Notes:
- If your answers are not legible or are otherwise difficult to
follow, I reserve the right not to give you any points.
- If you cheat in any way, I reserve the right to give you no points
for the exam, and to give you a failing grade for the course.
- You may bring in sheets with formulas, but no worked-out examples,
or definitions, or anything else.
- You must explain all your answers. For the quantitative questions,
you must show your formulas and your computation, else you may get
no credit at all.
1. (26 points) Read the following article and answer the questions
below:
- (5 points) What is the financial function of the futures markets?
- (5 points) How might this function be undercut because of the
failure of the futures prices to converge to the cash price at the
maturity of the futures contract?
- (8 points) Veteran traders and many farmers blame the new arrivals
in the commodities markets: hedge funds, pension funds and index
funds. These investors and speculators, they complain, are distorting
futures prices by pouring in so much money without regard to market
fundamentals. “The market sends a sell signal, but they don’t
sell,” said Kendell W. Keith, president of the National Grain
and Feed Association.
If this were the reason for the failure of the cash and futures
prices to converge can you come up with a trading strategy to make
money using both cash and futures markets?
- (8 points) Here is some information from the Brian Lehrer show
that aired on June 16, 2008, as reported on the WNYC website (http://www.wnyc.org/shows/bl/gouge_map_beer_07.html).
Our latest "crowdsourcing" project asks listeners to go
to their local grocery store and find out the price of three goods:
milk, lettuce and beer.
| Most
Expensive Beer: |
| Store |
Address |
Price |
| Garden
of Eden |
180 Montague
Street, Brooklyn, NY |
$12.99 |
| Gourmet
Garage |
Mercer St.
and Broome, New York, NY |
$10.99 |
| Least
Expensive Beer: |
| Store |
Address |
Price |
| Fine
Fare Supermarket |
Grand Street,
New York, NY Lower East Side |
$4.99 |
| Wine
Country/ Liquor City |
877 Saint George
Ave, Woodbridge, NJ |
$4.99 |
Can you explain the wide divergences in prices, considering the
notions laid out in the first paragraph of the article? Can you
use your answer to explain the divergence between cash and futures
prices noted in the article?
Odd Crop Prices Defy Economics
By DIANA B. HENRIQUES, New York Times, March 28, 2008
Economists note there should not be two prices for one thing at the
same place and time. Could a drugstore sell two identical tubes of
toothpaste, and charge 50 cents more for one of them? Of course not.
But, in effect, exactly that has been happening, repeatedly and mysteriously,
in trading that sets prices for corn, soybeans and wheat — three
of America’s biggest crops and, lately, popular targets for
investors pouring into the volatile commodities market. Economists
who have been studying this phenomenon say they are at a loss to explain
it.
Whatever the reason, the price for a bushel of grain set in the derivatives
markets has been substantially higher than the simultaneous price
in the cash market.
When that happens, no one can be exactly sure which is the accurate
price in these crucial commodity markets, an uncertainty that can
influence food prices and production decisions around the world.
These disparities also raise the question of whether American farmers,
who rely almost exclusively on the cash market, are being shortchanged
by cash prices that are lower than they should be.
“We do not have a clear understanding of what is driving these
episodic instances,” said Prof. Scott H. Irwin, one of three
agricultural economists at the University of Illinois at Urbana-Champaign
who have done extensive research on these price distortions.
Professor Irwin and his colleagues, Prof. Philip T. Garcia and Prof.
Darrel L. Good, first sounded the alarm about these price distortions
in late 2006 in a study financed by the Chicago Board of Trade. Their
findings drew little attention then, Professor Irwin said, but lately
“people have begun to get very seriously interested in why this
is happening — because it is a fundamental problem in markets
that have generally worked well in the past.”
Market regulators say they have ruled out deliberate market manipulation.
But they, too, are baffled. The Commodity Futures Trading Commission,
which regulates the exchanges where these grain derivatives trade,
has scheduled a forum on April 22 where market participants will discuss
these anomalies and other pressure points arising in the agricultural
markets.
The mechanics of the commodity markets are more complex than selling
toothpaste, however. The anomalies are occurring between the price
of a bushel of grain in the cash market and the price of that same
bushel of grain, as determined by the expiration price of a futures
contract traded in Chicago.
