Interest Rate Swap – NBC Institute

FM – May 2017 – L3 – Q6 – Financial Risk Management

Analyze the use of an interest rate swap between two companies for mutual benefit.

Question

Large Plc. (LP) wishes to borrow N200 million for five years to finance the purchase of new non-current assets. The preference of the company’s Directors is that these funds are borrowed at a fixed rate of interest. The company’s long-term debt is currently rated BBB, meaning LP would have to pay 6.5% p.a. for fixed rate borrowing. Alternatively, LP could borrow at a floating rate, i.e. the prime lending rate (PLR) + 2.25% at the present time.

The Directors of LP have recently been informed by its bank that TK Plc. is also currently looking to borrow N200 million for five years at a floating rate of interest, and its AA rating gives it access to floating rate borrowing at PLR + 1.50% per annum. TK Plc. would pay 5.50% per annum for fixed rate borrowing at the present time.

Required:

a. State FIVE reasons that a company might have for entering into an interest rate swap. (5 Marks)

b. Show how an interest rate swap could be used to the equal benefit of both companies, assuming that the terms of the swap agreement are such that LP’s swap payment to TK Plc. is to be 5.5% fixed per annum. (7 Marks)

c. Identify, with a supporting brief explanation, which of the two companies would be disadvantaged if the PLR were to fall consistently within the five-year term of the interest rate swap. (1 Mark)

d. Identify TWO risks that both companies will face, should they decide to enter into the interest rate swap agreement. (2 Marks)

Answer

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Tags: Borrowing, Interest Rate Swap, Risk Management
Level: Level 3

Topic: Financial Risk Management

AFM – Nov 2015 – L3 – Q4 – The use of financial derivatives to hedge against interest rate risk

Assess the advantages and disadvantages of interest rate swaps and recommend a hedging strategy. Also, explain internal factors for transfer pricing.

Question

JB Investments Holding Ltd (JB) is a multinational company that is committed to a policy of expansion into African countries. JB finances foreign projects with loans obtained in the currency in which project cash flows are received. JB financed an operation in Liberia with a syndicated loan of $20 million. Currently, the loan has three years to maturity. The loan requires semiannual interest payments at a fixed rate of 6.5% per annum, but JB prefers a floating interest rate as the pattern of cash flows from the Liberian project has changed.

The Finance Director talked to the creditors about JB’s preference for a floating interest rate. The creditors have agreed to accept a floating rate of LIBOR plus 200 basis points over the remaining three years of the loan term. However, the Finance Director feels that this rate is rather too high considering JB’s credit rating. She is therefore considering two alternatives for managing the interest rate risk exposure.

Alternative 1: Coupon swap with a bank
Engage in a coupon swap with UT Bank through which JB trades-in its fixed rate interest payments obligation for floating rate interest payments. The table below presents UT Bank’s bid and ask quotes for fixed dollar coupon rates:

Loan term to maturity	Bid	Ask	Treasury note (TN) rate
2 years	2-year TN rate + 30 basis points	2-year TN rate + 40 basis points	5.3%
3 years	3-year TN rate + 35 basis points	3-year TN rate + 50 basis points	5.9%
4 years	4-year TN rate + 40 basis points	4-year TN rate + 60 basis points	6.7%
5 years	5-year TN rate + 45 basis points	5-year TN rate + 70 basis points	7.8%

Floating rate quotation: Floating rates are pegged at 6-month dollar LIBOR plus 100 basis points.

Alternative 2: Coupon swap with another multinational company
Engage in a coupon swap with McEwen Ltd, a multinational company that has a floating rate dollar debt but prefers fixed coupon payments. The interest rate on McEwen’s dollar debt is LIBOR plus 150 basis points but it can borrow fixed rate dollars at 8%. Assume JB can borrow floating rate dollars at LIBOR plus 200 basis points.

Required:
(a)
i) Discuss TWO (2) advantages and TWO (2) disadvantages of hedging interest rate risk with an interest rate swap. (4 marks)
ii) Based on the restructuring deal with the creditors and the two interest rate swap alternatives, recommend a hedging strategy for interest payments on the $20 million debt. Support your recommendation with relevant computations. (10 marks)

(b) The Board of Directors of JB Investments Holdings Ltd is considering a transfer pricing policy for the transfer of goods and services among the company and its foreign subsidiaries.
Required:
Explain THREE (3) internal factors (motivations) for transfer pricing, which the board should consider in formulating a transfer pricing policy for the company. (6 marks)
(Total = 20 marks)

Answer

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Tags: Interest Rate Swap, Internal Factors, Motivation, Risk Hedging, Transfer Pricing
Level: Level 3

Topic: The use of financial derivatives to hedge against interest rate risk
Series: NOV 2015

FM – May 2020 – L2 – Q5c – Foreign exchange risk and currency risk management

Explain the differences between a foreign currency swap and an interest rate swap.

Question

Explain FOUR (4) differences between a foreign currency swap and an interest rate swap.

