Question Tag: Hedging

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  • 10 Marks

SCS – Nov 2024 – L3 – Q4c – Forward Rate Agreement for Interest Rate Risk Management

Calculation of settlement amount for FRA under different Ghana Reference Rate (GRR) scenarios.

The company has decided to use a Forward Rate Agreement (FRA) to manage its interest rate risk likely to arise from the short-term loan of GH¢15 million it intends to borrow in three months for a period of six months.

Required:

i) What is the purpose for a company to enter into an FRA arrangement? (2 marks)

ii) Calculate the amount of money that will be paid to settle the FRA at the beginning of the FRA period if, at the end of month 3, when the FRA becomes effective, the six-month Ghana Reference Rate (GRR) is as follows:

a) 37.50%
b) 28.50%

In each case, clearly state the party (i.e. FRA buyer or FRA seller) responsible for making the payment.

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  • 12 Marks

FM -NOV 2024 – L2 – Q3a – Foreign Exchange Risk Management

Explaining foreign exchange risk types and calculating the impact of forward contract hedging.

a) Dadisen PLC manufactures and sells pharmaceutical products in Ghana. It imports a significant portion of its pharmaceutical inputs from the USA. However, it only sells its products in Ghana. The company is considering establishing its foothold in The Gambia, Liberia, and Sierra Leone markets.

i) Dadisen PLC reports its results in its home currency. It pays for its purchases from the USA in US dollars but receives payments for its sales in Ghana cedis. All sales from Gambia, Liberia, and Sierra Leone are expected to be transferred into US dollar accounts each week. On average, the company generally takes 90 days to pay its suppliers and receives payment from its debtors within 60 days. In paying its suppliers, the company relies on bank overdrafts at an annual rate of 10%.

Over the last few years, the company has found that sales have been quite predictable, and it has been possible to plan sales levels and purchases of goods in advance. However, the company does not have adequate management skills for its foreign currency exposure. As a result, the company has reported exchange rate losses since 2020. The company is currently considering whether the forex exposure could be better managed.

Required:

Describe the following types of foreign currency exposure, giving examples of how they could impact the financial statements of Dadisen PLC:

  • Transaction risk
  • Translation risk
  • Economic risk

ii) The company estimates that it will need to borrow $1 million in three months’ time for a period of six months but is concerned about expected fluctuations in the exchange rate. The company is considering hedging this exposure using a currency forward contract. The company’s banker, GCB, has agreed to sell the US dollar forward for 9 months at GH¢17 to the dollar.

Required:
Compute the effect of the currency forward transaction on profitability if the spot exchange rate in 9 months is:

  • GH¢22
  • GH¢15

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  • 15 Marks

FM – May 2019 – L3 – Q6 – Interest Rate Risk Management

Evaluate the effect of using interest rate futures to hedge a loan and compare the total cost after hedging with an interest rate guarantee.

You are the head of the treasury group of Top Flight Aviation (TFA), a Nigerian company. The company operates chartered international flights for the elites in the country.

It is now December 31, and TFA needs to borrow £60 million from a UK bank to finance a new air jet. The borrowing and the purchase will be in three months’ time, and the borrowing will be for a period of six months.

You have decided to hedge the relevant interest rate risk using interest rate futures. Your expectation is that interest rates will increase from 13% by 2% over the next three months.

In the month of March, the current price of Sterling 3-month futures is 87.25. The standard contract size is £500,000.

Required:

a. Set out calculations of the effect of using the futures market to hedge against movements in the interest rate if:
(i) Interest rates increase from 13% by 2% and the futures market price moves by 2%;
(ii) Interest rates increase from 13% by 2% and the futures market price moves by 1.75%;
(iii) Interest rates fall from 13% by 1.5% and the futures market price moves by 1.25%;

In each case, show the hedge efficiency. The time value of money, taxation, and margin requirements should be ignored.

b. Show, for the situations in (a) above, whether the total cost of the loan after hedging would have been lower with the futures hedge chosen by the treasurer or with an interest rate guarantee which the treasurer could have purchased at 13% for a premium of 0.25% of the size of the loan to be guaranteed.

The time value of money, taxation, and margin requirements should be ignored.

(Total: 15 Marks)

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  • 20 Marks

FM – May 2019 – L3 – Q5 – Portfolio Management

Evaluate whether an option price is fair for hedging Yaro Plc. shares, and explain how changes in volatility and the risk-free rate affect the value of a call option.

You are the portfolio manager of an asset management company based in Kano. Your company has in its portfolio 27,750,000 shares of Yaro Plc., a company listed on the Nigerian Stock Exchange. The shares are currently trading at N3.60 per share.

