seminar5materials / P4AFM-RQB_PDF_d08 / P4AFM-RQB-As_d08

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 17 POLYTOT PLC

(a)

Possible currency hedges are a forward market hedge, currency futures hedge or currency options hedge.

Forward market hedge

The forward market hedge locks into a known exchange rate at the time the payment by the customer is made. It is a legally binding obligation.

A forward rate is required for four months’ time. This may be estimated by interpolating between the three month and one year forward rates.

1·5362 – 1·5140 = 0·0222 × 1/9 = 0·0025

The four month rate is 1·5362 – 0·0025 = 1·5337 1·5398 – 1·5178 = 0·220 × 1/9 = 0·0024

The four month rate is 1·5398 – 0·0024 = 1·5374

60% of the receipts will be in $US, i.e. the equivalent to 405m pesos.

At the official rate P405m98·20 = $4,124,236

Selling $ forward, $4,124,2361·5374 = £2,682,605

The balance of 270m pesos will be converted at 115% of the official rate

179·745270 = £1,502,128

Total expected receipts are £4,184,733.

Futures hedge

A futures hedge locks the transaction into an expected exchange rate. In this case December futures will need to be bought as the September contract will have expired by the date of the payment, 1 November.

Basis on the December contract is 1·5510 – 1·5275, or 2·35 cents. The expected basis on 1 November is 2/6 (the remaining period of the futures contract) × 2·35 cents, or 0·78 cents. The expected lock-in futures price, no matter what happens to actual spot rates, is 1·5275 + 0·0078 = $1·5353.

This is slightly better than the forward market rate.

However, basis on 1 November when the futures contract would be closed out (by buying an identical contract) might not be 0·78 cents, due to the existence of basis risk. A better or worse outcome than the expected lock-in rate is possible. The hedge is for $4,124,236

This will require 4,124,2361·5353 = £2,686,274 or 42·98 £62,500 contracts.

1041

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

43 contracts would be needed, a slight over hedge.

Futures contracts also require the payment of margin, a security deposit. Profit on futures contracts through favourable currency movement may be taken daily, but any losses will result in daily variation margin calls in order to keep the hedge open. The futures contract looks to offer a slightly better rate than the forward contract, but will involve more risks. The company must choose whether or not the expected extra return would compensate for these risks.

Currency options hedge

Currency options offer an advantage over both forwards and futures in that they not only protect against downside risk, they also allow the buyer of the option to take advantage of favourable currency movements by allowing the option to lapse. The price of this extra benefit is the option premium.

Given that the dollar is strengthening against the pound in the forward market, the currency option rates do not look very favourable. As Polytot wishes to exchange dollars for pounds, it will need to purchase December call options. Probably only the 1·5250 and 1·550 strike prices would be considered, as the other rates are far less favourable than the forward market.

86 contracts is $4,098,438 at 1·5250, leaving $25,798 over which could be sold forward at $1·5374/£ to yield £16,780.

85 contracts is $4,117,188 at 1·5500, leaving $7,048 over which could be sold forward to yield £4,584.

These outcomes are much worse than the forward or futures hedges, but if the dollar was to strengthen further, the options could be lapsed and the pounds purchased in November in the spot market. For example, in order for the 1·5250 option to become better than the forward market hedge the dollar would have to strengthen at least to approximately 1·5250 – (1·5250 – 1·5374 + 0·0335) or 1·5039/£.

The recommended hedge is either the forward market, (unless Polytot is happy with the extra risks of futures) or currency options at a probable strike price of 1·5250.

1042

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(b)

The proposed counter-trade needs to be compared with the 40% of expected receipts that are at 15% less than the official rate. Three million kilos at 50–60 pence per kilo gives receipts of between £1·5 and £1·8 million. This compares with £1,502,128 from the foreign exchange transaction. The price for the strawberries would need to be in excess of 50 pence per kilo. Other factors that would need to be considered in any counter-trade include:

How reliable is the supplier of the strawberries? Are they of suitable quality and could such a large quantity be supplied?

Strawberries are perishable and require specialised transportation. Who is responsible for the costs of transportation, insurance etc?

What additional administrative/organisational expense will the counter-trade involve?

What are the tax implications of a counter-trade in strawberries?

