Report: Analysis of Advanced Corporate Finance Principles and Models

This report provides an analysis of advanced corporate finance, focusing on financial tools and models used to calculate returns and risks. It begins with an examination of international diversification strategies and the application of the International Capital Asset Pricing Model (ICAPM), contrasting it with the domestic Capital Asset Pricing Model (CAPM) and evaluating their limitations. The report then delves into two tasks: evaluating investments in Euro-denominated bonds versus US bonds and calculating US dollar returns on Euro-denominated bonds. Furthermore, it explores the benefits of interest rate swaps and analyzes sovereign bond ratings by S&P. The analysis provides insights into portfolio diversification, risk management, and the application of financial models in making investment decisions.

Advance Corporate Finance
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Executive Summary
Corporate finance provides with a number of financial tools and models that allows calculating
returns from particular portfolios and also their associated risks. The scope of current analysis
focuses on analysing trends and principles of Advanced Corporate Finance. It analyses models
used for calculation of domestic returns on assets class portfolio as CAPM (Capital Asset Pricing
Model). It incorporates analysis pertaining to ICAPM (International Capital Asset Pricing
Model) which is used for calculating returns on global asset class diversified portfolios. Then
analysis of two tasks where one investor selects to invests in Euro Denominated Bonds and USD
Denominated Bonds are considered. Further analysis pertaining to SWAP of floating rate against
fixed rate of interest is done. Finally analysis of Sovereign Bond and S&P as its measure is
analysed critically.
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Table of Contents
Executive Summary.........................................................................................................................2
1.0 Introduction................................................................................................................................4
2.0 Examine the strategy of international diversification and the application of ICAPM..............5
3.0 Compare and contrast ICAPM and with domestic CAPM and critically evaluate the limiting
assumptions of these models...........................................................................................................7
4.0 Task 1: An evaluation of whether to invest the entire foreign bond allocation in euro-
denominated bonds or reallocate the money to US bonds over the next year.................................9
5.0 Task 2: Show your calculation of the US dollar return on the euro- denominated bonds.......10
6.0 Conclusions..............................................................................................................................14
7.0 Reference Lists........................................................................................................................15
8.0 Appendices..............................................................................................................................16
8.1 Appendix 1: Task 1..............................................................................................................16
8.2 Appendix 2: Task 2..............................................................................................................17
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1.0 Introduction
The domain of corporate finance is defined by analysing returns for various classes of assets and
understanding their risk rates. Investors invests into assets classes in order to maximize their
returns and minimize their risks associated with certain classes of assets (Boubakri, 2011). Asset
classes might be debt or equity that can be domestic or international. In case investors wishes to
diversify across several classes of investments he might wish to select a portfolio mixture of debt
and equity and in cases he wishes to diversify across countries, he might select global portfolios.
The scope of the current analysis concerns examining strategy of international diversifications.
Most investors wishes to m minimize risks and maximize returns. In order to maximize returns,
international diversification is often selected. Strategy involved in diversifying across
international markets includes analysing rate of returns, macroeconomic factors, risk free rate of
return and also taking into consideration currency rate fluctuations. Capital Asset Pricing Model
(CAPM) helps calculate return from risks calculations and risk free rate. However, it takes into
consideration domestic assets classes. To broaden financial analysis ICAPM (International
Capital Asset Pricing Model) is taken into consideration that takes into account currency rates
and also links returns to consumption patterns (Fama, 2014). In the second part of discussion
CAPM is contrasted with ICAPM, in order to understand their distinctions. Their individual
limitations are also discussed for gaining greater insights into them. Sovereign debt is a national
debt which is rated by S&Ps for benchmarking. S&Ps while analysing sovereign debts takes into
consideration various factors that includes payback capacity of the government, past payments,
risk factors and so on. In the end certain conclusion for overall understanding drawn from
ICAPM, CAPM and sovereign debt is drawn.
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2.0 Examine the strategy of international diversification and the
application of ICAPM
Strategy of international diversification is based on the theory that global portfolios earns higher
returns compared to domestic only portfolios. Historically, there has been a preference of
globally diversified portfolio as against domestic-only portfolios on the efficiency aspect. Global
portfolios are capable to generate higher levels of returns for same levels of risks and often take
lesser risks for same levels of returns (Dean, 2011). There remains investors anxiousness
regarding international investments as a result of poor performance outside of US in the last year.
