Questions on risk management feature regularly in the Advanced Financial Management exam. Performance information from recent exams suggests students tend to do less well on interest rate risk management questions than questions about foreign exchange risk management. This article will therefore explain the significance of the information you’ll be given in interest rate risk management questions and show you what you’ll be asked to do.
The scenario is adapted from Wardegul Co, Question 4 in the September/December 2017 sample questions which ACCA has published.
Scenario
Assume Wardegul Co has a newly-acquired subsidiary in Euria, where the local currency is the dinar (D). The subsidiary expects to receive D27,000,000 and wants to invest this D27,000,000. Assume it is now 1 October 2017 and the subsidiary expects to receive the money on 31 January 2018. It wishes the money to be invested for five months until 30 June 2018.
Currently the central bank base rate in Euria is 4·2%, but Wardegul Co’s treasury team has seen predictions that the central bank base rate could increase by up to 1·1% or fall by up to 0·6% between now and 31 January 2018. The treasury team believes that Wardegul Co can invest funds at the central bank base rate less 30 basis points.
The treasury team normally hedge interest rate exposure by using whichever of the following products is most appropriate:
- Forward rate agreements (FRAs)
- Interest rate futures
- Options on interest rate futures
Treasury function guidelines emphasise the importance of mitigating the impact of adverse movements in interest rates. However, they also allow staff to take into consideration upside risks associated with interest rate exposure when deciding which instrument to use.
A local bank in Euria, with which Wardegul Co has not dealt before, has offered the following FRA rates:
The treasury team has also obtained the following information about exchange traded Dinar futures and options:
Three-month D futures, D500,000 contract size
Prices are quoted in basis points at 100 – annual % yield