December 2014 Q2 Exam P4 past paper (SWAP part)

Dear Tutor,

I m finding difficult to understand ACCA P4 December Q2 answer from ACCA website.

I cannot understand how they got the effective rate in their correction can you please go through and direct me, it is very confusing.

Question:

2 Keshi Co is a large multinational company with a number of international subsidiary companies. A centralised treasury
department manages Keshi Co and its subsidiaries’ borrowing requirements, cash surplus investment and financial
risk management. Financial risk is normally managed using conventional derivative products such as forwards,
futures, options and swaps.
Assume it is 1 December 2014 today and Keshi Co is expecting to borrow $18,000,000 on 1 February 2015 for a
period of seven months. It can either borrow the funds at a variable rate of LIBOR plus 40 basis points or a fixed rate
of 5·5%. LIBOR is currently 3·8% but Keshi Co feels that this could increase or decrease by 0·5% over the coming
months due to increasing uncertainty in the markets.
The treasury department is considering whether or not to hedge the $18,000,000, using either exchange-traded
March options or over-the-counter swaps offered by Rozu Bank.
The following information and quotes for $ March options are provided from an appropriate exchange. The options
are based on three-month $ futures, $1,000,000 contract size and option premiums are in annual %.
March calls Strike price March puts
0·882 95·50 0·662
0·648 96·00 0·902
Option prices are quoted in basis points at 100 minus the annual % yield and settlement of the options contracts is
at the end of March 2015. The current basis on the March futures price is 44 points; and it is expected to be
33 points on 1 January 2015, 22 points on 1 February 2015 and 11 points on 1 March 2015.
Rozu Bank has offered Keshi Co a swap on a counterparty variable rate of LIBOR plus 30 basis points or a fixed rate
of 4·6%, where Keshi Co receives 70% of any benefits accruing from undertaking the swap, prior to any bank
charges. Rozu Bank will charge Keshi Co 10 basis points for the swap.
Keshi Co’s chief executive officer believes that a centralised treasury department is necessary in order to increase
shareholder value, but Keshi Co’s new chief financial officer (CFO) thinks that having decentralised treasury
departments operating across the subsidiary companies could be more beneficial. The CFO thinks that this is
particularly relevant to the situation which Suisen Co, a company owned by Keshi Co, is facing.
Suisen Co operates in a country where most companies conduct business activities based on Islamic finance
principles. It produces confectionery products including chocolates. It wants to use Salam contracts instead of
commodity futures contracts to hedge its exposure to price fluctuations of cocoa. Salam contracts involve a commodity
which is sold based on currently agreed prices, quantity and quality. Full payment is received by the seller
immediately, for an agreed delivery to be made in the future.
Required:
(a) Based on the two hedging choices Keshi Co is considering, recommend a hedging strategy for the
$18,000,000 borrowing. Support your answer with appropriate calculations and discussion. (15 marks)
(b) Discuss how a centralised treasury department may increase value for Keshi Co and the possible reasons for
decentralising the treasury department. (6 marks)
(c) Discuss the key differences between a Salam contract, under Islamic finance principles, and futures
contracts. (4 marks)
(25 marks)

Bellow Answer

Using swaps
Keshi Co Rozu Bank offer Basis differential
Fixed rate 5·5% 4·6% 0·9%
Floating rate LIBOR + 0·4% LIBOR + 0·3% 0·1%
Prior to the swap, Keshi will borrow at LIBOR + 0·4% and swaps this rate to a fixed rate. Total possible benefit is 0·8%
before Rozu Bank’s charges.
Keshi Co borrows at LIBOR + 0·4%
From swap Keshi Co receives LIBOR
Keshi Co gets 70% of the benefit
Advantage (70% x 0·8 – 0·10) 0·46%
Keshi Co’s effective borrowing rate (after swap) 5·04%

Alternatively (Swap)
From swap Keshi Co receives LIBOR
Keshi Co pays 4·54%
Effective borrowing rate (as above) 4·54% + 0·4% + 0·10% = 5·04%

I do understand the swap effective rate calculation answer is derived from ACCA official answer.