1.

Company background and comments on the firms earning and growth

prospects.

Petronas Dagangan Berhad (PDB) was incorporated in 1982 and became a listed
company on the Main Board of Bursa Malaysia in 1994. The Companys headquarter
is placed in Kuala Lumpur, Malaysia (Bloomberg, 2017). By referring the annual
report, the Chairman and a Non-independent Non-Executive Director of PDB is Md
Arif Mahmood. The vision of PDB is Brand of 1st Choice by delivering quality,
innovation, excellence and differentiating experience for petroleum products and
service in the country. According to the Bloomberg (2017), PDB is the main retailer
and marketer of downstream oil and gas products. There are four major business
sectors of PDB, namely retail, commercial, LPG and lubricants.

PDBs retail sector consists of the sales of fuel and non-fuel products,
convenience stores and others (Reuters, 2017). The fuel and non-fuel products are
RON95, RON97 and diesel whereas the convenience stores offered various facilities
and services in terms of banking, terminal and courier. All of the convenience stores
had achieved the goal by keep delivering the superior customer experience. Currently,
PDB had expanded its PETRONAS stations up to 1,000 and 760 Kedai Mesra
convenience stores throughout Malaysia (Bloomberg, 2017). Next, card business is
another important business in the retail sector with the purpose of building customers
loyalty towards them. Cards including loyalty card, fleet card, co-branded card and
gift card.

Besides that, company offers different types of petroleum products under the
commercial sector (Reuters, 2017). The petroleum products include Kerosene, Diesel,
Fuel Oil, Bitumen, Sulphur and Mogas. All of these petroleum products are marketed
in large quantity to the manufacturing, oil and gas exploration, transportation and
agriculture industries. Therefore, commercial business had successfully integrated
with a strong supply base, logistics and extensive distribution since 2008. PDBs
commercial business still can sustain a good financial performance in 2015 even the
issues of weakening Ringgit and uncertainties in economic condition aroused.

Apart from that, LPG sector is mainly focus on the sales of cooking gas to
both of the household and industrial customers. The cylinder sizes of cooking gas are
classified into 12kg, 14kg, 50kg cylinders and bulk sales. Gas PETRONAS is the

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brand name used to describe the cooking gas. Then, cooking gas is also positioned as
the number one in Malaysia since company able to focus on the cost optimization and
improve efficiency across the whole distribution network. In Philippines, LPG
business is the main sector of the downstream oil industry, which means that LPG
business is expanded internationally.

Last but not least, lubricant sector offers wide range of products such as
passenger car motor oils, commercial vehicle lubricants, industrial and marine
lubricants, PETRONAS LubeXperts and motorcycle oils (Reuters, 2017). The LPG
and lubricants businesses had operated internationally in Thailand, Vietnam, and
Philippines other than Malaysia. PDBs lubricants sector had achieved the best
performance by leveraging cross-functional knowledge of lubricants with Formula
One expertise to design and launch the most suitable solution for customers.

From the earnings aspect, the net profit of PDB has showing an increasing trend in the
year 2016. Due to the improved product margin, the net profit in the fourth quarter
2016 has rose by 5% quarter over quarter from RM 248.8 million to RM 261.5
million and with a 8% hike in revenue which achieved a higher record of RM 998.9
million (Teh, 2017). In spite of that, with an increase in sales volume, diesel margin,
and other income from Kedai Mesra, the profit also grew by 6.3% year over year.
With the higher net profit of 2016, PDB had declared the net dividend per share of
70.0 sen which relatively higher than year 2015 by 10.0sen (BIMB Securities
Research, 2016).

Moreover, PDBs core earnings (The interest received from deposits, impairment
charges on receivables, profits from discontinued operations and gains from foreign
exchange and movements in the assets are excluded) successfully achieved MIDF
Research and consensus full year expectation of RM 885 million (MIDF Research,
2017). The earnings of PDB had jumped substantially by 26% as compared to
previous year due to Mean of Plats Singapore (MOPS) plunged within a short
duration and caused a lower margin in the market in 2015. Otherwise, 2% increase in
sales volume tends to raise the earnings as well (Teh, 2017).

