Finance, Risk and Uncertainty

Finance, Risk and Uncertainty
Individual Assignment 2024/2025

SECTION A
Question 1

TFN Plc is an international leading electronic manufacturing company and is based in the UK where its main operations and head office are based. The business is a FTSE 250 company and reports in GBP(£). The marketplace is competitive with four other suppliers of the same electronics, three based in Europe and the other based in the US. TFN Plc customers are mostly based in the Americas where it sells its goods in USD based on a price list set for one year at the start of the year. It imports materials from European suppliers who require a lead time of three months from invoice to delivery.

It has one wholly owned subsidiary in Japan where it has a manufacturing site and a small sales office. There are outline plans to move more production to Japan away from the UK and thus TFN Plc will need to invest in larger manufacturing plant.

Financial Projections for 2025

Foreign Currency Exposures for 2025

The company has been using forward contracts to hedge both sales and purchases. The policy dictates that 100% of cover is put in place for the first six months and 70% for the following six months exposure for sales. The company buy the whole amount (i.e. 6 months of USD exposure) at the six month forward rate.

For purchases, the committed exposure is hedged and full cover is taken out i.e. 100%, every 3 months.

Foreign exchange rates – Spot and Forward US$/£1

ACT Plc, a UK-headquartered company, offers products and services to the defence, security and aerospace markets with both government and large global companies as its main customers. Approximately 31% of revenues is derived from contracts with the US government.

The company operates primarily in the United Kingdom, the United States and continental Europe. The geographic locations of revenues and non-current (fixed) assets are given in the table below for the financial years ended 31 March 2024 and 2023, respectively.

In the year ended 2024, ACT Plc had the following strategic focus areas:

• Investment in innovative and differentiated technology to align product investment to customer demand: during the year, the company invested GBP69m (2023: GBP49m) in research and development (R&D).
• Allocation of capital and investment on those areas that will deliver the best financial returns.

The ability to generate profitable organic revenue growth consistently is a key strategic objective and driver of value creation. This is supplemented by merger and acquisition (M&A) activity. In 2024, ACT made further progress in integrating US company AirCu (acquired in June 2024 for GBP400m) and exited certain markets and technologies to further focus on core capabilities.

Borrowings of USD-denominated bonds have total principal value of GBP463.9m / USD683.8m (2023: GBP438.5m / USD683.8m) and mature between March 2023 and October 2031.

December 2024 and May 2029

ACT’s debt carries either fixed rate or floating rates of interest. In managing its borrowing costs, the company monitors its exposure to movements in interest rates and, where necessary, uses interest rate swaps to manage the interest rate risk. One such swap agreement was entered into two years ago with original tenor five years under which ACT Plc pays a fixed rate of 5.0% against receiving LIBOR flat on notional of USD10m.

Questions

1. Evaluate key financial risks that might potentially materially affect ACT’s profitability.(7 marks)

Sun Africa Air Jet (SAAJ) is a low-cost airline headquartered in Nairobi, Kenyaoperating mainly across Africa and the Middle East. It prides itself on its industrialrelations record and its sustainable environmental policy to minimize its carbonfootprint.

SAAJ hedges its fuel requirements using derivatives contracts based on Brent Crude(ICE). A surge in fuel price above USD75 per barrel would have a significant impacton SAAJ’s profits with fuel making up key cost components for operations. SAAJuses swap contracts and collar contracts, and has entered the following three-waycollar on fuel:

SAAJ hedges up to 75% of total expected fuel requirement for the next twelve monthson a rolling annual basis, up to 60% in the following 12-month period and 50% in thesubsequent 12-month period.

Foreign exchange

SAAJ’s policy is to hedge between 65% – 85% of the next 12 months’ forecast surpluscash flows on a rolling basis, and 45% – 65% of the following 12 months’ forecastsurplus cash flows on a rolling basis.

It has entered a chooser option contract where it can choose to sell KES7,000.0m to acounterparty at an exchange rate of USD1 = KES95 or purchase 1,500,000 barrels ofoil at USD60 per barrel at December 31, 2025. The exchange rate at December 31,2023 was USD1 = KES102.22 and the oil price was USD56.14. (A chooser option isan option contract that allows the holder to decide whether it is to bea call or put prior to the expiration date. Chooser options usually have the sameexpiration date regardless of what decision the holder makes).

Interest rate

Interest rate exposure arises from SAAJ’s floating rate borrowings and is managed by

Interest rate swap contracts where appropriate, to generate the desired fixed interestrate profile.

The table gives the breakdown of borrowings by fixed rate and floating rate exposure:

Credit

SAAJ’s deposits and bank balances and derivative financial instruments are placed ortransacted with major financial institutions and reputable parties. As SAAJ does nothold collateral, the maximum exposure to credit risks is represented by the totalcarrying amount of these financial assets in the balance sheet. The Directors are of theview that the possibility of non-performance by these financial institutions is remotedue to their financial strength and support of their respective governments. Alltransactions are with investment grade counterparties other than KES8.5 million ofderivatives exposure.

Capital management.

SAAJ remains focused on maintaining an efficient capital structure that provides thelowest cost of capital and adequate financial reserves to withstand negative impactsfrom exogenous shocks. It reduced debt levels in the last financial year to achieve acapital structure that is consistent with a credit rating of BB.

