ACCA AFM Syllabus E. Treasury And Advanced Risk Management Techniques - Forward Rates - Past Papers ^{4 / 13}

Nutourne Co is a company based in the USA, supplying medical equipment to the USA and Europe.

It is 30 November 20X8. Nutourne Co’s treasury department is currently dealing with a sale to a Swiss customer of CHF12·3 million which has just been agreed, where the customer will pay for the equipment on 31 May 20X9. The treasury department intends to hedge the foreign exchange risk on this transaction using traded futures or options as far as possible. Any amount not hedged by a futures or option contract will be hedged on the forward market.

Futures and options contracts mature at the month end.

Non-executive director’s comments
A new non-executive director has recently been briefed about the work of the treasury department and has a number of questions about hedging activities. He wants to understand the significance of basis risk in relation to futures. He also wants to know the significant features of over-the-counter forward contracts and options, and why Nutourne Co prefers to use exchange-traded derivatives for hedging.

The non-executive director has also heard about the mark-to-market process and wants to understand the terminology involved, and how the process works, using the transaction with the Swiss customer as an example. The treasury department has supplied relevant information to answer his query. The contract specification for the CHF futures contract states that an initial margin of US$1,450 per contract will be required and a maintenance margin of US$1,360 per contract will also be required. The tick size on the contract is US$0·0001 and the tick value is US$12·50. You can assume that on the first day when Nutourne Co holds the futures contracts, the loss per contract is US$0·0011.

Required:
(c) Explain to the non-executive director how the mark-to-market process would work for the CHF futures, including the significance of the data supplied by the treasury department. Illustrate your explanation with calculations showing what would happen on the first day, using the data supplied by the treasury department. (6 marks)

The Adverane Group is a multinational group of companies with its headquarters in Switzerland. The Adverane Group consists of a number of fully-owned subsidiaries and Elted Co, an associate company based in the USA in which Adverane Group owns 30% of the ordinary equity share capital.

Balances owing between the parent, Adverane Co, and its subsidiaries and between subsidiaries are settled by multilateral netting. Transactions between the parent and Elted Co are settled separately.

Transactions with Elted Co
Adverane Co wishes to hedge transactions with Elted Co which are due to be settled in four months’ time in US$.

Adverane Co will owe Elted Co US$3·7 million for a major purchase of supplies and Elted Co will owe Adverane Co US$10·15 million for non-current assets. Adverane Group’s treasury department is considering whether to use money markets or exchange-traded currency futures for hedging.

Annual interest rates available to Adverane Co

Exchange traded currency futures
Contract size CHF125,000, price quotation US$ per CHF1
Three-month expiry: 1·1213
Six-month expiry: 1·1204

Netting
The balances owed to and owed by members of Adverane Group when netting is to take place are as follows:

The group members will make settlement in Swiss francs. Spot mid-rates will be used in calculations. Settlement will be made in the order that the company owing the largest net amount in Swiss francs will first settle with the company owed the smallest net amount in Swiss francs.

Transfer price arrangements
The Adverane Group board has been reviewing the valuation of inter-group transactions, as it is concerned that the current system is not working well. Currently inter-group transfer prices are mostly based on fixed cost plus a mark-up negotiated by the buying and selling divisions.

If they cannot agree a price, either the sale does not take place or the central treasury department determines the margin. The board has the following concerns:

As a result of the review, the Adverane Group board has decided that transfer prices should in future be based on market prices, where an external market exists.

Note: CHF is Swiss Franc, 3 is Euro, US$ is United States dollar and BRL is Brazilian Real.

Required:

Casasophia Co, based in a European country that uses the Euro (€), constructs and maintains advanced energy efficient commercial properties around the world. It has just completed a major project in the USA and is due to receive the final payment of US$20 million in four months.

Casasophia Co is planning to commence a major construction and maintenance project in Mazabia, a small African country, in six months’ time. This government-owned project is expected to last for three years during which time Casasophia Co will complete the construction of state-of-the-art energy efficient properties and provide training to a local Mazabian company in maintaining the properties.

The carbon-neutral status of the building project has attracted some grant funding from the European Union and these funds will be provided to the Mazabian government in Mazabian Shillings (MShs).

Casasophia Co intends to finance the project using the US$20 million it is due to receive and borrow the rest through a € loan. It is intended that the US$ receipts will be converted into € and invested in short-dated treasury bills until they are required. These funds plus the loan will be converted into MShs on the date required, at the spot rate at that time.

Mazabia’s government requires Casasophia Co to deposit the MShs2•64 billion it needs for the project, with Mazabia’s central bank, at the commencement of the project.

In return, Casasophia Co will receive a fixed sum of MShs1•5 billion after tax, at the end of each year for a period of three years. Neither of these amounts is subject to inflationary increases. The relevant risk adjusted discount rate for the project is assumed to be 12%.

Financial Information

Exchange Rates available to Casasophia

Currency Futures (Contract size €125,000, Quotation: US$ per €1)

2-month expiry 1•3633
5-month expiry 1•3698

Currency Options (Contract size €125,000, Exercise price quotation: US$ per €1, cents per Euro)

Casasophia Co Local Government Base Rate 2•20%
Mazabia Government Base Rate 10•80%
Yield on short-dated Euro Treasury Bills 1•80%
(assume 360-day year)

Mazabia’s current annual inflation rate is 9•7% and is expected to remain at this level for the next six months. However, after that, there is considerable uncertainty about the future and the annual level of inflation could be anywhere between 5% and 15% for the next few years.

The country where Casasophia Co is based is expected to have a stable level of inflation at 1•2% per year for the foreseeable future. A local bank in Mazabia has offered Casasophia Co the opportunity to swap the annual income of MShs1.5 billion receivable in each of the next three years for Euros, at the estimated annual MShs/€ forward rates based on the current government base rates.

Required:

Advise Casasophia Co on, and recommend, an appropriate hedging strategy for the US$ income it is due to receive in four months. Include all relevant calculations. (15 marks)