Financial Risk Management - Exchange Rate Risk - Interest Rate Risk Part 1: Exchange Rate Risk Bruce Engineering Plc has to pay its cost of design and planning work to a company not native to its own country, that is, to a French architectural company. This has exposed Bruce to risk that the exchange rate move against it. For example, what will happen if sterling weakens against Euro? Obviously, the customer (or Bruce, in our case) will have to pay more pounds to acquire same amount of Euros. As a result total cost of design and planning work will increase.
This risk could be eliminated by agreeing to pay in home currency, but this could be unacceptable to the supplier. Other risk mitigation techniques include using money market hedges, forwards or future contracts. Setting a Forward Market Rate Based on Interest Rates The company, Bruce Engineering Plc, may decide to use forward contract in order to hedge exchange rate risk associated with the project. For this the company may use a prevailing forward rate or it may predict and negotiate one for itself.
If the company wants to predict its own forward rate, it can base its calculation on the inflation rates (using Purchase Power Parity Theory), or on interest rates (using Interest Rate Parity Theory) of the two countries. We take the money market interest rates to predict the forward exchange rate. For June 2011 For September 2011 For December 2011 For March 2011 £ money market rate (0.99+0.79)/2=0.89 0.89/4=0.2225 (1.32+1.12)/2=1.22 1.22/2=0.61 (1.58+1.38)/2=1.48 1.48*3/4=1.11 (1.74+1.54)/2=1.64 € money market rate (1.28+1.08)/2=1.18 1.18/4=0.295 (1.59+1.44)/2=1.515 1.515/2=0.7575 (1.84+1.69)/2=1.765 1.765*3/4=1.32375 (2.01+1.71)/2=1.86 Spot rate £/€ (0.8670+0.8675)/2 =0.86725 0.86725 0.86725 0.86725 Forward rate £/€. 86725*. 2225/. 295 =0.6541 . 86725*. 61/. 7575 =0.6983 . 86725*1.11/1.32375 =0.7272 . 86725*1.64/1.86 =0.7647 So the forward rates to be chosen are £/€ 0.6541, £/€ 0.6983, £/€ 0.7272, £/€ 0.7647 for June 2011, September 2011, December 2011 and March 2011, respectively.
Future Contract The company can also use future contract to hedge this risk. The procedure to set up a future contract hedge is as follows: Step 1: Determine the type of transaction. We have to pay Euros at different times in future. We need Euros, this means that we have to buy currency futures dominated in Euros. Step 2: Determine the contracts to buy. As we need Euros in 3, 6, 9 and 12 months timing we need to buy contracts maturing in June 2011, September 2011, December 2011 and March 2011. Step 3: Determine the number of contracts.
Contract size is €100,000. We need €1.12m after every 3 months so we should buy 11 contracts (€1.12m/€100,000) for each of the three maturities. €20,000 will remain to exchange rate risk. Step 4: Contact exchange. Buy 11 June, September, December and March contracts at future prices of £ 0.8669/€, £ 0.8660/€, £ 0.8651/€ and £ 0.8640/€ respectively. Consequences of Adverse Exchange Rate Movement We suppose that tick size is £0.0001 or £10 per contract. If sterling weakens against € this means that if unhedged Bruce would have to bear additional cost of increased exchange rate but now the increased exchange rate would result in increased future prices.
Loss on purchase of Euros will cancel out gain on sale of futures (closing of future position) with net cost of payment remaining at original buy price of future. For example, if at 21 June 2011 spot rate move to £0.8685, cost of €1.1m will be as follows: Cost of €1.1m be €1.1m*0.8685= £ 955350 Gain on futures would be 16 ticks (8685-8669) or 16*11*£10= £ 1760 Net cost £ 955350-£ 1760= £ 953590 This is equal to purchasing value of futures (0.8669*1,100,000) Merits of Hedging If the bank offer fixed forward rates ‘over-the-counter’ that correspond to those calculated above the business should take the opportunity, as chances of devaluation of a currency never get eliminated, even when the Interest Rate Parity Theory suggest otherwise, as in this case. These hedges eliminate the risk of adverse movement in exchange rate.