Your company plans to sell the shares in six months’ time to pay dividends, and you plan to hedge the risk of Yaro’s shares falling by more than 5% from their current market value. A decision has therefore been taken to buy an over-the-counter option to protect the shares. A merchant bank has offered to sell an appropriate six-month option to your company for N1,250,000.

Yaro’s share price has an annual standard deviation of 13%, and the risk-free rate is 4% per year.

Required:

a. Evaluate whether or not the price at which the merchant bank is willing to sell the option is a fair price.

b. Explain briefly (without any calculations) how a decrease in the value of each of the following variables is likely to change the value of a call option:
i. Volatility of the stock price
ii. Risk-free rate

(Total: 15 Marks)

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  • 12 Marks

FM – May 2022 – L3 – Q6a – Foreign Exchange Risk Management

Evaluate hedging methods for a UK supplier payment of £5 million in three months.

a. You have worked with a major oil servicing company in Nigeria, with headquarters in the USA, for the past six years. Recently you completed your ICAN examinations, and you have been asked to join the international treasury department in New York City for a two-year attachment. The company is due to pay a UK supplier the sum of ₤5million in three months’ time. Your team is considering alternative methods of hedging the expected payment against adverse movements in exchange rate.

You are required to advise the company which of the following hedging strategies should be adopted for the payment due to be made in three months. Show all workings:
i. Forward contract (2 Marks)
ii. Currency futures (5 Marks)
iii. Currency options (5 Marks)

 

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  • 8 Marks

FM – Nov 2020 – L3 – Q4c – Interest Rate Risk Management

Calculates the interest payments for a loan based on varying NIBOR rates with a floating rate arrangement.

c. Calculate:
i. The interest payments if NIBOR is 10% (4 Marks)
ii. The interest payments if NIBOR is 7.5% (4 Marks)

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  • 4 Marks

FM – Nov 2020 – L3 – Q4b -Interest Rate Risk Management

Calculates the six-monthly fixed interest payment for a loan under a swap arrangement to secure a fixed interest rate.

b. A plc wants to borrow N200 million for five years with interest payable at six-monthly intervals. It can borrow from a bank at a floating rate of NIBOR plus 1% but wants to obtain a fixed rate for the full five-year period. A swap bank has indicated that it will be willing to receive a fixed rate of 8.5% in exchange for payments of six-month NIBOR.

Required:
Calculate the fixed interest six-monthly payment with the swap in place. (4 Marks)

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  • 20 Marks

FM – Nov 2023 – L3 – SB – Q2 – Foreign Exchange Risk Management

Analyze hedging methods for foreign exchange risk involving a future CHF transaction.

About one year ago, you were employed by Tesco, an American company based in New York. You work online from home in Nigeria and are a member of the international treasury of Tesco.

Tesco supplies medical equipment to the USA and Europe and also buys some basic raw materials from Europe. It is currently 30 November 2024. On 31 May 2025, Tesco is due to receive CHF16.3 million from a Swiss customer and also to pay CHF4.0 million to a Swiss supplier.

Exchange rates (quoted as US$/CHF1):

  • Spot: 1.0292 – 1.0309
  • Three months forward: 1.0322 – 1.0341
  • Six months forward: 1.0356 – 1.0378

Annual interest rates available to Tesco:

  • Switzerland: 3.2% (investing), 4.4% (borrowing)
  • USA: 4.6% (investing), 5.8% (borrowing)

Currency futures (contract size CHF125,000, futures price quoted as US$ per CHF1):

  • Future price: December – 1.0306, March – 1.0336, June – 1.0369

Currency options (contract size CHF125,000; exercise price quotation US$ per CHF1, premium in US cents per CHF1):

Calls Puts
Dec Mar June Dec Mar June
1.0375 0.47 0.50 0.53 0.74 0.79 0.86

Required:

  • a. Calculate the net receipt if hedged using a forward contract. (4 Marks)
  • b. Calculate the net receipt if hedged using money market hedging. (8 Marks)
  • c. Calculate the net receipt if hedged using futures. (10 Marks)
  • d. Calculate the net receipt if hedged using options. (8 Marks)
    (Total: 30 Marks)

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Has Case Study
  • 6 Marks

SCS – May 2020 – L3 – Q6 – International Financial Management

Explain a suitable foreign currency risk hedging method for Customer Focused Ltd in relation to the Look and Like Ltd contract.

