• 15 Marks

FM – May 2018 – L3 – SC – Q5 – Financial Risk Management

Use of forward rate agreements and interest rate management tools for borrowing concerns in Katangwa Limited.

Katangwa Limited will need to borrow ₦50 million in three months’ time for a period of six months. The company is concerned that interest rates are expected to rise over the next few months.

Interest rates and forward rate agreements (FRAs) are currently quoted as follows:

  • Spot 5.75 – 5.50
  • 3 – 6 FRA 5.82 – 5.59
  • 3 – 9 FRA 5.94 – 5.64

Required:

a. Explain how a forward rate agreement (FRA) may be useful to the company. Illustrate this on the basis that interest rates: i. Rise to 6.50% ii. Fall to 4.50%

(8 Marks)

b. Compare the use of interest rate futures with FRA in this instance. (4 Marks)

c. Explain how interest rate guarantees or a short-term interest rate cap could be used. (3 Marks)

a. Using a Forward Rate Agreement (FRA)
An FRA allows Katangwa Limited to lock in an interest rate for a future loan, reducing the risk of rising interest rates.

i. If interest rates rise to 6.50%:
– Katangwa can benefit from the FRA by paying the pre-agreed lower rate (e.g., 5.82%) instead of the increased market rate. – The bank compensates the company for the difference between the market rate (6.50%) and the agreed FRA rate, thereby effectively lowering their borrowing cost.

b. Comparison with Interest Rate Futures

  • Flexibility: Interest rate futures offer more flexibility than FRAs, as they can be traded on exchanges before maturity.
  • Liquidity: Futures contracts generally provide greater liquidity.
  • Precision: FRAs offer precise rate hedging tailored to the company’s specific borrowing dates and amounts, unlike standard futures.
  • Cash Flow Impact: With futures, margin requirements apply, which may affect cash flow, while FRAs are settled only at contract maturity.

c. Interest Rate Guarantees or Short-Term Interest Rate Cap

  • An interest rate cap allows Katangwa to benefit from falling rates while setting a maximum cap if rates rise above a specified level.
  • The cap involves a premium but ensures that interest expenses remain manageable.
  • With a rate guarantee or cap, Katangwa limits exposure to high rates while maintaining flexibility to benefit if rates decrease.

 

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