Risk -1

H Company, a large manufacturer, is planning to sell an existing subsidiary and use the
funds to buy land and build a new factory. The proceeds of the sale are likely to be delayed,
so the directors have estimated that $10 million will be needed in 3 months’ time for a
period of 6 months. Given this, the directors have decided that a bank loan would be
appropriate as a form of finance rather than equity sources.
After checking that interest rate yield curves in the financial press are normal rather than
inverted, the treasurer is now looking to hedge the interest rate exposure. Traditionally
H Company has used forward rate agreements (FRAs) for hedging interest rate risk
exposure but the treasurer is now considering using interest rate futures, although she is
concerned that futures will not be as good a hedge as the FRAs.
H Company’s bank have offered an FRA on the following terms:
3v9 FRA 7.2 – 7.8%

Which TWO of the following are possible reasons why the Directors decided that a
bank loan was preferable to equity in this case?
A The factory will act as security on the loan
B They believe Modigliani and Miller’s theory of gearing with taxation
C All equity sources have higher issue costs than the loan
D The servicing cost of the debt will be lower.

The answers are B and D. Can you explain why is it so? I didn’t understand the solution given in the kit.

2. It is now the 31st of January. The treasurer of F Company is reviewing cash forecasts and
funding requirements and has identified the need for the following transactions:
Transaction 1:
F Company will have a surplus of $1 million from 1st of May for 3 months, which will need
to be deposited to earn additional interest. The treasurer has seen inverted interest rate
yield curves in the financial press, so is considering using a 3v6 FRA quoted at 5% – 5.6% to
hedge the interest rate risk exposure. He is also considering the use of interest rate options
as an alternative strategy.
What is the payment/receipt payable on the FRA if the reference interest rate
moves to 5.5% on the 1st May?

Ca you tell me this one? I’m confused about this questions. Btw, i have watched all your free lectures 😀

221 PZK Co, whose home currency is the dollar, trades regularly with customers in a number of
different countries. The company expects to receive €1,200,000 in six months’ time from a
foreign customer. Current exchange rates in the home country of PZK Co are as follows:
Spot exchange rate: 4.1780 – 4.2080 euros per $
Six?month forward exchange rate: 4.2302 – 4.2606 euros per $
Twelve?month forward exchange rate: 4.2825 – 4.3132 euros per $
The interest rate in the home country of PZK Co is 4% per year.
As well as considering the use of derivatives to hedge the risk exposure presented by the
receipt, the treasurer of PZK is looking at ‘internal’ methods such as invoicing in dollars and
leading and lagging

With reference to PZK making foreign currency purchases, which of the following
statements concerning whether PZK Co should ‘lead’ or ‘lag’ in its management of
the anticipated receipt is true?
A The $ is expected to weaken against the €, so PZK should lead
B The $ is expected to weaken against the €, so PZK should lag
C The $ is expected to strengthen against the €, so PZK should lead
D The $ is expected to strengthen against the €, so PZK should lag

I’m literally confused about this question. Should foreign currency purchases or receivables be considered here..