A futures contract is an agreement to deliver a specific amount of
a commodity — 5,000 bushels of wheat, say — on a certain
date in the future. Such contracts are important hedging tools for
farmers, grain elevators, commodity processors and anyone with a stake
in future grain prices. A futures contract that calls for delivery
of wheat in July may trade for more or less for each bushel than today’s
cash market price. But as each day goes by, its price should move
a bit closer to that day’s cash price. And on expiration day,
when the bushels of wheat covered by that futures contract are due
for delivery, their price should very nearly match the price in the
cash market, allowing for a little market friction or major delivery
disruptions like Hurricane Katrina.
But on dozens of occasions since early 2006, the futures contracts
for corn, wheat and soybeans have expired at a price that was much
higher than that day’s cash price for those grains.
For example, soybean futures contracts expired in July at a price
of $9.13 a bushel, which was 80 cents higher than the cash price that
day, Professor Irwin said. In August, the futures expired at $8.62,
or 68 cents above the cash price, and in September, the expiration
price was $9.43, or 78 cents above the cash price.
Corn has been similarly eccentric. A corn futures contract expired
last September at $3.36, which was a remarkable 55 cents above the
cash price, but the contract that expired in March 2007 was roughly
even with the cash price.
“As far as I know, nothing like this has ever happened in the
corn market,” said Professor Irwin.
Wheat futures had been especially prone to this phenomenon, going
back several years. Indeed, the 2007 study by Professor Irwin and
his colleagues concluded that wheat price distortions reflected a
“failure to accomplish one of the fundamental tasks of a futures
market.”
And while the situation improved sharply for wheat futures in Chicago
late last year, it deteriorated for futures traded in Kansas City.
And it has gotten worse for corn and soybeans, Professor Irwin said.
Many people have a theory about why this is happening, but none of
them seem to cover all the available facts.
Mary Haffenberg, a spokeswoman for the CME Group, which owns the
Chicago Board of Trade, where these contracts trade, said the anomalies
might be a temporary result of “a lot of shocks to the system,”
including sharp increases in worldwide food demand, uncertainty about
supplies and surging commodity investments.
Veteran traders and many farmers blame the new arrivals in the commodities
markets: hedge funds, pension funds and index funds. These investors
and speculators, they complain, are distorting futures prices by pouring
in so much money without regard to market fundamentals.
“The market sends a sell signal, but they don’t sell,”
said Kendell W. Keith, president of the National Grain and Feed Association.
“So the markets are not behaving the way they otherwise would
— and the pricing formula for the industry is a lot fuzzier
and a lot less efficient than we’ve ever seen.”
Representatives of the new financial speculators dispute that. Their
money has vastly increased the liquidity in the futures markets, they
say, and better liquidity improves markets, making them less volatile
for everyone.
And, as Professor Irwin noted, if new money pouring into the market
has been causing these distortions, they probably would be occurring
more consistently than they are.
Some experienced commodity analysts think the flaw may be in the
design of the contracts, said Richard J. Feltes, senior vice president
and director of commodity research for MF Global, the world’s
largest commodity futures brokerage firm. If futures were settled
based on a cash index, it would eliminate these odd disparities, Mr.
Feltes said.
Ms. Haffenberg at the CME Group said cash settlement had “not
been ruled out,” but it raised the question of finding the appropriate
cash index. Other modest contract changes are awaiting approval of
the futures trading commission, she said.
“We are continuing to have industry meetings to discuss what
we need to do,” she said. “But we want to be careful,
before we undertake any changes, that above all, we don’t do
any harm.”
Moreover, defenders of the exchange’s current contract design
note that these widely used agreements have gone largely unchanged
for some time — and yet, have only begun to display this odd
and inconsistent behavior in the last few years.
Some economists are exploring whether some unperceived bottlenecks
in the delivery system explain what is going on. But traders say that
such bottlenecks would eventually become known in the market and prices
would adjust. Professor Irwin, whose research is continuing, said
there might not be a single explanation for the price distortions.
Markets may simply be responding to the uneven impact of new financial
technology, which allows more money to flow in and out, and to investors’
growing but fluctuating appetite for hard assets.
