Finance 4412Short Term Financial Management Topic Outline for Final Exam 1 Know the following the 3 main sources of firm financing how the effective interest rate on a bank line of credit is calculated interest cost commitment fee compensating balance requirement plus loan covenants that have to be satisfied a Bonds b Commercial Paper c Bank loans Issuing a line of credit for working capital i Banks 5 1 Req firms compensating balance in a hold DDA demand deposit account Ex 20 of any borrowed 2 Charge a loan commitment fee on the value of the unused line e g 25BP 0025 on unused loan amount my be held idle amount 3 Charge interest on the value of the loan made Amt borrowed int rate 4 Impose loan covenants that need to be met before the line of credit can be used i e if leverage x then no funds 5 Req proof that borrowed amount is used for short term purposes borrowed amount returned for few weeks each year 1a The main short term investment alternatives for a firm e g sweep accounts commercial paper treasury securities and How the discount yield is computed applies to treasury securities commercial paper corporate bonds etc a Sweep Accounts Firm s excess collected DDA funds swept into interest earning investments overnight pay bank fees for this service i Discount Yield Instruments Face value Mkt price face value ii Treasury Yields iii Commercial paper iv Bankers Acceptances b Repurchase Agreements Firm buys government securities from bank to earn interest 2 Know how spot and forward exchange rates work Be able to determine if an exchange rate has appreciated or depreciated and what this means for a country s price of imports seen at home and price of exports seen overseas Spot rate St is the exchange rate Today Forward Exchange rate Ft exchange rate in the future 1 week 10 years 1 The lb has depreciated and the dollar has appreciated This means the for the US Import prices from will decrease and Exports to will have increased by 4 3 each 2 In this case the dollar has depreciated and the lb has appreciated This means that the cost of imports will increase and the price of exports will decrease by 2 3 each 3 Be able to use a supply and demand graph to show how a flexible exchange rate is determined and how these supply demand curves are related to the demand for imports and the demand for exports Flexible exchange rate is determined by simple supply and demand Key Dfx demand of foreign exchange demand for imports Dm Sfx supply of foreign exchange demand for exports Dx Supply of foreign exchange Sfx is really showing the demand for US exports Dx Where the demand of foreign exchange Dfx is really showing the demand for foreign imports Dm When one country moves the other country does the opposite 3a Know the two main components of a country s balance of payments current account and capital account Reason for surplus deficit The two must sum to equilibrium so if one is higher than average it means the other must be lower than average 3b Why a net capital inflow into a country e g a foreign investment in a domestic firm is like an export of a product Both are classified as exports in the balance of payments and result in the same end product money coming in 4 Understand the rule on what determines the expected future spot exchange rate between two countries based on today s interest or inflation rates between two countries Interest Rate parity Def Relative level of interest rates in one country compared to another Relative purchasing power parity Def Relative rate of inflation in one country compared to another The country with the higher interest rate or inflation rate is expected to depreciate its currency by the Rule of thumb difference in interest rates Example How well does this rule work in practice If US interest rate 2 and UK interest rate 3 The UK is expected to depreciate the by 1 so the is expected to appreciate by 1 If interest rate parity were 100 correct the difference would be 0 all the time as we can see this is not true However over the long rule the average of times that the rate is above and below 0 4a Know how a firm s international future account receivables or payables could be protected from exchange rate changes before the funds in these accounts are actually received or paid A R Account receivable in FX foreign currency SELL 1 Do nothing and sell FX at spot rate when receive FX 2 Sell FX today in forward market to lock in a future exchange rate 3 Buy a put option to sell FX at a given strike price If spot rate is more favorable when receive FX then sell at spot No A R No A P 1 Buy a put option this is speculation as do not have an A R A P Account payable in FX foreign currency BUY 1 Do nothing and buy FX at spot rate when need to pay FX 2 Buy FX today in forward market to lock in a future exchange rate 3 Buy a call option to buy FX at a given strike price If spot rate is more favorable when need to pay FX then buy at spot 1 Buy a call option this is speculation as do not have an A P 5 Know how a firm can hedge its interest rate risk on a short term fixed or variable rate bank loan or a fixed or variable rate short term investment using the interest rate futures market or by using interest rate swaps Methods 1 Interest rate swaps Largest derivative market in the world 2 Interest rate futures contracts Hold an instrument that rises in value when I rates fall and vice versa 3 Interest rate options Puts and calls on interest rates a put option an I rate floor a call option an I rate ceiling Key to hedging and determining methods If interest rates are supposed to rise you want and Fixed rate If interest rates are supposed to fall you want a Variable rate SWAPS Interest rate swap Trades a stream of fixed rate payments receipts for a stream of variable rate payments receipts If a firm with a variable rate floating loan thought that rates would rise it would enter into a swap agreement to pay fixed and receive floating changing a variable rate loan into a fixed rate If the firm with a fixed rate loan thought that rates would fall it would enter into a swap agreement to pay floating variable and receive fixed changing a fixed rate loan into a variable rate The cash flows of an interest rate swap are interest rates applied to a set amount of capital nominal amt no principal is swapped only the net of interest rate payments Interest Rate Futures Can be a liability loan or an investment 5a Understand how interest rate cap and floor options work to reduce a …