- 20 Marks
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)
Find Related Questions by Tags, levels, etc.
- Tags: Interest Rate Swap, Internal Factors, Motivation, Risk Hedging, Transfer Pricing
- Level: Level 3