Introduction
The assignment is divided into two tasks. The first focuses on the management of foreign exchange risk using both over-the-counter and exchange traded techniques. Task two is about managing interest rate risk using a swap.
Below the task outlines are tables with the financial market information you need to carry out the tasks.
Collectively the marks for the tasks add up to 95 percentage points. The remaining 5 percentage points relate to presentation. Submission should be in the form of a physical copy. This is an individual, not group, piece of work. University regulations state that proven plagiarism means sanctions, up to expulsion from the curse.
Bruce Engineering Plc
UK company Bruce Engineering Plc is part of a consortium of companies involved in the construction of a major new sporting venue in North London. On 23 rd February Bruce commissioned a French architectural company to undertake design and planning work,
agreeing to pay €7.48 million. Payment is in in four equal instalments, due on 23 rd March 2018, 23 rd May, 23 rd October and 22 nd February. Three years ago (23 rd February) Bruce borrowed £102 million via a seven-year floating-rate note issue. The notes were sold at par (£100) and offer a coupon of sterling LIBOR plus 180 basis points. Interest is payable semi-annually on 23 rd February and 23 rd August each year. The periodic coupon rate is based on the six-month LIBOR at the start of each payment cycle.
On 23 rd February Bruce’s finance director (FD) made the following observations:
- The contractual agreement with the French company exposes Bruce to exchange rate risk.
- When the company undertook the note issue in 2015, short-term interest rates were very low making variable-rate borrowing very attractive compared to the fixed rate on offer. Furthermore, Bruce was able to reduce the cost of borrowing further by issuing
non-callable notes.
However, evidence of growing inflationary pressures in the UK, and recent comments by the Bank of England on monetary policy, has shifted market opinion towards a belief that interest rates are set to rise in the forthcoming period.
The FD went on to make the following recommendations:
- Hedge the exchange rate risk using over-the-counter or exchange-traded instruments.
- Agree a swap to transform the remaining interest payments on the loan into fixed rate payments.
Task 1: Exchange Rate Risk Management
- Explain Bruce’s exchange rate exposure and generate measures of over-the-counter forward rates for each payment based on covered interest rate parity.
i. The day-count convention applying to sterling money market transactions is actual/365 days, whilst for euro money market transactions it is actual/360 days.
ii. In the absence of interest rates corresponding to the terms of the transactions, use the available data to interpolate a suitable rate. - Show how Bruce could use currency futures to hedge the effects of exchange rate uncertainty associated with each payment.
- Assume that on 23 rd May 2018 the EUR/GBP spot rate is £0.80020 – £0.80036. Assess the efficiency of the futures-based hedge if the futures price on 23 rd May is £0.80100
- On 23 rd February a bank offers a one-month euro forward exchange rate of £0.87500. Show how an arbitrageur could profit and comment on the forward rate in relation to the principle of covered interest rate parity. (You might find the point easier to discuss by assuming the arbitrageur puts into play a specific sum of money).
- Discuss the relative merits for Bruce of the over-the-counter and exchange-traded methods of hedging currency risk. (Link the analysis to the specifics of Bruce’s risk management situation. Don’t limit the discussion to textbook-style generalisations)
Task 2: Interest Rate Risk Management
- Calculate:
i. The prices of the zero-coupon bonds listed in Table 4
ii. The annualised six-month forward rates from the current yields
iii. The par coupon rates. - Identify the rate at which Bruce can fix the remaining interest payments on its debt. Assume the bank charges four basis points for the swap.
- Compare the swap rate with the current variable rate on Bruce’s debt and discuss the advantages and disadvantages of Bruce entering into the swap agreement.
- Assume that Bruce pays interest on its debt based on a six-month sterling LIBOR of 1.47%. Calculate and comment on the transaction that occurs between Bruce and the bank counterparty to the swap.
- Show how the bank might seek to protect its return by entering into forward rate agreements.
