Which of the following statements are correct?
(1) Interest rate options allow the buyer to take advantage of favourable interest rate movements
(2) A forward rate agreement does not allow a borrower to benefit from a decrease in interest rates
(3) Borrowers hedging against an interest rate increase will buy interest rate futures now and sell them at a future date
A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3
| Spot exchange rate: | 4·1780–4·2080 euros per $ |
| Six-month forward exchange rate: | 4·2302–4·2606 euros per $ |
| Twelve-month forward exchange rate: | 4·2825–4·3132 euros per $ |
Required:
(b) If the interest rate in the home country of PZK Co is 4% per year, calculate the annual interest rate in the foreign customer’s country implied by the spot exchange rate and the twelve-month forward exchange rate. (2 marks)
| Spot rate: | 12·500–12·582 pesos per $ |
| Six-month forward rate: | 12·805–12·889 pesos per $ |
| Borrow | Deposit | |
|---|---|---|
| Peso interest rates: | 10·0% per year | 7·5% per year |
| Dollar interest rates: | 4·5% per year | 3·5% per year |
Required:
(b) Calculate whether a forward market hedge or a money market hedge should be used to hedge the interest payment of 5 million pesos in six months’ time. Assume that ZPS Co would need to borrow any cash it uses in hedging exchange rate risk. (6 marks)
BQK Co, a house-building company, plans to build 100 houses on a development site over the next four years. The purchase cost of the development site is $4,000,000, payable at the start of the first year of construction. Two types of house will be built, with annual sales of each house expected to be as follows:
| year | 1 | 2 | 3 | 4 |
| number of small houses sold | 15 | 20 | 15 | 5 |
| number of large houses sold | 7 | 8 | 15 | 15 |
Houses are built in the year of sale. Each customer finances the purchase of a home by taking out a long-term personal loan from their bank. Financial information relating to each type of house is as follows:
| small house | large house | |
| selling price | $200000 | $350000 |
| variable cost of construction | $100000 | $200000 |
Selling prices and variable cost of construction are in current price terms, before allowing for selling price inflation of 3% per year and variable cost of construction inflation of 4·5% per year.
Fixed infrastructure costs of $1,500,000 per year in current price terms would be incurred. These would not relate to any specific house, but would be for the provision of new roads, gardens, drainage and utilities. Infrastructure cost inflation is expected to be 2% per year.
BQK Co pays profit tax one year in arrears at an annual rate of 30%. The company can claim capital allowances on the purchase cost of the development site on a straight-line basis over the four years of construction.
BQK Co has a real after-tax cost of capital of 9% per year and a nominal after-tax cost of capital of 12% per year. New investments are required by the company to have a before-tax return on capital employed (accounting rate of return) on an average investment basis of 20% per year.
Required:
Discuss the effect of a substantial rise in interest rates on the financing cost of BQK Co and its customers, and on the capital investment appraisal decision-making process of BQK Co.