Revision 7 Answers
Revision 7 – Risk Management
Chapter 19 Foreign Exchange Risk
I.
Exchange Rate System and movement
1.
D
A weakening dollar implies, for example, an exchange rate that moves from,
say, $1:£1 to $2:£1. A UK exporter will therefore receive less £ sterling for
their $ revenue. However a UK company importing from the US will benefit
by way of a lower £ cost for any given $ price they need to pay for their
imports.
2.
A
As Pechora Co is invoiced in euros, it would not be exposed to currency risk.
As the euro strengthened against the US$, Kama Co would gain from the
currency movement.
3.
C
4.
A
A strengthening Euro means Euros are getting more expensive: they will cost
more dollars.
The exchange rate becomes €1 : $2.40 ($2 × 1.2)
The Euro receipt will be $1,000 / 2.4 = $416.67
5.
B
The spot rate for translating $ to € is 2.0000 + 0.003 = $2.003 / € – the worst
rate for someone
selling dollars. The dollar is at a premium so subtract the premium because the
exchange rate is to
the Euro so if the $ is strengthening then the Euro is weakening on the forward
market’. : $2.003 / € – $0.002 = $2.001 / €
The Euro receipt will be $2,000 / 2.001 = €999.50.
II.
Types of Foreign Currency Risk
6.
D
7.
A
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III. Causes of Exchange Rate Fluctuations
8.
D
By Interest Rate Parity:
F
1  10% / 4

1.4400 1  4% / 4
F  $1.4614
9.
A
Using interest rate parity, six-month forward rate = 20·00 x (1·07/1·03)0·5 =
20·39 Dinar per $
Alternatively, 20 x (1·035/1·015) = 20·39 Dinar per $
10.
D
By interest rate parity:
2.3540 1  6% / 4

