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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 40
INTEREST RATE RISK & FORWARD RATE AGREEMENTS
Following topics have been considered in this hand out:
CF ­ future receipt in FCY
Forward contract vs. currency futures
Interest rate risk
Hedging against interest rate
Forward rate agreements
Decision rule
CF ­ Future Receipt in FCY
When a firm is expecting a FCY receipt in future, the risk, contrary to payment scenario, is the fall in the
exchange rate below the current spot rates. A hedge would be to sell the FCY future today and the position
will be closed by buying the futures in future ­ when FCY receipt is expected. However, you must
remember that currency futures are settled on specified dates during a year. So the time factor should also
be considered.
Once the hedge has been established, if the spot rate moves adversely up to the time the currency is
received, the loss from adverse spot rate movement will be off set by gains on future trading.
On the other side, if spot rate moves favorable to the time currency is received, the profit from favorable
movement in spot rate will be reduced by the amount of loss on future trading.
Future contracts do not provide perfect or clean hedge normally. The reason is that contract size normally
does not equalize the FCY involved.
The first step, in establishing hedge, would be to work out the contracts needed to hedge the currency
exposure. This can be computed by dividing currency involved by the contract size. As stated above the
number of contracts should be in whole number, which will not result in clean hedge.
Then, once the number of contracts that have been sold (in this scenario) there will be a pause until the
time position is closed. If the spot rate has weakened or strengthened, calculation will be made to find out
the net gain or loss of the hedge.
It would be much helpful in understanding this concept by looking at the following example:
Note: this example has been especially constructed in foreign currencies ­ US$ & GBP, due to the reason
that currency future are not available in Pak rupees. This is again being done to aid your understanding of
international business environment.
In January, a UK company sold goods to a US customer and later promised to pay after 3 months. The total
value of goods is US$ 1,202,500.00. The current spot rate for GBP/US$ is $1.5000 and early April GBP
future contract are being traded at $1.4800 on a contract size of GBP 62,500.
UK supplier is exposed to exchange risk on future income of $1,202,500.00. If sterling weakens, UK trader
will gain but if sterling strengthens, he will lose.
The UK supplier can set up a futures position by hedging the risk of strengthening of sterling or weakening
of US$.
To do this the UK seller will sell US$ using sterling futures. A sterling future is for GBP 62,500/- and the
buyer of the sterling future is buying sterling or selling US$
Buyer needs to buy sterling future.
At the future price of $1.4800 the $ receipt after 3 months will be worth:
= $1,202,500.00 /1.4800 = GBP 812,500
The UK trader needs to buy:
812,500 / 62,500 per contract = 13 contracts
The overall financial position will be:
Income from trading
$ 1,202,500/=
Profit on future selling:
400 ticks x 6.25 x 13
=
$ 32,500/=
Total value
=
$ 1,235,000/=
Exchange into sterling at spot rate of $1.52/GBP:
$1,235,000/1.52 = GBP 812,500
Effective ex rate is
$1,202,500 / 812,500 = $1.48
135
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Corporate Finance ­FIN 622
VU
Forward contract vs. Currency future
In currency futures, commodity exchanges are involved and credit risk is eliminated. However, a forward
contract is made between parties and each party needs to confirm the credit worthiness of each other.
Reversal of currency future is very simple. Large buyers and sellers exist. Reversing forward contract is
difficult. Original parties have to set off the deal. Future currency contract become a "commodity" and
reversing does not require original parties.
Size of contract: no size restriction is placed in forward contract and is up to parties to deal or contract in
the magnitude they like. However, in future currency contract the size is pre-determined or fixed. In this
scenario, perfect hedge is not possible.
In forward contract, no margin is required but in currency future parties have to put an initial margin.
Interest Rate Risk Management:
Apart from exchange rate fluctuations, another source of risk in foreign exchange market is interest rate
risk.
It is the risk of incurring losses or gains due to adverse / favorable movements in interest rates.
For example, a firm is expecting FCY receipts / payment and this income/payment will depend on interest
rate at that time.
The firm's assets (some) whose value is sensitive to interest rates.
Firms and companies dealing in money market hedges are the most effected by the interest rate variations.
Most of banks and financial institutions have significant exposure based on short-term floating interest
rates.
For example, some large companies have forecasts of receiving handsome amounts of cash, or have
forecasted surplus cash in short term. Income from short-term investments will be dependant upon the
interest rates and if the short-term interest rates are falling then there will be a loss in terms of lower interest
income from investment.
The other side, if a company is planning to borrow at variable rate of interest, the interest amount charged
each time varying according to whether short-term interest rates have risen or fallen since the previous
payment.
To quote another example how interest rate fluctuations affect the financials of the company, a company
may have invested in bonds and any change in interest rate will affect the value of investment in balance
sheet.
Examples of interest rate risk ­ short term investments, investment in bonds, borrowings in short term ­
variation in short term interest rate.
Interest rate risk is higher when interest rates are extremely sensitive and their future direction is
unpredictable.
Hedging against the interest rate risk
1) Forward rate agreements
2) Interest rate futures
3) Interest rate options
4) Interest rate swaps
We shall discuss these individually.
Forward Rate Agreements ­ FRA
This is a contract and a financial instrument that is used has hedge against interest rate adverse fluctuations
on deposit or loans starting in near future. This resembles to forward exchange rate agreements to fix the
exchange rates.
Features of FRAs:
It is between a bank and a client for fixing future interest rate on notional amount of loan or deposit. The
loan or deposit is for a stated period starting on a specified time in future.
The size of the notional loan or deposit is agreed between the bank and the client.
FRAs are cash settled.
At settlement date buyer and seller must settle the contract.
The FRA rate for three months loan/deposit starting in a 6 months time is normally expressed as 6v9 FRA.
The buyer of a FRA agrees to pay fixed interest rate (FRA rate) on notional loan/deposit. At the same
buyer will receive interest on notional loan/deposit at benchmark rate of interest.
On the other side, seller of FRA agrees to pay interest on the notional amount at benchmark rate and
receives interest at a fixed rate.
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Corporate Finance ­FIN 622
VU
Decision Rule:
When a FRA reaches its maturity ­ the settlement date, both the seller and buyer must settle the contract.
If the fixed rate in the agreement is higher than the reference rate (may be KIBOR), the buyer of the FRA
makes a cash payment to the seller. The payment is for the amount by which the FRA rate exceeds the
reference rate.
If the fixed rate in the agreement is lower than the reference rate, the seller of the FRA makes a cash
payment to buyer ­ exactly the reverse of above. The payment is for the amount by which the FRA rate is
less than the reference rate.
FRA offer companies the facility to fix future interest today either on short-term borrowing or deposit for
an agreed future period. An effective interest rate can be fixed on future short-term borrowing by buying an
FRA. Alternatively, an effective interest rate can be fixed on short-term deposit or investment by selling
FRA.
Mechanism:
Step 1: Understand the scenario confronted to the company. This means that weather the company plans to
borrow or will have surplus cash to invest. The hedge will depend on that scenario. If the company plans to
borrow in future then it will need to buy FRA and if company intends to put some investment in short term
deposit, it needs to sell FRA.
Step 2: The bank or some vendor will be identified who trades in FRAs and terms are negotiated. Terms
generally include the duration of notional deposit, amount of notional deposit and rate.
Step 3: On the settlement date, there will be cash payment / receipt from/to bank to company based on the
prevalent rate. Calculations will return the amount to be paid or received.
137
Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk