Fin3145 Global Issues In Financial Assessment Answers

Tasks

Task 1

Task 2

1. Estimates of unemployment for the upcoming year have been developed as follows:

Calculate the expected unemployment rate and the standard deviation.

• Calculate NewBank’s Return on Assets (ROA)and Net Interest Margin (NIM) for its first month. Assume that net interest equals EBT, and that NewBank is in the 28% tax bracket.
• Calculate NewBank’s Return on Equity (ROE)and final balance sheet including its tax liabilities. Assuming NewBank is required to establish a loan loss reserve at 0.5% of the loan value for commercial loans, how is this recorded?
• Recalculate NewBank’s ROE and final balance sheet including its tax liabilitiesin this instance.
• AssumingNewBank’s target ROE is 5%, how much net fee income must it generate to meet this target?
• After making payments for three years, one of the mortgage borrowers defaults on the mortgage. NewBank immediately takes possession of the house and sells it at auctionfor $175,000. Legal fees amount to $25,000. If no loan loss reserve was established for the mortgage loans, how is this event recorded?

1. Briefly discuss the different available sources of finance for small and medium companies (SMEs). The word count for this element should.

Task 3

In the final page there is a table containing a list of the largest Initial Public Offerings (IPOs) that have occurred so far in 2017, with the Current Price column representing the share price of March, 24th.

1. For each of the companies calculate the Market Capitalisation at the time of IPO and now. If you had won a lottery prize of $2,275 on January 15th and decided to invest your winnings in the next available IPO and then sold your investment on the 24th of March, how much money did you make and what yearly return does that represent (Assume your broker charges $25 per transaction).
2. The following is an extract from an article published on November, 21st 2016 on the U.S. News website: "Of all the possible 2017 IPOs, a public offering from ride-hailing giant Uber, valued at nearly $70 billion, would doubtlessly be the biggest of the year. Uber CEO Travis Kalanick has spoken of pushing back an Uber IPO for as long as possible, but a recent merger of Uber China with bitter Chinese rival Didi Chuxing could pave the way for a 2017 offering. This makes a 2017 IPO more likely since China was a huge profit suck for Uber. Still,Uber lost over $1.2 billion in the first half of 2016. "Uber needs to get expenses and losses under control quickly," says K C Ma, professor of finance at Stetson University."

Discuss the reasons for and against an investor subscribing Uber's shares if and when the company decide to seek a stock market listing. The word count for this element should.

Task 4

Assuming the manager wants a duration gap of 4.00 years, what level of Saving Accounts should the bank raise? Calculate in approximate $mill and assume that any difference between assets and liabilities is held as cash (duration = 0).

Task 5

1. A bank issues a $5 million commercial mortgage with a nominal APR of 6%. The loan is fully amortized over 10 years requiring monthly payments. The bank plans on selling the loan after 4 months. If the required nominal APR increases by 65 basis points when the loan is sold, what gain or loss does the bank incur?
2. That same bank has a differential advantage in issuing variable-rate mortgages, but does not want the interest income risk associated with such loans. The bank currently has a portfolio of $33,000,000 mortgages with an APR of prime +175 basis points, reset monthly. Prime is currently 3%. A swap has been arranged to turn the current cash flows into a fixed interest payment of 5.75% on a notional amount of $33,000,000 in return for its variable interest income. If the bank agrees to this, what interest is received and given in the first month? What if prime suddenly increased 220 basis points?
3. A bond portfolio manager administers a $100 million portfolio. The portfolio currently has
   a duration of 6.5 years. The manager wants to shorten the duration to 5 years using T-bill futures. T-bill futures have a duration of 0.3 years and are trading at $990 (face value =$1,000). How can the fund manager achieve this objective?
4. In 2002, following the bankruptcy of Enron, the United States introduced the Sarbanes-Oxley Act, commonly referred to as SOX. Discuss the aims, main requirements and penalties contained in the Act.  The word count for this element should be 450-550 words