2.3820
1 i / 4
i = 10.83%
11.
D
Inflation rates are not relevant to interest rate parity theory, they are relevant to
purchasing power parity theory.
12.
D
Purchasing power parity means the cost of identical goods in different
economies should be the same. If they aren’t the same, businesses will buy
from one location and sell to the other to make a profit, thus the interaction of
supply ad demand will bring the prices back into line. Any differences in
inflation between countries therefore creates supply and demand for
currencies that evens out the price differences inflation causes.
13.
IV.
C
Foreign Currency Risk Management
14.
C
15.
B
16.
C
Leading with the payment eliminates the foreign currency exposure by
removing the liability.
Borrowing short-term in euros to meet payment obligation in three months’
time matches assets and liabilities and provides cover against the exposure.
A forward exchange contract is a popular method of hedging against exposure.
17.
B
18.
C
19.
A
20.
D
Item 1 relates to economic exposure.
21.
A
The first two methods can be used to hedge against economic exposure. The
Statement 1 is incorrect. Matching receipts and payments can be used to
manage transaction risk. Statement 2 is correct.
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last two methods can be used to hedge against transaction exposure.
22.
B
All of the hedging methods are designed to hedge against transaction risk.
Hence, only the first pairing is correct.
23.
C
Statements 1 and 2 are true: As they are binding contracts, forward contracts
fix the rate to that rate noted in the contract. By the same token therefore they
are not flexible (statement 3 is false.) The contract contains named parties so
the contracts cannot be sold on to someone else (statement 4 is false).
24.
B
Statement 1: False: Futures contracts are subject to a brokerage fee only (for
example there is no spread on the rate) so are relatively cheap.
Statement 2: True: It is not possible to purchase futures contracts from every
currency to every other currency – there are only limited combinations
available.
Statement 3: False. Futures contracts can be ‘closed out’ so if, for example,
customers pay early or late, the timing of the futures hedge can accommodate
this.
Statement 4: True. Futures contracts are for standardised amounts so may not
match the size of the transaction being hedged precisely.
25.
C
Option C is correct. The company is selling euros and so the higher three
months forward rate applies.
Hence: Sterling receipts = 200,000/1·4897 = £134,255
26.
A
The forward rate is $1·5595 – $0·0025 = $1·5570
The amount received is: $500,000/$1·5570 = £321,130
Option B uses the lower spot figure and the lower premium figure in the
calculations.
The forward rate is $1·5535 – $0·0025 = $1·5510
The amount received is: $500,000/$1·5510 = £322,373
Option C uses the higher spot figure and the higher premium figure in the
calculations.
The forward rate is $1·5595 – $0·0030 = $1·5565
The amount received is: $500,000/$1·5565 = £321,234
Option D uses the lower spot figure and the higher premium figure in the
calculations
The forward rate is $1·5535 – $0·0030 = $1·5505
The amount received is: $500,000/$1·5505 = £322,477
27.
C
The annual borrowing rate for euros is 9% (that is, 3% for 4 months).
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The business will borrow:
€500,000/1·03 = €485,437
This will then be converted at the spot rate:
€485,437/1·4520 = £334,323
28.
C
Euro: 2,125,000/1·0071 = Euro2,110,019 (3 mths at 1/4 of 2·84%)
In £ = 2,110,019/1·2230 = £1,725,281
Total cost = £1,725,281 x 1·0143 = £1,749,953 (3 mths at 1/4 of 5·72%)
Other options:
A: Yearly rate: Euro 2,125,000/1·0284 = Euro 2,066,317; 2,066,317/1·2230 =
£1,689,548; 1,689,548 x 1·0572 = £1,786,190
B: Yearly rate and incorrect exchange rate: Euro 2,125,000/1·0284 = Euro
2,066,317; 2,066,317/1·2270 = £1,684,040; 1,684,040 x 1·0572 = £1,780,367
D: Quarter of yearly rate, but incorrect exchange rate: Euro 2,125,000/1·0071
= Euro 2,110,019; 2,110,019/1·2270 = £1,719,657; 1,719,656 x 1·0143 =
£1,744,248
Answer 1
(a)
The objectives of working capital management are profitability and liquidity. The
objective of profitability supports the primary financial management objective, which is
shareholder wealth maximisation. The objective of liquidity ensures that companies are
able to meet their liabilities as they fall due, and thus remain in business.
[1 mark]
However, funds held in the form of cash do not earn a return, while near-liquid assets
such as short-term investments earn only a small return. Meeting the objective of liquidity
will therefore conflict with the objective of profitability, which is met by investing over
the longer term in order to achieve higher returns.
Good working capital management therefore needs to achieve a balance between the
objectives of profitability and liquidity if shareholder wealth is to be maximised.
[2 marks]
(b)
Cost of current ordering policy of PKA Co
Ordering cost = €250 x (625,000/100,000) = €1,563 per year
Weekly demand = 625,000/50 = 12,500 units per week
Consumption during 2 weeks lead time = 12,500 x 2 = 25,000 units
Buffer stock = re-order level less usage during lead time = 35,000 – 25,000 = 10,000 units
Average stock held during the year = 10,000 + (100,000/2) = 60,000 units
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Holding cost = 60,000 x €0·50 = €30,000 per year
Total cost = ordering cost plus holding cost = €1,563 + €30,000 = €31,563 per year
[3 marks]
1/2