On the other hand, PDB suffers a reduction in segment revenue in the Liquefied
petroleum gas. The segment revenue has declined by -13% year over year to RM
1,420.2 billion as the volume has shrank by 1% year over year to 1,625.4million

2
liters. However, the lubricant business of PDB has recorded a better performance as
the revenue and sales volume has risen by 8 % and 4% year over year respectively.
Furthermore, the Petronas lubricant brand has become the first non-Japanese brand to
supply products to Honda in 2016 (MIDF Research, 2017).

In addition, the operating cash flow of PDB in 2016 has tripled from the year earlier
to RM 1.98 billion, doubling its current cash hoard at RM 2.43 billion compared with
only RM1.25b a year earlier (MIDF Research, 2017). This impressive improvement
of cash flow is attributable to aggressive cost cutting efforts implemented by PDB
throughout the year 2016.

In the growth prospect, PDB predicted the volume of traffic will be getting higher
during the festival season of Chinese New Year (CNY) in the first quarter of 2017
(Teh, 2017). However, the volume growth and operational efficiency are used to
support the long term earnings sustainability of PDB.

Apart from that, PDB estimated a better growth prospect in first quarter of 2017.
Average selling price is expected to be higher as the crude oil price has been
recovered coupled with the weaker Malaysia Ringgit. However, the price spike was
not volatile, which is unlikely to lead to earnings shock in coming quarters. Overall,
earnings are expected to be more stable than previous years as crude oil prices are
unlikely to experience sharp declines as compared to the past two years (Teh, 2017).

On the other hand, MIDF Research foresee that PDB will have some impacts arise on
earnings. As their expectation, the sales volume forecasted to increase in 2017 as the
core earnings expected to increase by 8.5% to the amount of RM 955.2 million. MIDF
Research is being optimistic that the company may achieve an increase in sales
volume because PDB has taken aggressive initiatives to boost throughput of each
station (MIDF Research, 2017).

Last but not least, MIDF Research forecasts that the price target of PDB will
increased from RM 25.48 per share to RM 26.63 per share based on unchanged three
year moving average of 26x CY17 PER. They expected to continue to rate the stock
OUTPERFORM as this solid set of 2016 outcomes. Also, PDB forecasted that the
stronger earnings in 2017 are price catalysts in the near term. The call risk includes

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the reducing in volume of business and a sudden plunge in MOPS within a brief
period of time (MIDF Research, 2017).

2. The rationale of hedging using financial derivatives

In this century, financial derivative plays a significant role in order to secure

the financial infrastructure and maintain a stable financial system. Financial
derivatives means an instrument whose value depends on, or derived from, the value
of another asset like futures, forwards, swaps, options, exotics and etc. The use of this
tool also actively traded in the over the-counter and exchanges.

According to A.Rovanin and HANI (2014), financial derivatives help in

transferring risks from risk adverse people to risk oriented people. Various strategies
can be used like hedging, arbitraging, speculating, spreading and so on to control and
manage efficiently by the investors. A derivative is a great risk management tool to
safeguard against the risk of an asset movement as well as manage the risky price
movement. For example, we can use hedging to offset the position in a related
security when the prices are volatile to reduce the adverse price movements.

Furthermore, ROVANIN and HANI (2014) also found that derivatives help
to catalyse entrepreneurial activity. It helped to speed up the growth of entrepreneurs
by creating new products, business and thus enhance the employment opportunities.
Derivatives also helped in attracted many creative and well-educated professionals,
young investors as well as other experts with an entrepreneurial attitude. This in turn
helps to encourages the competitive trading and boost up the growth of financial
market.

Derivatives also helped in the discovery of futures and current price on both
the futures and spot market (ROVANIN & HANI, 2014). Continuous flow of
information from various factors like political situations, debt default, refugee
displacement and others will affect the future marker prices and the demand and
supply of the asset or commodities. In addition, different information obtained from
the futures markets trading of various commodities and securities to the society which
also helped us to figure out suitable or favourable equilibrium prices in the markets.
Thus, adequate and better distribution of resources results in the society.