Answer: 1(a)

In this modern global economy, banks operate on large scales which often adopts gigantic proportions. In 1998, each of the three top banks of UK reported more profit than the combined profit of UK’s five publicly traded supermarkets added together. The top 10 banks of UK are collectively worth £200 billion. This illustrates the extent to which these large banks’ have control over the monetary transaction system, which includes cheques, cards, cash and electronic payments. This makes the innovation and efficiency of these institutions crucial for UK’s economy. The purpose of the Cruickshank Report was to focus on these anomalies and suggest ways to overcome them either through policy changes or through enactment of strictest laws for those who were taking the economy towards unmanageable periods, (Barkoczy, 2013).

The report instigated in depth investigation in the following sectors:

• money transaction systems;
• personal banking services;
• small and medium-sized businesses banking services.

The conclusions drawn by this report about these sectors was that in all the three sectors competition is ineffective. The findings of the report highlighted the problems related to the profound competition being faced by the money transaction sector. Recommendations were made for a licensing system which should be supervised by an independent ‘Payments System Commission’ (PayCom). In the second sector mentioned above, the personal banking sector shows encouraging signs of increased competition, especially in the fields of mortgages, credit cards and personal loans. In the sector for banking services for small and medium-sized businesses, the report has recommended further investigation, (Barkoczy, 2013).

Overall, the report made wide-ranging policy recommendations to the Government for the banking sector. The main recommendations were:

• to increase transparency in supervision of banks;
• to put in place the right institutional incentives;
• to deliver effective competition scrutiny;
• to eliminate regulatory distortions.

The Report investigated in depth and its review can be split into three major categories:

1. Money Transactions.

This concerned the flow of money between individuals, firms and the Government through the existing payment systems. The Report considered all the main modes of money transactions, including cash machines, cheques, credit and debit cards, direct debits, standing orders and high value payments.

1. Services to Personal Customers.

In this category, investigation was done into saving products, current accounts, mortgages, personal loans and credit cards.

1. Services to Small and Medium Enterprises (SMEs).

In this category, the focus was mainly on current accounts and external finance.

The Report raised the following questions for each of the three categories:

• Is there an effective competition?
• Will the things change for the better in future?

Unfortunately, the answer to the first question was a unified ‘no’ for all the three categories. Money transaction services were being conducted in the UK through many unregulated networks, most of which were being controlled by the few large banks were also dominating the services to personal customers and SMEs.

The Report suggested that policy decisions were becoming mandatory for the government to break this cartel of the big banks. The biggest problem which this Report was foreseeing in the coming future related to the very high charges which these big banks were manipulating at their own will. The Report was of the view that such high charges were not only creating artificial barriers to entry level customers, these higher costs were also hampering the business of the retailers who were accepting credit and debit cards and small customers were paying charges for cash withdrawals up to six times of their cost.

Answer: 1(b)

Borrowings in the Present Context

Liabilities, the first item reported on a bank's balance sheet pertains to those sources of funds which bring revenue to a bank and the most important source is deposit accounts. Among these, the checking accounts are considered as the most important deposit accounts by banks. If a customer goes to a bank when he needs money, it is obligatory for the bank to allow the customer to withdraw his money from his checking account on demand, (Barkoczy, 2013).

Current Situation

Currently, checking accounts are number one liability for a bank because the bank owes this money to the customer. This is the reason why checking accounts are being paid lower interest rate and have become the cheapest fund source for banks.

Non-transaction Deposits

Such deposits are the second liability for a bank and include the different type of savings accounts offered by them. Non-transaction deposits include:

• Savings accounts which are the most common deposits in this category.
• Certificates of Deposit accounts offer maturities ranging from several months to over 5 years. Since they are less liquid than a regular savings account, the interest paid on them is higher.
• Time Deposits are large denomination accounts whose value exceeds $100,000. Investors can sell such time deposits through the secondary markets even before their maturity and are an alternative to T-Bills.