Economic order quantity = ((2 x 250 x 625,000)/0·5) = 25,000 units
Number of orders per year = 625,000/25,000 = 25 per year
Ordering cost = €250 x 25 = €6,250 per year
Holding cost (ignoring buffer stock) = €0·50 x (25,000/2) = €0·50 x 12,500 = €6,250 per year
Holding cost (including buffer stock) = €0·50 x (10,000 + 12,500) = €11,250 per year
Total cost of EOQ-based ordering policy = €6,250 + €11,250 = €17,500 per year
[3 marks]
Saving for PKA Co by using EOQ-based ordering policy = €31,563 – €17,500 = €14,063 per
year.
[1 mark]
(c)
The information gathered by the Financial Manager of PKA Co indicates that two areas of
concern in the management of domestic accounts receivable are the increasing level of bad
debts as a percentage of credit sales and the excessive credit period being taken by credit
customers.
Reducing bad debts
1.
The incidence of bad debts, which has increased from 5% to 8% of credit sales in the
last year, can be reduced by assessing the creditworthiness of new customers before
offering them credit and PKA Co needs to introduce a policy detailing how this should
be done, or review its existing policy, if it has one, since it is clearly not working very
well.
2.
In order to do this, information about the solvency, character and credit history of
new clients is needed. This information can come from a variety of sources, such as
bank references, trade references and credit reports from credit reference agencies.
Whether credit is offered to the new customer and the terms of the credit offered can
then be based on an explicit and informed assessment of default risk.
[3 – 4 marks]
Reduction of average accounts receivable period
1.
Customers have taken an average of 75 days credit over the last year rather than the 30
days offered by PKA Co, i.e. more than twice the agreed credit period. As a result, PKA
Co will be incurring a substantial opportunity cost, either from the additional
interest cost on the short-term financing of accounts receivable or from the
incremental profit lost by not investing the additional finance tied up by the longer
average accounts receivable period. PKA Co needs to find ways to encourage accounts
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receivable to be settled closer to the agreed date.
2.
Assuming that the credit period offered by PKA Co is in line with that of its
competitors, the company should determine whether they too are suffering from
similar difficulties with late payers. If they are not, PKA Co should determine in what
way its own terms differ from those of its competitors and consider whether offering
the same trade terms would have an impact on its accounts receivable. For example, its
competitors may offer a discount for early settlement while PKA Co does not and
introducing a discount may achieve the desired reduction in the average accounts
receivable period.
3.
If its competitors are experiencing a similar accounts receivable problem, PKA Co
could take the initiative by introducing more favourable early settlement terms
and perhaps generate increased business as well as reducing the average accounts
receivable period.
4.
PKA Co should also investigate the efficiency with which accounts receivable are
managed. Are statements sent regularly to customers? Is an aged accounts receivable
analysis produced at the end of each month? Are outstanding accounts receivable
contacted regularly to encourage payment? Is credit denied to any overdue accounts
seeking further business? Is interest charged on overdue accounts? These are all matters
that could be included by PKA Co in a revised policy on accounts receivable
management.
[3 – 4 marks]
(d)
Money market hedge
PKA Co should place sufficient dollars on deposit now so that, with accumulated interest, the
six-month liability of $250,000 can be met. Since the company has no surplus cash at the
present time, the cost of these dollars must be met by a short-term euro loan.
Six-month dollar deposit rate = 3·5/2 = 1·75%
Current spot selling rate = 1·998 – 0·002 = $1·996 per euro
Six-month euro borrowing rate = 6·1/2 = 3·05%
Dollars deposited now = 250,000/1·0175 = $245,700
Cost of these dollars at spot = 245,700/1·996 = 123,096 euros
Euro value of loan in six months’ time = 123,096 x 1·0305 = 126,850 euros
[3 marks]
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Forward market hedge
Six months forward selling rate = 1·979 – 0·004 = $1·975 per euro
Euro cost using forward market hedge = 250,000/1·975 = 126,582 euros
[2 marks]
Lead payment
Since the dollar is appreciating against the euro, a lead payment may be worthwhile.
Euro cost now = 250,000/1·996 = 125,251 euros
This cost must be met by a short-term loan at a six-month interest rate of 3·05%
Euro value of loan in six months’ time = 125,251 x 1·0305 = 129,071 euros
[2 marks]
Evaluation of hedges
The relative costs of the three hedges can be compared since they have been referenced to the
same point in time, i.e. six months in the future. The most expensive hedge is the lead
payment, while the cheapest is the forward market hedge. Using the forward market to
hedge the account payable currency risk can therefore be recommended.
[1 mark]
Answer 2
(a)
Movements in exchange rates can be related to changes in interest rates and to changes in
inflation rates. The relationship between exchange rates and interest rates is called interest
rate parity, while the relationship between exchange rates and inflation rates is called
purchasing power parity.
Explanation of interest rate parity

