SCHOOL OF MANAGEMENT
MN-3503: Financial Innovation and Risk Management
DEGREE EXAMINATIONS: MAY/JUNE / 2022
Answer ALL Questions
Question 1
Consider a publicly listed pharmaceutical company in the UK with 400 million shares outstanding and it has sales abroad. The company develops and commercialises new drugs. Assume the cost of equity is 8%. The company believes that there is an equal probability that total earnings next year will be either £1,100 million or £550 million. The firm has an existing debt with a face value of £600 million with 8% annual interest rate. Assume the bankruptcy costs are £100 million. The firm has identified 4 potential projects as follows:
|
Project
|
Fund required
|
Present Value
(PV)
|
NPV
|
|
Project A: drug for
Coronavirus Infection
|
£200 million
|
£550 million
|
£350 million
|
|
Project B: drug for
Alzheimer (Dementia)
|
£500 million
|
£2,000 million (50%)
£400 million (50%)
|
£1,500 million (50%)
-£100 million (50%)
|
|
Project C: drug for
Liver Fluke Infestation
|
£200 million
|
£500 million
|
£300 million
|
|
Project D: drug for Sun Allergy
|
£100 million
|
£300 million
|
£200 million
|
Besides, the costs of issuing new debts or equity given the company’s existing leverage ratio are shown in below table.
|
New capital
|
Cost of debt
|
Cost of equity
|
|
£100 million
|
8%
|
10%
|
|
£200 million
|
9%
|
11%
|
|
£300 million
|
10%
|
12%
|
|
£500 million
|
12%
|
15%
|
(a) Based on above information, identify potential costs (problems) might rise due to risky earnings. Discuss how hedging can mitigate the costs (problems) identified if the earnings are 825 million after hedging. Use calculations to support your discussion. [15 marks]
(b) Discuss alternative strategies for resolving the problems identified in (a). [5 marks]
(c) Suppose the firm needs to redeem the existing debt (£600 million) and the firm decides to borrow £500 million new debts to fund projects.
(i) Explain the asset substitution problem. Use calculations to support your explanation. [8 marks]
(ii) Discuss the value of hedging on mitigating the asset substitution problem. Use calculations to support your discussion, assuming hedging could replace the lottery of £1,500 million and -£100 million NPV of project B with £700 million. [5 marks]
Question 2
(a) You wish to invest in two risky securities with the following details:
|
Return for Security 1
|
Return for Security 2
|
Probability
|
|
15
|
12
|
0.2
|
|
19
|
14
|
0.3
|
|
21
|
10
|
0.3
|
|
25
|
20
|
0.2
|
The correlation coefficient (p12 ) between returns of the two securities is -0.6.
(i) Calculate the expected rate of return(r) and risk(σ) for the following portfolios:
I. 100% security 1
II.40% security 1 and 60% security 2
III.60% security 1 and 40% security 2
IV. 100% security 2. [12 marks]
(b) Explain how you could combine the risk-free instrument and a risky portfolio with an expected return of 20% to obtain an expected return of 34%. Assume the risk-free rate of interest is 6%. [5 marks]
(c) Suppose an insurance company has £350 million in capital available. The gain from an investment portfolio of this bank during 12-month period is normally distributed with a mean of £70 million and a standard deviation rate of £160 million. The insurance company considers 99% 12-month value at risk (α=2.33) for setting its economic capital. Assume the 1% tail of the loss distribution has the following values: 0.6% probability corresponds to a £700 million loss and 0.4% probability corresponds to a £20 million loss. Calculate annual risk-adjusted return on capital (RAROC) of the investment portfolio, which considers the expected tail loss. [8 marks]
(d) Suppose a project initially costs £900 million and generates cash flows of £350 million per year for three consecutive years. Cash flows are realised at the end of each year. The firm could decide to close down the project immediately after inception and would recover £800 million. The firm could also choose to abandon the project and sell off assets at the beginning of year 2 and recover £700 million with 40% chance or £400 million with 60% chance. The firm also could sell off assets at the beginning of year
3 and realise £300 million with 40% chance or £100 million with 60% chance. Assume the discount rate is 5%. Advise the firm whether and when it should exercise the option (i.e. abandon the project) and calculate the value of the option. [8 marks]
Question 3
(a) Discuss the main factors driving the development of “Alternative Risk Transfer” . [12 marks]
(b) Explain “Catastrophe (CAT) Bond” and discuss its advantages and disadvantages. [10 marks]
(c) Examine the determinants of online Peer-to-Peer (P2P) lending. [11 marks]