Current Situation

These accounts are paid interest but do not allow the check-writing privileges to the customer. Hence, such deposits allow for fewer services for the bank.

Borrowings

Borrowings are the last liability for a bank. These are the funds which banks borrow and then lends the same to one of their borrowers at a higher rate of interest than what it is paying on its borrowings.

Current Situation

Now, borrowings are not categorised as deposit accounts. Banks are at liberty to borrow from the Federal Reserve or even from other banks. 

Bank Capital

The Bank's net worth or capital is the last item on a bank's balance sheet. In short, Capital equals Total Assets minus Total Liabilities. Creditors consider a bank’s capital important as it is a financial cushion against the loans and obligations.

Current Situation

Since banks nowadays organize themselves as corporations and hence the corporate bank's capital is considered as the stock sold to the investors plus the bank's profit. As compared to a decade ago, a bank's net worth now averages nearly 12%. Since the last financial crisis, banks have started accumulating more capital in order to deal with any future financial crises.

Answer: 1(c)

Investment banking sector, in the current global scenario is on a tight leash and cannot say that it is business as usual. This is no longer the option available to the investment banking industry as times have changed drastically: there is a growing interest in utilities, digital technologies and the ecosystems, as investment banks all over the world are looking beyond their own perimeters and are trying to accelerate creation of new capabilities, (Cch, 2013). Broadly, the challenges being faced by investment banks include –

Macroeconomic Risk

This has become one of the top concerns for all who are at the helm of merchant banking system. Although many economies across the world have started achieving positivity in growth, still, for the investment banker, uncertainties are there in the macroeconomic environment. When this is put together with the high levels of debt across corporate and consumer sectors, the asset bubbles are still over stretched and can burst in the event of a significant instability. Specific concerns for investment banks currently include the declining Chinese economy and its resulting impact on the world economy. A slow growth rates in the emerging economies, combined with the unresolved conditions of the eurozone are also of concern and there is still lack of clarity over the interest rates’ future.

Regulations

Although these do not cause a concern for risk managers in the investment banking industry, still, the industry analysts and bankers are worried about the tightening regulatory policies across the globe. A feeling is persistent that these policies tend to become ineffective when they are excessive and costly. Investment bankers are also concerned about the impact which the increasing regulatory requirements may have on the innovation and diversity of the industry, (Cch, 2013).

Technology Risk

Of all the urgent concerns, an outdated IT system is the most significant concern for the global investment banker. An investment banker’s inability in investing securely in an agile system which can enhance the digital and mobile banking, can result in a significant loss when confronted with the risk of a cyber theft. According to industry experts, reports the Operational Risk & Regulation Magazine, the burden created by multiple legacy systems because of mergers in some banks has already started causing problems of authority. Investment banks are also facing serious competition from various disruptive innovators who have come to the position of providing their customers with seamless information across a variety of channels, (Cch, 2013).

Criminality: Cyber Attacks

Cyber Attacks or Cyber Thefts are being increasingly seen as a serious threat by investment banks. Many managers are worried that many of the banks are currently not equipped to prevention of attacks or thefts from hackers or industrial espionage experts. This is further compounded by the bankers’ increased adoption of newer as well as potentially high-risk technology, such as crypto-currencies, distributed ledgers and real-time payments. Bankers are also worried about the fact that under-investment in the banking technology system will leave the industry vulnerable to a potentially large and crippling attack. In this regard, with strengthened technology systems, even a strong banking system is only as strong as its weakest link, rendering the system vulnerable to cyberattacks, (Cch, 2013).

Task- 02

Answer: 2(a)

Calculation of the unemployment rate and Standard Deviation.

Standard deviation is the square root of variance. To calculate standard deviation, it is required to first calculate the variance and then take its square root.