Interest rate parity holds that the relationship between the spot exchange rate and
the forward exchange rate between two currencies can be linked to the relative
nominal interest rates of the two countries.

The forward rate can be found by multiplying the spot rate by the ratio of the
interest rates of the two countries. The currency of the country with the higher

nominal interest rate will be forecast to weaken against the currency of the country
with the lower nominal interest rate.
Both the spot rate and the forward rate are available in the current foreign exchange
market, and the forward rate can be guaranteed by using a forward contract.
[2 – 3 marks]
Explanation of purchasing power parity

Purchasing power parity holds that the current spot exchange rate and the future
spot exchange rate between two currencies can be linked to the relative inflation
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rates of the two countries. The future spot rate is the spot rate that occurs at the end of
a given period of time.

The currency of the country with the higher inflation rate will be forecast to weaken
against the currency of the country with the lower inflation rate. Purchasing power
parity is based on the law of one price, which suggests that, in equilibrium, identical
goods should sell for the same price in different countries, allowing for the exchange
rate.

Purchasing power parity holds in the longer term rather than the shorter term and
so is often used to provide long-term forecasts of exchange rate movements, for
example for use in investment appraisal.
[2 – 3 marks]
(b)
The costs of the two exchange rate hedges need to be compared at the same point in time, e.g.
in six months’ time.
Forward market hedge
Interest payment = 5,000,000 pesos
Six-month forward rate for buying pesos = 12·805 pesos per $
Dollar cost of peso interest using forward market = 5,000,000/12·805 = $390,472
[1 mark]
Money market hedge
ZPS Co has a 5 million peso liability in six months and so needs to create a 5 million peso
asset at the same point in time. The six-month peso deposit rate is 7·5%/2 = 3·75%.
[1 mark]
The quantity of pesos to be deposited now is therefore 5,000,000/1·0375 = 4,819,277 pesos.
The quantity of dollars needed to purchase these pesos is 4,819,277/12·500 = $385,542 and
ZPS Co would borrow this quantity of dollars now.
[1 mark]
The six-month dollar borrowing rate = 4·5%/2 = 2·25% and so in six months’ time the debt
will be 385,542 x 1·0225 = $394,217. This is the dollar cost of the peso interest using a
money market hedge.
[2 marks]
Comparing the $390,472 cost of the forward market hedge with the $394,217 cost using a
money market hedge, it is clear that the forward market should be used to hedge the peso
interest payment as it is cheaper by $3,745.
[1 mark]
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V.
Foreign Currency Derivative
29.
C
30.
D
The correct answer is Option D as both statements are incorrect. The investor
described in Statement 1 is engaged in arbitrage transactions and not hedging.
Preference shares are primary financial instruments and are not derivatives.
31.
D
Futures contracts are standardised and can be traded on a futures exchange,
whereas forward contracts are tailored to the buyer’s requirements and cannot
be traded in this way.
32.
C
Statement 2 is correct. Statement 1 is incorrect. Futures contracts are
standardised.
33.
C
Future contracts are standardised and can be sold on an exchange. A short
position can be sold by buying contracts, a long position can be closed by
selling contracts.
34.
D
Both statements are incorrect. European options are exercised at a specific
date. An in-the-money option has a more favourable strike price to the option
holder.
35.
A
Both statements are correct. [The intrinsic value of a call option is the higher
of (i) the market price of the underlying item minus the exercise price and (ii)
zero)].
36.
B
Statements 1 and 3 are correct. Statement 2 is incorrect. A European-style
option can only be exercised on the expiry date of the option. Statement 4 is
also incorrect. Employee share options are a form of call option.
37.
B
A put option gives the holder the right to sell currency
38.
A
(1) The investor can buy the shares at 860p compared to a market price of
880p. The option should therefore be exercised.
(2) The investor can sell the £600,000 for €900,000 compared to €870,000 on
the spot market. The option should therefore be exercised.
39.
C
The put option would be exercised. As the strike price is lower than the spot
rate, it would be better to sell dollars at this lower rate.
The call option should be allowed to lapse. As the market price is below the
strike price, it would be better to buy the shares at the market price.
40.
A
The US company needs to buy £s to make the payment. It should therefore
buy sterling futures now and then close its position in three months’ time by
selling sterling futures. The US company needs to buy £s to pay the supplier
