Risk Management

Question 1

In relation to an irredeemable security paying a fixed rate of interest, which of the following statements is correct?

Answer 1

Irredeemable loan notes are a tax efficient way of raising finance

Question 2

Which of the following is an illustration of the principal–agent problem?

Answer 2

Managers avoiding debt finance because lower interest payments avoids the need for careful cash management.

Question 3

Which of the following statements are correct in relation to Islamic Finance?

Answer 3

1. Mudaraba is a form of equity finance where profits are shared according to a pre-agreed contract and losses solely attributable to the provider of the capital.
2. Sukuk cannot bear interest. The sukuk holders’ return for providing finance is a share of the income generated by the bonds.

Question 4

What will be the issue price of each paper?

Answer 4

Issue price = $10,000 / (1 + (0.06 x 90/360)) = $9,852

Question 5

Which of the following statements about an over-the-counter interest rate option are correct?

Answer 5

It is an agreement with a financial institution.

The option may or may not be exercised.

Question 6

Which TWO of the following hedging techniques can be used by Tudor Co to protect against a rise in interest rates?

Answer 6

• Interest rate collar
• Interest rate cap

Question 7

Using exchange rates based on interest rate parity, what is the dollar income received from the project?

Answer 7

Using IRPT and the formula
Fo = So x (1+ic) / (1+ib)

We need to predict a 6-month rate and a 12-month rate and then divide the Dirhams by the respective predicted exchange rates.

6-month rate 4 x 1.04/1.03 = 4.038 so Dirhams 200 / 4.038 = $49.5
12-month rate 4 x 1.08/1.06 = 4.075 so Dirhams 400 / 4.075 = $98.2
Total = $49.5m + $98.2m = $147.7m

Question 8

Which TWO of the following statements are true regarding money market hedge and forward contracts?

Answer 8

The forward contract and the money market hedge have the advantage of being tailored precisely to Tudor Co’s requirements.

The forward contract will result in Tudor Co receiving the dollar equivalent of The Dirham receipts in six- and twelve-months’ time, whereas the money market hedge will provide Tudor Co with dollar receipts today.

Question 9

In relation to the yield curve, which of the following statements is/are correct?

Answer 9

An inverted yield curve can be caused by government action to tackle high inflation.

A kink (discontinuity) in the normal yield curve can be due to differing yields in different market segments.

Question 10

Country Y interest rate 1% per year
Country X interest rate 3% per year
Country X expected inflation rate 2% per year
Spot exchange rate in Country Y 1.60 peso per $1

What is the current six-month forward exchange rate in Country Y (to two decimal places)?

Answer 10

Forward rate = 1.60 x (1.015/1.005) = 1.62 pesos per $

Question 11

What is the future dollar value of the dinar receipt using a money market hedge?

Answer 11

Dollar value = (12m x 1.005)/(1.04 x 57.52) = $201,602

Question 12

Which hedging methods will assist Park Co in reducing its overall foreign currency risk?

Answer 12

Taking out a dinar-denominated overdraft

Question 13

Which of the following statements is consistent with an upward-sloping yield curve?

Answer 13

The risk of borrowers defaulting on their loans increases with the duration of the lending

Question 14

Future spot rate assumptions?

Answer 14

Free market
No barriers to trade
No transport or transaction costs

Question 15

The spot market?

Answer 15

The spot market is where you can buy and sell a currency now.

Question 16

The forward market?

Answer 16

The forward market is where you can buy and sell a currency, at a fixed future date.

Question 17

Advantages of forward market?

Answer 17

Flexibility with regard to the amount
Relatively straightforward

Question 18

Disadvantages of forward market?

Answer 18

Contractual commitment that must be completed on the due date

No opportunity to benefit from favourable exchange movements.