Required

(a) Evaluate four risks which might have an adverse impact on SAAJ’s operations. (4 marks)

(b) Analyse the fuel price and currency derivatives hedges that SAAJ’s hasimplemented and assess the market risks the  company remains exposed to, despite these hedges. (5 marks)

(c) Assess the risks that SAAJ may encounter by using derivatives.(3 marks)

(d) Evaluate the benefits and drawbacks for SAAJ of using a sensitivity to a USD 5 change up or down in the price to measure the impact of moves in the price of fuel on net profit. Discuss one other approach could they take to measure sensitivity of fuel price and net profit? (3 marks)

Question 4

Assume today is the 21st of February. Using the information below, FT Extract, answer the following questions (parts iand ii). You work for a US company that is due to pay £200 million in June (US importer). You, as a treasurer of thecompany, have decided to use currency futures to hedge the currency exposure risk of this transaction.

FT Extract

i. Using the information content is FT Extract above set out the hedge. Assume that you will pay £200 million on the same day as the June futures contracts mature. The exchange has a total spread of $0.10 on the average quote. (3 marks)

ii. Estimate the cash flows in June if the actual exchange rate and the future price is $1.98/£1 on the day you pay the £200 million and close your futures position. (3 marks)

Question 5

Over the counter options

90 day options on C$ with strike price of C$1.80/US$1:

i. Determine the C$ value of the US$ receivable if you lock in this amount using a forward contract. (1 marks)

ii. Illustrate money market hedge CJ Ltd for this situation. Present and explain your calculations in detail. (4 marks)

iii. Draw a diagram that illustrates the risk profile of the underlying risk facing CJ Ltd, the forward contract and the option contract (y axis effective C$ receipt, x axis C$/US$). Determine the exchange rate, C$/$, at which the option hedge would produce a better outcome for the firm than the forward hedge and also the exchange rate at which the option hedge would produce a better outcome than being unhedged. (3 marks)

The treasurer of GOGET plc is evaluating the possibilities of borrowing £150 million for a period of four years. GOGET’s credit rating is good, and an assessment of borrowing opportunities indicates that it will be possible to borrow at a fixed rate of interest at 7 per cent per annum or at a floating rate of LIBOR + 4 per cent per annum. As GOGET’s treasurer believes that interest rates are likely to fall over the next four years she would prefer to borrow at a floating rate.

GOGET’s bank is currently working on arranging a four year loan, also for £150 million, foranother one of its customers, CHICAGO plc. This company is smaller and less well known than GOGET plc, and its credit rating is not as high. CHICAGO plc could borrow at a fixed rate of 11 per cent per annum or a floating rate of LIBOR + 6 per cent. CHICAGO plc has indicated to the bank that it would prefer a fixed-rate loan. The bank has suggested the two companies engage in a swap that might benefit both of them. The bank’s commission would be 1 per cent. CHICAGO’s treasurer suggests that any swap benefits, after allowing for the bank’s commission, should be shared equally between the two companies.

Explain the course of action necessary to implement the swap, draw the swap diagram and outline the financial benefits from the swap.

Question 7

Using the information below from the FT answer the following question.

Today is the 21st of March. If you are due to invest £50 million in June for three months and you want to achieve a minimum rate on your investment and use the 94875 option. The tick value is £12.50, and the contract value is £500,000.

Question 8

Benny is a U.S. arbitrageur. The one-year interest rate offered in the U.S. is 5.0% - 5.5%, while the one-year interest rate offered in Brazil is 34.0 – 35.0%. The spot rate is 4.90 – 5.00 BRL/1 USD (Brazilian Real/US Dollar). Beckham Bank offers Benny a one-year BRL/ 1 USD forward contract at 5.80-5.95 BRL/1 USD.

Question 9

The monthly cash budget for Dinamo plc shows that the company will likely need to borrow £25 million in March (it is now the 1st of December) for three months. 3 Month LIBOR is currently 5.50%, and the company can borrow at 3 month LIBOR + 2.50%Financial markets have been volatile recently, and the finance director of Dinamo plc fears that short-term interest rates could rise by as much as 1.25% to 6.75%. However, if inflation falls, short-term interest rates could fall by 0.65% to 4.85%. Nonetheless, worried about the possible increased interest cost the finance director decides to hedge their interest rate risk using interest rate futures.

Tick size is £12.50.

a) Set up the interest rate futures position for Dinamo Plc to hedge their interest rate risk on their proposed borrowing. (2 marks)

b) Illustrate the cash flows and estimate the results of undertaking an interest futures hedge on the LIFFE exchange in March if 3 Month LIBOR (assume no basis risk between the underlying interest rate and the future price):11

Question 10

You were expecting to need to borrow £100m from the end of July to the end of December 2024 in connection with a planned acquisition and had hedged the interest rate on this borrowing by buying an OTC FRA contract on 31 March 2024.

However, the acquisition has unexpectedly failed and as at today, 30 April 2024, you no longer need to borrow this sum.

The company expected to need to borrow £100m in four months' time and was exposed to the risk that interest rates would rise, increasing the cost of the proposed loan.

Purchasing an FRA eliminated the interest risk on the loan but introduced a new interest rate risk, this time to falling interest rates, which crystallises if the acquisition fails.

Calculate the mark-to-market valuation of the FRA contracts as at 30 April 2024 in your answer based on the figures given below:

SECTION C Question 11 (For this question you are expected to carry out some online/library based research. You need to access the financial information/financial statements of your chosen firm. Note full references for sources must be given. Please answer the question and do not make your discussion too descriptive).

As a risk analyst, you would be expected to identify financial risks, measure, and then manage them.

Identify the major financial risks facing your chosen firm. What is your assessment of the hedging activity? Explain your answer.