and so a sterling call option is required.
41.
A
Option A is correct as it offers the business the opportunity to sell euros that
will be received in the future at a predetermined rate.
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Option B is inappropriate as it involves buying euros in the future. It would be
appropriate if payment in euros was required.
Option C does not hedge against currency movements.
Option D would be appropriate if payment in euros was required.
42.
A
The Farland business will want to sell the US $ when they receive them which
implies either a US$ put (sell) option purchased in Farland, or a Splot call
(buy) option purchased in America. In this second alternative payment would
be in US$, effectively giving up US$ in return for Splot.
43.
C
The company needs to buy sterling with US dollars in two months’ time. It
must, therefore, buy sterling futures now and then sell them in two months’
time thereby closing its position. The company will need to buy sterling call
options now.
44.
C
In two months’ time, the euros must be sold for dollars. Hence, the company
should sell euro futures now and buy them in two months’ time.
45.
A
Forward contracts and swaps cannot be traded on an organised exchange.
46.
B
The first statement is correct. However, futures contracts are standardised.
Answer 3
(a)
1.
Pecking order theory suggests that companies have a preferred order in which they
seek to raise finance, beginning with retained earnings. The advantages of using
retained earnings are that issue costs are avoided by using them, the decision to use
them can be made without reference to a third party, and using them does not bring
additional obligations to consider the needs of finance providers.
2.
Once available retained earnings have been allocated to appropriate uses within a
company, its next preference will be for debt. One reason for choosing to finance a new
investment by an issue of debt finance, therefore, is that insufficient retained earnings
are available and the investing company prefers issuing debt finance to issuing
equity finance.
3.
4.
Debt finance may also be preferred when a company has not yet reached its optimal
capital structure and it is mainly financed by equity, which is expensive compared to
debt. Issuing debt here will lead to a reduction in the WACC and hence an increase
in the market value of the company.
One reason why debt is cheaper than equity is that debt is higher in the creditor
hierarchy than equity, since ordinary shareholders are paid out last in the event of
liquidation.
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5.
Debt is even cheaper if it is secured on assets of the company. The cost of debt is
reduced even further by the tax efficiency of debt, since interest payments are an
allowable deduction in arriving at taxable profit.
6.
Debt finance may be preferred where the maturity of the debt can be matched to
the expected life of the investment project. Equity finance is permanent finance and
so may be preferred for investment projects with long lives.
[7 marks]
(b)
Annual interest paid per foreign bond = 500 x 0·061 = 30·5 pesos
Redemption value of each foreign bond = 500 pesos
Cost of debt of peso-denominated bonds = 7% per year
Market value of each foreign bond = (30·5 x 4·100) + (500 x 0·713) = 481·55 pesos
[3 marks]
Current total market value of foreign bonds = 16m x (481·55/500) = 15,409,600 pesos
[1 mark]
(c)(i)
Interest payment in one year’s time = 16m x 0·061 = 976,000 pesos
Explanation of market hedge
A money market hedge would involve placing on deposit an amount of pesos that, with added
interest, would be sufficient to pay the peso-denominated interest in one year. Because the
interest on the peso-denominated deposit is guaranteed, Boluje Co would be protected against
any unexpected or adverse exchange rate movements prior to the interest payment being
made.
[2 marks]
Illustration of money market hedge
Peso deposit required = 976,000/ 1·05 = 929,524 pesos
Dollar equivalent at spot = 929,524/ 6 = $154,921
Dollar cost in one year’s time = 154,921 x 1·04 = $161,118
[2 marks]
(c)(ii)
Cost of forward market hedge = 976,000/6·07 = $160,790
The forward market hedge is slightly cheaper
[2 marks]
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(d)
1.
Boluje receives peso income from its export sales and makes annual peso-denominated
interest payments to bond-holders. It could consider opening a peso account in the
overseas country and using this as a natural hedge against peso exchange rate risk.
2.
[1 – 2 marks]
Boluje Co could consider using lead payments to settle foreign currency liabilities.
This would not be beneficial as far as peso denominated liabilities are concerned, as the
peso is depreciating against the dollar. It is inadvisable to lag payments to foreign
suppliers, since this would breach sales agreements and lead to loss of goodwill.
Foreign currency derivatives available to Boluje Co could include currency futures, currency
options and currency swaps.
3.