“Those factors may be combining to create this highly volatile
environment for discovering prices,” he said. “But for
now, that is pure conjecture on my part.”
What is not happening in these markets is equally mysterious. Normally,
price disparities like these are quickly exploited by arbitrage traders
who buy goods in the cheap market and sell them in the expensive one.
Their buying and selling quickly brings the prices back into balance
— but that is not happening here.
“These are highly competitive markets with very experienced
traders,” he said. “Yet they are leaving these profits
alone? It just doesn’t make sense.”
2. (32 points) Use the balance sheet and income statements for Atrexia
Corp. (given below) and answer the following questions:
|
Balance
Sheet at Year-end |
|
1994 |
1995 |
1996 |
1997 |
| Assets |
|
|
|
|
| Cash |
20 |
45 |
83 |
883 |
| Accounts Receivable |
690 |
900 |
853 |
845 |
| Inventories |
11014 |
14064 |
15989 |
15897 |
| Total
Current Assets |
11724 |
15009 |
16925 |
17625 |
| Property, Plant, and Equipment (net
of depreciation) |
15675 |
18485 |
21497 |
22904 |
| Other Assets |
1151 |
1607 |
1316 |
1287 |
| Total Assets |
28550 |
35101 |
39738 |
41816 |
|
|
|
|
|
| Liabilities and Shareholders'
Equity |
|
|
|
|
| Accounts Payable |
4104 |
5907 |
6442 |
7628 |
| Notes Payable |
1646 |
1882 |
2798 |
618 |
| Other Current Liabilities |
1656 |
2184 |
2214 |
2711 |
| Total Current Liabilities |
7406 |
9973 |
11454 |
10957 |
| Long-Term Debt |
10460 |
12320 |
13203 |
12596 |
| Total Liabilities |
17866 |
22293 |
24657 |
23553 |
| Common Stock |
697 |
851 |
1099 |
1895 |
| Retained Earnings |
9987 |
11957 |
13982 |
16368 |
| Total Shareholders' Equity |
10684 |
12808 |
15081 |
18263 |
| Total Liabs and Shareholders'
Equity |
28550 |
35101 |
39738 |
41816 |
Here are the Income Statements:
|
Income
Statements for Years ending |
|
|
1995 |
1996 |
1997 |
| Sales |
|
83412 |
94749 |
106146 |
| Expenses: |
|
|
|
|
| Cost of Goods Sold |
|
65586 |
74564 |
83663 |
| Marketing and Administrative |
|
12858 |
14951 |
16788 |
| Interest |
|
706 |
888 |
845 |
| Income Taxes |
|
1581 |
1606 |
1794 |
| Total Expenses |
|
80731 |
92009 |
103090 |
| Net Income |
|
2681 |
2740 |
3056 |
Dividends paid to shareholders for 1995 were $711; for 1996, they
were $715; and for 1997, they were $670. Cost of Goods sold includes
depreciation of $2231 in 1995, $2300 in 1996 and $2445 in 1997.
- Compute the debt-to-equity ratio for 1994, 1995, 1996 and 1997.
How has it been changing?
- Compute EBIT for 1995, 1996 and 1997 and then use it to compute
the Cash Coverage Ratio for those years.
- Compute the Net Profit Margin and Asset Turnover for the three
years, 1995, 1996 and 1997.
- Can you make a statement about the overall strategy of the firm,
using the Dupont Identity?
3. (25 points) You need $100,000 to make some much-needed improvements
to your house. At the beginning, you think that you might be getting
a large payment in six months time from your employer as back-pay.
So you approach your bank for a bridge loan. Your bank is willing
to lend you $100,000 for six months; at the end of the six months,
you have to pay the bank back $105,830.05.
Unfortunately, you discover that, as a result of a recent court decision,
the back-pay is not going to be forthcoming. You go back to your bank,
which agrees to extend the amount of time you will have to repay the
loan to three years. However, the bank does not want to take the risk
that you may not be solvent in three years time. Hence they ask you
to repay the loan in equal monthly instalments over the three years,
with the first payment to be made in one month. The bank is kind enough
to keep the effective annual interest rate on the new longer-term
loan the same as on the original bridge loan. What will be the amount
of the monthly payment?
