B.

RISK MANAGEMENT

INTEREST RATE RISK MANAGEMENT

Question 01(Forward rate agreement)

Plots Ltd has arranged a Tshs100 million loan from its bank in order to expand its business. The
interest terms are six-month LIBOR plus 1%. The interest at present is 6.5%. LIBOR is reset
every 6 months and payable in arrears. The company does not want to pay more than 7.0% and
the company will borrow Tshs100 million in the next two months. However, it anticipates that
interest rates will fall in the medium term and does not want to be locked into a 7% rate.
The company buys an FRA from a bank which is 2 v 8 and rate at 6.0-7%%.
Required:
Calculate the net pay-off if:
(a) at the end of six months, LIBOR is 6.5%
(b) at the end of 12 months, LIBOR is 5.8%
Question 02(Interest rate option)

Urawa ltd is bases on Europe, is expecting to borrow £50,000,000 for one year starting in four
months. Currently there is uncertainty on the market, this has led to some economist to predict rise
in interest rate. Urawa company is of opinion that interest rate could rise by 5% in four months’
time and it wish to protect themselves using derivatives. The company can borrow at LIBOR+
1%,and the currently LIBOR is 10%.Currenlty company is considering hedging interest rate
exposure using interest rate option.
Contract Size £5,000,000
Option premium per contract £10,000
Strike rate 9%

Required
a) Advice URAWA ltd whether borrowers’ option or lender’s option should be purchased, set the
hedge position and calculate its cost
b) Calculate Gross cost of borrowing and gain on option if interest rate increase by 5% to 15%

Question 03 (Interest rate Futures)

The financial director of Picky Co. Ltd., a UK based company is concerned that interest rates
could become more volatile for many major trading countries following recent turmoil in credit
markets. It is now March and Picky Co. Ltd. is expected to need to borrow £12,000,000 for a
period of six months commencing in six months’ time. The corporate treasurer of Picky Co. Ltd.
expects interest rate to increase by 2% during the next six months and has decided to hedge the
interest rate risk using interest rate futures. September sterling six-month time deposit futures are
currently priced at 94.28. Futures prices are expected to increase by 2%. The contract size is
£500,000 and the minimum price movement is one tick (the value of one tick is 0.01% per year
for the contract size).

REQUIRED:
Illustrate the possible results of hedging interest rate risk using interest rate futures hedge if
interest rate in six months’ time increase by 3% and the September futures market price decreases
by 2%. [Hint: Set the hedge position and calculate the hedge efficiency] (10 Marks)

Question 04(interest rate swap)

The following five-year loan interest rates are available to Stentor, an AA credit rated company,
and to Evnor, a BB+ rated company.

Fixed rate Floating rate

Stentor 8.75% LIBOR = 0.50%
Evnor 9.50% LIBOR + 0.90%

A bank is willing to act as an intermediary to facilitate a five year swap, for an upfront fee of
£20,000 and an annual fee of 0.05% of the swap value. The swap size is £10,000,000. Both
fees are payable by each of the companies. The gross swap benefit will be divided as follows:
Stentor 80%
Evnor 20% Taxation may be ignored.
 Required:
1. Evaluate, using an illustrative swap, whether or not an interest rate swap may be arranged
that is beneficial to both companies (6 marks). [Hint: Calculate the Gross SwapBenefit]
2. Calculate the Net Swap Benefit to each of the counterparties for Year 1 & Year 2 (6Marks)
Question 05 (interest rate swap)
SUMREY Company, a British engineering firm, borrowed £17 million in March 2015 at a fixed
rate of 11% per annum. The loan is due to be repaid in March 2016. The LIBOR in March 2015
is 11% per annum and SUMREY feels that the LIBOR will decrease during the next two years
and would like to explore the possibility of an interest rate swap. Alpha Commercial Bank, the
Company’s bank has offered to arrange an interest rate swap for one year with a SERPEM
Company that has obtained floating rate finance at London Interbank Offered Rate (LIBOR)
plus 1.25%.
Terms of the Swap
SUMREY Company will pay LIBOR plus 1.5% to SERPEM Company
SERPEM Company will pay 12% to SUMREY Company. The corporate tax is at 35%.
One of SUMREY’S directors has questioned this proposal, commenting, “Do the terms of this
swap offer us the best possible deal? I wonder whether we will be getting any savings in
interest costs.”

REQUIRED:
(i) Assuming the swap goes ahead on the original terms proposed by Alpha Commercial Bank
and the LIBOR turns out to be 10% per annum for the whole year, advise Sumrey Company
on the worthiness of the proposed swap. (10 Marks)
(ii) The LIBOR falls to 9% after six months. (5 Marks)

Question 01 November 2021( shorterm interest rate futures)

Mwameja Construction Limited has planned to borrow TZS.200 million for 3 months beginning early July
2021 and expects to pay interest at LIBOR plus 0.6%. The company plans to use 3-months futures to
hedge its exposure to increasing interest rates. Mwameja Construction sells July, 3 months’ futures at a
price of 96.28. Mwameja subsequently, closes the position in early July 2021 at a price of 95.57. At the
same time the company borrows TZS.200 million at 5.03%, which is the current LIBOR rate
of 4.43 plus 0.6%. Assume the unit of trading is TZS.5 million, the tick size is 0.01%

and the value of 1 tick is TZS.125.

REQUIRED:

Determine the Net Interest Amount payable by Mwameja Construction Ltd. (4 marks)

Question 02 November 2021( interest rate swap and interest rate option)

a) Explain the meaning and usage of interest rate caps and collars as a hedging tools. Briefly discuss the
advantages of each. (6 marks)

(b) Consider two firms, A and B, that have the same financial needs in terms of maturity and principal.
The two firms can borrow money in the market at the following

conditions:

• Firm A: 11% at a fixed rate or Libor + 2% for a $10 million loan and a 5-yearmaturity.

• Firm B: 9% at a fixed rate or Libor + 0.25% for a $10 million loan and a 5-yearmaturity.

REQUIRED:

(i) Suppose firm B prefers a floating-rate debt and firm A prefers a fixed rate debt. Structure a swap deal
to optimize their financial conditions. (7 marks)

(ii) If firm B prefers a fixed-rate debt and firm A prefers a floating-rate debt, will there be a swap to
structure so that the two firms optimize their financial conditions? Explain. (3 mark)