Gerstein Fisher long-term belief is focused on globally diversified portfolio. There are no
appropriate tools for predicting a single market that has capability to consistently perform
amongst top global stock markets. As a single market cannot be predicted, diversifying across a
large number of countries can allow gaining high returns. Global market diversifications
provided multiple benefits from their reactions to domestic monetary and fiscal policy cycles that
has been found to be beneficial when combined with US investments.
Performance cannot be held as the only argument for purpose of international investments.
Diversification can lead to benefits from investing in low cross-correlation countries that can
contribute towards reducing volatility for the total portfolio for long-term period (Lai, 2009).
Global diversification allows diversifying risks-adjusted returns for portfolio performances. a
fixed strategic percentage of global investments internationally can allow significant benefits.
Application of ICAPM (International Capital Asset Pricing Model) is consumption oriented
asset pricing model that delivers returns expected from a security. ICAPM was introduced by
Sharpe (1964) and Lintner (1965) and extended by black (1972) as an extension to CAPM model
that takes into consideration time-varying factors. The underlying assumption in this theory is
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that investors will hedge their position of risks based on future returns, unemployment rates,
inflation and so on. In this type of portfolio, primary investment that is lined to the market is also
hedge for mitigation of risk perceived. Hedging portfolios will be separate based on risk factor of
investors (Maio, 2012). The model uses mean-variance analysis for arriving at normal
distribution for risk consumption for a period of time. As it covers a number of periods it
includes multiple beta coefficient for varied portfolios. Expected return taking into account
global factors for calculation of ICAPM is;
Applying ICAPM in international market can provide that the market is integrated. In case
market is segmented, (Arouri, 2009) then discrepancies in asset prices of same risk profiles
results from varied currencies that are used. The above factor of often leads to inefficient type of
asset pricing hence ICAPM can be applied for selection of optimal portfolios by analysing
impact from currency movements on asset prices that has same risk profiles in varied countries.
Thus, it can be said that ICAPM can easily be applied for global portfolios where investor aim at
diversifying stock returns for varied risk profiles.
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3.0 Compare and contrast ICAPM and with domestic CAPM and critically
evaluate the limiting assumptions of these models
Answer: Investment in any asset class involves substantial amounts of risks that can be
minimized by way of financial tools by analysing expected returns. The CAPM and ICAPM are
financial tools that helps arrive at expected returns associated with a particular class of assets.
CAPM takes into account required rate of return on an asset, risk-free rate along with the assets
sensitivity to the market (Cochrane, 2009). These financial tools and models are defined with
certain underlying assumptions as absence of taxes, no transaction costs, investors can easily
obtain risk-free rate of lending and investors are risk averse in nature. These underlying
assumptions cannot be fully be accepted into real world setting hence CAPM and ICAPM is
regarded as tools for calculating expected returns on certain class of investments. ICAPM is
often considered to be more useful as compared to CAPM in general practice, however ICAPM
also has certain limitations on its practicality. From calculations of returns, it can easily be said
that investors want to be compensated for their time value of money which is obviously more
than the risk free rate of return. As investing into market requires bearing of considerable risks,
investors requires certain amount of premium to be paid over the risk free rate of return in the
market (Bali, 2009). ICAPM is an expanded form of CAPM model that allows for investors
getting premium for bearing risks and be paid for being exposed directly or indirectly to foreign
currency. ICAPM integrates currency effects into CAPM considerations when investors holds an
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asset especially in foreign portfolio. Further sensitivity to foreign currency provides additional
profitability impacts either directly or in an indirect manner.
CAPM and ICAPM provide methods that allow calculations of returns over risk free rates or
rates of interests. Domestic CAPM incorporates that investors are investing into specific asset
class where they reside. This model assumes that domestic investor does not have access to
opportunities in international markets for the purpose of diversification of risks. In this model
capital markets of countries are assumed to be separated from each other and segmented as per
international perspective. As per this perspective beta is a measure of the country’s market index,
which is the equity premium delivered at local market premium (Elbannan, 2014). The model
has applicability in the real practical world but does not take into consideration currency rates.
ICAPM on the other hand enables market investors in the global forum. It encompasses
diversification of portfolio by earning a diversified rate of return according to its risk factors.
Similarities of CAPM and ICAPM is that both the models assumes investors being risk averse in
nature having uniform expectation of returns and risks from all asset classes. These models also
assumes that investors holds some combinations of risk-free assets and market portfolio (Khan,
2008). Differences of these models are in their market portfolio that constitutes them, while
domestic CAPM comprises of all domestic equity assets. ICAPM includes globally diversified
risky asset classes. CAPM does not include any hedging options, whereas ICAPM includes
currency hedging or a hedging portfolio to overcome risk associated with particular asset class
investments.