Customer Focused Ltd has received a proposal from a potential supplier, Look and Like
Ltd, to provide fresh produce (Exhibit 2a) and is considering whether to accept. Kpakpo
Armah has written a note (Exhibit 2b) about Look and Like Ltd.
Required:
Using the information available, including information you feel relevant from your answer
to Section A:

Describe an appropriate foreign currency risk management hedging method for the risk the company might face in the future as described in Exhibit 2b.

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  • 1 Marks

BL – Nov 2023 – L1 – SA – Q6 – Business Ethics and Corporate Governance

This question asks about a company's method to hedge against business risks.

A means by which a company may hedge against business risk is called
A. Limitation of Liability
B. Limitless Liability
C. Moderated Liability
D. Arbitraging
E. Modulating

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  • 20 Marks

FM – MAY 2016 – L2 – Q5 – Foreign exchange risk and currency risk management | Hedging with options

Discuss differences between forward and futures contracts, types of currency risk exposure, disadvantages of hedging with futures, and reasons for differences in interest rates across different maturities.

a) AD Ventures imports tomato paste from Italy for sale in Ghana. AD Ventures typically buys the tomato paste on an open account and pays the euro invoice value two months after receipt of goods. AD Ventures has suffered heavy exchange rate losses of late due to the continuous depreciation of the Ghanaian cedi against the euro. AD Ventures will receive a consignment of tomato paste on 15th May 2016. The value of this consignment is EUR540,000, which must be settled in two months’ time (settlement deadline being 15th July 2016).

The current spot exchange rate for the euro is GH¢4.7110/EUR. Financial pundits forecast that the Ghanaian cedi will depreciate against the euro in the coming months. The owner-manager of AD Venture, Akua Donkor, is worried about the probable foreign exchange loss her business may suffer when the invoice value is settled in two months’ time.

Akua Donkor has heard of the possibility of hedging AD Ventures’ currency exposure with a forward contract or futures contract but does not know what these contracts are. She has asked you to advise her on what to do to hedge against the underlying exposure relating to the EUR540,000 tomato paste consignment.

You would like to recommend a futures market hedge to Akua Donkor. You searched the derivatives market; and you found a futures contract on the euro that matures in August 2016. Other relevant details of the contract follow:

  • Contract size: EUR100,000
  • Futures contract price: GH¢4.8112/EUR

Required:
i) Explain to Akua Donkor FOUR differences between a forward contract and a futures contract. (4 marks)
ii) Currency risk exposure may be transaction risk, economic risk, or translation risk. Which of the three kinds of currency risk exposure is AD Ventures facing in relation to the EUR540,000 tomato paste consignment? Explain why. (4 marks)
iii) Explain to Akua Donkor THREE disadvantages of hedging the euro exposure with a futures hedge. (6 marks)

b) It has been observed that interest rates on debt securities or loans differ for different maturities. For the week ending 28th August 2015, the annual interest rate on the 1-year Government of Ghana note was 22.5% whereas the annual interest rate on the 2-year note was 23%.

Required:
With THREE reasons, explain why interest rates on debt securities and loans are different for different maturity periods. (6 marks)

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  • 20 Marks

FM – AUG 2022 – L2 – Q3 – Foreign exchange risk and currency risk management

Calculate interest rates, required sinking fund contributions, and identifies currency risk exposure with recommended hedging strategies.

a) Jeanne Cosmetics Ltd is located in Taifa and is now considered as the leader of organic and natural cosmetic products in the municipality. Per the cash management policy of Jeanne Cosmetics Ltd, any excess cash that is idle for more than three months should be invested. Three months ago, the company invested GH¢100,000 of idle cash in a 3-month fixed deposit account. The investment matures today, and the company will receive a maturity value of GH¢105,000.

Required:
i) Compute the interest rate earned on the account over the investment holding period. (2 marks)
ii) Suppose the interest rate on the account remains the same, and the company rolls over the principal, compute the annual simple interest rate on the investment. (2 marks)
iii) Suppose the interest rate on the account remains the same and the company rolls over both the principal and interests, compute the annual compound interest rate on the investment. (2 marks)

b) Apphia Fabrics Ltd plans to replace its existing manufacturing plant with a newer version in three years’ time. The replacement cost of the existing plant is GH¢10 million currently. However, experts forecast that the cost of the newer version of the plant will be GH¢12 million in three years’ time.

On the advice of the Finance Manager, the company will start saving from now to raise the required amount to buy the plant in three years’ time. Consequently, the company has signed an investment agreement with DT Financial Services Ltd. Per the agreement, the company will deposit equal amounts into an interest-bearing account at the beginning of each of the next three years. The annual nominal interest rate on the account is 16%, but interest will be compounded monthly.