The Standard Deviation formula is –

σ = √[ ∑(x-mean)^2 / N ]

where

σ = standard deviation

xi = each value of dataset

x (with a bar over it) = the arithmetic mean of the data

N = the total number of data points

By using the formula

σ = √[ ∑(x-mean)^2 / N ]

we find the mean is = (30+18+8+2) / 4 = 58 / 4 = 14.5

Hence,

σ = √[ (30-14.5)^2 + (18-14.5)^2 + (8-14.5)^2 + (2-14.5)^2 / 4 ]

σ = √[ (15.5)^2 + (3.5)^2 + (-6.5)^2 + (-12.5)^2 / 4]

σ = √[ (240.5 + 12.25 + 42.25 + 150.06) / 4]

σ = √[ (445.06) / 4]

σ = √[ 111.265]

σ = 10.55

The standard deviation is 10.55

Answer: 2(b)

NewBank’s first month profitability ratios calculate to –

• ROA (Return on Assets)

ROA is calculated by using the following formula –

ROA = Net Income / Average Total Assets

Net Income of NewBank for its first month of operations is 0.75% simple interest which the bank earns on the commercial loan of $25 million. The Average Total Assets are taken as the average of the (beginning Total Assets at the start of the relevant period + ending Total Assets at the end of the relevant period) / 2. In the case of first month of NewBank, the opening total assets and the ending total assets are same, hence the average will remain the same as the total assets. Hence,

ROA = Net Income for first month / Total Assets

         = $187,500 / $3,562,500

         = 5.26%

• Return on Equity (ROE)

ROE is calculated by using the following formula –

ROE = Net Income / Average Stockholder equity

Net Income of NewBank for its first month of operations is 0.75% simple interest which the bank earns on the commercial loan of $25 million. The Average Stockholder Equity is taken as the average of the (beginning Total Stockholder Equity at the start of the relevant period + ending Total Stockholder Equity at the end of the relevant period) / 2. In the case of first month of NewBank, the opening Stockholder Equity and the ending Stockholder Equity is same, hence the average will remain the same as the total Stockholder Equity. Hence,

ROE = Net Income / Average Stockholder equity

         = $187,500 / $6,000,000

         = 3.125%

• Assumed ROE

In case NewBank wishes to fulfil its target of 5% ROE on the basis of its existing Shareholder Equity, then working on the formula shown above, NewBank will have to achieve the following Net Income for a month –

ROE = Net Income / Average Stockholder equity

Hence, Net Income = (ROE x Average Stockholder equity) / 100

        = (5% x 6,000,000) / 100

        = $300,000

• Default Mortgage

At the end of third year of mortgage, each mortgage will have a balance of $238,845.62. This will mean that each mortgage has paid $11,154.38 towards its outstanding. Hence, the total mortgage outstanding at the end of third year will be $23,884,562. The Balance Sheet of NewBank at the end of three years of operations, after settling the case of the default mortgage, will be

Answer: 2(c)

Common Financing Sources

• Promoter

The easiest way of financing own business is through contribution of own money. This can be managed by using own savings or a home-equity credit line or by selling an asset or borrowing against owned personal asset, such as bonds, stocks or mutual funds. This contribution can be made either as equity or as a loan to the company.

• Family and Friends

Relatives and friends, having surplus funds may be willing to lend money for the venture or may even take up an equity stake in the company.

• Small Business Administration (SBA)

The SBA has number of loan programs for small businesses. Their primary program is the 7(a) Loan Guaranty Program. SBA provides loans for small businesses through this program, especially for those entrepreneurs who are not in position to get finance through normal lending channels on reasonable terms.

• Banks

Although banks offer lot of loans for small businesses, they are usually the hardest place to get loan for a start-up business. This is because banks usually prefer those borrowers who have a history of making money as the bank wants to be sure that the business will earn and be able to repay the loan. A borrower with a good business plan and personal assets which can be pledged as collateral security or a guarantor or a co-borrower who has a more satisfactory financial position than the main promoter stands to qualify for a loan from a bank even if the business is a start-up.

