4. Analysis of Strategic Investment under Maximum Equity Value
4.1 Measurement of Risk and Return
國
立 政 治 大 學
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N a tio na
l C h engchi U ni ve rs it y
4. Analysis of Strategic Investment under Maximum Equity Value
Mergers or acquisitions are often used to grow business and gain market share to increase profits as a result of economies of scale by financial institutions. Therefore, to best understand the difference between pursuing a growing return and acquiring equity stakes, a company should spend some time analyzing and measuring its risk exposure to be within its reasonable risk appetite. However, the importance of risk tolerance is often neglected if companies only pay attention to factors that maximize shareholder value and returns while considering the strategy of acquisition and reinvestment.
To meet the social expectations of financial institution behavior in raising economic activities and leveraging environments, it is necessary for company to execute the valuation of both risk and return before making M&A or reinvestment decisions. Other than self-discipline, financial institutions are also required to adhere with the authorities’ regulations, such as capital requirement when looking for maximized value in conducting M&A or reinvestment decisions.
We adopt option model with contingent claim to analyze the return and related risk after foreign financial institution acquires equity stakes. The foreign financial institution’s assets after acquiring equity stakes is composed of some of the original assets before its M&A strategy and some of equities of the invested Chinese bank.
With the goal of maximizing stockholder equity value of foreign financial institution acquiring equity stakes and considering the capital control and the limitation of financial institutions in its local country, we discuss the factors that effect risk and volatility.
4.1 Measurement of Risk and Return
Based on this model of analyzing return and risk of acquiring equity stakes, we also consider the exchange rate risk that is relevant for cross-border investment of acquiring equity stakes and assumed that both asset values of foreign financial institution and invested Chinese bank would also follow some dynamic models. Here, the assumptions of such dynamic model are set as follows:
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Assumption 1: The dynamics of the asset value of a foreign financial institution acquiring equity stakes are given as:
d
where rd is the instantaneous risk-free rate of foreign financial institution,
Vd
is the constant volatility of the rate of return of the asset of the foreign financial institution, and is a Wiener process under foreign financial institution’s domestic risk-neutral probability measure.
Q Vd
W
Assumption 2: The dynamics of asset value of an invested Chinese bank are given as:
f
where rf is the instantaneous risk-free rate of invested Chinese bank,
Vf
is the constant volatility of the rate of return of the asset of an invested Chinese bank, and is another Wiener process under an invested Chinese bank’s foreign risk-neutral probability measure.
Q Vf
W
Assumption 3: The dynamics of the exchange rate are given as:
X
where RMB treats as quoted currency that means 1 RMB is equal to X units of local currency of foreign financial institution acquiring equity stakes, is the X constant volatility of the exchange rate and is another Wiener process under foreign financial institution’s domestic risk-neutral filtered probability space.
Q
WX
According to Assumption 1-3, there are three types of risk factors in our framework, which are mutually correlated. The instantaneous correlation coefficients are assumed to be constant and are defined as follows:
)]
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Furthermore, the dynamics of the asset value of an invested Chinese bank, in units of foreign financial institution’s home country currency, is . By Ito’s lemma with (9) and (10), we have
With the restrictions of the proportion of acquiring equity stakes of one foreign finan
e asset value of the foreign financial institution will
12) where is the proportion of asset value that is not invested in acquiring equity
s home country currency. By (11) cial institution being no more than 20% and 25% for all foreign financial institutions, it is difficult to achieve main operating control and dominating rights under this M&A strategy. As noted above, foreign financial institutions that acquire equity stakes will emphasize sharing the profit of an invested Chinese bank and diversifying risk as financial investment. In this way, there is no operating synergy or interaction between the two banks.
After acquiring equity stakes, th
be volatile with gains or losses in this investment. Under the assumption of no interaction, the asset value of the foreign financial institution will be composed of asset values that are not invested in acquiring equity stakes and stockholder equity of an invested Chinese bank:
I 1 d 2 f(d); (
Chinese bank in units of foreign financial
)
Furthermore, the dynamics of the asset value of a foreign financial institution after
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acquiring equity stakes is
.
We also have the constant volatility of the rate of return of the asset of the foreign financial institution after acquiring equity stakes I
Vd
As above, the instantaneous volatility is affected by the correlation coefficient of asset
(2) The correlation coefficients of asset returns of foreign financial institutions and
(3) The correlation coefficients of asset returns of invested Chinese banks and their return of the foreign financial institution acquiring equity stakes and the invested Chinese bank. This also includes the correlation coefficients of individual asset and exchange rate. The investment risk of acquiring equity stakes for foreign financial institutions would be diversified in the following situations:
(1) The business models and sources of profit of foreign financial institutions acquiring equity stakes and invested Chinese banks are complementary or uncorrelated.
their related cross currency are negative or uncorrelated. This derives that the RMB is not heavy weighted or, most wholly, currency in the portfolio is negatively correlated to RMB in foreign financial institutions’ multiple investment portfolios.
related cross currency are also negative or uncorrelated. This means that the business of the invested Chinese bank is primarily focused on local currency assets or its portfolio of overseas assets is negative with the exchange rate of the foreign financial institution acquiring equity stakes via domestic currency and RMB.