ICAPM is particularly useful in cases of portfolio management and stock selection while
undertaking assumptions. These models can highly influence selection and designing of portfolio
for investors for selecting amongst two assets classes across varied countries. ICAPM can be
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used along with other financial tools allowing investors to select assets that will meet their
expectations on required rate of return (Dempsey, 2013). However, ICAPM assumes that global
markets are integrated and efficient, in case this assumptions does not apply then allocating
stocks selection can result in currency advantage that can result in alpha. Limiting assumptions
of these models encompasses that CAPM includes asset classes from domestic markets only.
Whereas limiting conditions for ICAPM is that it considers international classes of investments.
4.0 Task 1: An evaluation of whether to invest the entire foreign bond
allocation in euro-denominated bonds or reallocate the money to US
bonds over the next year
Answer:
Total Asset for investments is $25 billions
Foreign Investments comprises of 3.7 billions, which is 15% of total portfolio
Stock Investments is 2.25 billion, invested at Portfolio Beta 1.1, 0.95 and 1.3
Bond Investments is 1.5 billion
Euro Denomination Bond rate is 4.50%
US Denomination Bond Rate is 2.90%
1 Year Forward Exchange Rate is $1.5 per Euro
Current Exchange Rate is $1.4 per Euro
Return on Euro Denominated Bond is 0.072321 billion (Appendix 1)
Return on USD Denominated Bond is 0.0435 billion
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From above returns calculated on Euro Denominated bond and looking at 1 Year forward
rate it can be concluded that it is best to invest in it. Euro Denominated Bonds will generate
better returns compared to USD denominated Bonds. As 1 Year forward outlook for Euro
Exchange Rate is $1.5 per euro, it is advisable to remain invested into Euro Bonds rather than
diverting into US Bonds. Interest rate of US bond is low hence investor will benefit from higher
rate of interests as well as higher currency exchange rate.
5.0 Task 2: Show your calculation of the US dollar return on the euro-
denominated bonds
a) Discuss the reasons why a variable for fixed interest rate swap
may be desirable, in general, for a company such as ABC
Limited.
Answer:
A fixed-for-floating swap is contractual agreement between two parties, where one party swaps
interest rate for cash flows for a fixed loan with a floating rate loan of another party. The
principal of the loan is not exchanged. This type of arrangement can highly reduce interest
expense by swapping for a fixed rate of interest that is lower than fixed rate that is paid currently.
Manufacturing company as ABC Limited making motor components taken a floating-rate loan
from bank. The company wants to swap it for fixed-interest rate exposure from one-year
quarterly-paying pension fund at 6%. The floating rate for 360-day year interest is LIBOR + 1%,
where annual LIBOR rates are available for quarter 1 being 5.5%, quarter 2 being 5.4%, quarter
3 being 5.8% and quarter 4 being at 6.0%. Fixed rate interest swap is desirable for a company
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like ABC Limited as interest rate predictions in the future might rise. It can enable the company
to better match liabilities and assets which are sensitive to interest rate movements. It also helps
to diversify total loan portfolio by exchanging interest rates. It is generally performed with the
expectation that interest rates in the market is expected to rise.
With volatility in interest rate market, it might be best suited that the company uses hedging
option and opts for fixed rate of interest as in case of rise in interest rate, there might more
payments incurred by the company. Hedging for fixed rate of interest rate would also allow to
prevent uncertain cash flows in the future. The company can easily access its cash flows for
future period, which might otherwise would have been impossible in cases of floating rates of
interests.
b) Show your calculations of the quarterly swap payments due from
ABC Limited for the duration of the swap agreement and comment
on alternative hedging possibilities which open to the company. (20
marks)
Answer: ABC Company had a notional amount of GBP2, 000,000, which was swap for fixed
interest payment with TrustInvest Corp. TrustInvest Corp on the other hand decided to pay a
LIBOR+1% rate for the amount. Discounting factor for arriving at cash flows have been
calculated in Appendix 2. This is the annual payment SWAP rate that has to be paid quarterly at
1.86% annually. Quarterly SWAP payment is 9300 for a period of 1 year during the swap
agreement. Total SWAP payments is GBP 37200 which is highly profitable for the Company.
