The following scenario relates to questions 1 to 5
HMC Co. a large manufacturer, is planning to sell an existing subsidiary and use the funds to buy land and build a new factory. The proceeds of the sale are likely to be delayed, so the directors have estimated that $10 million will be needed in 3 months’ time for a period of 6 months. Given this, the directors have decided that a bank loan would be appropriate as a form of finance rather than equity sources.
After checking that interest rate yield curves in the financial press are normal rather than inverted, the treasurer is now looking to hedge the interest rate exposure. Traditionally HMC Co. has used forward rate agreements (FRAs) for hedging interest rate risk exposure but the treasurer is now considering using interest rate futures, although she is concerned that futures will not be as good a hedge as the FRAs.
HMC Co.’s bank have offered an FRA on the following terms:
3v9 FRA 7.2 – 7.8%
1. Which TWO of the following are possible reasons why the Directors decided that a bank loan was preferable to equity in this case?
2. Which of the following would NOT be a possible explanation for the normal yield curve observed?
3. What is the payment/receipt payable on the FRA if the reference interest rate moves to 7.6% in 3 months’ time?
4. Which TWO of the following are reasons why futures are not always a perfect hedge?
5. Which of the following statements concerning FRAs and interest rate futures is/are true?
(i) In both cases HMC Co. stills needs to borrow the money at the market rate in three months’ time.
(ii) Both have standardised contract sizes.
(iii) Both result in a net gain or loss that can be offset against the loss or gain on the associated real world borrowing.
Peony Co (Mar/Jun 19)
The following scenario relates to questions 6–10.
Peony Co's finance director is concerned about the effect of future interest rates on the company and has been looking at the yield curve.
Peony Co, whose domestic currency is the dollar ($), plans to take out a $100m loan in three months' time for a period of nine months. The company is concerned that interest rates might rise before the loan is taken out and its bank has offered a 3 v 12 forward rate agreement at 7.10–6.85.
The loan will be converted into pesos and invested in a nine-month project which is expected to generate income of 580 million pesos, with 200 million pesos being paid in six months' time (from today) and 380 million pesos being paid in 12 months' time (from today). The current spot exchange rate is 5 pesos per $1.
The following information on current short-term interest rates is available:
Dollars 6.5% per year
Pesos 10.0% per year
As a result of the general uncertainty over interest rates, Peony Co is considering a variety of ways in which to manage its interest rate risk, including the use of derivatives.
6. In relation to the yield curve, which of the following statements is correct?
7. If the interest rate on the loan is 6.5% when it is taken out, what is the nature of the compensatory payment under the forward rate agreement?
8. Using exchange rates based on interest rate parity, what is the dollar income received from the project?
9. In respect of Peony Co managing its interest rate risk, which of the following statements is/are correct?
10. In relation to the use of derivatives by Peony Co, which of the following statements is correct?
The following scenario relates to questions 11–15.
Karlyn Co is based in a country whose currency is the dollar ($). The company regularly imports goods denominated in Euro (€) and regularly sells goods denominated in dinars. Two of the future transactions of the company are as follows:
Three months: Paying €650,000 for imported goods
Six months: Receiving 12 million dinars for exported capital goods
Karlyn Co has the following exchange rates and interest rates available to it:
Spot exchange rate (dinars per $1):
Six-month forward rate (dinars per $1):
Spot exchange rate (€ per $1):
Three-month forward rate (€ per $1):
Six-month interest rates:
The finance director of Karlyn Co believes that the upward-sloping yield curve reported in the financial media means that the general level of interest rates will increase in the future, and therefore expects the reported six-month interest rates to increase.
11. What is the future dollar value of the dinar receipt using a money market hedge?
12. Indicate, by clicking in the relevant boxes, whether Karlyn Co will find each of the following hedges to be effective or not effective in hedging the foreign currency risk of the two transactions.
A. Buying a tailor-made currency option for its future euro payment
B. Taking out a forward exchange contract on its future dinar receipt
C. Leading the euro payment on its imported goods
13. Which hedging methods will assist Karlyn Co in reducing its overall foreign currency risk?
1. Taking out a long-term Euro denominated loan.
2. Taking out a dinar-denominated overdraft.
14. Indicate, by clicking in the relevant boxes, whether the following statements are True or False.
A. Purchasing power parity can be used to predict the forward exchange rate
B. The international Fisher effect van be used to predict the real interest rate
15. Which of the following statements is consistent with an upward-sloping yield curve?
Zigto Co (6/12, amended)
The following scenario relates to questions 16–20.
Zigto Co is a medium-sized company whose ordinary shares are all owned by the members of one family. The domestic currency is the dollar. It has recently begun exporting to a European country and expects to receive €500,000 in 6 months' time. The company plans to take action to hedge the exchange rate risk arising from its European exports.