4. (32 points) Answer any four of the following questions:
- Can the market value of equity for a firm be different from the
book value of equity? If your answer is yes, explain why with an
example that shows the underlying circumstances and the reason why
the firm market value in your example differes from the book value.
If your answer is no, explain why the two have to always be the
same.
- Give an example of a type of financial institution that helps
in the settling and clearing of payments. Write about four or five
sentences to explain how it provides such a financial function.
- Explain moral hazard and provide an example.
- What is the matching principle? Provide a reason why you think
firms should follow the matching principle in reporting their income
and provide a statement why you think they shouldn't.
- Provide an example of a turnover ratio and show how it might be
used.
- What is the difference between a nominal rate of return and a
real rate of return on a particular asset? Suppose inflation last
period turned out to be unexpectedly high, whereas you think (contrary
to the received market opinion) that inflation is going to be unexpectedly
low next period. In such circumstances, would you expect next period's
real return on an asset to be higher or lower than the realized
real rate of return on that asset last period?
Solutions
1.a. The futures markets have two functions -- one to allow market
participants to hedge and thereby to transfer risk. If a farmer is
long wheat (i.e. s/he has wheat fields which s/he will harvest in
the future, s/he can sell short in the futures markets, thus locking
in a price at which he can sell his/her wheat ultimately.
b. The way hedging works is as follows. The farmer sells in the futures
markets today to remove the risk of the cash price at harvest time
moving against him. When the futures contract matures, he buys back
the futures contract and sells in the cash market. If the futures
price converges to the cash price at maturity, the farmer will be
able to offset his loss (gain) in the cash market against the gain
(loss) in the cash market. However, if there is no convergence, there
is no guarantee of such offset. Correspondingly, there will be less
risk transfer.
c. Since Mr. Keith seems to claim that futures prices stay too high,
a simple strategy would be to buy the futures contract and sell spot
grain short. At maturity, sell the futures contract at a high price
and buy in the cash market to cover the short position. The gain in
the futures position should be greater than the loss in the cash position
if what Mr. Keith says is right.
d. One possibility for the price divergence is that people are paying
for convenience. The application to our situation is that there may
be some other characteristic of the futures contract that is not reflected
in the cash grains market. For example, it is possible to take positions
in the futures market with very little cash.
2. a. The long-term debt to equity ratio (where equity is the book
value of shareholders' equity) works out to 0.9790, 0.9619, 0.8755
and 0.6897 respectively for the years 1994 through 1997. It has been
consistently dropping. This seems to be because dividends have been
dropping inspite of an increase in net income. Retained Earnings,
clearly, have been growing up.
The question is -- why has the firm not increased debt? The answer
might be that it is going to, soon; that it was just waiting to confirm
that the value of equity had reached a permanently higher level. Alternatively,
the firm may have believed that the earlier leverage was too high
and is cutting down on debt.
b. EBIT for the last three years can be computed as Net Income +
Interest + Taxes, which works out to $4968, $5234 and $5695. We can
use this to compute the cash coverage ratio, which is defined as (EBIT
+ Depreciation)/Interest. This works out to 10.2, 8.48 and 9.63 for
1995, 1996 and 1997 respectively.
c. The Net Profit Margin (NI/Sales) is 3.21%, 2.89% and 2.88%; the
Asset Turnover is 2.621, 2.532 and 2.603.
d. It's difficult to make a statement regarding strategy since we
don't know what industry the firm is in, and what is a "normal"
profit margin number. However, it looks like profit margin is dropping,
while asset turnover is going up. From this, one might tentatively
conclude that the firm is moving towards a high volume -- low margin
strategy. On the other hand, one would have expected a high volume
strategy to also be lower risk, and hence indicating a desired interest
in the debt ratio, which has not occurred.
3. The six-month effective rate is 105830.05/100000 or 5.83%. This
can be annualized as (1.0583)2 -1 or 12% p.a. This converts
to a monthly rate of (1.12)1/12 -1 or 0.949%. (If we were
interested, we coudl compute the APR as 0.949% x 12 or 11.3866%.
If you borrowed $100,000 at an effective annual rate of 12% to be
repaid in 36 equal monthly instalments, we'd solve for 100000 = (C/0.00949)[1-(1/1.00949)36].
Solving for C, we get $3292.21
