Pls do not handwrite the answer, this is for easy reading Question:- 3a) Explain
ID: 2621319 • Letter: P
Question
Pls do not handwrite the answer, this is for easy reading
Question:-
3a) Explain the differences between an option and a forward contract.
3b) Suppose your company uses imported iron ore to produce steel rods for export. Discuss how your company can use options, forward and futures contracts to mitigate the risks of its business.
3c) When it comes to sourcing long terms financial resources, a company can issue 2 types of securities: bonds or shares
3ci) Assess the benefits and disadvantages of each of these sources of financing.
3cii) Preference shares and convertible bonds are both called " hybrid" instruments. Explain how they are structured and assess the similarities between them and why they are characterised as "hybrid".
3ciii) Discuss the impact of a rise in interest on bonds and shares
Explanation / Answer
3a) An option contractis a contract that gives the right, but not an obligation to buy or sell the underlying on or before a stated date and a stated price.
A forward contract is a contractual agreement between two parties to buy/sell an underlying assets at a certain future date for a particular price that is predetermined on the date of contract.
3b)The concept of currency hedging is the use of various financial instruments like option, forward and future contracts to mitigate the risk of its business.
3ci) BONDS : Bond is an instrument of indebtness of the bond issuer to holder.
Bond has a clear advantage over other securities. . The volatility of bonds is lower than that of stock. . They are often liquid and fairly easy for an institution to sell a large quantity of bonds without affecting the price much. Bonds enjoy a measure of legal protection.
Disadvantages : Bobds are subject to risks such as interest rate risk, prepayment risk,, credit risk, reinvestment and liquidity risk.
Shares : The share is the part of capital. .
Advantages : Shares are the permanent source ofcapital and do not create any obligation to pay fixed rate of dividend. Shareholders have voting rights.
Disadvantages : Company cannot take advantage of trading on equity if it only issue equity shares. Investors who desire to invest in securities with fixed income have no attraction for such shares.
3cii) Preference shares have two main characteristics
Firstly, the preference in the payment is given to them at the time of winding up of the company. Secondly, they have preferential rights with respect to dividends also.
Convertible bonds are the type of bonds that the holder can convert into specified number of shared of common stock in the issuing company
One of the largest similarities between preference shares and convertible bonds is that they both receive regular payments from company.
Hybrids is securities that combine two or more different financial instruments characteristics.
The most common examples are convertible bond and preference shares as they posses the characteristics of two different securities characteristics.
3ciii) When interest rate rise, bond price fall and bond investors especially those who remain in bond funds will feel some degree of pain. .
When interest rate rise, it doesnot directly affect the stock market but make borrowings more expensive. Companies that need to borrow significant amonut are subject to floating rate of interest will pay more to do so. This expense tend to hurt return on capital. The stock price goes down