- There are a total of 120 marks available. Marks for each question, or part of a question, are given in parentheses.
- Record your answers to the multiple choice questions on the General Purpose Answer Sheet using a blue/black pen or 2B pencil.
- All Questions must be answered.
- Write your answers in the spaces provided.
- Illegible handwriting risks loss of marks.
MATERIALS PERMITTED / NOT PERMITTED:
- No dictionaries are permitted.
- A non-programmable calculator (no text retrieval capacity) is permitted.
- Financial calculators may be used.
- One double-sided A4 hand-written sheet may be used. Students are required to hand in all their notes with their exam paper.
- Mobile telephones must be turned off and left at the front of the room.
- Candidates are required to obey all instructions provided by the Final Examination Supervisor and must refrain from communicating in any way with another student once they have entered the final examination venue.
- Candidates may not write or mark the exam materials in any way during reading time.
- Candidates may only access authorised materials during this examination. A list of authorised material is available on this cover sheet. If it is alleged you have breached these rules at any time during the examination, the matter may be reported to the University Discipline Committee for determination.
Rough Working Paper
Page 2 of 8
Question 1 [10 Marks]
- Write a brief synopsis (no more than 5 lines) of the case study which your group presented in class this semester. (5 marks)
Award 1 mark for each unique point.
Points must be precise rather than general in nature.
- Write a brief synopsis (no more than 5 lines) of one case study presented in class this semester, other than the
one you presented. (5 marks)
Award 1 mark for each unique point.
Points must be precise rather than general in nature.
Question 2 [20 marks]
Morocco Energy Pty Ltd is a mining company based in Australia. It recently sold to a Japanese client, minerals worth JPY80,000,000 which is due to be received in 9 months (or 270 days). Currently there exists a bank loan plus interest due in 9 months’ time as well. Given this, the company wants to be certain about how much in AUD they will be receiving. Assume a 360 day count in your calculations. The following quotes are available from a bank:
Spot exchange rate JPY98.41/AUD
9-month forward rate (JPY/AUD): Counterparty’s credit rating: A+ JPY96.78/AUD
9-month interest rate (p.a.) – JPY: Bank’s credit rating: AA 0.25%
9-month interest rate (p.a.) – AUD: Bank’s credit rating: AAA 2.50%
Premium for a Put option on JPY at strike price of JPY100/AUD AUD0.0005/JPY
The put option above is exchange-traded. In addition, the finance department of the company forecasts the spot rate in 9 months to be JPY94.8/AUD.
- a) In 9 months’ time, what will be the receipts in AUD from the Japanese client using forwards, a money market hedge and options? Show all calculations. (10 marks)
- Sell JPY forward contract. (2 marks)
At maturity in 9 months, the company exchanges at the locked rate and receives JPY80000000/96.78 = AUD826617.07 – CERTAIN
- Money market hedge. (4 marks)
Borrow JPY now against future receipts – Principal of JPY80000000
i.e. borrow the PV of JPY80000000 which is JPY80000000/ (1+0.0025 x 270/360) = JPY79850280.72
Exchange now to AUD811404.13 at spot rate JPY98.41/AUD
Put this amount as a term deposit at a bank:AUD811404.13 x (1+0.025 x 270/360) =
AUD826617.96 – CERTAIN
Use the JPY80000000 receipt of income to pay down our debt in JPY
- Buy a put option on the JPY. (4 marks)
FV(premium) = AUD0.0005 x 80000000 x (1 + 0.025 x 270/360) = AUD40750.00
We will only exercise a put option if the ending Spot Rate is below the strike price of JPY100/AUD.
Net proceeds from option = option payoff – premium, if exercised
If we exercised the right to sell JPY at 100/AUD, we will receive AUD800000.00
Net proceed will then be AUD759250.00. – [MINUMUM]
That is, we will at least receive AUD759250.00, because we can sell for more in the spot market if spot rate turns out to be higher than the strike.
If the ending spot rate is as expected (i.e. JPY94.8/AUD), net proceed will be AUD803131.86
Note: Simple interest used above and is encouraged; slightly different answer due to continuous compounding will not lose marks.
- b) Identify and briefly explain the risks of each of the three hedging methods. (6 marks)
- Forward hedge. (2 marks)
This is a certain outcome. Using forward involves very little (counterparty credit) risk. It safeguards the company against a fall in value of the JPY/AUD forward rate in 9 months. But locking the exchange rate in means it precludes gains.
- Money Market Hedge. (2 marks)
This is another certain outcome. Almost no risks other than the banks’ credit risk. The banks credit ratings are AA and AAA which mean their credit risk is negligible. Similar to forward, mm hedge also precludes gains.
- Buy Put Option. (2 marks)
The option premium plus interest is borne whether the option is exercised or not and has to be paid up front. Compared to forward and mm hedge, options provide a floor to the receipt value while allow the company to enjoy the upside if JPY/AUD rise above the strike price. In addition, the fact that the option is traded on an exchange means the counterparty credit risk is negligible.
- c) Which alternative should the company choose? Justify with reasons. (4 marks)
Summary of the three hedging methods
|Type of hedging||Proceed (AUD)||Comment|
|1. Forward||826617.07||– CERTAIN|
|2. Money Market Hedge||826617.96||– CERTAIN|
|3. Put Option||759250.00||– MINIMUM|
Both Forward contract and Money Market Hedge give the same value which is higher than that of the minimum and expected proceeds of the option.
