Question

Question 6 10 pts You are the treasurer for a company and realize that you will require additional operating funds in three months for three months. Answer the following questions: 1. You are at risk to changes in interest rate. Describe how movements in interest rates might affect your company given this need. 2. There are many ways to mitigate your exposure to the above risk. Discuss two and the pros/cons of each. You should answer these questions in a couple of short paragraphs. HTML Editora I V A 3 3 x := E B B - A - Ix 5 N VX beton 3 V 3 © x 12pt Paragraph @

Answer 1

1. The company is subject to a risk of increase in interest rates, and if that happens, consequantly the interest obligation / hit to the P&L will increase if they are planning to go long on a loan

2. a) One of the ways is to enter in to a Forward Rate Agreement. That is enter in to a 3X6 FRA, which shall allow them to borrow for three months, in three months' time. If they lock in the interest rate now by entering in to an FRA now, and if on the FRA settlement date, the interest rates are higher than the contracted FRA price of the loan, that shall give them potential savings on the interest obligation.

Pros: 1. Customised loan agreement, 2. Mitigates interest rate exposures

Cons: 1. Conversely if the interest rates move downward, the FRA will make the Company liable to borrow at a higher rate than the market and that will turn counter-productive financially

b) The other way to mitigate the risk is enter in to a fixed for floating swap -- that is, take over a fixed obligation from the other party and give to them your floating rate obligations and that could reduce your interest obligations in an increasing interest rate regime.

Pros: 1. Mitigates interest rate exposures in cases where the economy is witnessing a rise in interest rates

Cons: 1. Conversely if the interest rates move downward, the swap will make the Company liable to borrow at a higher rate than the market and that will turn counter-productive financially