Advanced financial management revision question and answer

a) A Kenyan company has agreed to sell goods to an importer in Zedland at an invoiced price of Z 150,000 (Zed (Z) is the currency of Zedland). Of this amount, Z 60,000 will be payable on shipment, Z 45,000 one month after shipment and Z 45,000 three months after shipment.

The quoted foreign exchange rates (Z per KSh.) at the date of shipment as as follows:

Spot 1.690 – 1.692
One month 1.687 – 1.690
Three months 1.680 – 1.684

The company decides to enter into appropriate forward exchange contracts through a bank in order to hedge these transactions.

i) State the advantages of hedging in this way. (2 marks) Calculate the amount in Kenya Shillings that the Kenyan Company would receive.
(3 marks) Comment with hindsight on the wisdom of hedging in this instance, assuming that the spot rates at the dates of receipt of the two installments of Z 45,000 were as follows:

Fist installment 1.69 – 1.69
Second installment 1.700 – 1.704

b) Large companies with significant borrowings or overseas trade often use interest rate swaps and currency swaps.

Explain how interest rate swaps and currency swaps may be used.
)Advantages of forward exchange contracts to the exporter
– There is guaranteed profit margin on sale of goods since the fixed sales revenue is known in advance.
– It is important for cash flows projections and budgeting.
– It protects an exporter against unfavorable fluctuations in exchange rates.

ii) The company shall receive cash in Zeds and sell them to the bank at forward rates to realize Ksh.

The amount of Ksh. Received would thus be as follows:

iii) Without hedging the company would receive the following amount of Kshs.

ii) Without hedging the company would receive the following amount of Kshs.

X borrows at variable floating interest rate of LIBOR + 0.5% Y borrows at 11% fixed interest rate

The 2 firms agree to exchange obligations where X will pay Y interest at 11.75% fixed interest rate (12.5%

+ 11%)½ while Y agrees to pay X at LIBOR.

The net cost of financing will be as follows:

If X had borrowed at fixed rate it could be paying @ 12.5% p.a. Therefore net % interest saving = 12.5% – 12.75% = 0.25%

If Y had borrowed at fixed interest rate it could be paying interest @ 11% p.a.

Currency Swaps
Also called back to back loans, two parties agree to swap equivalent amounts of currency for a given period. Debt is thus exchanged from one currency to another.
E.g. assume a Kenyan Company (importer) requires UK£10,000 to pay a UK firm in 3 months. Consequently, a UK firm (importer) requires Ksh.1,250,000 in 3 months time to pay a Kenyan exporter.
The two firms will swap the currencies immediately/today where the Kenya firm will receive UK£10,000 and deposit it in the UK bank. The UK firm will receive Ksh.1,250,000 today and deposit it in a Kenyan bank. The two firms will wait for settlement date to pay their respective creditors.
In the meantime, they will earn interest income without the worry of prevailing exchange rate on 3 months payment date.

Advantages of Swaps
Parties are able to simulate each others borrowing while retaining their obligations to the original lenders. Each is able to borrow at lower interest rate.
They can restructure the timing of payments such that there is matching of cash out flows and in flows. Swaps are easy to arrange and flexible since they can be of any size and are reversible.
Transaction costs are very low only relating to legal costs of arranging the swap agreement. Interest rate swaps provides means of financial speculations.
Poor credit rating firms can obtain access to foreign markets and borrow at the foreign country currency at lower interest rates.

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