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The question stated that now is mid-December, the company HAS borrowed $30 million to purchase equipment. The $30 million is due in 2 month’s time.
NO OTHER DATES WERE PROVIDED.Thus, I understand that settlement date is on mid- February, where the company has to start borrowing the loan.
NO information was given as to how long the period for the loan to be fully repaid.
However, The answer given was:
1. To assume the loan was borrowed in Mid Dec, and repaid on February.
*I don’t understand this. Shouldn’t the loan be borrowed BEGINNING on Mid-February? as Payment was only Due on Mid-February itself.* Also, I would like to know if it is possible to hedge AFTER borrowing?
2. FRA prices were given for 3v6, 3v5, 3v8. My lecturer said that as the question implies that the loan was borrowed for 2 months ( mid dec to mid feb), we should just take the nearest accurate FRA price, which is 3v5.
*From what I understand, FRA 3v5 means to borrow a loan in 3 months time for a period of 5 months (pls correct me if I am wrong :)); So, is it really acceptable to assume that FRA 3v5 can be used on a 2 month loan?
(This is a question which my lecturer cleverly amended based on another question, and all students feel that the question has errors/incomplete info, or either we do not have sufficient knowledge to understand it.) We still wonder if the question had insufficient info/incorrect info provided., thus I decided to seek opinion from a tutor on this platform.
Thank you!
It is difficult for me to give a precise answer without seeing the whole question.
However if you have typed the the first 2 lines correctly then it is either a very silly question or has been worded extremely badly.
Since it says they have borrowed 30M then it suggests that the money has already been borrowed and is repayable in 2 months time. In this case there is no hedging needed – they will have borrowed at fixed interest already!Hedging is only relevant if they will be borrowing the money in 2 months time, and therefore the interest rate they will pay is uncertain.
If they will be borrowing the money in 2 months time, then they could use an FRA, but it certainly would not be FRA 3v5. It would be an FRA 2v? (where ? would be the month the loan was due to finish, so if it were going to be a 6 month loan then it would be an FRA 2v8)
Again, as you have written it then it is an appalling question.
I think you would be better watching my free lectures on interest rate risk management where I explain all of the hedging methods, in detail, with examples. (And FRA’s are hardly mentioned in the P4 exam – it is more relevant to F9 – and when they are mentioned it is only for 1 or 2 marks. Far, far more important for P4 is knowing how to use interest rate futures, and interest rate options on futures.)
Thank you! All I needed was an experienced tutor like you to confirm that it was a weird question. From now onwards I will refer to your lectures to understand and learn better.
Anyway for reference this was the original question:
Assume now is mid December.
The finance manager of a company, which is involved in the export and import of frozen food for distribution in the European Market, purchased equipment amounting to $30 million which is due in 2 months’ time. In order to finance the purchase, the company has borrowed $30 million from the capital market. There is a rumour that the central bank will increase the interest rates in the near future. The finance manager is concerned with the risk exposure.
(The rest of the question provided the company’s borrowing rates, 3 months sterling futures for Dec, Mar, June; 3 month options for the following 3 months as well, and FRA prices as mentioned above in my earlier comment).
Required:
Illustrate how the interest rate risk might be hedged against if interest rate increases by 0.5%.The lecturer gave another answer later, and from what I understand, it is now assumed that the company borrowed in 2 months’ time (which is supposedly correct in concept) and, well, as no borrowing period was provided, just assume borrow till the next available futures price date (March). thus we can assume the company borrowed for 1.5 months!
Which is plain ridiculous as it contradicts the FRA calculation of borrowing for 2 months.
Anyway like you said, the word HAS indicates that the money has already been borrowed, which defeats the entire purpose of hedging.
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