Thus the company remain concerned only with the cash flow arising, whatever currency it is arising in. These hedges can be offered both over the counter and exchange traded.
Both offers have their own merits and demerits. Over the counter or OTC hedges are made to provide for an individual hedger’s specific needs. Hedger can tailor it according to the timing and amount of cash flow arising. While on the other hand exchange traded hedges are attractive because they are securer than OTC hedges, as they are backed by a fully regulated exchange. Moreover, exchange traded hedges are inexpensive in comparison with OTC because of low negotiations cost. Another benefit of exchange traded hedges is that they are more liquid than OTC because of their standardized form. Yet benefits of fulfilling specific needs sometime over-weigh cost of negotiations and lower marketability. Part 2: Zero Coupon Bond Prices Zero coupon bond prices can be calculated by discounting par value of the bonds (£100) to present value using zero coupon yields Zero coupon bond price 21 March 2011 £100/1.05352 = £94.92 21 March 2012 £100/1.03537 = £96.58 21 March 2013 £100/1.01753 = £98.28 One Year Forward Rate Forward rates can be calculated using zero coupon yield as base.
First year forward and open market interest rate is deemed to be equal i. e., 1.753% Second year forward rate can be calculated by accruing return for first and second year; FV1 = £100*(1.01753) = £ 101.753 FV2 = £ 100*(1.03537) = £ 103.537 Forward rate for year 2 = FV2/FV1 - 1 = 103.537/101.753 - 1 = 1.75% FV3 = £ 100*(1.05352) = £ 105.352 Forward rate for year 3 = FV3/FV2 - 1 = 105.352/103.537 - 1 = 1.75% Swap Rate We would take borrowing rate of Bruce Engineering plc as its cost of capital. Cash outflow in respect of interest payment is: £ 42m * 5.45% = £ 2,289,000 PV of floating coupon = £ 2,289,000* 2.837 = £ 6,493,033 Payment of interest under floating rate would be £ 6,493,033/ 2.847 = £ 2,280,658 or 5.43% Thus bank would enter into a swap by transferring basis risk to Bruce.
Floating rate accepted would be 5.47% Floating Rate for Bruce As calculated above bank would agree on floating rate of 5.47% for this period. This can be expressed as LIBOR + 3.72% for future calculations. If we compare this with the prevailing expected return we find it too excessive. From this information we conclude that Bruce should redeem these bonds and issue new ones.
But redemption cost of these bonds is another important cost to be considered. PV of interest payments using SWAP is £ 6,493,033 PV of interest payments of re-issued loans £42m £42,000,000*2.84%* 2.837= £3,383,721 Add: redemption cost £1,000,000 £4,383,721 As the interest cost of re-issued is less than interest cost of SWAP so Bruce should prefer re-issuing of debt. If Bruce converts to floating rate this means that the company has benefited from decrease in interest rates. But this is yet not certain that the rate will remain constant or they will decrease even more.
There is a possibility that the rate moves unfavorably. That is the rate my increase leaving the company with increased interest cost. Forward Rate Agreements If the bank is to receive floating rate on swap it is exposed to risk of decrease in interest. To ensure a fixed receipt of interest the bank may enter into a Forward Rate Agreement. For example, if it want to hedge interest rate risk for 21 March 2013 interest receipt it may sell12-24 FRA. Lets assume that a 12-24 FRA at 2.1-1.9 is agreed and that market interest rate is 1.7% at 21 March 2012. This means that at 21 March 2012 FRA is to be settled at 21 March 2012.
And the depositing rate is always the lowest. Consequences 2013 Interest receivable on loan £42m*1.7% = £ 714000 2012 FRA compensation Receivable £42m*(0.017-0.019) = £ 84000 Effective interest rate 1.9% £798000 So the interest received in swap agreement in example of Bruce plc is limited to 1.9% what ever the interest rate arise.