CONTACTA (Preliminaries)

QUESTION REQUIREMENTS

1. Hedging interest rate risk using interest rate futures

• What’s the contract about?
• Concern of the borrower (as per Q)
• Show the hedge using data provided in the Q
• Other additional relevant assumptions

2. Treasury transactions
• Make know what the Head of Treasury has done – ‘speculating’ NOT ‘hedging’
in the money market. It is not an MMH.
• Financial impact of the transactions.
• Risks Contacta is exposed to and how to mitigate the risks – FRAs
• FR impact – any benefit from applying hedge accounting
• To improve the control environment in treasury transactions – key controls that
could be introduced

3. Chairman’s Concerns
• Debt or equity finance as directors’ opinions
• Impact of raising more debt on the share options
• How share options can influence ED’s decision making

Explain how the proposed interest rate futures could hedge
the interest rate risk arising in respect of the £15 million loan.
Illustrate your explanation with calculations, using the
illustrative data, assumptions and other information provided
by Ron Steven (Exhibit 2).
State any additional relevant assumptions.
Regarding the treasury transactions (Exhibit 3):
• Explain, with supporting calculations, the potential
financial impact of the series of transactions. Use the
information and the working assumption provided.
Briefly discuss the appropriateness of the working
assumption.
• Explain the financial risks to which Contacta is exposed.
Explain how these risks can be mitigated using a
forward rate agreement and illustrate with supporting
calculations.
• Briefly explain whether there is any benefit from
applying hedge accounting for financial reporting
purposes.
• As part of a risk assurance engagement, set out key
controls that could be introduced by the Contacta board
to improve the control environment for these types of
treasury transactions.
Regarding the concerns of the chairman (Exhibit 4):
(a) Explain, with supporting calculations, the factors to be
considered by the Contacta board in deciding whether to
raise debt or equity for future long-term finance. Evaluate the
opinion of the executive directors as expressed in the quote
from Catherine Greggs.
(b) Evaluate:
• how the executive share options may influence the
executive directors’ decision making.
• the probable impact of raising more debt in future on the
value and risk of the executive share options.
CONTACTA (Preliminaries)
13 (12)
• Analyse and assimilate the data provided in a
structured manner
• Carry out structured and logical analysis of interest
rate exposure in the absence of hedging
• Demonstrate and explain the impact of interest
rate futures hedging with supporting calculations
• Set out and explain assumptions and other
relevant factors to be considered
• Use judgement and analysis of the data to
evaluate the limitations and risks with interest rate
hedging
19 (16)
• Assimilate information to explain the nature and
consequences of the series of transactions
• Assimilate data and provide calculations of the
impact of the transactions
• Critically appraise the working assumption
• Demonstrate an understanding of the financial
risks to which Contacta is exposed
• Use judgement to identify the most appropriate
method of hedging
• Assimilate the information to demonstrate that
hedge accounting is not needed as there is no
accounting mismatch due to fair value movements
through profit or loss
• Select the key controls required to improve the
control environment for these types of treasury
transactions
15 (14)
• Use judgement to identify and evaluate key
financing risks
• Demonstrate a clear understanding of the nature of
the risks
• Analyse, compare and evaluate the alternative
views expressed by the executive and non-
executive directors
• Assimilate data and other information to capture
different implied and explicit risk factors
• Analyse and assimilate the data provided
• Demonstrate an understanding of the factors which
influence option prices in the circumstances of the
scenario
• Evaluate the consequences of the options for
different types of director decisions
• Analyse the impact of increased gearing on option
prices and options risk
47 (42)