Safehaven | The Prudential Forensic Analysis and Fundamental Valuation Sample Trade Addendum

February 03, 2009

The Prudential Forensic Analysis and Fundamental Valuation Sample Trade Addendum
by Reggie Middleton

This is the sample trade addendum for the Professional Prudential analysis. As I have stated in the Banco analysis, these are illustrative sample trades, and are not to be taken as investment advice in any way whatsoever. I am just giving an oversimplified example of how I may or may not put a speculative trade together, particular when dealing with a company from overseas whose position may introduce currency risk/opportunity.

Below you find the currency payoff matrix for Prudential, similar to the one offered for the Banco Bilbao Vizcaya Argentaria SA Analysis. We have created pay off matrix for Prudential ADR option (since the options were illiquid we have assumed theoretical price using Black-Scholes model) as well as Prudential Options in local exchange for varying combinations of calls and puts of GBP. We have conducted analysis for PRU futures with currency futures.

Contents of the downloadable The Prudential Plc Forensic Analysis and Fundamental Valuation Sample Trade Addendum. 2009-02-02 21:06:17 1.20 Mb

include:

Sample Trade 1 - Sep - ADR PUK Option. 1
Sample Trade 2 - Sep PUK (GBP) Option
Arbitrage
Sample Futures Trade
The Currency ArgumentT. 12

Time permitting, I may be able to post a more advanced trade tomorrow.

Sample Futures Trade

Underlying

26-Jan-09

PUK LM

PUK US

Exchange rate 1.40

Note: 1 ADR = 2 Underlying shares of PUK

Price of PUK ADR (based on expected movement in currency and underlying)

			Depreciation of GBP			Appreciation of GBP
% change in price			-25%	-15%		15%	25%
			*GBP USD - Exchange rate*
			1.05	1.19	1.40	1.61	1.75
-25%	PUK in GBP	€ 2.4	$5.0	$5.7	$6.7	$7.7	$8.3
-15%		€ 2.7	$5.7	$6.4	$7.6	$8.7	$9.5
		€ 3.2	$6.7	$7.6	$8.9	$10.2	$11.1
15%		€ 3.7	$7.7	$8.7	$10.2	$11.8	$12.8
25%		€ 4.0	$8.3	$9.5	$11.1	$12.8	$13.9

Without hedging - (for someone who is short ADR)
*% change in price*			-25%	-15%		15%	25%
			*GBP USD - Exchange rate*
			1.05	1.19	1.40	1.61	1.75
-25%	PUK in GBP	€ 2.4	72%	52%	29%	12%	3%
-15%		€ 2.7	52%	34%	14%	-1%	-9%
		€ 3.2	29%	14%	-3%	-16%	-23%
15%		€ 3.7	12%	-1%	-16%	-27%	-33%
25%		€ 4.0	3%	-9%	-23%	-33%	-38%

Assuming that an investor enters a short PUK ADR and simulaneously enters a long GBP / Short Dollar contract (3 m contract)
Current 3 month GBP exchange rate is 1.40 (against spot of 1.40)

With hedging			(Same as above - price of underlying ADR )
*% change in price*			-25%	-15%		15%	25%
			*GBP USD - Exchange rate*
			1.05	1.19	1.40	1.61	1.75
-25%	PUK in GBP	€ 2.4	$5.0	$5.7	$6.7	$7.7	$8.3
-15%		€ 2.7	$5.7	$6.4	$7.6	$8.7	$9.5
		€ 3.2	$6.7	$7.6	$8.9	$10.2	$11.1
15%		€ 3.7	$7.7	$8.7	$10.2	$11.8	$12.8
25%		€ 4.0	$8.3	$9.5	$11.1	$12.8	$13.9

