Interest rate risk management

In September 2011, ACCA published an article for candidates preparing to sit Paper P4 on interest rate risk management. Since then, this topic has appeared in several papers and this article has been updated to reflect what the examining team is expecting to see from a successful candidate.

So how do you answer a Paper P4 question on interest rate risk management? The purpose of this article is to show how you can maximise your marks by producing an answer that will impress the examining team and markers on a topic that has caused students significant difficulty.

We must start by understanding the examining team’s philosophy – what is expected of Paper P4 candidates? From reading previous articles and reviewing past exam questions, we can identify three recurring themes:

1. Exam questions have been – and will continue to be – scenario based, requiring students to demonstrate their analytical skills. The requirements have been clear and without ambiguity.
2. They require candidates to apply the skills they have learned in the classroom and from textbooks to solve the issues raised. The calculations that need to be performed will be carried out under an element of time pressure – therefore, good technique is essential.
3. Most importantly, to successfully pass, candidates must be able to discuss and give advice – it is not sufficient to leave the answer as a string of figures and computations lacking relevant explanations.

It is therefore clear that, as a Paper P4 candidate, you know what you have to do to pass. There can be no replacement for thoroughly studying the entire syllabus, with the emphasis on the major topics such as risk management. Revision through practising as many past exam – or exam style – questions as possible is absolutely essential. With the latter in mind, let’s consider a question on interest rate risk management and tackle it in an efficient and effective manner.

Question - Titans FC (Revised)
Titans FC is the most successful football club in the country having recently secured a record number of premier league titles. Success on the pitch has been matched with business success. The club has a strong financial position and a solid revenue stream generated from worldwide sales of its merchandise and a substantial amount of income earned from sponsorship agreements.

Titans FC is a listed company as 10% of the issued share capital was sold via an initial public offering (IPO) last year. The Steelers family currently owns the remaining 90% of the equity in Titans FC but leave the running of the club to its board (BoD) and the club’s experienced team manager.

Today, 15 December 20X1, the BoD has two financing decisions to make that will benefit Titans FC both in the short and long term.

New player
The team manager has approached the BoD with the proposal regarding the acquisition of a new player in the next transfer window, which will open in a couple of weeks’ time (1 January 20X2). The player has expressed a strong interest in joining Titans FC and is currently valued at $30m. Initial discussions with the player’s agent indicate that Titans FC will have to settle the full value with Santini AFC, the player’s current club, by 15 March 20X2. This will, he says; secure the player’s services.

The BoD agrees with the team manager and wants to make the appropriate funds available. However, the club’s finance director (FD) has stated that the club will need a temporary loan facility from the club’s bankers for a period of two months, as Titans FC will not receive funds from its sponsorship contracts until 15 May 20X2.

The FD has spoken to the bankers who have agreed to provide the $30m needed. Given Titans FC’s credit rating, the short-term loan will be at a rate of 90 basis points above the LIBOR. Currently, LIBOR is at 6%. The bank has also suggested that, due to current economic uncertainty, LIBOR may rise by 1% or even fall by 0.5% over the coming months.

With this in mind, Titans FC’s board has sanctioned the FD to manage this risk in a manner he thinks will best suit Titans FC. The FD has obtained the following data from the money and traded derivatives markets.

Derivative contracts may be assumed to mature at the end of the month.

Three months sterling future ($500,000 contract size, $12.50 tick size)

December    93.870
March           93.790
June             93.680
 

Options on three months sterling futures
($500,000 contract size, premium cost in annual %)

FRA prices:

New Training Facilities

The team manager has suggested that the club needs to invest in new training facilitates which will lead to better player performance and fitness. The BoD have assessed this proposal have agreed to spend the necessary $150m needed. Titans FC will fund $50m from cash resources due to come in from its sponsors and will finance the balance with a five-year loan to be taken out on 1 July 20X2.

The club’s bankers have agreed to provide the finance on either at a fixed rate of interest of 8% pa or at a variable rate of LIBOR + 1% pa. The bankers have also informed Titans FC that they have another client, Kendri Co, who is seeking finance of the same value over the same term. Kendri Co’s credit rating is not as good as Titans FC and they can raise finance at either 11% pa or LIBOR + 2% pa.