• Credit Cards

In case the promoter has a credit card, it can build in line of credit. Although, this option is one of the costliest ways for financing the company, under exceptional circumstances a promoter can use them as a source of finance for a start-up business.

• Leasing Companies

Leasing companies are a safe way of financing office equipment, vehicles and other equipment used for running a business. Since a large initial amount is not required, leasing can be a good option for a start-up business.

• Customers

In case the promoter already has customers, it may find them willing to pay in advance for the products they buy.

• Trade Credit

Under certain conditions, vendors and suppliers may become willing to sell the material to the business on credit.

• Small Business Investment Centers (SBICs)

SBICs are privately owned and managed investment firms which are licensed and regulated by SBA. SBICs can provide venture capital and start-up finance for small businesses.

• Venture Capital Firms

Venture capitalists do provide finance to start-up companies but only when they are convinced that the business has exceptional growth potential.

• Investment Banking Firms

Investment bankers take stakes in companies which are in the public domain. This option is only available to those small businesses which possess a strong growth history and have a strong growth potential.

• Private Placement

A private placement is available against an offer of stock.

Task- 03

Answer: 3(a)

Table – 01: Values of the IPO’s at Issue Date and at 03/24/2017

In case I wanted to invest the lottery amount of $2,275 received by me on 15 Jan 2017 into the next available IPO, I will have the option of choosing from four IPOs which were offered to public on 26 and 27 of Jan 2017. The details of my earnings from them are sown in the table below.

Table – 02: Income from IPO’s from Issue Date to 03/24/2017

If I had to pay $25 per transaction to the broker, my net earnings from these IPOs will be as shown in the table below.

Table – 03: Net Income from IPO’s and the Annualised Effect

Answer: 3(b)

Medium-term Challenges Uber Faces

On the downside, Uber is facing three challenges. First, Uber’s fleet size is dependent on the size its rental car companies. Second, the renting process is under regulatory threats. Third, use of credit card in certain sectors is posing a financial challenge. On the first point, Uber is being pushed into a corner by those companies from whom it rents cars on large scale. On the second point, the rental companies are not adhering to the law of the land and the regulators are black listing Uber as it is the licensed holder for providing the cab service to the users. On the third point, credit card penetration in most of the countries is low and slow and Uber cannot be forced to close the option and go for cash payments only although other companies are open to the cash option, Uber will have to bring in this additional option for customers, especially in the developing countries where customers need a ride amidst the inadequate public transportation, (Barkoczy et al, 2010).

Fleet Scarcity Downsizing Uber’s Business

In most of the locations, where Uber has established services, fleet scarcity is affecting the business. Although Uber keeps a large inventory of cars through its affiliates, the reported average waiting time in the outskirt areas is more than 20 minutes although in the central districts, it is 5-10 minutes. Uber reports that it is adding 100-150 cars to the company's network every week. Low availability of cars and low penetration of credit cards is really hurting Uber and giving an advantage to the competitors in most cities. This is putting a cap on the number of customers which Uber can attract. Uber must develop a pre-paid payment system for markets in the developing countries if it wants to beat competition.

Higher costs and Lower Utilisation not in favour of Uber

Although Uber is making aggressive entries into the developing countries’ markets and is creating a lot of waves by releasing visual and print advertisements, the actual impact which it is making in these countries is relatively modest. In the opinion of the experts, Uber's fleet accounts for only 2-4% of the available industry fleet in a specific country. A big reason for this low penetration, which is increasing Uber’s costs is the number of regulatory hurdles which Uber is trying to overcome before it is able in imparting a serious footprint in the developing countries. Experts believe that unlike in the developed countries such as US and Europe, Uber has not been able to pose a serious threat to the cab industry in the developing countries.