(c)Advantages of the Euromarkets include:

They are more flexible than many domestic markets and not subject to the same degree of control.

The cost of borrowing in the Euromarkets is often slightly less than for the same currency in relevant domestic capital markets.

Interest is normally payable gross, which is attractive to some investors.

Very large sums can be quickly raised, without the queuing process that exists in many domestic capital markets.

Issue costs are relatively low.

There is an active secondary market in many types of Euromarket security.

Eurobonds, in particular, offer the opportunity to swap interest payments into a more convenient form (e.g. fixed to floating rate), often at lower costs than borrowing directly.

Potential problems include:

The Grobbian company would either need to be rated highly by one of the international rating agencies in order to be able to access the markets, or it would probably be necessary for the company to offer a guarantee from its government in association with any issue.

Any Euromarket borrowing is likely to be in dollars or another hard currency. The company will need to convince the market that it has access to sufficient hard currency to fully service the interest and principal payments.

1043

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Answer 18 GALEPLUS PLC

(a)Advantages of currency swaps include:

They allow companies to undertake foreign currency hedging, often for longer periods than is possible with forwards.

They are usually cheaper than long term forwards, where such products exist.

Finance may be obtained at a cheaper rate than would be possible by borrowing directly in the relevant market. This occurs by taking advantage of arbitrage if a company has a relative funding advantage in one country.

They may provide access to finance in currencies that could not be borrowed directly, e.g. due to government restrictions, or lack of a credit rating in the overseas market.

Currency swaps offer the opportunity to restructure the company’s debt profile without physically redeeming debt or issuing new debt.

Currency swaps might be used to avoid a country’s exchange control restrictions.

Potential problems include:

If the swap is directly with a corporate counterparty the potential default risk of the counterparty must be considered. Swaps arranged with a bank as the direct counterparty tend to be much less risky.

Political or sovereign risk, the possibility that a government will introduce restrictions that interfere with the performance of the swap.

Basis risk. With a floating to floating swap basis risk might exist if the two floating rates are not pegged to the same index.

Exchange rate risk. The swap may result in a worse outcome than would have occurred if no swap had been arranged.

(b)

(i)Interest rate differentials:

The overall arbitrage opportunity from using a currency swap is 2·55% per year. Banks fees are 0·75% per year leaving 1·8%. 75% of 1·8% is 1·35% that would be the benefit per year to Galeplus in terms of interest saving from using a currency swap.

1044

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(c)

(i)

A swaption is an option on a swap. It allows the buyer to choose whether or not to undertake the swap, depending upon exchange rates in three years time. The swap rate in this example is the current spot rate of 85.40 rubbits/£. A swaption at this exercise price would offer no benefit to Galeplus relative to the straight swap unless the rubbit were to strengthen relative to 85·40/£, in which case the swap would not be used as the end of year 3 spot rate would be more favourable to Galeplus. Given the relative inflation rates in the UK and Perdia, according to the purchasing power parity theory it is very unlikely that the rubbit will strengthen relative to the pound. The use of a swaption is not recommended.

(ii)

The currency put option will limit the downside risk of the year 3 cash flows whilst allowing Galeplus to take advantage of favourable exchange rate movements. Using the worst case exchange rate forecasts, the option would be exercised at the end of year 3.

Discounted cash flows (million rubbits)

Using the best case exchange rate forecasts, the option would not be exercised at the end of year three as the expected spot exchange rate at that time is more favourable.

Discounted cash flows (million rubbits)

In both cases the outcome from the put option is very poor. The end of year 3 exchange rate of the rubbit would have to be much stronger than 160/£ in order for the option to be the preferred hedge. The rate would have to move to approximately 108 rubbits/£, which is unlikely. Unless Galeplus is prepared to take the risk of this happening the use of currency options is not recommended.

1046

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 19 MJY PLC

From a group perspective a sensible hedging strategy would be to net off as many offsetting currency receipts and payments as possible, and to only hedge the relevant net amounts.

As MJY is a UK based multinational, the payments and receipts in pounds are not exposed to currency risk and should be ignored.

All $ and € receipts and payments within the group and with third party companies are relevant when estimating the group currency exposure. In the case of intragroup trade, a receipt for one company is a payment for another.

