a) MSAF Ltd (MSAF) would need 3-month US$500,000 loan in two months' time to finance the importation of raw materials for production. MSAF can borrow in the Eurocurrency market at LIBOR plus 200 basis points. The LIBOR is currently sitting at 8%, but management of MSAF fear that interest rate might rise by the time the loan would be taken. To protect MSAF's interest rate risk exposure, management signs a forward rate agreement (FRA) deal with CAPUT Bank Plc. The FRA traded rate is set at 10% on the spot date. Required: i. Discuss three advantages of hedging interest rate risk with a forward rate agreement as against interest rate futures. ii. Suppose the LIBOR settles at 9% in two months' time, evaluate the outcome of the hedge.
(a) MSAF Ltd (MSAF) would need 3-month US$500,000 loan in two months' time to finance the importation of raw materials for production. MSAF can borrow in the Eurocurrency market at LIBOR plus 200 basis points. The LIBOR is currently sitting at 8%, but management of MSAF fear that interest rate might rise by the time the loan would be taken. To protect MSAF's interest rate risk exposure, management signs a forward rate agreement (FRA) deal with CAPUT Bank Plc. The FRA traded rate is set at 10% on the spot date.
Required:
i. Discuss three advantages of hedging interest rate risk with a forward rate agreement as against interest rate futures.
ii. Suppose the LIBOR settles at 9% in two months' time, evaluate the outcome of the hedge.
(b) The PT Group is a multinational group of companies comprising the U.S. parent and three subsidiaries in other countries. Companies within the group trade amongst themselves, and settlement and currency issues have been a major concern. The PT Group has decided to introduce a system of netting to settle balances owed within the group every three months. The settlement currency is the U.S. dollar (US$).
Today is 1 June. The predicted balances owing to, and owed by, the group companies at the end of March are as follows:
Owed by Owed to Local currency (millions)
PT (USA) Horan (South Africa) US $12.17
Horan (South Africa) Massie (Europe) SA R42.65
Giffen (Denmark) PT (USA) D Kr21.29
Massie (Europe) PT (USA) US $19.78
PT (USA) Massie (Europe) €1.57
Horan (South Africa) Giffen (Denmark) D Kr16:35
Giffen (Denmark) Massie (Europe) €1.55
The predicted exchange rates, used in the calculations of the balances to be settled, are as follows:
D Kr US$ SAR €
1 D Kr = 1.0000 0.1823 1.9554 0.1341
1 US $ = 5.4855 1.0000 10.7296 0.7358
1 SAR = 0.5114 0.0932 1.0000 0.0686
1€ = 7.4571 1.3591 14:5773 1.0000
Settlement will be made in the order that the company owing the largest net amount in dollars’ will first settle with the company owed the smallest net amount in dollars.
Note: D Kris Danish Krone, SA R is South African Rand, US $ is United States dollar and € is Euro.
Required:
Calculate the inter-group transfers which are
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