International Risk Management 

Introduction

The assignment is divided into two tasks. The first focuses on the management of foreign exchange risk using both over-the-counter and exchange traded techniques. Task two is about managing interest rate risk using a swap agreement.

Page 4 provides the financial market information necessary for undertaking the assignment tasks.

Collectively the marks for the tasks add up to 95 percentage points. The remaining 5 percentage points relate to the standard of presentation. Issues such as clearly delineating the tasks being addressed, presenting the numerical work with due emphasis on ensuring that key results stand out, pointed rather than general or meandering commentary are key considerations in determining the presentation score.

Introduction

On 10^th February 2020 a US company Bellingham Inc. exported a consignment of aircraft parts to a Spanish airline company. Bellingham was set to receive payment in two instalments of Euros. The payments were set to occur on the following dates:

1. €1.4 million on 10^th March 2020
2. €2.6 million on 10^th June 2020

Three years ago (10^th February 2017) Bellingham borrowed $80 million via a six-year floating-rate, non-callable, note issue. The notes were sold at par ($100) and offer a coupon rate of $LIBOR plus 300 basis points. Interest is payable semi-annually on 10^th February and 10^th August. The coupon rate is based on the six-month $LIBOR at the start of each payment cycle.

Task 1: Bellingham Inc’s Exchange Rate Risk

1. Explain Bellingham’s exchange rate exposure and generate over-the-counter forward rates for each payment based on covered interest rate parity.
2. The day-count convention applying to both dollar and euro money market transactions is actual/360. Note that this year there are 29 days in February)
3. In the absence of interest rates corresponding to the terms of the transactions, use the available data to interpolate a suitable rate.
4. Explain how Bellingham could use currency futures to hedge the effects of exchange rate uncertainty associated with each of the euro payments.
5. Assume that on 10^th March 2020 the GBP/USD spot rate is $1.1200-1.1204. Assess the efficiency of the futures contract hedge for the 10^th March payment if the futures price that day is on the day is $1.1207.
6. On 10^th February a bank offered a one-month EUR/USD forward exchange rate of $1.1100. Show how an arbitrageur could profit and assess the forward rate on offer in relation to the principle of covered interest rate parity. (You might find the point easier to discuss by assuming the arbitrageur puts into play a specific sum of money).
7. Discuss the relative merits for Bellingham of the over-the-counter and exchange-traded methods of hedging currency risk. (Link the analysis to the specifics of your numerical outcomes of Bellingham’s risk management options. Analysis limited to textbook-style generalisations will not be well rewarded).

Task 2: Interest Rate Risk Management

1. Calculate:
2. The prices of the zero-coupon bonds listed in Table 4
3. The par coupon rates
4. The six month and annualised forward rates from the current yield
5. Use the relevant par coupon result to explain how Bellingham can use an interest rate swap to transform the remaining interest payments on the loan from variable rate to fixed rate payments. Specify the swap rate assuming that the counterparty bank deals on the basis of a swap spread of +/- 8 basis points.)
6. Compare the swap rate with the current variable rate on Bellingham’s debt and outline the terms of the first settlement payment.
7. Explain the interest rate risk that Bellingham has the opportunity to hedge and discuss factors likely to influence the company’s decision to hedge or not. [The discussion should focus on the incorporate a consideration of the current market outlook on the direction of dollar interest rates over the next couple of years.
8. Show how the bank that is party to the swap could protect its earnings using forward rate agreements.