However, considering the fact that the counterparty credit risk is typically lower with the money market hedge (since you get to pick which bank to save your money in), money market hedge is superior to using forward contracts and is thus recommended.
MM hedge & explain – 4 marks
Forward or MM hedge (no explanation) – 2 marks
Put Option – 0 mark
Note: Part marks will be given for wrong but consistent answer due to wrong calculation in part a.
Question 3 [10 marks]
(a) Write a brief description of the potential risks of issuing shares in the country of a subsidiary. (4 marks)
ANS. The potential risks include the following:
- The shares may not sell, or may only sell at a lower price than intrinsic value, if there is a narrow market in that country.
- The shares may be purchased by a competitor or by parties with goals which conflict with those of the parent.
- An exchange rate depreciation of the country of the subsidiary could lead to a loss of value of the parent’s share investment in the subsidiary. – Depending on the country, dangers of changes in legislation (including taxation) or stock exchange regulation which may negatively impact on the value and/or liquidity of the subsidiary’s shares.
- In some countries, the risk of expropriation through government share acquisition..
- Possible changes in foreign investment rules could lead to forced sales of certain shareholdings.
(b) What is the difference between payment in advance and payment in arrears? Explain the different risks from the perspective of an importer and an exporter.
What may be a better alternative to payment in advance and payment in arrears? (6 marks)
In international trade, payments in advance arrangements require the importer to pay the exporter before the goods are shipped. [Such payments are used primarily when the importer has a low or no credit rating, and/or in countries where political risks are high and/or where it is perceived that an importer may have difficulty getting foreign exchange and/or the goods have to be produced to costly specifications.]
Payments in arrears normally operate where the importer is permitted to order goods, with payment based on an invoiced amount, with or without a required payment date, but normally after the goods are received and inspected by the importer. [Such payments are used primarily when the exporter allows sales to an importer on open account and/or where there is a long-term and trusted trading arrangement between the parties.]
Payments in advance are less risky from the exporter’s perspective, as he does not have to finance the goods during their shipment.
By making payments in advance, the importer bears the risk of their goods being damaged in transit (unless insured) and possibly paying the shipping costs. Other risks are that the exporter defaults in delivery, becomes insolvent, disappears, provides the goods late, provides goods not of merchantable quality and / or not what was ordered. Importers may find that enforcement through the exporting country’s courts may also prove risky. Payments in arrears is risky to the exporter Letter of credit may be a better alternative.
Question 4 [20 marks]
Rice Ltd and Spelt Ltd are two companies that can borrow for a three year term at the following rates.
|International credit rating Fixed-rate borrowing cost||AA 5.5%||BB 8.5%|
|Floating-rate borrowing cost||LIBOR||LIBOR + 1.5%|
- Calculate the quality spread differential (QSD). (2 marks)
The QSD = [8.5% – 5.5%] minus [LIBOR + 1.5% – LIBOR] = [3%] – [1.5%] = 1.5%.
- Assume that Rice desires floating-rate debt and Spelt desires fixed-rate debt. No swap bank is involved in the transaction. Detail the process of an interest-rate swap where both Rice and Spelt have an equal cost savings in their borrowing costs. After the swap, what will their interest rate be? (6 marks)
- Rice needs to issue fixed rate debt at 5.5% and Spelt needs to issue floating- rate debt at LIBOR + 1.5%.
- Rice needs to pay LIBOR to Spelt. Spelt needs to pay 6.25% to Rice.
- If this is done,
- Rice’s floating-rate all-in cost is: [5.5% + LIBOR – 6.25%] = LIBOR – 0.75%, a 0.75% saving over issuing floating rate debt on its own (which would be at LIBOR – see question above); and
- Spelt’s fixed-rate all-in cost is [LIBOR + 1.5% + 6.25% – LIBOR] = 7.75%, a
0.75% saving over issuing fixed rate debt on its own (which would be at 8.5% – also see question above).
NOTE: It is possible to obtain the result in (c) by other paths or swap combinations. Award full marks for alternative strategies, as long as each party achieves a 0.75% saving over the above respective available market rates.
(iii) Re-do part (ii), however this time assuming that Northern Trust, a swap bank, is involved as an intermediary. You are advised that Northern Trust is quoting 3-year dollar interest rate swaps at 5.8 – 5.9 per cent against LIBOR flat.
After the swap, what will their (Rice and Spelt) interest rates be? How much is the share of QSD to the Rice, Spelt and Northern Trust? (10 marks)
- Rice will again issue fixed-rate debt at 5.5% and Spelt will issue floating-rate debt at LIBOR + 1.5%.
- In terms of the question,
- Rice will receive 5.8% from the swap bank, and pay LIBOR to the swap bank, while – Spelt will pay 5.9% to the swap bank and receive LIBOR from the swap bank.
- If this is done,
- Rice’s floating-rate all-in cost is [5.5% – 5.8% + LIBOR] = LIBOR – 0.3%, a
0.30% saving over issuing floating-rate debt on its own (at LIBOR); and
- Spelt’s fixed-rate all-in cost is [LIBOR + 1.5% + 5.9% – LIBOR] = 7.4%, a 1.1% saving over issuing fixed-rate debt on its own (at 8.5%).
As the swap bank has quoted a swap at “5.8-5.9% against LIBOR flat”, this clearly favours Rice. Under these swap conditions, the QSD is not shared equally. Of the QSD of 1.5%, 0.1% goes to the swap bank. 0.3% to Rice and 1.1% to Spelt.
(iv) In what circumstances would an organisation use an Interest rate swap? (2 marks)