QUESTION 1
ThinkTank Co. is thinking about investing in one of two corporate bonds, both of
which have a $1,000 par value and pay coupon interest annually. The first bond's
market price is $1,079.68, and it has a 6% coupon rate and is scheduled to be
redeemed at par in five years. The second bond is set to be issued with a 4% coupon
rate and will also be redeemable at par in five years. Both bonds are anticipated to
have the same gross redemption yields, or yields to maturity, which are based on a
company's credit rating.
When deciding which bond to invest in, ThinkTank Co. views the bond's tenure as a
crucial consideration.
Required:
(a) Determine the Macaulay duration of the two bonds ThinkTank Co is considering
for investment.
(9
marks)
(b) Discuss the usefulness of duration as a measure of the sensitivity of a bond price
to changes in interest rates.
(8 marks)
(c) Industry risk, earnings protection, financial flexibility, and management
assessment are some of the factors that credit agencies consider when determining a
company's credit rating.
Briefly explain each criterion and suggest factors that could be used to assess it.
(8 marks)
(25 marks)
QUESTION 2
Volleyball Co is a UK-based company which has the following expected transactions..
One month:
Expected receipt of US$240 000
One month:
Expected payment of US$140 000
Three months:
Expected receipts of US$300 000
The finance manager has collected the following information:
Spot rate (US$ per £):
1.7820 ± 0.0002
One month forward rate (US$ per £):
1.7829 ± 0.0003
Three months forward rate (US$ per £):
1.7846 ± 0.0004
Money market rates for Headway Co:
Borrowing
Deposit
One year sterling interest rate:
4.9%
4.6
One year dollar interest rate:
5.4%
5.1
Assume that it is now 1 April.
Required:
a) Outline the differences between transaction risk, translation risk and economic
risk.
b) Explain how inflation rates can be used to forecast exchange rates.
(6 marks)
c) Calculate the expected sterling receipts in one month and in three months using
the forward market.
(3 marks)
d) Discuss how sterling currency futures contracts could be used to hedge the threemonth dollar receipt.
(5 marks)
Question 3
You are the Finance director of Symbiotic Engineering and expect that a bid to build a
new plant in Botswana may be accepted in three months time. If the contract is
accepted, an immediate capital spend of US$150million will be required in three
months and the company will receive a US$75million grant from the Botswana
Development Fund in nine months time. The current Pula/US$ exchange rate is Pula
0.6900 to the US$.
Three month and nine month Pula LIBOR is 2.76563 per cent and 3.05194 per cent
respectively. The three and nine month US$ LIBOR is 4.62313 per cent and 4.73031
per cent respectively. You have decided to hedge the exchange rate risk by the
purchase of Pula/US$ at-the-money options which have a contract size of 100 000
Pula. The monthly volatility of the Pula against US$ is 6.35 per cent. At the current
exchange rate, the project has a net present value of US$25 million at the company’s
cost of capital of 8.5 per cent.
The board of directors are concerned about the use of derivatives in managing the
firm’s treasury operations. They argue that the diversity of the firm’s interests in
South Africa, Namibia and Zambia means that such hedging transactions are
unnecessary.
Required:
(a) Prepare a memorandum, to be considered at the next board meeting, which
summarises the arguments for and against foreign currency risk hedging and
recommends a general policy concerning the hedging of foreign exchange risk.
[8 marks]
(b) Prepare a short report justifying your use of derivatives to minimise the firm’s
exposure to foreign exchange risk. Your report should contain:
(i) The likely option price for an at-the-money option, stating the circumstances in
which the option would be exercised. You should use the Black-Scholes model for
both transactions, adjusted on the basis that deposits generate rate of return of LIBOR.
[6 marks]
(ii) A summary of the issues the board should bear in mind when reviewing a hedging
proposal such as this, taking into account the limitations of the modelling methods
employed and the balance of risk to which the firm will still be exposed to when the
position is hedged.
[6 marks]
[Total 20 marks]