INTEREST RATES RISK MANAGEMENT

REVIEW QUESTIONS

QUESTION ONE: QN 5 ( a) May 2016

The financial Director of Picky Co. Ltd a UK based company is concerned that interest rates could
become more volatile for major trading countries following recent turmoil in credit markets. It is now
march and Picky Co Ltd is expected to borrow £ 12,000,000 for the period of six months commencing in
six months time. The Corporate treasurer of Picky Co. Ltd expects interest rate to increase by 2% during
the next six months and decided to hedge the interest rate risk using interest rate futures. September's
sterling six month time deposit futures are currently priced at 94.28. Future prices are expected to
decrease by 2%. The contract size is £ 500,000 and minimum price movement is one tick (The value of
one tick is 0.01% per year for the contract size.

REQUIRED:

Illustrate the possible results of hedging interest rate risk using interest rate futures, if interest rate in
six months time increased by 3% and September future market price decrease by 2% (Hint: Set the
hedge position and calculate hedge efficiency) ( 10 marks)

QUESTION TWO: QN 1 (b) NOV 2015

SUMREY COMPANY, a British engineering firm, borrowed £17 million in March 2015 at a fixed rate of
11% per annum. The loan is due to be repaid in March 2016. The LIBOR in March is 11% per annum and
SUMREY feels that the possibility of an interest rate swap. Alpacas Commercial Bank, the company's
bank has offered to arrange an interest rate swap for one year with SEPREM Company that has obtained
floating rate Finance at London Interbank Offered Rate (LIBOR) plus 1.25 %.

Tens of Swap:

1. SUMREY Company will pay LIBOR plus 1.5 to SEPREM company

2. SEPREM Company will pay 12% SUMREY Company. The Corporate tax rate 35%.
3. One of SUMREY's directors has questioned this proposal commenting, Do the terms of this swap
offer us the best possible deal? I wonder whether we will be getting any savings in interest cost.

REQUIRED:

Assume the swap goes ahead on original terms proposed by Alpha Commercial Bank and the LIBOR
turns to 9% per annum for the whole year, Advice SUMREY Company on the worthiness of the proposed
swap. ( 15 marks)

QUESTION THREE: QN 2 May 2019

An interest rate swap is to be arranged between Sepide Company AA credit rates company, and Everis
Co, a BB+ rated company. Sepide Co can borrow at a fixed rate of 10.1% or floating rate at LIBOR plus
1%. Everis can borrow at a fixed rate of 11.5% or floating rate at the LIBOR +1.4%. Mipango Bank is
willing to act as intermediary to facilitate a five years swap.

Size of swap TZS TZS 100 million.

Payment to Mipango Bank (Payable by each of companies)

 Upfront fee TZS 50,000

 Annual fee 0.25% of the swap value

The overall swap benefit is to be shared as follows, Sepide Co 70%, Everis Co 30%

Required:

a. Evaluate, whether or not an interest rate swap that is beneficial to both firms may be arranged.
Ignore taxation ( 3 marks)
b. Calculate the net savings made by each party in each of the first two years of the swap ( 4
marks)
c. Comment on the possible benefits to a company of undertaking an interest rate swap ( 3 marks)

QUESTION FOUR: QN 6 (b) May 2019

Bravo Co which is based in Britain has two issues that need immediate solutions. The two issues are
outlined below

ISSUE 1:

During the financial year ended 31st December, 2018, Bravo Company, had created a cash surplus
amounting to £ 60 million. The company is planning to invest the surplus in £ denominated securities in
three month's time for a six month period. Bravo is worried company can normally invest surplus at
LIBOR-0.2%. The company is worried about of sharp decline in lending rates in near future.

ISSUE 2:

It is now 31st December 2018. The company wishes to borrow £ 60 million in three month's time for a six
month period. The company can normally borrow from its bank at LIBOR +0.5%. The company is
worried about the risk of a sharp rise in borrowing rates in the near future.

Bruce Commercial Bank, a bank trading in forward Rate Agreements (FRAs) quoted prices for the £ as
follows:

FRA Terms and Prices

1. 3/9 4.45-3.4
2. 6/9 4.30-3.25
3. 6/12 4.14-3.12

Principal is £ 60 million

Reference rate is LIBOR

You are hired as an investment advisor for Bravo Company and the managing Director wants your advice
on the matter

REQUIRED:

i. Provide a brief explanation on how FRAs works (3 marks)

 ii. Estimate the effective lending and borrowing rates should the LIBOR turn out to be 3.5%. Advice
the managing director accordingly (7 marks)

QUESTION FIVE: QN 2(b) Nov 2019

KINGEGE is a Tanzanian based company and you happen to be its corporate Treasurer. In October 2019
you realized that in mid November the company will need to borrow $ 1 million for 3 month. You are
concerned that interest rates might rise in the intervening period. The following data is made available
to you in October. October spot $ interest rate is 10%