Answer

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Tags: Financial risk management, Foreign currency swap, Interest Rate Swap, Swap contracts
Level: Level 2

Topic: Foreign exchange risk and currency risk management
Series: MAY 2020

FM – NOV 2021 – L2 – Q3 – Foreign exchange risk and currency risk management

Computation of future value of deposits under different scenarios, currency risk hedging strategy, and explanation of swap contracts.

Question

a) You are the assistant to the Finance Manager of Kunta Medical Centre. Your boss is negotiating a deal with an investment company investing GH¢500,000 over 3 years. The main terms of the proposed investment deal are that if the amount is deposited now and invested continuously for 3 years, it would attract an 18% annual interest rate with quarterly compounding. However, if the initial deposit of GH¢500,000 is maintained and additional deposits of GH¢50,000 each are made at the beginning of year 2 and year 3, the deposits would attract 18.0% annual interest in year 1, 18.5% in year 2, and 19% in year 3, all with quarterly compounding.

Your boss has asked you to do some computations to inform her about the growth of the deposits based on the terms of the proposed deal.

Required:
i) Suppose GH¢500,000 is deposited now, and there are no top-up deposits in the future; Compute the future value of the deposit at the end of the third year. (3 marks)

ii) Suppose the initial deposit of GH¢500,000 is made now, and the top-up deposits of GH¢50,000 each are made in the future per the terms of the proposed investment deal;

Compute the future value of the initial deposit at the end of the third year. (3 marks)
Compute the aggregate future value of the top-up deposits at the end of the third year. (3 marks)
Compute the aggregate future value of all the deposits at the end of the third year. (1 mark)

b) Sesamu Dried Fruits Ltd is a fruits processing company in Ghana. The company has exported raw mangoes to a distributor in Japan. The invoice value of JP¥20 million is to be collected in three months. The exchange rate between the Ghanaian cedi (GH¢) and the Japanese yen (JP¥) is currently GH¢0.0584/JP¥1. It is expected that the Ghana cedi may appreciate against the JP¥ in the coming months.

Required:
Using the leading and lagging strategy for hedging currency risk exposure, is it advisable for the company to lag the collection of the JP¥ invoice value? (5 marks)

c) COVID-19 has led to volatility in the international money market. Although international business has seen some improvement, progress has been very slow. As a result, the risk of losing part of an investment due to exchange rate and currency value fluctuations are very high.

Required:
Explain how Interest Rate Swap and Currency Swap can be used to mitigate the effects of market volatility. (5 marks)

Answer

Find Related Questions by Tags, levels, etc.

Tags: Compound Interest, Currency Swap, Foreign Exchange Risk, Interest Rate Swap, Investment, Leading and Lagging Strategy
Level: Level 2

Topic: Foreign exchange risk and currency risk management
Series: NOV 2021

FM – May 2017 – L3 – Q6 – Financial Risk Management

Analyze the use of an interest rate swap between two companies for mutual benefit.

Question

Required:

a. State FIVE reasons that a company might have for entering into an interest rate swap. (5 Marks)

c. Identify, with a supporting brief explanation, which of the two companies would be disadvantaged if the PLR were to fall consistently within the five-year term of the interest rate swap. (1 Mark)

d. Identify TWO risks that both companies will face, should they decide to enter into the interest rate swap agreement. (2 Marks)

Answer

Find Related Questions by Tags, levels, etc.

Tags: Borrowing, Interest Rate Swap, Risk Management
Level: Level 3

Topic: Financial Risk Management

AFM – Nov 2015 – L3 – Q4 – The use of financial derivatives to hedge against interest rate risk

Assess the advantages and disadvantages of interest rate swaps and recommend a hedging strategy. Also, explain internal factors for transfer pricing.

Question

Loan term to maturity	Bid	Ask	Treasury note (TN) rate
2 years	2-year TN rate + 30 basis points	2-year TN rate + 40 basis points	5.3%
3 years	3-year TN rate + 35 basis points	3-year TN rate + 50 basis points	5.9%
4 years	4-year TN rate + 40 basis points	4-year TN rate + 60 basis points	6.7%
5 years	5-year TN rate + 45 basis points	5-year TN rate + 70 basis points	7.8%

Floating rate quotation: Floating rates are pegged at 6-month dollar LIBOR plus 100 basis points.

Answer

Find Related Questions by Tags, levels, etc.

Tags: Interest Rate Swap, Internal Factors, Motivation, Risk Hedging, Transfer Pricing
Level: Level 3

Topic: The use of financial derivatives to hedge against interest rate risk
Series: NOV 2015

FM – May 2020 – L2 – Q5c – Foreign exchange risk and currency risk management

Explain the differences between a foreign currency swap and an interest rate swap.

Question

Explain FOUR (4) differences between a foreign currency swap and an interest rate swap.

Answer

Find Related Questions by Tags, levels, etc.

Tags: Financial risk management, Foreign currency swap, Interest Rate Swap, Swap contracts
Level: Level 2

Topic: Foreign exchange risk and currency risk management
Series: MAY 2020

FM – NOV 2021 – L2 – Q3 – Foreign exchange risk and currency risk management

Computation of future value of deposits under different scenarios, currency risk hedging strategy, and explanation of swap contracts.