Currency futures
Currency futures are standardised contracts for the purchase or sale of a specified
quantity of a foreign currency.
These contracts are settled on a quarterly cycle, but a futures position can be closed
out any time by undertaking the opposite transaction to the one that opened the futures
position.
Currency futures provide a hedge that theoretically eliminates both upside and
downside risk by effectively locking the holder into a given exchange rate, since
any gains in the currency futures market are offset by exchange rate losses in the
cash market, and vice versa.
In practice however, movements in the two markets are not perfectly correlated and
basis risk exists if maturities are not perfectly matched.
Imperfect hedges can also arise if the standardised size of currency futures does not
match the exchange rate exposure of the hedging company.
Initial margin must be provided when a currency futures position is opened and
variation margin may also be subsequently required.
Boluje Co could use currency futures to hedge both its regular foreign currency receipts
and its annual interest payment.
4.


Currency options
Currency options give holders the right, but not the obligation, to buy or sell foreign
currency.
Over-the-counter (OTC) currency options are tailored to individual client needs,
while exchange-traded currency options are standardised in the same way as
currency futures in terms of exchange rate, amount of currency, exercise date and
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settlement cycle.



5.




An advantage of currency options over currency futures is that currency options do
not need to be exercised if it is disadvantageous for the holder to do so.
Holders of currency options can take advantage of favourable exchange rate
movements in the cash market and allow their options to lapse.
The initial fee paid for the options will still have been incurred, however.
Currency swaps
Currency swaps are appropriate for hedging exchange rate risk over a longer period
of time than currency futures or currency options.
A currency swap is an interest rate swap where the debt positions of the
counterparties and the associated interest payments are in different currencies.
A currency swap begins with an exchange of principal, although this may be a
notional exchange rather than a physical exchange.
During the life of the swap agreement, the counterparties undertake to service each
others’ foreign currency interest payments. At the end of the swap, the initial
exchange of principal is reversed.
[6 – 7 marks]
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Chapter 20 Interest Rate Risk
1.
B
‘A’ describes gap exposure. C and D is interest rate risk but not specifically
basis risk.
2.
A
Gap exposure occurs when interest rates on deposits and on loans move at
different times. The fact that the company has benefitted in this instance
means the rates have moved favourably.
3.
D
Expectations theory: The shape of the curve reflects market expectations
about future interest rate movements.
Liquidity preference theory explains why the curve is generally upward
sloping – implying a higher periodic rate of return is required to compensate
for money being tied up for longer with longer term debt.
Market segmentation theory explains why the curve may be kinked or even
discontinuous as different investors (with different risk appetites) invest in
different types of debt. For example, many banks will invest in short dated
bonds, but pension funds are more likely to invest in long dated ones. The
differences in the investor risk/return preferences are reflected through
changes in the shape and steepness of the curve in places.
4.
B
5.
C
6.
B
7.
Company borrows at LIBOR + 45 b.p.
Borrowing fixed at 5.70% + 45 b.p.
%
5.95
6.15
Compensation payment to FRA bank
0.20
Company borrows at LIBOR + 60 b.p.
Borrowing fixed at 6.65% + 60 b.p.
%
7.00
7.25
Compensation payment to FRA bank
0.25
B
Option A uses the 3 v 6 bid figure as the relevant FRA rate:
%
Company borrows at LIBOR + 60 b.p.
7.00
Borrowing fixed at 6.60% + 60 b.p.
7.20
Compensation payment to FRA bank
0.20
Option C assumes that the borrowing rate is fixed at the FRA figure (6.65%)
%
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Company borrows at LIBOR + 60 b.p.
7.00
Borrowing fixed at 6.65%
6.65
Compensation received from FRA bank
0.35
Option D uses the 3 v 9 offer figure as the relevant FRA rate:
%
Company borrows at LIBOR + 60 b.p.
7.00
Borrowing fixed at 6.61%
6.61
Compensation received from FRA bank
8.
C
0.39
Need a FRA based on 2 v 5, and bid or borrowing rate, i.e. 3·37%, add 0·65%
to give 4·02%.
The other choices are the other three LIBOR rates plus 0·65%.
9.
C
An interest rate cap is a series of borrowers’ options on a notional loan.
An American-style option may be exercised before the expiry date.
10.
B
The first statement is true. The second statement is false and describes an
American-style option. A European-style option gives the right to buy or sell
at the expiry date.
11.
C
12.
D
Statement 1: Options don’t have to be exercised so if an option would
otherwise yield a loss, it can be abandoned.
Statement 2: As the question refers to exchange traded options this is true.
Over-the-counter options however cannot be traded.
Statement 3: Sizeable premiums are payable for the ability to abandon
options that aren’t in the investor’s favour.
Statement 4: Exchange traded options are standardised contracts so are for
standard sized loans/deposits. They aren’t tailored to an investor’s particular
amounts or dates. In comparison, over-the-counter options are tailored.
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Answer 4
