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:
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.
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)
Options on three months sterling futures
($500,000 contract size, premium cost in annual %)
|3 v 6||7.01 – 6.91|
|3 v 5||7.08 – 7.00|
|3 v 8||7.28 – 7.20|
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.
(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)
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:
Let me show you how my answer would look followed by my explanations of each step I have taken.
Answer - Part (a)
* March futures ints = 100 – 93.790
Titans FC could take two strategies to manage the short-term interest rate risk:
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.
Irrespective of whether LIBOR rises or falls, the effective annual cost of the short-term finance will be 7.08 + 0.90 = 7.98%
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.
The cash flows and final APRs will be:
|Loan interest $30m x|
(LIBOR + 0.90)% x 2/12
|Close out the hedge|
(5.53-6.21)/0.01 x $12.50 x 40
(7.03-6.21)/0.01 x $12.50 x 40
|Total cash cost||(354,000)||(354,000)|
(354/30,000) x 12/2 x 100
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.
The cash flows and final APRs will be:
|Loan interest payable|
as for futures above
Cap is exercised when March futures
Cash received will be
|Total cash cost||(332,750)||(356,250)|
(332.75/30,000) x 12/2 x 100
(356.25/30,000) x 12/2 x 100
|No Hedge (LIBOR + 0.90)|
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:
Answer - Part (b)
This answer is self-explanatory.
(1) Table of interest rates.
LIBOR + 1%
(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
|Paid to the Bank||(8)||Paid to the Bank||(LIBOR +2)|
|Received from Kendri Co*||10||Received from Titans FC||LIBOR + 2|
|Paid To Kendri Co||(LIBOR + 2)||Paid to Titans FC *||(10)|
(LIBOR + 0.5)
*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.
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