Question

Your boss has asked you to do some computations to inform her about the growth of the deposits based on the terms of the proposed deal.

Required:
i) Suppose GH¢500,000 is deposited now, and there are no top-up deposits in the future; Compute the future value of the deposit at the end of the third year. (3 marks)

ii) Suppose the initial deposit of GH¢500,000 is made now, and the top-up deposits of GH¢50,000 each are made in the future per the terms of the proposed investment deal;

Compute the future value of the initial deposit at the end of the third year. (3 marks)
Compute the aggregate future value of the top-up deposits at the end of the third year. (3 marks)
Compute the aggregate future value of all the deposits at the end of the third year. (1 mark)

Required:
Using the leading and lagging strategy for hedging currency risk exposure, is it advisable for the company to lag the collection of the JP¥ invoice value? (5 marks)

Required:
Explain how Interest Rate Swap and Currency Swap can be used to mitigate the effects of market volatility. (5 marks)

Answer

Find Related Questions by Tags, levels, etc.

Tags: Compound Interest, Currency Swap, Foreign Exchange Risk, Interest Rate Swap, Investment, Leading and Lagging Strategy
Level: Level 2

Topic: Foreign exchange risk and currency risk management
Series: NOV 2021

Question Tag: Interest Rate Swap

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FM – May 2017 – L3 – Q6 – Financial Risk Management

Analyze the use of an interest rate swap between two companies for mutual benefit.

AFM – Nov 2015 – L3 – Q4 – The use of financial derivatives to hedge against interest rate risk

Assess the advantages and disadvantages of interest rate swaps and recommend a hedging strategy. Also, explain internal factors for transfer pricing.

FM – May 2020 – L2 – Q5c – Foreign exchange risk and currency risk management

Explain the differences between a foreign currency swap and an interest rate swap.

FM – NOV 2021 – L2 – Q3 – Foreign exchange risk and currency risk management

Computation of future value of deposits under different scenarios, currency risk hedging strategy, and explanation of swap contracts.

FM – May 2017 – L3 – Q6 – Financial Risk Management

Analyze the use of an interest rate swap between two companies for mutual benefit.

AFM – Nov 2015 – L3 – Q4 – The use of financial derivatives to hedge against interest rate risk

Assess the advantages and disadvantages of interest rate swaps and recommend a hedging strategy. Also, explain internal factors for transfer pricing.

FM – May 2020 – L2 – Q5c – Foreign exchange risk and currency risk management

Explain the differences between a foreign currency swap and an interest rate swap.

FM – NOV 2021 – L2 – Q3 – Foreign exchange risk and currency risk management

Computation of future value of deposits under different scenarios, currency risk hedging strategy, and explanation of swap contracts.

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FM – May 2017 – L3 – Q6 – Financial Risk Management

Analyze the use of an interest rate swap between two companies for mutual benefit.

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AFM – Nov 2015 – L3 – Q4 – The use of financial derivatives to hedge against interest rate risk

Assess the advantages and disadvantages of interest rate swaps and recommend a hedging strategy. Also, explain internal factors for transfer pricing.

You're reporting an error for "AFM – Nov 2015 – L3 – Q4 – The use of financial derivatives to hedge against interest rate risk"

FM – May 2020 – L2 – Q5c – Foreign exchange risk and currency risk management

Explain the differences between a foreign currency swap and an interest rate swap.

You're reporting an error for "FM – May 2020 – L2 – Q5c – Foreign exchange risk and currency risk management"

FM – NOV 2021 – L2 – Q3 – Foreign exchange risk and currency risk management

Computation of future value of deposits under different scenarios, currency risk hedging strategy, and explanation of swap contracts.

You're reporting an error for "FM – NOV 2021 – L2 – Q3 – Foreign exchange risk and currency risk management"

FM – May 2017 – L3 – Q6 – Financial Risk Management

Analyze the use of an interest rate swap between two companies for mutual benefit.

You're reporting an error for "FM – May 2017 – L3 – Q6 – Financial Risk Management"

AFM – Nov 2015 – L3 – Q4 – The use of financial derivatives to hedge against interest rate risk

Assess the advantages and disadvantages of interest rate swaps and recommend a hedging strategy. Also, explain internal factors for transfer pricing.

You're reporting an error for "AFM – Nov 2015 – L3 – Q4 – The use of financial derivatives to hedge against interest rate risk"

FM – May 2020 – L2 – Q5c – Foreign exchange risk and currency risk management

Explain the differences between a foreign currency swap and an interest rate swap.

You're reporting an error for "FM – May 2020 – L2 – Q5c – Foreign exchange risk and currency risk management"

FM – NOV 2021 – L2 – Q3 – Foreign exchange risk and currency risk management

Computation of future value of deposits under different scenarios, currency risk hedging strategy, and explanation of swap contracts.

You're reporting an error for "FM – NOV 2021 – L2 – Q3 – Foreign exchange risk and currency risk management"

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