FM

Question 1

What does ARR stand for in investment appraisal?

Answer 1

Average Annual Return

ARR is the average annual profit of an investment expressed as a percentage of its average investment.

Question 2

What does NPV represent in investment appraisal?

Answer 2

Net Present Value

NPV is the present value of future cash flows minus the initial investment.

Question 3

What is an annuity?

Answer 3

A series of equal payments made at regular intervals.

Question 4

Define perpetuity in financial terms.

Answer 4

An annuity that continues indefinitely.

Question 5

What is the IRR?

Answer 5

Internal Rate of Return

IRR is the discount rate that makes the net present value (NPV) of all cash flows from a project equal to zero.

Question 6

True or False: If IRR > r, the project returns less than what is required.

Answer 6

False

Question 7

List two benefits of using the payback period for investment appraisal.

Answer 7

• Simple to calculate
• Importance of liquidity

Question 8

What is a major disadvantage of the payback period?

Answer 8

Ignores the time value of money.

Question 9

What does NPV consider that ARR does not?

Answer 9

Time value of money.

Question 10

List two negatives of NPV.

Answer 10

• Time-consuming calculations
• Does not factor in liquidity

Question 11

What is sensitivity analysis?

Answer 11

Examination of how changes in input variables impact a financial outcome.

Question 12

What does scenario analysis involve?

Answer 12

Evaluating potential future financial outcomes by considering various possible scenarios.

Question 13

In sensitivity analysis, how is the sensitivity of ENPV to sales volume calculated?

Answer 13

= ENPV / Present Value of Sales Volume

Question 14

What is the coefficient of variation (CV)?

Answer 14

A standardized measure of dispersion of a probability distribution, expressed as a percentage of the mean.

Question 15

What is systematic risk?

Answer 15

Risk inherent to the entire market that cannot be diversified away.

Question 16

Define non-systematic risk.

Answer 16

Unique risk to a particular company or industry that can be reduced through diversification.

Question 17

What does the Gordon Growth Model calculate?

Answer 17

Current price of an ordinary share as the PV of a stream of constantly growing dividends.

Question 18

What is WACC?

Answer 18

Weighted Average Cost of Capital

WACC is the average rate a company expects to pay to finance its assets.

Question 19

List two advantages of WACC.

Answer 19

• Provides a comprehensive measure of overall cost of capital
• Simplifies investment decisions

Question 20

What is the formula for CAPM?

Answer 20

𝒓𝒋 = 𝒓𝒇 + 𝜷𝒋(𝒓𝒎 − 𝒓𝒇)

Question 21

What is the main advantage of CAPM?

Answer 21

Considers systematic risk.

Question 22

What is a disadvantage of the Dividend Valuation Model (DVM)?

Answer 22

Not applicable to non-dividend-paying stocks.

Question 23

What does gearing refer to?

Answer 23

Use of borrowed funds to increase potential return on an investment.

Question 24

What is a forward contract in forex hedging?

Answer 24

A customized agreement to buy or sell a specific currency at a predetermined exchange rate on a future date.

Question 25

What is the primary advantage of a forward contract?

Answer 25

Eliminates exchange rate risk.

Question 26

What is the main disadvantage of a forward contract?

Answer 26

Both parties are obligated to fulfill the contract.

Question 27

What is an OTC call option?

Answer 27

Gives the buyer the right to buy a specific amount of foreign currency at a predetermined exchange rate.

Question 28

What does a put option allow the buyer to do?

Answer 28

Sell a specific amount of foreign currency at a predetermined exchange rate.

Question 29

Fill in the blank: Gearing = _______.

Answer 29

Debt / Equity

Question 30

What is a Put Option?

Answer 30

A Put Option allows the buyer to sell foreign currency at a higher strike price if the spot exchange rate is lower than the strike price before expiry.

Question 31

What happens if the spot rate is higher than the strike price in a Put Option?

Answer 31

The buyer can let the option expire worthless and sell the currency at the better spot rate.