Uber Can Make a Difference

However, experts are of opinion that Uber can make a difference in two areas, where they believe Uber will be able to alter the landscape of the cab industry in the developing countries. On the driver front, Uber is raising the driver compensation by 30% in 2016. Secondly, Uber is bringing up utilisation (utilisation is defined as the percentage of fleet that is out on the road) and occupancy (occupancy is the percentage of distance travelled with a passenger in the vehicle) assumptions to 73% and 52% for 2016, respectively. Thirdly, Uber is planning to delay the tariff increase due to a weaker economy in most developing countries till the second half of 2016. Uber has so far implemented only about half of the tariff increase officially sanctioned to it and is keeping the option of raising tariffs by 13% in case it becomes necessary to do so.

Answer: 3(c)

Credit Risk

Credit Risk is defined by the Bank for International Settlements (BIS) as the potential which a borrower of the bank or a counterparty will fail in fulfilling its obligations as per the agreed terms of lending. Credit risk can occur by failure of honouring repayment of an acceptance, interbank transaction, loan, trade finance, swap, financial futures, options, foreign exchange transaction, equities, bonds or in the extension of guarantees and commitments or settlement of transactions. In simple words, a financial institution is at a credit risk if the borrower from the bank fails to repay the loan because of loss in business, death, inadequate income, unwillingness or for any other economic reason. Even if the credit card user fails in paying on time, the bank stands to face a credit risk, (Barkoczy et al, 2010).

Market Risk

A Market Risk, according to McKinsey is defined as the risk of losses occurring in the trading book of the bank due to change in its equity price, commodity price, credit spreads, interest rate or foreign-exchange rate and because of other indicators whose values are set in the public market. In a more simpler term, the Bank for International Settlements (BIS) gives the definition of market risk as the risk of losses either in on- or in off-balance sheet positions, which may arise from movement in market prices. Market risk is faced by banks who are investment bankers as they are active in the capital markets.

Operational Risk

Operational risk is defined by the Bank for International Settlements (BIS) as the risk of losses which result either from inadequate or from failed internal processes, people or systems or from any unavoidable external events. Although operational risk includes legal risk, it excludes any strategic or reputation risk. Operational risk widely occurs in banks because of human errors or technology mishaps. An operational risk can be the incorrect information filled in while clearing a check by an employee or leaking of confidential information because of malfunction in the system, (Barkoczy et al, 2010).

Task- 04

Answer: 4(a)

The formula is

where:

P = monthly payment

L = Loan amount

c = monthly interest rate (annual interest rate divided by 12)

n = number of months in the loan (no. of years x 12)

In the current situation, the loan amount is $250,000, the annual interest rate is 3.50% which means that the monthly interest rate will be is 0.291%, or 0.00291). The term of the loan is for 25 years, making it for 300 months, the monthly payment calculated to $ 7,276.33. this has been calculated by using the below formula –

P = L*[c(1+c)^n] / [(1+c)^n -1]

P = 250000*[0.00291*2.3910] / [2.3910-1)]

P = 1,250.50

The Principal amount payment at this stage will be $833.33 per month, hence the interest income will be $417.17 per month.

Now, if the rate jumps to 4% after the first three months, the monthly payment will be recalculated at that point in time, so that the loan is paid-off in the original 25-year time. To find the new monthly payment, the above formula is used again, but this time L= $250,000 – ($1,250.50*3) = $246,248.50, c = 0.04/12=0.0033333 and n=297. The new monthly payment will be $1,307.40.

P = L*[c(1+c)^n] / [(1+c)^n -1]

P = 246,248.50*[0.003333*2.6865] / [2.6865-1)]

P = 1,307.40

The Principal amount payment at this stage will be $829.12 per month, hence the interest income will be $478.28 per month.

Overall, the monthly interest income for the bank increases by $61.11 per month because of change in annual rate of interest from 3.50% to 4.00%. Hence in the first 12 month period, the bank stands to have an extra income of $733.32.

Answer: 4(b)

Now, if these figures are adjusted to 1 year duration periods, the amounts obtained will be –

The next assumption is that the bank manager wants the duration gap to be 4 years. Under this duration, the following data will be available in the balance sheet of the bank.

