- 20 Marks
Question
a) You are the assistant to the Finance Manager of Kunta Medical Centre. Your boss is negotiating a deal with an investment company investing GH¢500,000 over 3 years. The main terms of the proposed investment deal are that if the amount is deposited now and invested continuously for 3 years, it would attract an 18% annual interest rate with quarterly compounding. However, if the initial deposit of GH¢500,000 is maintained and additional deposits of GH¢50,000 each are made at the beginning of year 2 and year 3, the deposits would attract 18.0% annual interest in year 1, 18.5% in year 2, and 19% in year 3, all with quarterly compounding.
Your boss has asked you to do some computations to inform her about the growth of the deposits based on the terms of the proposed deal.
Required:
i) Suppose GH¢500,000 is deposited now, and there are no top-up deposits in the future; Compute the future value of the deposit at the end of the third year. (3 marks)
ii) Suppose the initial deposit of GH¢500,000 is made now, and the top-up deposits of GH¢50,000 each are made in the future per the terms of the proposed investment deal;
- Compute the future value of the initial deposit at the end of the third year. (3 marks)
- Compute the aggregate future value of the top-up deposits at the end of the third year. (3 marks)
- Compute the aggregate future value of all the deposits at the end of the third year. (1 mark)
b) Sesamu Dried Fruits Ltd is a fruits processing company in Ghana. The company has exported raw mangoes to a distributor in Japan. The invoice value of JP¥20 million is to be collected in three months. The exchange rate between the Ghanaian cedi (GH¢) and the Japanese yen (JP¥) is currently GH¢0.0584/JP¥1. It is expected that the Ghana cedi may appreciate against the JP¥ in the coming months.
Required:
Using the leading and lagging strategy for hedging currency risk exposure, is it advisable for the company to lag the collection of the JP¥ invoice value? (5 marks)
c) COVID-19 has led to volatility in the international money market. Although international business has seen some improvement, progress has been very slow. As a result, the risk of losing part of an investment due to exchange rate and currency value fluctuations are very high.
Required:
Explain how Interest Rate Swap and Currency Swap can be used to mitigate the effects of market volatility. (5 marks)
Answer
i) If GH¢500,000 is deposited now with no top-up deposits, the future value of the account will be GH¢847,940.72:
ii) If GH¢500,000 is deposited now and the GH¢50,000 top-ups are made, the future value of the account will be GH¢992,518.17:
- The initial GH¢500,000 deposit will be compounded in the first, second, and third years at the respective interest rates. Its FV at the end of the third year may be calculated as under:
FV3 = GH¢500,000 × 1.720375196 = 𝐆𝐇¢𝟖𝟔𝟎, 𝟏𝟖𝟕. 𝟔0 - The FV of the GH¢50,000 top-up deposits will be GH¢132,330.57:
- The first top-up, which occurs at the beginning of the second year, will be invested in the second and third years. Its FV may be calculated as under:
- The second top-up, which occurs at the beginning of the third year, will be invested in the third year. Its FV may be calculated as under:
Aggregate FV of top-ups = GH¢72,132.01 + GH¢60,198.56 = GH¢132,330.57 - Aggregate FV3 = GH¢860,187.60 + GH¢132,330.57 = GH¢992,518.17
- The first top-up, which occurs at the beginning of the second year, will be invested in the second and third years. Its FV may be calculated as under:
b) Sesamu Dried Fruits Ltd – Currency risk problem:
Applying the leading and lagging strategy:
- Leading refers to collecting an underlying foreign currency receivable earlier to avoid a potential currency loss in the future.
- Lagging refers to delaying the collection of an underlying foreign currency receivable to enjoy a potential currency gain in the future.
Given that the cedi is expected to appreciate against the yen, the best time to collect the receivable is now or at least earlier than the agreed settlement date in four months. Thus, lagging the receivable collection is not advisable; the company should instead lead the collection.
- Interest Rate Swap: An agreement between two parties to exchange one stream of interest payments for another over a set period. Commonly, it involves exchanging fixed-rate payments for floating-rate payments based on LIBOR.
- Currency Swap: A derivative contract that involves the exchange of interest payments and, in some cases, principal amounts denominated in different currencies. Currency swaps are primarily used to hedge potential risks associated with fluctuations in currency exchange rates or to obtain lower interest rates on loans in a foreign currency.
- Topic: Foreign exchange risk and currency risk management
- Series: NOV 2021
- Uploader: Kwame Aikins