ACCA FM Syllabus G. Risk Management - Forward Rates - Past Papers ^{1 / 6}

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.

What is the six-month forward exchange rate predicted by interest rate parity?

A. €1·499 per $1
B. €1·520 per $1
C. €1·566 per $1
D. €1·588 per $1

The home currency of ACB Co is the dollar ($) and it trades with a company in a foreign country whose home currency is the Dinar. The following information is available:

What is the six-month forward exchange rate?

A. 20·39 Dinar per $
B. 20·30 Dinar per $
C. 20·59 Dinar per $
D. 20·78 Dinar per $

GXJ Co, whose home currency is the dollar, wishes to borrow €12 million for a period of six months in three months’ time. The lending bank will fix the interest rate for the loan period at its prevailing lending interest rate when the loan is taken out. The finance director of GXJ Co believes this lending interest rate could be a minimum of 3·5% per year or a maximum of 5·5% per year. The uncertainty regarding the future interest rate is caused by the volatile state of the economy and impending elections which could lead to a change in political leadership and direction. Interest on the euro loan would be payable at the end of the loan period.

The finance director of GXJ Co would like to hedge the interest rate risk arising from the future loan and the company’s bank has offered a 3–9, 4·5%–3·5% forward rate agreement.

The finance director is also concerned about the foreign currency risk associated with the euro interest payment which would be due in nine months’ time.

The following exchange rates are available:

Required:
(a) Evaluate the proposed forward rate agreement as a way of managing the interest rate risk anticipated by GXJ Co. (3 marks)

Rose Co does not have any surplus cash to use in hedging the future euro receipt.

Required:
(a) Evaluate whether a money market hedge or a forward market hedge would be preferred on financial grounds by Rose Co. (5 marks)

(b) Briefly explain the nature of a forward rate agreement and discuss how a company can use a forward rate agreement to manage interest rate risk. (5 marks)

Required:
(a) Calculate the loss or gain compared to its current dollar value which PZK Co will incur by taking out a forward exchange contract on the future euro receipt, and explain why taking out a forward exchange contract may be preferred by PZK Co to not hedging the future euro receipt. (4 marks)

What is the six-month forward exchange rate?

A. 20·39 Dinar per $
B. 20·30 Dinar per $
C. 20·59 Dinar per $
D. 20·78 Dinar per $

Zigto Co is a medium-sized company whose ordinary shares are all owned by the members of one family. It has recently begun exporting to a European country and expects to receive €500,000 in six months’ time. The prospect of increased exports to the European country means that Zigto Co needs to expand its existing business operations in order to be able to meet future orders.

All of the family members are in favour of the planned expansion, but none are in a position to provide additional finance. The company is therefore seeking to raise external finance of approximately $1 million. At the same time, the company plans to take action to hedge the exchange rate risk arising from its European exports.

Zigto Co could put cash on deposit in the European country at an annual interest rate of 3% per year, and borrow at 5% per year. The company could put cash on deposit in its home country at an annual interest rate of 4% per year, and borrow at 6% per year. Inflation in the European country is 3% per year, while inflation in the home country of Zigto Co is 4·5% per year.

The following exchange rates are currently available to Zigto Co:

Current spot exchange rate 2·000 euro per $
Six-month forward exchange rate 1·990 euro per $
One-year forward exchange rate 1·981 euro per $

Required:

Calculate whether a forward exchange contract or a money market hedge would be financially preferred by Zigto Co to hedge its future euro receipt.