The bank is willing to arrange an interest rate swap in return for a fee of 0.5% pa from each party.

Requirements

(a) Demonstrate and explain the possible ways in which the interest rate risk may be managed, in relation to the purchase of the new player, using the information provided above. Advise the board of Titans FC on an appropriate course of action based on your analysis. (18 marks)

(b) Demonstrate how Titans FC could benefit from the swap offered by the bank. (7 marks)

(25 marks)

While there is clearly a lot information to digest, a well-prepared candidate must stay positive before attempting to answer the question. Three points to note at this stage:

1. Time allocation – 1.8 minutes per mark means that we have to complete the question in 45 minutes, with 32 minutes spent on Part (a) and 13 minutes on Part (b). Time discipline should already be familiar to those sitting Paper P4, but it is especially vital for this exam.
2. Understand the requirements – pick out the key words in the question. In Part (a) above, they are ‘demonstrate’, ‘explain’, ‘interest rate risk’ and ‘advise’; similarly, in part (b), ‘demonstrate’ and ‘benefit’. From here, it is clear which style of answer is required and, more importantly, which area of the syllabus is being tested.
3. Order of attack – it is a fallacy that many students believe that they must undertake the exam in question order and that individual elements of questions must be done in the order set. This is simply not true. As stated above, staying within the time allocation is what matters the most.
   
   In addition, the question requirements may be independent of each other. This will allow a candidate to attempt the question in an order that suits them. The Titans FC question fits this style; Part (b) could be attempted before preparing an answer to the initial requirement.

Let me show you how my answer would look followed by my explanations of each step I have taken.

Answer - Part (a)

Timeline:

* March futures ints = 100 – 93.790

Titans FC could take two strategies to manage the short-term interest rate risk:

• Lock or fix the rate today. This will remove both upside and downside movement in LIBOR. This can be achieved by using a FRA or an interest rate future.
• Create a cap or ceiling rate. Titans FC will then know what the maximum interest rate the club will pay on the short-term loan facility. They will use an appropriate interest rate option to create the ceiling rate.

FRA

15/12
Titans will obtain a $30m FRA 3 v 5 at a rate of 7.08% pa from the OTC market. This will LOCK the LIBOR at that annual rate.

15/3
Irrespective of whether LIBOR rises or falls, the effective annual cost of the short-term finance will be 7.08 + 0.90 = 7.98%

Financial Futures

15/12
To create an effective locked rate, Titans FC will SELL March futures at the current price of 93.790%.

Given contract lengths are standardised at three months, the number of contracts needed will be $30m/$0.5m x 2mths/3mths = 40

Titans FC would also have to pay a deposit (margin) to be held on the market for the period of the hedge. This is cash flow issue for Titans FC, but it is not a cost for this hedge.

15/3
The cash flows and final APRs will be:

Traded options

15/12
There are various ways in which Titans FC can choose a rate at which to cap the interest rate. One method is to choose an option, which caps the value at the current LIBOR of 6%. This will be a MARCH PUT AT 94.000.

The number of contracts will be as for futures above = 40.

The premium payable now is 0.255% x 40 x $500,000 x 3/12 = $12,750.

This is non-refundable and is, hence, a cost of using options.

15/3
The cash flows and final APRs will be:

ADVICE

Titans FC only needs the credit facility for a short period of time. Locking the rate will provide the company with certainty. It will know what the cash cost of the loan will be and can plan accordingly. The FRA is more expensive in this case compared to futures.

However, the options will provide Titans FC with an element of flexibility should rates fall. There is a cost for this, which is the non-refundable premium. Titans FC may choose to reduce this cost by selecting to cap at a higher rate than 6.00% or using a collar hedge. The latter will involve the entity sacrificing some benefits if rates fall below the floor level.

The recommendation is to use futures given the certainty it provides and short-term period of the hedge.