From a group view, relevant $ receipts are: 90 + 50 + 40 + 20 + 30 = 230 $ payments are: 170 + 120 + 50 = 340

$110,000 net payments need to be hedged

€receipts are: 75 + 85 + 72 + 20 + 52 + 35 = 339

€payments are: 72 + 35+ 50 + 20 + 65 = 242

€97,000 net receipts need to be hedged

Forward market hedges:

Buy $ 3 months forward: $1·7835110,000 = £61,676

Sell € 3 months forward: 1·439097,000 = £67,408

Currency options:

It is now 31 December. The time of the transactions is 31 March. As the February options will have expired, May options should be used. Pounds need to be sold to purchase dollars, therefore MJY will need to purchase put options. The dollar payment is $110,000, which is the equivalent of approximately one £62,500 option contract.

Option hedge

Worse case outcomes using currency options: 1·80:62,500 + 1,856 – 1,400 = £62,956 1·78:62,500 + 1,460 – 700 = £63,260

These are both much worse than the forward hedge, but if the dollar was to weaken to more than the relevant strike price, the option could be lapsed, and the necessary $110,000 purchased in the spot market at a more favourable exchange rate.

For a relatively small hedge of this nature a multinational company would probably use a forward contract as it involves less administrative time and costs, and fixes the payment of £61,676.

1047

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Answer 20 LAMMER PLC

(a)Report on possible hedging strategies for the foreign exchange exposure in five months’ time

Only relevant net dollar exposures should be hedged. Net dollar imports in five months time are $1,150,000. This is the amount to be hedged. The transactions in sterling are not exposed and should not be hedged. The exposure may be hedged using the forward foreign exchange market, a money market hedge, currency futures hedge or currency options hedge. A combination of these hedges is also possible, or alternatively a partial hedge may be selected that protects only part of the exposure.

Forward market hedge:

No five month forward rate is given. The rate may be interpolated from the three month and one year rates for buying dollars.

The estimated five month forward rate is: 1·9066 × 79 + 1·8901 × 92 = 1·9029

Hedging with a forward contact will fix the £ payment at:

$1,150,0001·9029 = £604,341

Money market hedge:

In order to protect against any future strengthening of the dollar, Lammer could borrow £ now and convert £ into dollars to ensure that the company is not exposed if there are changes in the $/£ exchange rate.

Borrow £595,373 at 5·5% per annum for five months, total cost £609,017 Convert into $ at the spot rate of $1·9156/£ to yield $1,140,496

Invest in the USA at 2·0% per annum to yield a total of $1,150,000 which will be used to make payment for the imports.

($1,140,496 × 1·008333 = $1,150,000)

A money market hedge is more expensive than the forward hedge.

Currency futures hedge:

The currency exposure is in five months’ time. To protect against the risk of the dollar strengthening December futures should be sold.

The basis is 1·9156 – 1·8986 = 1·7 cents. This relates to a futures contract maturing in seven months’ time.

The expected basis in five months’ time is 1·7 × 72 = 0·486 cents

The expected lock-in futures rate may be estimated by:

1·8986 + 0·00486 = 1·9035

1048

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(b)Estimated effect on value:

The strengthening of the dollar is expected to reduce the present value of cash flows, and, if the market is efficient, the market value of Lammer, by £727,370.

(c)

Economic exposure relates to the change in the value of a company as a result of unexpected changes in exchange rates. Unless there are known contractual future cash flows it is difficult to hedge economic exposure using options, swaps, or other financial hedges as the amount of the exposure is unknown.

Economic exposure is normally managed by internationally diversifying activities, and organising activities to allow flexibility to vary the location of production, the supply sources of raw materials and components, and international financing, in response to changes in exchange rates.

To some extent multinational companies may offset economic exposure by arranging natural hedges, for example by borrowing funds in the USA, and then servicing the interest payments and the repayment of principal on the borrowing with cash flows generated by subsidiaries in the USA.

Marketing strategies may also be used to offset the effects of economic exposure. For example if UK products were to become relatively expensive in the USA due to a fall in the value of the dollar, a UK company might adopt an intensive marketing campaign to create a better brand or quality image for its products.

1050