On underlying:
*% change in price*			-25%	-15%		15%	25%
			*GBP USD - Exchange rate*
			1.05	1.19	1.40	1.61	1.75
-25%	PUK in GBP	€ 2.4	72%	52%	29%	12%	3%
-15%		€ 2.7	52%	34%	14%	-1%	-9%
		€ 3.2	29%	14%	-3%	-16%	-23%
15%		€ 3.7	12%	-1%	-16%	-27%	-33%
25%		€ 4.0	3%	-9%	-23%	-33%	-38%

On 3 month Futures:
Long 3 M GBP at			1.35
Expected exchange rate at expiry			1.05	1.19	1.40	1.61	1.75
Gain / Loss on long GBP			-22%	-12%	4%	19%	30%

Net return for Hedged investor (Short ADR and Long GBP)
*% change in price*			-25%	-15%		15%	25%
			*GBP USD - Exchange rate*
			1.05	1.19	1.40	1.61	1.75
-25%	PUK in GBP	€ 2.4	34%	34%	34%	34%	34%
-15%		€ 2.7	18%	18%	18%	18%	18%
		€ 3.2	0%	0%	0%	0%	0%
15%		€ 3.7	-13%	-13%	-13%	-13%	-13%
25%		€ 4.0	-20%	-20%	-20%	-20%	-20%

Net benefits of Hedging:
*% change in price*			-25%	-15%		15%	25%
			*GBP USD - Exchange rate*
-25%	PUK in GBP		-38%	-18%	5%	22%	30%
-15%			-34%	-16%	4%	19%	27%
			-29%	-14%	4%	16%	23%
15%			-25%	-12%	3%	14%	20%
25%			-23%	-11%	3%	13%	18%

1) Investor in short ADR would benefit from decrease in value of underlying and depreciation of Euro.

2) However in case of appreciation of Euro, the gains in short underlying (BBV), if any, would be wiped out due to currency impact.

3) If an investor wants to play on weakening of Euro as well then he could keep his Short ADR un-hedged.

4) Otherwise if investor wants to play only on the underlying (with a negative view) without exposing himself to the currency risk then he could take a short position in the underlying and long Euros.

5) We have determined investment returns for hedged as well as un-hedged (short) investor in form of scenario analysis for various changes in price of BBVA and exchange rate in form of tables to gauge the relative performance of hedge and un-hedge investor in form of tables.

6) A hedged investor would perform better compared to an un-hedged investor when Euro appreciates while un-hedged investor would perform better than hedged investor when Euro depreciates.

Currency argument

As worsening economic news flow to continue from both Europe and US region both Euro and Dollar are expected to remain weak against major world currencies. As U.S. economy deteriorates and expectations of a protracted recession turn out to be a reality, dollar is expected to remain under pressure from major world currencies. Unless U.S. economy takes a u-turn or other regions deterioration sharply, dollar is expected to remain weak. Since economic conditions in US are expected to continue to remain challenging US dollar is expected to depreciate vis-a-vis major world currencies. However relative to Europe we expect the US dollar to perform better, as the European economy which until now has been relatively insulated by the slowdown (relative to US) it is showing increasing signs of weakness. As the European region crawls into a recession the European Central Bank which until now has held up interest rates will be forced to lower its bench mark interest rates. With Fed maintaining a zero interest rate policy as the ECB lowers its benchmark rates, the interest rate gap between Euro and Dollar is further expected to narrow down providing some strength to dollar. Also with US already maintaining a zero interest rate policy there will obviously not be any further Fed rate cuts of substance, which could provide some strength to dollar. Besides interest rate parity, swift policy actions and a massive stimulus package already announced by the US may may cause the US to emerge from recession much faster than Europe which could provide further support for US dollars vis-à-vis Euro.

Besides these fundamental arguments the data for Euro futures seem to imply that market participants are expecting Euro to weaken. As of December 31,2008 12 month Euro futures were trading at a discount of nearly 0.63% to Spot while 3 year and 9 year Euro futures were trading at a discount of 1.7% and 8.5%, respectively.

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

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