November 3 months Euro dollar future is 11%

The contract size for Euro dollar future is $1 million

November spot rates are as follows 9%, 11%, 13%

REQUIRED

Show how you might hedge his position using a future market operation. Assume the funding
requirement is on the last day of November futures trading. Illustrate your answer with reference to the
November spot rate. (10 marks)

QUESTION SIX: QN 2 (b) NOV 2020

GXJ Co, whose home currency is the dollar, wishes to borrow € 12 million for a period of six months in
three months time. The lending bank will fix the interest rate for the loan period at its prevailing lending
interest rate when the loan is taken. GXJ Co finance director believes this lending interest rate could be
a minimum of 3.5% per year. The uncertainty regarding the future interest rate is caused by the volatile
state of the economy and impending elections which could lead to a change in political leadership and
direction. Interest on the euro loan would be payable at the end of the loan period.

The finance director would like to hedge the interest rate risk arising from the future loan and the
company's bank has offered a 3-9, 4.5%-3.5% per annum forward rate agreement.

The finance director is also concerned about the foreign currency risk associated with the euro interest
payments which would be due in nine month's time.

The following exchange rates are available

Spot rate (€ per $ 1) 1.7964- 1.8306

Nine month forward rate (€ per $ 1) 1.7191- 1.7505

REQUIRED:

i. Evaluate the proposed forward rate agreement as a way of managing the interest rate risk
anticipated by GXJ Co (6 marks)
ii. Analyse the foreign currency risk associated with the future interest payment of GXJ Co and
briefly discuss ways that this risk might be hedged (5 marks)

QUESTION SEVEN: QN 4 (a) NOV 2019

Write short notes on the following:

 Features of interest rate futures (4 marks)

 Floating to fixed interest rate swaps (3 marks)

QUESTION EIGHT: QN 2 NOV 2014

Assume today's date is 1st July, 2014 and you are the corporate Treasurer of Regensburg Technology, a
company which specializes in manufacturing and supply of specialist telecommunications equipment.
The company currently has short term debts amounting to Euro 16 m, and these shall be due for
repayment in six months ‘ time. However, due to the declining sales resulting from economic slowdown
in the country, you have now forecasted that only Euro 4 million will be paid on the due date and the
remainder will have to rolled over for a further six months. You are therefore considering to use
derivatives to hedge the financial challenges facing the company.

Assume that the company can borrow funds at EURIBOR +1% (ignore taxation).

The following financial data has been availed to the company on 1st Ju6, 2014.

EURIBOR rates

3 month 1.45965

6 month 1.75450

12 month 2.10750

Forward Rate Agreement “6 by 12"

Bid Asked

1.25% 1.85%

NYSELIFFE € 1,000,000 3M EURIBOR Futures

November 2014 98.25

March 2015 98.10

NYSELIFFE € 1,000,000 3M EURIBOR Options

Calls Puts

November March November March

99000 0.005 0.014 0.906 1.010

99125 0.000 0.005 1.028 1.128

REQUIRED:
 i. Design an appropriate hedging strategy by using the derivative instruments quoted in the data
listed above, with full explanation of the reasons for your choices. ( Clearly state all assumptions
made and show all workings) (6 marks)
ii. Critically appraise the use of forward Rate agreements (FRAs), Futures and Options to hedge
interest rate risk and advise Regensburg Technology the best derivative instrument it should use
in hedging its interest rate risk among the three instruments given (6 marks)

If on 1st January 2015 the market rates shall have moved to:

EURIBOR rates:

3 month 1.35965

6 month 1.56500

12 month 2.00750

Future Price

March 2015 98.00

March Option Prices

Calls Puts

March March

99000 0.00 0.014

99125 0.025 0.230

i. Evaluate the hedges you have constructed in (i) above by providing a numerical evaluation and
written discussion of the outcomes
ii. Indicate whether in hindsight the advice given in (ii) above was correct. (8 marks)

QUESTION NINE: QN 5 (a) and (b)

a) Discuss “Accounting exposure and its impact on shareholders wealth maximization of a

multinational Corporation (5 marks)
b) It is early January 2014. CBG Resources limited intends to borrow £ 2 million in may for three
months and is concerned about the risk of rising interest rates. It can borrow at LIBOR plus 1%.
The current three month LIBOR rate (spot rate) is 4.625%. June futures for short sterling have a
current market price of 95.35.

REQUIRED:

i. Show how CBG Resources can set up for the exposure to the risk of increase in the three month
LIBOR rate
ii. Calculate the gain/loss from the interest rate future contract if in may the three month LIBOR is
5.5% and the June futures price is 94.25 (5 marks)

QUESTION TEN: NBAA TEST YOUR SELF

Hitec Electronics Ltd has planned to borrow Tshs100million for 3 months beginning next month (in early
July 20X6) and expects to pay interest at LIBOR plus 0.6%. The company has had discussions with a bank
to use 3-month futures to hedge its exposure to increasing interest rates.