4
 Lastly, derivatives can increase savings and investment in the long run. A
derivative serves as an insurance to protect the investors by providing them to
purchase the underlying asset at a lower price and generate a better return later. The
transfer of risk may also enable the marker participants to widen their volume of
activity in the future such as investment.

3. Plot a 1-year-chart using daily stock price and daily price of the selected
derivatives contract (End date: 29/12/2016) and compare the movement
between the two price series.

Daily Stock and Future Price

KLCI Futures Price Petronas Dagangan Price

From the graph presented above, it show that from December 2015 until end
of February of 2016, the graph of Petronas Dagangan and KLCI Futures had
illustrated the same movement. Follow with March onwards, the movement of the
Petronas Dagangan Price had shown a downward trend until the end of April and it
start to move sideways from the mid of May until the end of the November while the
movement of KLCI futures had been fluctuating from end of February until the end of
April and follow with fluctuating again until the end of November. From the end of
February until end of April, there is inverse relationship between KLCI futures price
and Petronas Dagangan price which will distort the market and is bad for setting
hedging strategy thus the investor may suffer the losses.

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 4. Calculate beta of the selected stock, correlation between the two series,
and standard deviation for the two series using Excel Spreadsheet.

Formulae Answer
Beta =COVARIANCE.P(Daily Return for Stock Price, 0.629023289
Daily Return of KLCI Stock Index)/VAR.P(Daily
Return of KLCI Stock Index)
Correlation =CORREL(Daily Return for Stock Price, Daily 0.377450454
Return for Futures Price)
Standard deviation =(STDEV.P(Daily Return for Stock Price)) 0.008042816
of stock
Standard deviation =(STDEV.P(Daily Return for Futures Price)) 0.005910894
of futures

5. Explain how to set up a hedge on the 3rd January 2017. Determine

performance of the hedging as at 20th February 2017.

When an individual or company choose to use futures markets to hedge a risk, the
objective is to take a position that neutralizes the risk as far as possible (Hull, J.C.,
2012)

A short hedge refer to a hedge that involves a short position in futures contract. A
short hedge is appropriate when the hedger already owns an asset and expects to sell it
in the future. It can also be used when an asset is not owned currently but will be
owned at certain time in the future (Hull, J.C., 2012)

Stock Price RM 23.80

3/1/2017
Stock Index Future 1634.50
Stock Price RM 24.24
20/1/2017
Stock Index Future 1715.50

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To hedge the risk in a portfolio, the number of contracts that should be shorted as

VA
N= , where
VF

V A : the value of the portfolio

: the beta of the portfolio

V F : the value of the futures contract

On 3rd January 2017:

Assume that the amount to be hedged is RM10,000,000, therefore

V A = RM 10,000,000

Beta is obtained from the Excel Spreadsheet which is = 0.6290

The KLCI Futures Index is 1,634.50, therefore

VF = 1,634.50 X RM 50 = RM 81,725

RM 10,000,000
Number of contracts=0.6290 X = 76.97 contracts
RM 81,725

Therefore, 77 contracts should be shorted at 1634.50 to hedge the portfolio.

On 20 February 2017:

RM 10,000,000
Number of shares outstanding on 30 December 2016 = RM 23.8 = 420,168

shares

Loss in the cash market = (RM 23.8 RM 24.24) x 420,168 shares = - RM

184,873.92

We close out the futures position by selling 77 at KLCI futures contracts at 1,715.50.

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Profit gain in the futures market = (1,715.5 1,632.0) x RM 50 x 77 = RM 321,475

RM 321,475
Hedge efficiency ratio = RM 184,873.92 x 100 = 173.89%

Therefore, the hedge efficiency ratio is 173.89%, which means it is efficient in setting
up the short hedge to reduce the risk of the portfolio. The hedge is successful.

6. In some cases, you fail to achieve fully-hedge. Discuss the arguments

against the hedging.

It is possible for a full hedge to fail if the equity is negative under certain
circumstances. Hedging is definitely not free of charge as there are certain costs
associated with hedging. So there is insurance premium in the case of insurance.
There is premium and brokerage in the case of derivatives (Parikh, 2016). Hence,
most people do not do hedging as they assume that hedging expenses as unnecessary.

