Question

Question 3 Part A Malfoy plc is a UK company that expects to receive $3,600,000 from a US customer in three months' time. Due to the size of the receipt, the company plans to minimise the risk of an adverse exchange rate movement through the use of a money market hede The following data regarding annual interest rates and the current spot rate is available US dollar (USD) British pound (GBP) 12 Month Borrowing 2.750 3.755 12 Month Lending 2.625 3.575 Spot rate (US$/£) Required (a) Construct a money market hedge based on the information provided and calculate the expected receipt in GBP (£), and the effective $/£ forward rate. (7 marks) (b) Discuss two other methods of managing exchange rate risk and suggest scenarios in which they might be used. (5 marks) Part B Granger plc (Granger) is highly geared and is keen to manage its exposure to interest rate risk. A large portion of the company's borrowings is floating rate debt at LIBOR + 3% and Granger is considering hedging the interest rate to minimise risk. Granger's bank has offered the following hedging options: • • A forward rate agreement (FRA) at 4% interest A cap at 4% interest. There will be a premium cost of 1% per year for the cap The bank is prepared to buy a floor from Granger at 3.85% interest for a premium of 0.75% per annum. Assume that LIBOR is currently 0.75% but is expected to move to 1.25% Shortly Question continued overleaf ACF300 Page 5 of 8

Answer 1

PART A.

3 months US borrowing interest =(2.750*(3/12))%=0.6875%

Present Value of receivable of $3600000 at 0.6875% interest rate =3600000/(1+0.006875)=$3,575,419

Borrow $3,575,419 for 3 months at annual borrowing rate of 2.750%

Convert at spot rate to GBP

Spot rate =(1.3015+1.3035)/2=1.3025 USD/GBP

Amount of GBP received =3575419/1.3025=2,745,043 GBP

Invest 2745043 GBP at British Lending Rate of 3.575%

3 months interest =3.575/4=0.89375%

Expected receipt in GBP=2745043*(1+0.0089375)=2,769,577

Amount to be received at end of 3 months =GBP 2,769,577

The Loan in USD will be repaid with interest from the $3600000 receivable

Effective Forward Rate :

$3600000 /GBP 2,769,577

$(3600000/2769577)/GBP

$1.2998/GBP

(b) Two other methods of managing exchange rate risk

1. Fix the rate through a 3 month forward contract to buy GBP for $3600000

The rate will be fixed today and the contract will be executed  after 3 months

2. Buy CALL option on GBP . If the rate goes up , there will be loss on spot , but this will be offset by gain in Call option