(a) The financial manager of Town Ltd. is concerned about the volatility of interest rates. His company needs to borrow Sh. 100 million in six months time for a period of two years. Current interest rates are 15% per year for the type of loan that Town Ltd. needs. The financial manager does not wish to pay an interest rate higher than this. He is considering using different alternatives. For the following four alternatives, briefly explain how each could be useful to the financial manager:

(i) Forward rate agreement.

(ii) Interest rate futures

(iii) Interest rate options.

(iv) Interest rate swaps.

(b) (i)What assumption underlie the capital asset pricing model (CAPM)?

(ii) Many of the underlying assumptions of CAPM are violated in the real world. Does that fact

invalidate the model‟s conclusions? Explain.

(c) The managing director of Bicdo Ltd., a company quoted on the Nairobi Stock Exchange (NSE) has asked you to assist in estimating the firm‟s equity beta co-efficient. The firm is all equity financed and listed in the NSE five years ago. You have gathered the following information from the NSE for the last four years:

Required:

Use the capital asset pricing model (CAPM) to estimate the beta of Bicdo Ltd.

**ANSWER**

**(a) (i)Forward rate of agreement (FRA)**

This is a contract between a bank and a company to lend or borrow a given amount of money at an agreed future interest rate.

IA case of borrowing the Bank will loose if leading rate at the time of borrowing the borrower is higher than the agreed interest rate

FRA involve one year borrowing and the borrowing is in batches of UK ƒ500,000

**(ii) Interest rate futures**

• This is a contract to borrow or lend a fixed amount of money at a given rate and within a specified future period typically 3 months

• Futures are closed out and people can buy or ell the futures e.g. the purchase of a interest rate futures entitle the buyer to receive interest which the sale of futures involve obligations to pay interest charges

• Interest rate futures are closed out reversing earlier e.g if one sold the contract today, he will

buy it at a future date. Initial deposits called margins are required

• The contracts must be in whole

**(iii) Interest rate options**

• This are also called interest rate Guarantee (IRG) and involve the right to borrow or lend at a guaranteed interest rate at a fixed future date.

• If on exercise date the interest rate guranteed turns out to be unfavourable, the borrower/depositor will allow the option to lapse

• A cost called premium is paid to buy options

**(iv) Interest rate Swaps**

• an agreement to exchange interest rate obligations between two parties where one party has a fixed interest rate bond but anticipate decline in interest rate while another has floating interest bond but anticipate increase in interest rate. Both parties would swap the interest obligations to take advantage of anticipated charges in interest rates. It does not involve actual cashflow of the principal loan

• The loan, interest rate and period of loans must be equal

**(b) (i)Assumptions of CAPM**

• Investors are single period wealth maximisers

• There is no inflation

• Investors have homogeneous expectations regarding risk and return of a security

• There is no inflation

• Capital markets are perfect with no Taxes and there is free flow of information

• Risk free rate is known and constant

• All investors can lend and borrow unlimited amount of funds at risk free rate

**(ii)** Empirical studies have not completely invalidated C.A.P.M. It is still applicable in computing the cost of equity, valuation of securities and gearing adjustments among others.

• However, the existence of frictions in the market such as taxes, transaction costs, information costs and information asymmetry tend to invalidate CAPM

**(c) (i)** The total returns from a share will consist of returns from capital gains plus returns on

dividend (dividend yield)

The average % returns over the 3 years period for Bicdo Ltd stock market would be determined as follows