ACCA AFM Syllabus E. Treasury And Advanced Risk Management Techniques - Interest rate swaps - examples - Past Papers ^{9 / 13}

(1) Cocoa-Mocha-Chai (CMC) Co is a large listed company based in Switzerland and uses Swiss Francs as its currency.

A four-year CHF60,000,000 loan taken out to part-fund the setting up of four branches.

Interest will be payable on the loan at a fixed annual rate of 2•2% or a floating annual rate based on the yield urve rate plus 0•40%.

The loan’s principal amount will be repayable in full at the end of the fourth year.

Over-the-counter products

In addition to the exchange-traded products, Pecunia Bank is willing to offer the following over-the-counter derivative products to CMC Co:

(i) A forward rate between the US$ and the CHF of US$ 1•0677 per CHF1.
(ii) An interest rate swap contract with a counterparty, where the counterparty can borrow at an annual floating rate based on the yield curve rate plus 0•8% or an annual fixed rate of 3•8%.

Pecunia Bank would charge a fee of 20 basis points each to act as the intermediary of the swap.

Both parties will benefit equally from the swap contract.

Required:

(b) Demonstrate how CMC Co could benefit from the swap offered by Pecunia Bank. (6 marks)

Sembilan Co, a listed company, recently issued debt finance to acquire assets in order to increase its activity levels. This debt finance is in the form of a floating rate bond, with a face value of $320 million, redeemable in four years. The bond interest, payable annually, is based on the spot yield curve plus 60 basis points. The next annual payment is due at the end of year one.

Sembilan Co is concerned that the expected rise in interest rates over the coming few years would make it increasingly difficult to pay the interest due. It is therefore proposing to either swap the floating rate interest payment to a fixed rate payment, or to raise new equity capital and use that to pay off the floating rate bond. The new equity capital would either be issued as rights to the existing shareholders or as shares to new shareholders.

Ratus Bank has offered Sembilan Co an interest rate swap, whereby Sembilan Co would pay Ratus Bank interest based on an equivalent fixed annual rate of 3•76¼% in exchange for receiving a variable amount based on the current yield curve rate. Payments and receipts will be made at the end of each year, for the next four years. Ratus Bank will charge an annual fee of 20 basis points if the swap is agreed.

The current annual spot yield curve rates are as follows:

The current annual forward rates for years two, three and four are as follows:

Required:

Based on the above information, calculate the amounts Sembilan Co expects to pay or receive every year on the swap (excluding the fee of 20 basis points). Explain why the fixed annual rate of interest of 3•76¼% is less than the four-year yield curve rate of 3•8%. (6 marks)

Sembilan Co, a listed company, recently issued debt finance to acquire assets in order to increase its activity levels. This debt finance is in the form of a floating rate bond, with a face value of $320 million, redeemable in four years. The bond interest, payable annually, is based on the spot yield curve plus 60 basis points. The next annual payment is due at the end of year one.

Sembilan Co is concerned that the expected rise in interest rates over the coming few years would make it increasingly difficult to pay the interest due. It is therefore proposing to either swap the floating rate interest payment to a fixed rate payment, or to raise new equity capital and use that to pay off the floating rate bond. The new equity capital would either be issued as rights to the existing shareholders or as shares to new shareholders.

Ratus Bank has offered Sembilan Co an interest rate swap, whereby Sembilan Co would pay Ratus Bank interest based on an equivalent fixed annual rate of 3•76¼% in exchange for receiving a variable amount based on the current yield curve rate. Payments and receipts will be made at the end of each year, for the next four years. Ratus Bank will charge an annual fee of 20 basis points if the swap is agreed.

The current annual spot yield curve rates are as follows:

The current annual forward rates for years two, three and four are as follows:

Required:

Demonstrate that Sembilan Co’s interest payment liability does not change, after it has undertaken the swap, whether the interest rates increase or decrease. (5 marks)

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:

Given that Casasophia Co agrees to the local bank’s offer of the swap, calculate the net present value of  the project, in six months’ time, in €. Discuss whether the swap would be beneficial to Casasophia Co. (10 marks)