# Critically assess the useful of money market hedging

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## Question 1 – Money Market Hedging                                                                      (50 marks)

Z Gmbh (a German based company) wants to use money market hedging to reduce currency risk for anticipated future cashflows in A\$.

The cashflows are as follows:

• A receipt of A\$2m after 2 months
• A payment of A\$3.5m after 4 months

The current spot rates are A\$1.7512 – 1.7578/€.

The interest rates available to Z Gmbh are as below:

Deposit (pa)                Borrowing (pa)

Germany                     3.75%                          9.15%

Australia                     2.65%                          8.35%

(a)        Perform a money market hedge on each of the two transactions individually.                                                                                                                                                (6 marks)

(b)       Combine the transactions (i.e. attempt to net off the payment with the receipt) and perform a money market hedge on the balance.                                             (4 marks)

(c)        Critically assess the useful and prevalence of money market hedging as a method of managing foreign currency risk.                                                               (5 marks)

(d)       If inflation in Australia was 4% per annum and 7% in Germany use the Fischer equation to calculate what the spot rates would have been on the transaction date and whether, with the benefit of hindsight, they should have used a money market hedge.                                                                                                            (5 marks)

Further financial information was gathered regarding alternative forms of hedging as below:

 Call options (c/€) Put options (c/€) 2 months 4 months 2 months 4 months K = \$1.7450/€ 0.87 0.98 0.41 0.55

The future spot rates are anticipated to be as below:

S2mth                 A\$1.7490 – 1.7538/€

S4mth                            A\$1.7432 – 1.7482/€

(e)        What would be the € proceed from the receipt and the € cost for the payment if the above Forward rates were used separately on the transactions?              (6 marks)

(f)       What would be the € proceed from the receipt and the € cost for the payment if the above options were used separately on the transactions?                            (10 marks)

(g)        Discuss the principle of purchasing power parity and evaluate its ability to act as standard of currency valuation                                                                 (5 marks)

(h)      Compare and contrast the motivation, risk appetite and objectives of speculators and hedgers.                                                                                                       (9 marks)

TOTAL 50 MARKS

Question 2 – Interest Rate hedging

Potato Gmbh requires a short-term loan to improve liquidity in the short-term while awaiting a large payment from a lottery win. They anticipate that they will need to borrow €6.1m for six months from the 1st of July (it is now the 1st of April). The FD has gathered the below information regarding possible hedges against an increase in the interest rate:

So                                            4.37%

Sn        (in 3 months’ time)     3.13%

Futures Price                           96.31               (Current) (Underlying bond size of €125k)                                                 96.94               (In 3 months’ time)

Option prices                          0.07%/€           (Call Option with K = 3.45%)

0.28%/€           (Put Option with K = 3.45%)

(a)        With the benefit of hindsight which hedge should Potato Gmbh have taken (show all workings required to come to your conclusion)?                                      (12 marks)

(b)        Critically discuss THREE factors that could be influencing the interest rate and causing it to change.                                                                                       (5 marks)

(c)        Critically discuss how the following factors may influence may be considered when borrowing additional funds: (Max word count is 90 words)

1. Term of the loan
2. Fixed vs floating interest rates

iii.        Currency of loan                                                                     (9 marks)

(d)      Describe the construction of an interest rate collar and assess the impact it will have on the interest rate that a borrower may end up paying. (Max word count is 50 words)                                                                                                                (5 marks)

Potato are also considering a 10-year loan to fund a medium-term UK business expansion. Having heard about interest rate swaps the following information has been gathered:

 Potato X Y Z Fixed 7.8% 8.2% 10.5% 6.1% Floating L + 1.9% L + 2.7% L+ 5% L + 0.7% Preference Fixed Fixed Floating Floating

The fee for having the swap agreed is 0.25%. Potato can only perform a swap with one of X, Y or Z.

(e)        Which potential counter-party would produce the lowest preferred rate for Potato (X, Y or Z)? What are the terms of that swap?

(HINT: you may want to work out whether a swap is feasible for X, Y and Z and how much benefit is created for each alternative)                                       (14 marks)

(f)        Critically assess the additional challenges of performing a currency swap with a foreign organization relative to a domestic interest rate swap.

(5 marks)

TOTAL 50 MARKS

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