Zigto Co could put cash on deposit in the European country at an annual interest rate of 3% per year, and borrow at 5% per year. The company could put cash on deposit in its home country at an annual interest rate of 4% per year, and borrow at 6% per year. Inflation in the European country is 3% per year, while inflation in the home country of Zigto Co is 4.5% per year.
The following exchange rates are currently available to Zigto Co:
Current spot exchange rate
2.000 euro per $
Six-month forward exchange rate
1.990 euro per $
One-year forward exchange rate
1.981 euro per $
Zigto Co wants to hedge its future euro receipt. Zigto Co is also trying to build an understanding of other types of currency risk and the potential impact of possible future interest rate and inflation rate changes.
19. Are the following statements true or false?
A. Purchasing power parity tends to hold true in the short term.
B. Expected future spot rates are based on relative inflation rates between two countries.
C. Current forward exchange rates are based on relative interest rates between two countries.
20. Are the following statements true or false?
A. Transaction risk affects cash flows.
B. Translation risk directly affects shareholder wealth.
C. Diversification of supplier and customer base across different countries reduces economic risk.
The following scenario relates to questions 21–25.
PGZ Co. is a company based in Centreland whose home currency is the Centreland Colon (CC), has been regularly buying components from and selling finished products to businesses in Flyland, where the currency is the Flyland Franc (FF).
One particular payment of 3,000,000 Flyland Francs has to be made by PGZ Co to a supplier in Flyland in three months’ time. The following information is available.
Spot rate 6.170 – 6.210 Flyland Francs to the Centreland Colon
Three-month forward rate 6.321 – 6.362 Flyland Francs to the Centreland Colon
Interest rates that can be used by Noon Co are as follows.
Flyland Franc interest rate
18.0% per annum
13.5% per annum
Centreland Colon interest rate
8.1% per annum
6.3% per annum
21. What is the cost in Centreland Colons of a forward market hedge?
22. Which of the following relationships attempt to explain the difference between forward and spot rates of exchange between two currencies and the relative rates of interest in the countries of origin of the two currencies?
23. What is the cost in Centreland Colons of a money market hedge?
24. Which TWO of the following statements on the characteristics of interest rate futures are incorrect?
Rose Co (6/15, amended)
The following scenario relates to questions 26–30.
Rose Co expects to receive €750,000 from a credit customer in the European Union in 6 months' time. The spot exchange rate is €2.349 per $1 and the 6-month forward rate is €2.412 per $1. The following commercial interest rates are available to Rose Co:
4.0% per year
8.0% per year
2.0% per year
3.5% per year
Rose Co does not have any surplus cash to use in hedging the future euro receipt. It also has no euro payments to make.
Rose Co is also considering using derivatives such as futures, options and swaps to manage currency risk.
In addition, Rose Co is concerned about the possibility of future interest rate changes and wants to understand how a yield curve can be interpreted.
26. What could Rose Co do to reduce the risk of the euro value dropping relative to the dollar before the €750,000 is received?
27. What is the dollar value of a forward market hedge in six months' time?
28. If Rose Co used a money market hedge, what would be the percentage borrowing rate for the period?
29. Which of the following statements is correct?
30. Which of the following statements is correct?
The following scenario relates to questions 31–35.
It is now the 31st of January. The treasurer of Forlorn Co. is reviewing cash forecasts and funding requirements and has identified the need for the following transactions:
Forlorn Co. will have a surplus of $1 million from 1st of May for 3 months, which will need to be deposited to earn additional interest. The treasurer has seen inverted interest rate yield curves in the financial press, so is considering using a 3 v 6 FRA quoted at 5% – 5.6% to hedge the interest rate risk exposure. He is also considering the use of interest rate options as an alternative strategy.
Forlorn Co. also needs to borrow $20 million longer term debt to finance expansion. The treasurer would prefer to borrow at a floating rate but does not feel that the company can obtain competitive rates. He is thus considering the possibility of borrowing fixed and entering into a swap arrangement. Forlorn Co.’s advisors have identified Apostle Co. as a possible counter party. Details of the current borrowing rates that each company can achieve are as follows:
Best fixed rate
Best variable rate
LIBOR + 3%
LIBOR + 1%
31. Which TWO predictions are normally associated with an inverted yield curve?
32. What is the payment/receipt payable on the FRA if the reference interest rate moves to 5.5% on the 1st May?
33. Which of the following best describes an interest rate option?
34. With reference to interest rate swaps, which of the following statements it true?
35. Indicate, by clicking in the relevant boxes, whether the following statements concerning the swap are true or false.
A. If Apostle Co. defaults on the loan it has taken out, then Forlorn Co. would also be liable under the swap
B. Under the swap loan principals are exchanged
C. Apostle Co. has been offered lower interest rates due to having a better credit rating