Answer: 4(c)

The basic difference between Hedging and Speculation is that the former is a means of reducing risk, whereas the latter is involved in intentionally taking a risk for making a profit. 

Comparison Chart

Definition of Hedging

The term hedging means a technique by which price risk can be managed. Its use is made for minimising or eliminating the probability of a substantial loss or profit by an investor, due to rapid movements in the price of an asset, which can be a commodity or a financial instrument. This is made possible by the investor by holding contrary positions in two different markets so as to counterbalance the risk of loss. Thus, if there is a loss or gain in the cash position because of any price fluctuation, it can be offset by the movements in the price of a future position, (Barkoczy et al, 2010).

Definition of Speculation

Speculation is the process of buying and selling of an asset by incorporating considerable risk, in the hope of generating good returns due an anticipated change in the price level of the asset. Speculators look for opportunities in order to make huge profits, by taking advantage of the fluctuations in the price of the financial asset. The asset may be a stock, bond, commodity, currency, derivative or any other tradable item. A speculator will not trade in a random investment but would take a calculated and analysed risk. The risk may result in bearing the loss of initial outlay in a futures contract or it may turn into rewards, (Barkoczy et al, 2010).

Key Differences Between Hedging and Speculation

The key difference between hedging and speculation are:

1. Hedging is the act of preventing an investment from any unforeseen price changes. On the other hand, a speculator trades in an underlying asset carrying an element of high-risk, in order to earn profits, is carrying on the process of speculation.
2. Hedging is a means of controlling or eliminating risk. On the other hand, speculation depends on risk, in the hope of making good returns.
3. Hedging offers protection against undesired price fluctuations. On the other hand, Speculation involves incurring risk to generate profits from price changes.
4. Hedgers are risk averse, who secure their investments by the hedging process. Speculators, being risk lovers, take deliberate risks and are responsible for providing liquidity to the market.

Conclusion

In simpler terms, hedging aims at protection and happens mostly in cases related to futures contract. The purpose is to secure the asset from unforeseen price falls in the near future. The investor refrains from incurring any risk but this minimises the chances of good gains. Whereas in speculation, the speculators is always on the lookout for an opportunity which offers him the chance of a good gain, but this comes with a significant amount of risk for the speculator losing on his capital outlay. Because speculators are heavy and reckless investors, they are responsible for providing stabilisation in the financial market. This happens because when a normal investor will avoid a riskier financial transaction, a speculator will go for it. Thus, they become the biggest source of liquidity to the stock markets, (Barkoczy et al, 2010).

Task- 05

Answer: 5(a)

The Prime Rate is set by the commercial banks at 3 percentage points (also known as 300 basis points) above the lending rate set by the Federal Bank. This is the rate at which interest is charged by banks on the lending made on commercial basis. In banking circles, APR refers to Annual Percentage Rate of chargeable interest charged by banks on commercial lending. APR, sometimes also referred to as Effective APR (EAPR), refers to the interest rate charged for the whole of year, rather than a monthly rate, as is applied on a mortgage loan or a credit card.

In this case study, the mortgage is initially done at 6% and after 4 months, the rate changes to 6.65%. In the first four months, the bank earns interest amount of $24,540 if the interest rate is 6.00%. Now, if the interest rate is increased by 65 basis points, the interest earning in the four months will become $27,216. Hence, the bank makes a loss of $2,676.

Answer: 5(b)

In the current case study, the bank earns an interest amount of $130.625 in the first month when the $33 million mortgage is made at +175 basis points over the APR of 3%. In comparison, the $33 million, when advanced at fixed rate interest of 5.75%, will earn an interest of $158,125 in the first month. Hence the bank stands to have a notional loss of $27,500. If the second option of 220 basis points is selected, the interest warned on $33 million mortgage will be $144,375. In this scenario, the notional loss will be $13,750.