Question 32

What is an advantage of using options in hedging?

Answer 32

* Flexibility and Choice * Customisation * Defined Cost

Question 33

What is a disadvantage of options in hedging?

Answer 33

* Upfront Cost (Premium) * Potential for No Benefit * Complexity * Counterparty Risk * Limited Liquidity

Question 34

What is a Forex Hedge - Currency Futures?

Answer 34

Standardised contracts traded on exchanges, obligating the purchase or sale of a fixed currency amount at a predetermined rate and future date.

Question 35

What is the first step in using Currency Futures for hedging?

Answer 35

Determine the Future Contracts required.

Question 36

What is the advantage of futures contracts?

Answer 36

* Standardisation and Liquidity * Reduced Counterparty Risk * Transparency * Margin Requirements

Question 37

What is a disadvantage of futures contracts?

Answer 37

* Lack of Customisation * Mark-to-Market * Basis Risk * Obligation to Deliver/Receive

Question 38

What is a Money Market Hedge?

Answer 38

A technique to offset foreign currency exposure by creating a matching liability or asset in the foreign currency using money market instruments.

Question 39

What is a key advantage of a Money Market Hedge?

Answer 39

It locks in an effective exchange rate and eliminates exchange rate risk.

Question 40

What is a disadvantage of a Money Market Hedge?

Answer 40

* Requires Access to Money Markets * Impact of Interest Rate Differentials * Transaction Costs * Operational Complexity

Question 41

What does Purchasing Power Parity (PPP) state?

Answer 41

Identical goods should cost the same in different countries when exchange rates are considered.

Question 42

What is the formula for Expected Future Spot Rate according to PPP?

Answer 42

Expected Future Spot Rate = Spot Rate × (1 + Foreign Inflation Rate) / (1 + Domestic Inflation Rate).

Question 43

What is the purpose of Interest Rate Parity (IRP)?

Answer 43

To calculate a fair forward exchange rate and predict future spot rates using interest rate differentials.

Question 44

What is the principle behind Interest Rate Parity?

Answer 44

Returns from investing in either currency should be equivalent, considering both interest rates and exchange rate fluctuations.

Question 45

What are Exchange Traded Options?

Answer 45

Options on interest rate futures, granting the right to buy or sell a futures contract at a specified strike price.

Question 46

What is the first step in trading Exchange Traded Options?

Answer 46

Determine whether to use a put or call option.

Question 47

What is the objective of Index Futures?

Answer 47

To protect against potential fall in value of an index.

Question 48

How is one point valued in Index Futures?

Answer 48

One point = 10.

Question 49

What is the method for determining contracts required in Index Futures?

Answer 49

Selling Price / (Index x 10).

Question 50

What is the objective of Index Options?

Answer 50

To protect against potential fall in value of an index.

Question 51

What is an Interest Rate Option?

Answer 51

It grants the buyer the right, but not the obligation, to trade an interest rate at a specified level on or before a future date.

Question 52

What does an FRA option provide?

Answer 52

The holder with the right, but not the obligation, to enter into a forward rate agreement at a predetermined rate.

Question 53

What is a key benefit of OTC interest rate options?

Answer 53

They allow for customised terms without going through an exchange.

Question 54

Money Market Hedge - Hedge Future Payment in Foreign Currency

Answer 54

Borrow £ now | Deposit LCY now

Question 55

Money Market Hedge - Hedge Future Receipt in Foreign Currency

Answer 55

Deposit £ now | Borrow LCY now

Question 56

Forward Contract Hedge - Advantages & Disadvantages

Answer 56

Advantage: Tailored to user Disadvantage: No secondary market

Question 57

Money Market Hedge - Advantages & Disadvantages

Answer 57

Advantages: Accelerates receiving home currency for receipts Disadvantages: More difficult to execute and may use up credit lines / liquidity

Question 58

OTC Currency Options - Advantages & Disadvantages

Answer 58

Advantages: Possible upside potential Disadvantages: Premiums can be expensive and no secondary market