The requirement here was for candidates to evaluate whether a money market hedge of a forward market hedge would be preferred on financial grounds by a company. Many answers gained full marks here.

Since a euro receipt was expected in six months’ time, a money market hedge would need to set up a euro liability of equal size in six months, by borrowing in euros now, converting to dollars and placing the dollars on deposit.

The six-month euro borrowing interest rate, the spot exchange rate and the sixmonth dollar deposit interest rate were therefore needed.

The dollar deposit would give a future value that could be compared with value of the forward market hedge in six months. The hedge that gave the higher dollar value would be preferred on financial grounds.

Some answers made errors relating to incorrect interest rates or to incorrect exchange rates. Occasionally, an answer inverted the money-market hedge, treating the euro receipt as a euro payment and therefore making a euro deposit.

Candidates were asked here to briefly explain the nature of a forward rate agreement and to discuss how a company could use a forward rate agreement to manage interest rate risk.

Many candidates gained very low marks here because they thought that a forward rate agreement (FRA) was a forward exchange contract (FEC), and discussed how an FEC could be used to manage foreign currency risk, when the question asked about interest rate risk.

An FRA is the interest rate equivalent of an FEC.

Candidates who understood the nature and use of an FRA gained good marks by explaining that it was a contract between a company and a bank for a specified interest rate on a nominal amount of money for a specified period.

Compensation payments are made either by the bank or the company, based on the difference between the specified interest rate and the actual interest rate on the contract date, thereby fixing the interest rate for the company and insulating it from adverse or favourable interest rate movements for the period. The FRA is separate from the related debt transaction, which can be with a different bank.

The key learning point here is the importance of understanding the difference between an FEC and an FRA.

In terms of examination technique, answers to this question reinforce the need for you to address the question requirement (interest rate risk) and avoid including irrelevant material (foreign currency risk, interest rate parity) in your answer.