Answer: 5(c)

A portfolio manager may frequently have to exert effort in determining whether a particular bond will outperform if the time duration is reduced. Hence, a comparison is required between alternate assets, before deciding whether it should be used as a replacement for the existing asset. By changing the time duration in such bonds, simply for the purpose of adjusting the generic portfolio’s duration, the portfolio manager will risk sacrificing a hard-won upside potential of the asset which is unique to the asset he is holding. In most cases, given the wide offer spreads that frequently apply to individual bond issues, the portfolio manager may be able to find it relatively expensive to tweak portfolio duration target.

The bond portfolio managers describe this as the ‘barbell portfolio’. Duration gives them a first approximation whether the performance of the two diverse assets will be similar, but the duration will only apply well when the small parallel yield curve shifts. In fact, a barbell performs relatively better when the yield curve flattens.

Answer: 5(d)

Aims of the Act

President George W. Bush of the USA signed the Sarbanes-Oxley Act of 2002, popularly referred to as “the SOX” on July 30, 2002 and thus made it into a law. The SOX is, in fact, a revision of US Federal Securities Laws which had been applicable to public companies for a long time. The main purpose of the SOX is to provide an “Oversight Board” which will have the authority to look into complaints related to regulations concerning the public accounting firms which conduct audit for public companies. The other main responsibilities of the Oversight Board (OB) would be –

• Adoption of new independence standards for the auditor and audit committee.
• To ensure that the executive officers of a public company certify the Securities and Exchange Commission (SEC) reports of the company.
• To restrict the directors and executives of the company from trading in the company’s stock during the period of benefit plan blackout.
• To substantially increase the liability of the company’s management and other concerned officials, for violations committed regarding federal securities laws.
• To delegate additional responsibilities on attorneys for reporting securities law violations and any conflicts of interest.

Requirements from the Act

The SOX has the responsibility to establish a “Public Company Accounting Oversight Board (PCAOB) for –

• Registering and conducting inspection of those public accounting firms which are responsible for preparing audit reports of public companies. This will be applicable to all those securities which have been registered under Section 12 of the Securities Exchange Act of 1934 (as amended) or those cases where it is compulsory to file a report under Section 15(d) of the SE Act of 1934 or in cases where a registration statement has been filed under the Securities Act of 1933 (as amended).
• PCAOB will oversee the audit of public companies.
• PCAOB will establish standards for audit quality control, independence, ethics and any other similar standards and rules which are related with the preparation of audit reports for public companies.
• PCAOB will inspect, investigate and also enforce compliances that are related to the registered public accounting firms and their associated persons, as well as the obligations and liabilities of the accountants.
• PCAOB will work under a specific budget and rules of operations as per guidelines provided in the SOX.
• PCAOB will conduct disciplinary proceedings as well as impose sanctions for violations of SOX.

Penalties under the Act

Effective from July 30, 2002, Section 906 of the SOX will enforce that CEOs and CFOs of public companies provide a written statement to the company about any periodic report filed with the SEC on or after July 30, 2002 and certify that:

• The report complies fully with the requirements given under Section 13(a) or 15(d) of the SE Act of 1934.
• Information contained in the report presents in a fair manner all material aspects, financial conditions and results about the operations of the company.

Any CEO or CFO who is responsible for providing the above certification and:

• knowing that the report does not meet the two standards mentioned above can be fined up to $1.0 million or imprisoned for up to 10 years or both;
• wilfully provides the certification with the knowledge that the report does not meet the two standards noted above, can be fined up to $5 million or imprisoned for up to 20 years or both.

References

Barkoczy, S. (2013). Foundations of Taxation Law. (5^th ed.). North Ryde, NSW: CCH Australia Limited.

Barkoczy, S., Rider, C., Baring, J. and Bellamy, N. (2010). Australian tax casebook. (10th ed.). North Ryde, NSW: CCH Australia.

Cch. (2013). Australian Master Tax Guide. Sydney, NSW: CCH Australia Limited.