Hitec sells July 3 month futures at a price of 96.28. Hitec subsequently closes the position in early July
20X6 at a price of 95.57. At the same time the company borrows Tshs100million at 5.03%, which is the
current LIBOR rate of 4.43 plus 0.6%.

Assume the unit of trading is Tshs5million, the tick size is 0.01% and the value of 1tick is Tshs125

Required

What is the net interest amount payable by Hitec? Prove by calculations that the net amount payable on
the loan is the same as the amount locked through selling the futures.

QUESTION ELEVEN (example)

Beck Ltd requires a Tshs20billion loan starting 3 months from today and repayable three months after
that date at a floating interest rate. The current floating interest rate is 9%The company is unable to
predict the movement of interest rates in the coming three months. The board of directors of Beck Ltd
believes that interest rates may go up. To protect itself from an increase in interest costs, Beck Ltd
decides to hedge its interest rate risk by purchasing a “3-6 FRA” today.

The bank is ready to guarantee a rate of 9.5% for the next three months.

Therefore, by entering into a forward interest rate agreement at 9.5%, Beck Ltd has limited its interest
cost to Tshs475m for the future three-month period, calculated as (Tshs20billion x 9.5% p.a.) x 3/12 If
interest rates go up to, say, 10%, Beck Ltd has saved interest of Tshs25m (Tshs500million -
Tshs475million) by entering into an FRA. However, if, after three months, interest rates fall to 8.5%, the
interest cost would be Tshs425million ((Tshs20billion x 8.5% p.a.) x 3/12). In this case, Beck Ltd will have
to pay Tshs50million (Tshs475 - Tshs425) to the bank. Irrespective of what happens to interest rates in
the three-month period, Beck will pay interest at 9.5% to the bank.

QUESTION TWELVE:NBAA TEST YOUR SELF

A company with a Tshs10 billion floating rate exposure with rollovers to be fixed by reference to the 6-
month LIBOR rate expects the short-term interest rates to increase. The next rollover date is due in 2
months. The company seeks a quote from its banker for a 2-8 USD FRA quote (or a 6 month LIBOR 2
months hence). The bank quotes a rate 6.68 and 6.71). The customer locks the offered rate 6.71.

Required

Calculate the amount that the company gains or losses if the interest rate increases/decreases by 100
basis points.

QUESTION THIRTEEN NBAA TEST YOUR SELF

Tan and Zan Companies can borrow for a five-year term at the following rates: Credit rating Fixed-rate
borrowing cost Tan AA 11.5% Floating-rate borrowing cost LIBOR Zan BB 13.0% LIBOR + 1%

Assume the swap bank is quoting five -year interest rate swaps at 11.7.7% - 11.8% against LIBOR flat.
(a) Calculate the quality spread differential (QSD).

b) Assume Tan desires floating-rate debt and Zan desires fixed-rate debt. Develop an interest rate swap
in which both Tan and Zan have cost savings in their borrowing costs.

QUESTION FOURTEEN : Self Examination Question (NBAA)

The CEO of Autocrat Plc is reviewing the company's interest rate and currency risk strategies for the next
few months. There has recently been considerable political instability with some countries showing signs
of moving towards economic recession whilst others are still showing steady growth. Both interest rates
and currency rates could become more volatile for many major trading countries. Autocrat is expected
to borrow £6.5 million for a period of six months commencing in six months’ time. The company also
needs to make a US$ payment of $4·3 million in 3 months’ time.

Assume that it is now 1 December. Futures and options contracts may be assumed to expire at the end
of the relevant month, and the company may be assumed to be able to borrow at the 3 month LIBOR
rate.

LIFFE futures prices (£500,000 contract size)

March 95·56

June 95·29

LIFFE options on futures prices, £500,000 contract size. Premiums are annual %

CALLS PUTS

March June March June

95250 0.445 0.545 0.085 0.185

95500 0.280 0.390 0.170 0.280

95750 0.165 0.265 0.305 0.405

Foreign exchange rates

Spot $ 1.4692- 14735

3 month forward $1.4632 - 1.4668/£

Currency option prices

Philadelphia Stock Exchange $/£ options, contract size £31,250, premiums are cents per £

CALLS PUTS

March April March April

1.450 3.12 - 1.56 -

1.460 2.55 2.95 1.99 2.51

1.470 2.14 - 2.51 -

(a) If the interest rates increase by 0.75% in six months’ time, illustrate the possible results of

(i) futures hedge; and

(ii) options hedge

Recommend which hedge should be selected and explain why there might be uncertainty as to the
results of the hedges.

(b) Illustrate and discuss the possible outcomes of forward market and currency options hedges if
possible currency rates in three months' time are either:

(i) $1.4350 -$1.4386/£ or

(ii) $1.4780 -$1.4820/£.