Alternative possible hedging possibility in rising interest rate market is to have lower rate of
floating rate discounted to LIBOR.
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ABC Company can easily hedge with currency rate swaps that offers strategy to overcome
current positions. Currency hedges are done on a continuous basis by investors, bankers,
portfolio managers and retail investors. Hedging with currency exchange rates can allow
potential changes to be made in one currency against the other and can be used for overcoming
interest rate risks. However, there are no notional principals present in currency swaps to hedge
against possibility of risk exposure. It can be done to achieve better rates of lending and hedge
against any possible interest rate fluctuations.
c) Consider the following statement:
“The debt of national governments – sovereign debt - is rated by
nationally recognised statistical rating organisations such as
Standard and Poor’s (S&P).”
With referenced to the above statement, explain what you
understand by “sovereign debt” and critically discuss the key
factors you would expect to be used by rating agencies, such as
S&P, for sovereign debt ratings.
Answer: A Sovereign Debt is also known as a government debt, public debt or national debt and
is a central governmental debt. Government of a country issues Sovereign Debt in foreign
currency for financing of a country’s development and growth (White, 2010). A country’s
Sovereign Debt ratings provides stability of the issuing government that allows investors to
weigh risks while analysing sovereign debt investments. Sovereign Debt is rated by nationally
recognized statistical rating organization as Standard and Poor’s (S&P). This type of debt can be
external or internal in nature, in case categorised as internal debt then it is owed to lenders within
the country. In case sovereign debt is classified as external debt then it is owed to foreign
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lenders. Sovereign Debt is classified by the duration of the debt until its repayment is due. In
cases of short-term classified debt, it is usually less than a year (Candelon, 2011). If debt is
classified as long term debt, then it can last for more than 10 year duration.
Sovereign debt is issued by governments by giving out bills, bonds or by issuing of securities.
Some sovereign bonds borrow directly from world organizations as World Bank and other
international financial organizations. Sovereign bonds involves small amounts of lending risks,
default risks and in the country’s own currency it is the risk-free rate of investment. Sovereign
credit rating is the credit rating of a country or of the sovereign entity. Rating of sovereign bonds
provides investors insights into level of risks associated with investment to be made in a
particular country which encompasses political risks. Rating agencies evaluates the country’s
political and economic environment for arriving at a credit rating. For developing countries, it
becomes essential to arrive at good sovereign ratings for having an access to international bond
markets. S&Ps issues credit ratings for sovereign bonds, which are essential as it allows the
country access to foreign markets for the purpose of attracting direct foreign investments.
Standards and Poors provides a solid rating that demonstrate transparent and country’s standing
position. S&P provide BBB- or higher credit ratings for sovereign bonds that are investment
grade belwo which they do not consider worth investing. Key factor S&P considers while rating
a country’s sovereign bonds apart from its political and economic conditions are its risk portion
that defines a government’s capability to meet debt obligations. Some other factors that rating
agencies considers are debt service ratio, import ratio, growth I n domestic supply, variance of
export revenue and so on.
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6.0 Conclusions
Analysing above trends in capital asset pricing models it can said that investors need to diversify
their portfolio with global assets. Calculating returns on assets on global portfolio is suitable by
way of ICAPM model. Investors evaluate performance of their asset classes by evaluating their
portfolio as per CAPM model in case of domestic markets and ICAPM model when evaluating
globally diversified portfolios. In each situation these models plays an active role to determine
and understand risk appetite associated with an investor.
While investing in debt market with currency hedge, an investor is more likely to select a higher
interest paying market compared to a lower interest paying market. Especially in case where 1
Year forward rate is expected to rise against the other currency.
Interest rate swap is an option that is selected by company in case of predicting an interests rate
rise to hedge situation. Often a fixed rate of interest is hedged against floating rate of interest or
floating rate of interest against fixed rate. LIBOR acts as the benchmark for interest rates against
which companies or investors calculates their position.
Sovereign Debt is a national debt, which is rated by S&P index. This index uses various
parameters for judging sovereign ratings of bonds. A sovereign bond is usually evaluated such as
to attract suitable number of investors into purchase of bonds. S&P makes use of various
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pertinent criteria such that appropriate rating for sovereign bonds can easily be arrived at. It
reflects a government’s capability or willingness to repay back loans and debts of the country.
7.0 Reference Lists
Arouri, M. E. (2009). Are stock markets integrated? Evidence from a partially segmented
ICAPM with asymmetric effects. arXiv preprint arXiv:0905.3875.
