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Tutorial Questions - Week 5

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14 views

Tutorial Questions - Week 5

Uploaded by

londontower2001
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Tutorial Questions - Managing Financial Risk - Interest Rate

Q1.

Company ABC and Company XYZ need to raise funds to pay for capital improvements at their
manufacturing plants. Company ABC is a well-established firm and prefers to borrow at fixed rate.
Company ABC can borrow funds either at 11% fixed rate or at EURIBOR + 1% floating rate. Company
XYZ is a fledgling start-up firm and prefers to borrow at floating rate. Company XYZ can borrow funds
either at 10% fixed rate or at EURIBOR + 3% floating rate.

(a) Is there an opportunity here for Company ABC and Company XYZ to benefit by means of an interest
rate swap?

(b) Suppose you have just been hired at a bank that acts as a dealer in the swaps market, and your boss
has shown you the borrowing rate information for your clients Company ABC and Company XYZ.
Describe how you could bring these two companies together in an interest rate swap that would make
both firms better off while netting your bank a 2% profit. Assume that Company ABC and Company
XYZ will share the benefit equally.

(c) Draw the graph to reflect the relation among the dealer, Company ABC and Company XYZ in this
interest rate swap.
Q2.

Dubois Ltd is a consumer electronics wholesaler with a highly seasonal business. In one half year, the
business is highly cash generative but in the other half year, the company needs to borrow to cover its
costs. Dubois will move into this borrowing period in three months' time and expects to borrow £5
million for the entire low season half year. The directors are concerned that interest rates are expected
to rise over the next few months. Interest rates and FRAs are currently quoted as follows:

Spot 5.75 – 5.50


3–6 FRA 5.82 – 5.59
3–9 FRA 5.94 c 5.64

The 6-month £500,000 interest rate futures maturing in three months is quoted at 94.15.

(a) Explain how a forward rate agreement (FRA) may be useful to the company. Illustrate this on the
basis that interest rates rise to 6.5% or fall to 4.5%.
(b) Explain how the 6-month £500,000 interest rate futures may be useful to the company and illustrate
its usefulness under the same two interest rate scenarios of a rise to 6.5% or a fall to 4.5%.
Homework:

Q3.

Company ABC and Company XYZ need to raise funds to pay for capital improvements at their
manufacturing plants. Company ABC is a well-established firm with an excellent credit rating in the
debt market. It prefers to borrow at fixed rate and can borrow funds either at 8% fixed rate or at LIBOR
+ 1% floating rate. XYZ Company is a fledgling start-up firm without a strong credit history. It prefers
to borrow at floating rate and can borrow funds either at 9% fixed rate or at LIBOR + 5% floating rate.

(a) Is there an opportunity here for Company ABC and Company XYZ to benefit by means of an interest
rate swap?

(b) Suppose you have just been hired at a bank that acts as a dealer in the swaps market, and your boss
has shown you the borrowing rate information for your clients Company ABC and Company XYZ.
Describe how you could bring these two companies together in an interest rate swap that would make
both firms better off while netting your bank a 1% profit. Assume that Company ABC receives 75% of
the benefit while Company XYZ gets 25% of the benefit.

(c) Draw the graph to reflect the relation among the dealer, Company ABC and Company XYZ in this
interest rate swap.
Q4.

A company needs to borrow £50 million for one year starting in three months’ time at LIBOR. The
company’s bank makes the following offers:

• A ‘3–15’ FRA at 5% interest (i.e., an FRA starting in three months and lasting 12 months)
• An option at 5% interest for a premium of 1% pa

Requirement:

Assuming interest rates move to either 3%, 4%, 5% or 6%, illustrate the effective rate paid by the
company assuming it:

(a) has no hedge


(b) uses an FRA
(c) uses an option

Q5.

It is late March and a corporate treasurer has identified the need to borrow £10 million for a three-month
period commencing at the end of June. Current (i.e., spot) interest rates are 6% per annum. Three-month
sterling interest rate futures for June are trading at 93. Futures contracts size is £500,000.

Requirement:

Explain how futures will provide a hedge. Assume the spot rate moves to 6%, 7% and 8% to help
illustrate your answer.

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