W7 AFM Lecture & Seminar
In times of volatile interest rates companies borrowing large sums of money may wish to hedge
against adverse movements in interest rates that could have a significant effect on the level of
interest payments. Similarly, companies lending large sums of money may wish to hedge
against interest rates falling which will have an adverse effect on interest received. It is
important to know how to apply interest rate derivatives in particular scenarios and also to
recommend the best instrument for that scenario. Make sure you are familiar with the
advantages and disadvantages of the different instruments for evaluation purposes.
Lecture
Q1: FRA – hedge payments
Alex Co is an international transport operator based in the Eurozone which has been invited to
take over a rail operating franchise in Mini Co in Miniland, where the local currency is the
dollar ($).
Alex Co is expected to invest rail operating $5million in three months and the funds is expected
to be obtained from local bank for 6 months before Alex Co accesses other funds resource.
Alex expected to access the borrowing rate based on the bank quote more 20 basis point. The
local bank has current annual borrowing rate 5%. However, due to the uncertainty of the
economic situation, the interest rate is expected to increase or decrease by 0.8%. Alex Co’s
finance director considers forward interest rate agreement to hedge the uncertainty of interest
rate change, known the 3-9 FRA: 5.30%.
Required: Calculate the net interest payment and effective interest rate if Alex Co chooses
to use forward rate agreement to hedge the interest rate risk.
Q2: FRA – hedge receipts
Alex Co is expecting to receive $24m receipt from customer in three months on 1 January
2021, which will be invested until it required for a large project on 1 May 2021. Alex can
invest funds at bank rate less 20 basis point. However, the interest rate could increase or
decrease by as much as 0.9% over the coming months and it’s difficult to predict. Alex is
considering forward rate agreement to hedge the interest rate risk over next three months. The
current bank rate is 4.09%. Calculate the net receipt and effective interest rate if bank
offers the following forward rate agreements to Alex Co: 3-4 FRA: 4.78% and 3-7 FRA:
4.82%.
Q3: Swap
Alex Manufacturing and Mini Products both seek £1m funding at the lowest possible cost.
Alex would prefer the flexibility of floating rate borrowing, while Mini wants the security of
fixed rate borrowing. Alex is the more credit-worthy company. They face the following rate
structure. Alex, with the better credit rating, has lower borrowing costs in both types of
borrowing.
Alex Mini
Credit rating AAA BBB
Fixed rate cost of borrowing 8% 12%
Floating rate cost of borrowing LIBOR + 1% LIBOR + 2%
Alex wants floating rate debt, so it could borrow at LIBOR+1%. However, it could borrow
fixed at 8% and swap for floating rate debt. Mini wants fixed rate, so it could borrow fixed at
12%. However, it could borrow floating at LIBOR+2% and swap for fixed rate debt.
Demonstrate how Alex and Mini could benefit from the swap arrangement?
Seminar
Q1: FRA – hedge receipts
Alex Co based in the Eurozone is a multinational company which has subsidiaries in different
countries. On 1 January 2021. The central treasury function has just received information about
a future transaction by a newly-acquired subsidiary in Miniland, where the local currency is the
Minar (M). The subsidiary expects to receive M30,000,000 on 30 April 2021. It wants this
money to be invested locally in Miniland, most probably for six months until 31 October 2021.
A local bank in Miniland, with which Alex Co has not dealt before, has offered the following
FRA rates:
4–10: 5.10%
5–11: 5.18%
Alex Co’s treasury team is aware that economic conditions in Miniland are currently uncertain.
The central bank base rate in Miniland is currently 4.3% and the treasury team believes that it
can invest funds in Miniland at the central bank base rate less 30 basis points. However,
treasury staff have seen predictions that the central bank base rate could increase by up to 1.1%
or fall by up to 0.6% between now and 31 March 2021.
Required: (i) Calculate the net receipt and effective annual interest rate if Alex Co uses
forward rate agreement to hedge the interest rate uncertainty.
(ii) Explain how forward rate agreement works to hedge interest rate risk.
Q2: Swap
Two firms, Alex and Mini, that can issue a US$ denominated bond in either fixed-rate or
floating-rate terms. The annual interest costs are assumed to be 9% and 10.5% respectively, for
Ales and Mini in the fixed-rate bond market. In addition, each firm can arrange floating
financing. Firm Alex pays six-month LIBOR plus zero basis points, while firm Mini pays six-
month LIBOR plus 50 basis points. Alex Co and Mini Co would split any benefit equally of the
swap. Explain a swap strategy that may bring benefits for Alex and Mini.