Explaining my approach:

• When reading the question, I draw and complete the timeline. This gives me control of the data in this part of the question and I need to refer to the timeline later in the answer. The timeline also shows the basis computation.
• Making a statement to set the scene gives the answer a foundation and a base to move forward from. I have stated that Titans FC have two choices – to lock the rate or set a cap.
• On all the hedging methods, I have chosen a simple format stating how the hedge is set up on 15/12 and the evaluation of the hedge on 15/3.
• Identifying the correct FRA is important. As the finance will be needed 3 months from today (15/12) and the loan will be for two months, a ‘3 v 5’ is the relevant FRA. In addition, the FRA locks the LIBOR for a loan at the higher of the two rates listed – 7.08%. (The lower rate is applicable to locking interest earned on investments).
• The evaluation of the FRA is straightforward, but the credit risk premium must be added to obtain the annual rate of 7.98%.
• The futures hedge relies on the use of the timeline. With the loan finance starting on the 15/3 the March futures are the relevant ones to use.  The downside risk would be if LIBOR rises from 6.00%, which will cause the March futures interest to move up from 6.21% and correspondingly the March futures price to fall. Hence, this is the reason to SELL March futures at 93.790.
• Please note very carefully how I have computed the number of contracts. The loan value divided by the standard contract size has to be scaled based upon the PERIOD OF THE LOAN over the standard contract length of 3 months.
• Setting up a columnar layout for the evaluation of the hedge will help to save time. The interest payable is a simple calculation, but it is important to remember the loan is for a two-month period.
• The profit or loss on the hedge is computed based upon the number of contracts (40) into the tick value ($12.50). The final component is to refer to the timeline and compute the tick movement up/down on the March futures interest rate from the value on 15/12 of 6.21%.
• The total cash cost should be converted into an APR to allow a comparison with the other methods of hedging.
• Creating a ceiling rate in this case leads to Titans FC purchasing March put options. (Call options would have been used to create a floor rate). As stated in my answer, there are various ways of choosing a ceiling rate. I use a simple philosophy here. I wish to set the ceiling rate at a value exactly or as close to the current LIBOR.
• In the exam, you can either evaluate an option at one rate and explain why this rate is the most suitable, or evaluate the option at two different rates to demonstrate which one is better. 
• Note how the premium is computed.
• The evaluation of the hedge uses a similar columnar layout as mentioned above. The interest payment and premium are simply ‘copy and paste’ values.  The option will only be exercised if the March futures interest rate on 15/3 exceeds 6.00%. Reference needs to be made back to the timeline.
• Finally the advice section starts with a summary of the relevant APRs. This makes the comments a little easier to put together. As long as you make comments based upon your numbers, marks will be awarded.

Answer - Part (b)
This answer is self-explanatory.

(1) Table of interest rates.

(2) Comparative Advantage       
It can be seen that due to Titans FC’s better credit rating it has an ABSOLUTE ADVANTAGE in both the fixed and floating rates.

However, when comparing Kendri Co with Titans FC, it has to pay a RISK PREMIUM of 3% more in the fixed rate market but only 1% more in the in the floating rate market. Hence, Kendri Co is said to have a COMPARATIVE ADVANTAGE in the FLOATING RATE market.

Kendri Co should take out a FLOATING RATE loan from the bank and Titans FC should borrow at the FIXED RATE. A swap can be arranged such that each party will save (3%-1%) x ½ = 1% pa excluding fees.

(3) Suggested swap

*11% - 1% = 10%

Titans FC would pay an annual floating rate of LIBOR + 1% without undertaking the swap and this is reduced by 0.5% if the swap is undertaken.
 

Conclusion

It is imperative that candidates intending to attempt Paper P4 follow a comprehensive mode of study covering all areas of the syllabus. This coupled with practising past Paper P4 questions within the relevant time constraints is the best way to be ready for the forthcoming test.

This article has concentrated on one of the key syllabus areas of interest rate risk management.  It has demonstrated that, although this topic is not exactly easy, with good exam technique and application of the relevant methods achieving a mark worthy of a pass is well within the bounds of all students.

Sunil Bhandari, freelance Paper P4 tutor
www.SunilBhandari.com