ACCA FM Syllabus G. Risk Management - Interest Rate Risk - Past Papers ^{4 / 4}

Herd Co is based in a country whose currency is the dollar ($). The company expects to receive €1,500,000 in six months’ time from Find Co, a foreign customer. The finance director of Herd Co is concerned that the euro (€) may depreciate against the dollar before the foreign customer makes payment and she is looking at hedging the receipt.

Herd Co has in issue loan notes with a total nominal value of $4 million which can be redeemed in 10 years’ time. The interest paid on the loan notes is at a variable rate linked to LIBOR. The finance director of Herd Co believes that interest rates may increase in the near future.

The spot exchange rate is €1·543 per $1. The domestic short-term interest rate is 2% per year, while the foreign short-term interest rate is 5% per year.

As regards the interest rate risk faced by Herd Co, which of the following statements is correct?

A. In exchange for a premium, Herd Co could hedge its interest rate risk by buying interest rate options
B. Buying a floor will give Herd Co a hedge against interest rate increases
C. Herd Co can hedge its interest rate risk by buying interest rate futures now in order to sell them at a future date
D. Taking out a variable rate overdraft will allow Herd Co to hedge the interest rate risk through matching

The directors of Plam Co expect that interest rates will fall over the next year and they are looking forward to paying less interest on the company’s debt finance. The dollar is the domestic currency of Plam Co. The company has a number of different kinds of debt finance, as follows:

The 7% loan notes were issued domestically while the 10% loan notes were issued in a foreign country.

The interest rate on the long-term bank loan is reset to bank base rate plus a fixed percentage at the end of each year.

The annual payment on the bank loan consists of interest on the year-end balance plus a capital repayment.

Relevant exchange rates are as follows:

Required:
(b) Identify and discuss the different kinds of interest rate risk faced by Plam Co. (5 marks)

Which of the following statements is correct?

A. Governments may choose to raise interest rates so that the level of general expenditure in the economy will increase
B. The normal yield curve slopes upward to reflect increasing compensation to investors for being unable to use their cash now
C. The yield on long-term loan notes is lower than the yield on short-term loan notes because long-term debt is less risky for a company than short-term debt
D. Expectations theory states that future interest rates reflect expectations of future inflation rate movements

In relation to hedging interest rate risk, which of the following statements is correct?

A. The flexible nature of interest rate futures means that they can always be matched with a specific interest rate exposure
B. Interest rate options carry an obligation to the holder to complete the contract at maturity
C. Forward rate agreements are the interest rate equivalent of forward exchange contracts
D. Matching is where a balance is maintained between fixed rate and floating rate debt

The statement of financial position of BKB Co provides the following information:

BKB Co has an equity beta of 1•2 and the ex-dividend market value of the company’s equity is $125 million. The ex-interest market value of the convertible bonds is $21 million and the ex-dividend market value of the preference shares is $6•25 million.

The convertible bonds of BKB Co have a conversion ratio of 19 ordinary shares per bond. The conversion date and redemption date are both on the same date in five years’ time. The current ordinary share price of BKB Co is expected to increase by 4% per year for the foreseeable future.

The overdraft has a variable interest rate which is currently 6% per year and BKB Co expects this to increase in the near future. The overdraft has not changed in size over the last financial year, although one year ago the overdraft interest rate was 4% per year. The company’s bank will not allow the overdraft to increase from its current level.

The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. BKB Co pays profit tax at an annual rate of 30% per year.

Required:

Comment on the interest rate risk faced by BKB Co and discuss briefly how this risk can be managed.