamental’ analysis and what are the weaknesses of technical analysis?
(10 marks)
Question 4
25 marks
Review the sections of BP’s Annual Report 2018 that focus on risk management and assess its overall risk management process.
• i.Comment on the strengths and weaknesses of BP’s risk management processes.
(15 marks)
• ii.Explain whether, in your view, BP practises enterprise risk management (ERM).
(10 marks)