One of the potential hurdles in failing is fees. Normally, hedge funds are
charged with high fees in which often cited as a reason to not use them to extend
where the returns after risk-adjusted and paid fees are not taken into consideration. It
is a mistake for us to have the thought of viewing this issue in a narrow perspective
although we agree that fees do matter. This is mainly due to the goal that we put as
priority which is the risk-adjusted returns and eventually we have the attitude to avoid
looking at fees in isolation, as well as instead gauge the level of cost in relation to the
expected value that the investment might add (Anonymous, 2013). If we look in
another dimension, such conclusion actually leads us to the knowledge that there are
still small numbers of hedge funds that are worth paying for its high fees even though
we knew that the returns of such hedge funds would most probably covered by its
high fees. For instance, it is always worth to take the relationship between fees paid
and value added by traditional investment managers into consideration (Anonymous,
2013). Plenty of studies proved that equity managers tend to underperform as a group
in a way that the fees paid exceed the amount of value added which results losses for
the investors. If we were to make comparison, a good hedge fund does exist whereby
higher fees only consume a tiny portion of the value added. Also, the favor move

8
towards the investors due to its ratio of fees to value added. Coming to senses, paying
higher fees is not necessarily a disadvantage to the investors if its results it a better
investment net returns which is acceptable. Not surprising that making fee
minimization as part of the focus of an investment program at the expense is crucial to
provide a good investment outcome. After all, what seems cheap initially could be
very expensive in the long run (Anonymous, 2013).

Next up is liquidity. Liquidity can be categorized into two aspects and it is

worth considering. The first aspect is the liquidity offered through a funds normal
redemption cycle. Secondly, a much more problematic aspect is the ability or a fund
to abide by its normal redemption terms during stress environments (Anonymous,
2013). However, we often neglect the fact of taking normal redemption as a constraint
since such redemption is highly known in advance and is mostly plan-able although
investors often having the expectation to earn a return premium with lower level of
liquidity. Generally, majority of the diversified portfolio investments offer daily
liquidity. Therefore, having such investments which offer daily, weekly, or monthly
liquidity in a small portion should have little noticeable impact towards the total
portfolio liquidity. As for the second aspect, of not remaining by the normal
redemption terms, is mainly a huge concern and was extremely poorly-handled by
certain amount of hedge funds back in year 2008 when they used all kinds of methods
in preventing its clients from redeeming. In order to manage this risk, comparison can
be made between the redemption terms of each hedge fund to the liquidity of its
underlying investments and ensure that these are appropriate. Talking about risk, there
is another limitation of hedging that not every risk can be hedged. Furthermore,
existence of risk-free will not be there to cover fully by insurance which have to
results some losses to be borne by the insured (Parikh, 2016). In the case of financial
markets, not all asset class has the corresponding hedge too. Hence, it is important to
consider the liquidity of each fund and the whole portfolio in both normal and stress
environments. This is to ensure liquidity is being maintained in an appropriate level
relatively to the liquidity that is being offered to the investors.

Moreover, potential hurdle of hedging can be defined in terms of transparency.

As far as the investors concern, portfolio transparency is high on a number of levels.
But what is more important is that investor played an important role in understanding
the construction of every funds portfolio as well as the instruments that are contained

9
in it. On the other hand, studies showed that despite some investors negative
experiences, transparency is not entirely an issue to be worried. On a daily basis, most
of the hedge fund managers have faced the problem in discussing their portfolio and
distributing useful summaries of the portfolios salient features (Anonymous, 2013).
Another limitation is on the profit of hedging. For example, if the price of a particular
stock rises to $130, then the investor who has initially done his hedging will only gain
profit of $10 instead of $30. In other words, investors will be having losses of $20.
Besides, some investors do not prefer hedges from the companies. They would prefer
exposure to the risks of industry and at the same time to see hedging as an
impediment to their own risk management as an investor (Parikh, 2016). This case
especially happen during failure in hedging which can lead the company to reverse its
course and removing hedges due to level of pressure given by investors.

Investors often take hedging as a tool that companies can use to manage their
risk level. Of course, it carries both advantages and disadvantages. However, it serves
a useful purpose regardless of how things work out in the end; it is not how well you
start but how well you finish it.

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