(a)
Financial analysis
Fixed interest debt proportion (2006) = 100 x 2,425/ 2,425 + 1,600) = 60%
Fixed interest debt proportion (2007) = 100 x 2,425/(2,425 + 3,225) = 43%
Fixed interest payments = 2,425 x 0·08 = $194,000
Variable interest payments (2006) = 274 – 194 = $80,000 or 29%
Variable interest payments (2007) = 355 – 194 = $161,000 or 45%
(Alternatively, considering the overdraft amounts and the average variable overdraft interest
rate of 5% per year:
Variable interest payments (2006) = 1·6m x 0·05 = $80,000 or 29%
Variable interest payments (2007) = 3·225m x 0·05 = $161,250 or 45%)
Interest coverage ratio (2006) = 2,939/ 274 = 10·7 times
Interest coverage ratio (2007) = 2,992/ 355 = 8·4 times
Debt/equity ratio (2006) = 100 x 2,425/ 11,325 = 21%
Debt/equity ratio (2007) = 100 x 2,425/ 12,432 = 20%
Total debt/equity ratio (2006) = 100 x (2,425 +1,600)/ 11,325 = 35%
Total debt/equity ratio (2007) = 100 x (2,425 +3,225)/ 12,432 = 45%
[1 – 2 marks]
Discussion of effects of interest rate increase:
1.
Gorwa Co has both fixed interest debt and variable interest rate debt amongst its
sources of finance. The fixed interest bonds have ten years to go before they need to
be redeemed and they therefore offer Gorwa Co long term protection against an
increase in interest rates.
2.
3.
4.
5.
6.
In 2006, 60% of the company’s debt was fixed interest in nature, but in 2007 this had
fallen to 43%.
The floating-rate proportion of the company’s debt therefore increased from 40% in
2006 to 57% in 2007.
The interest coverage ratio fell from 10·7 times in 2006 to 8·4 times in 2007, a decrease
which will be a cause for concern to the company if it were to continue.
The debt/equity ratio (including the overdraft due to its size) increased over the same
period from 35% to 45% (if the overdraft is excluded, the debt/equity ratio declines
slightly from 21% to 20%).
From the perspective of an increase in interest rates, the financial risk of Gorwa Co
has increased and may continue to increase if the company does not take action to halt
the growth of its variable interest rate overdraft. The proportion of interest payments
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Revision 7 Answers
linked to floating rate debt has increased from 29% in 2006 to 45% in 2007. An
increase in interest rates will further reduce profit before taxation, which is lower
in 2007 than in 2006, despite a 40% increase in turnover.
[3 – 4 marks]
Interest rate hedging:
1.
One way to hedge against an increase in interest rates is to exchange some or all of the
variable-rate overdraft into long-term fixed-rate debt. There is likely to be an
increase in interest payments because long-term debt is usually more expensive than
short-term debt. Gorwa would also be unable to benefit from falling interest rates if
most of its debt paid fixed rather than floating rate interest.
2.
Interest rate options and interest rate futures may be of use in the short term,
depending on the company’s plans to deal with its increasing overdraft.
3.
For the longer term, Gorwa Co could consider raising a variable-rate bank loan,
linked to a variable rate-fixed interest rate swap.
[2 – 3 marks]
Answer 5
A derivative is an asset whose performance is based on the behavior of an underlying
asset (commonly called underlyings, for example, shares, bonds, commodities, currencies,
exchange rates). Derivative instruments include options, forward contracts, futures, forward
rate agreements and swaps. Hedging protects assets against unfavourable movements in
the underlying while retaining the ability to benefit from favourable movements. The
instruments bought as a hedge tend to have opposite-value movements to the underlying and
are used to transfer risk.
Exchanged traded derivatives have lower credit risk, higher regulation, higher liquidity
and the ability to reverse positions. However, they are not always flexible.
OTC derivatives are tailor made to allow perfect hedging but do suffer from low
regulation, high credit risk and the inability to reverse a hedge.
Forward contract
 A forward contract is an agreement to undertake an exchange at a future date at a
set price. This minimizes the uncertainty of price fluctuations for both parties.
 Unlike option, both parties are committed to complete the transaction.
 The main forward markets are for foreign exchange.
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Revision 7 Answers
Forward rate agreement (FRA)
 FRA is used for hedging interest rate risk. They are agreements about the future level
of interest rates, and compensation is paid based on the difference between the rate of
interest at a predetermined time and the level when the FRA was established.


A cap is a hedging technique used to cover interest rate risk on long term borrowing,
by which a borrower can benefit from interest rate falls but can limit exposure if
interest rates rise. Cap compensates the purchaser if market interest rates rise above an
agreed level.
Floor compensates the purchaser should interest rates fall below an agreed level. Interest
rate collar has both a cap and a floor.
Swap
 A swap is an exchange of payment obligations to reduce exposure to interest rate
changes, particularly over the longer term where a swap can run the lifetime of a loan.
 The swap could be an interest rate swap (for example between fixed and floating rate
obligations) or currency swap where interest payments are in different currencies.
 Swaps reduce exposure to rising interest rates, enable the matching of interest rate
assets with debts, and enable lower overall interest rates to be achieved when
markets fluctuate.
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