Required:
Compute the equal annual deposit required to raise the required amount in three years’ time. (4 marks)

c) Aduro Pharmaceuticals Plc is a Ghana-based multinational company with a production facility in India and marketing subsidiaries in some West African countries. The Treasury Department of the company is considering strategies for managing its foreign exchange risk exposures. In particular, the Treasury Department is concerned about the following two cases of foreign exchange risk exposures:

Case 1:
The exchange rate between the Ghanaian cedi (GH¢) and the British pound sterling (GBP) is currently GH¢8.1125/GBP1. The company recently borrowed GBP500,000 from an offshore bank to buy active chemicals for the production of paracetamol syrup. The loan is to be paid in six months’ time. Market pundits project that the Ghanaian cedi would depreciate against the pound sterling over the next six months.

Case 2:
The exchange rate between the Ghanaian cedi (GH¢) and the Indian rupee (INR) is currently GH¢0.0799/INR1. The company’s production subsidiary in India presents its financial statements in the Indian rupee. The net worth of this production subsidiary in India is INR20 million. The company would be preparing its consolidated financial statements in a few months’ time. Market pundits project that the Ghanaian cedi will appreciate against the Indian rupee.

Required:
i) For each case, identify the type of currency risk exposure the company is facing. (2 marks)
ii) In respect of Case 1, recommend TWO (2) internal strategies and TWO (2) external hedging strategies the Treasury Department can use to manage the foreign exchange risk exposure. (8 marks)

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  • 25 Marks

FM – NOV 2018 – L2 – Q3 – Discounted cash flow | Introduction to Investment Appraisal

Involves calculating the net present value (NPV) of a project and discussing reasons for different interest rates and hedging techniques.

a) Sevista Ltd is evaluating the purchase of a new machine to produce product SEP, which has a short product life-cycle due to rapidly changing technology. The machine is expected to cost GH¢1 million. Production and sales of product SEP are forecasted to be as follows:

Year Production and sales (units/year)
1 35,000
2 53,000
3 75,000
4 36,000

The selling price of product SEP (in current price terms) will be GH¢20 per unit, while the variable cost of the product (in current price terms) will be GH¢12 per unit. Selling price inflation is expected to be 4% per year and variable cost inflation is expected to be 5% per year. No increase in existing fixed costs is expected since Sevista Ltd has spare capacity in both space and labour terms. Producing and selling product SEP will call for increased investment in working capital.

Analysis of historical levels of working capital within Sevista Ltd indicates that at the start of each year, investment in working capital for product SEP will need to be 7% of sales revenue for that year. Sevista Ltd pays tax of 25% per year in the year in which the taxable profit occurs. The new machine is expected to have no scrap value at the end of the four-year period. Sevista Ltd uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.

Required:

i) Determine the net present value of the proposed investment in product SEP.
(13 marks)

ii) Advise whether the project should be undertaken.
(2 marks)

b) Fluctuations in interest rates are a major concern to entrepreneurs and business executives. It has been observed that interest rates on loans vary according to the term of the loan. Besides, interest rates vary over time for varied reasons.

Required:

i) Explain THREE (3) reasons why interest rates on loans may differ for different maturities as explained by the term structure of interest rates.
(6 marks)

ii) Suggest FOUR (4) ways of hedging the company’s exposure to interest rate risk.
(4 marks)

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  • 10 Marks

FM – MAY 2019 – L2 – Q3b – Foreign exchange risk and currency risk management | Hedging with options

Calculate profit or loss from option contracts and advise on whether to exercise the options for Universal Plastics Ghana Ltd.

Universal Plastics Ghana Ltd imported raw materials from U.S.A. and Europe for the manufacture of plastic products. The company entered into option contracts with ZAA Bank Ghana Ltd to hedge its six months’ currency risk or exposure. The details of the option contracts are as follows:

Details Transaction Amount Strike Price/ Exchange Rate Spot Rate on Maturity Date Option Premium Paid to the Bank
OPTION A Bought Call option to buy USD against GH¢ US$10m USD/GH¢ 4.7 USD/GH¢ 4.5
OPTION B Bought Call option to buy EURO against GH¢ EUR 8m EUR/GH¢ 5.9 EUR/GH¢ 6.3

Required:

  1. Calculate the profit or loss of OPTION A and advise Universal Plastics Ghana Ltd whether to exercise or not. (4 marks)
  2. Calculate the profit or loss of OPTION B and advise Universal Plastics Ghana Ltd whether to exercise or not. (4 marks)
  3. Calculate the overall profit or loss on the decision to hedge based on (i) and (ii) above. (2 marks)

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