Bali, T. &. (2009). A cross-sectional investigation of the conditional ICAPM. In URL:
http://www. bus. wisc. edu/finance/workshops/documents/Bali-Engle. pdf.
Boubakri, S. &. (2011). Financial integration and currency risk premium in CEECs: Evidence
from the ICAPM. Emerging Markets Review, 12(4), 460-484.
Candelon, B. S. (2011). Sovereign rating news and financial markets spillovers: Evidence from
the European debt crisis (No. 11-68). International Monetary Fund.
Cochrane, J. H. (2009). Asset Pricing:(Revised Edition). Princeton university press.
Dean, W. G. (2011). Feedback trading and the behavioural ICAPM: multivariate evidence across
international equity and bond markets. Applied Financial Economics, 21(22), 1665-1678.
Dempsey, M. (2013). The capital asset pricing model (CAPM): the history of a failed
revolutionary idea in finance? Abacus, 49(S1), 7-23.
Elbannan, M. A. (2014). The capital asset pricing model: an overview of the theory.
International Journal of Economics and Finance, 7(1), 216.
Fama, E. F. (2014). Two pillars of asset pricing. American Economic Review, 104(6), 1467-85.
Khan, M. (2008). Are accruals mispriced? Evidence from tests of an International capital asset
pricing model. Journal of Accounting and Economics, 45(1), 55-77.
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Lai, L. H. (2009). Underwriting systematic risk and profit margin in fuzzy CAPM and ICAPM
models: the case of aviation coverage. Contemporary Management Research, 5(4).
Maio, P. &.-C. (2012). Multifactor models and their consistency with the ICAPM. Journal of
Financial Economics, 106(3), 586-613.
White, L. J. (2010). Markets: The credit rating agencies. Journal of Economic Perspectives,
24(2), 211-26.
8.0 Appendices
8.1 Appendix 1: Task 1
TASK 1
USD
Total Assets 25 billion
Foreign Investment 3.75 billion
15% of Total
Portfolio
Stocks 2.25 billion
60% of Foreign
Investment
Portfolio B 1 1.1
Portfolio B 2 0.95
Portfolio B 3 1.3
Bonds 1.5 billion
40% of Foreign
Investment
Interest Rate
Euro Bond 4.50%
USD Bond 2.90%
1-Year Forward Exchange
Rate $1.5 per euro
Current Exchange Rate $1.4 per euro
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Return on Euro
denominated bond
1.5 billion bonds X 4.5% Euro Bond
X 1.5/1.4
Return on Euro
denominated bond 0.072321 billion
Return on USD
denominated bond 1.5 billion X 2.9%
Return on USD
denominated bond 0.0435 billion
8.2 Appendix 2: Task 2
Compan
y ABC
TrustInvest
Corp
Fixed Rate 6%
LIBOR +
1%
Discounting
factor
The fixed annual rate of swap is c, annual fixed
amount is C and notional amount is N
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Company ABC should pay c/4*N or C/4 per quarter
and will receive Libor rate +1%*N
is the notional value of fixed rate of bond which is equal
to notional amount of swap -GBP 2,000,000
Loan
GBP
2,000,000
Floating Rate
LIBOR+1%
Discounti
ng
Factor
6%
6.50% 0.00711
6.40% 0.556
6.80% 0.43956
7% 0.3636
1.36627
Calculation of
Discounting Factor
1+(Libor
6.50%/4)*90/360
(Libor
6.50%/4)*9
0/360 1.40625
0.0071
1
1st Quarter
2nd Quarter
(Libor
6.40%/4)*1
80/360 1.80000
0.5560
0
3rd Quarter
(Libor
6.80%/4)*2
70/360 2.27500
0.4395
6
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4th Quarter
(Libor
7.0%/4)*36
0/360 2.75000
0.3636
0
C=4*
(1-0.3636)/(0.00711+0.55600+0.43
956+0.3636)
C=1.863
%
Annualizes
Swap rate
Quarterly
SWAP
Payments
2,000,000
*1.863/4
Quarterly
SWAP
Payments 9300
If Company ABC wishes to enter swap agreement for notional value of GBP2,000,000 for
receiving floating rate for fixed rate payment, annualized swap rate will be 1.86%
Company ABC hence has to pay a swap
payment of GBP 9300
Total Swap Payments made throughout
the term of the Swap
GBP
9300*4
GBP
37200
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