Watson Co’s finance director is concerned about the effect of future interest rates on the company and has been looking at the yield curve. Watson Co, whose domestic currency is the dollar ($), plans to take out a $100m loan in three months’ time for a period of nine months. The company is concerned that interest rates might rise before the loan is taken out and its bank has offered a 3 v 12 forward rate agreement at 7·10–6·85. The loan will be converted into pesos and invested in a nine-month project which is expected to generate income of 580m pesos, with 200m pesos being paid in six months’ time (from today) and 380m pesos being paid in 12 months’ time (from today). The current spot exchange rate is 5 pesos per $1.

The following information on current short-term interest rates is available:

Dollars 6·5% per year

Pesos 10·0% per year

As a result of the general uncertainty over interest rates, Watson Co is considering a variety of ways in which to manage its interest rate risk, including the use of derivatives.

(a) In relation to the yield curve, which of the following statements is correct?

A             Expectations theory suggests that deferred consumption requires increased compensation as maturity increases

B             An inverted yield curve can be caused by government action to increase its long-term borrowing

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

D             Basis risk can cause the corporate yield curve to rise more steeply than the government yield curve

  

 

(b) If the interest rate on the loan is 6·5% when it is taken out, what is the nature of the compensatory payment under the forward rate agreement?

A             Watson Co pays bank $600,000

B             Watson Co pays bank $250,000

C             Watson Co pays bank $450,000

D             Bank pays Peony Co $600,000

  

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

A             $112·3m

B             $114·1m

C             $116·0m

D             $112·9m

  

(d) In respect of Watson Co managing its interest rate risk, which of the following statements is/are correct?

(1) Smoothing is an interest rate risk hedging technique which involves maintaining a balance between fixed-rate and floating-rate debt;

(2) Asset and liability management can hedge interest rate risk by matching the maturity of assets and liabilities

A             1 only

B             2 only

C             Both 1 and 2

D             Neither 1 nor 2

  

(e) In relation to the use of derivatives by Watson Co, which of the following statements is correct?

A             Interest rate options must be exercised on their expiry date, if they have not been exercised before then

B             Watson Co can hedge interest rate risk on borrowing by selling interest rate futures now and buying them back in the future

C             An interest rate swap is an agreement to exchange both principal and interest rate payments

D             Watson Co can hedge interest rate risk on borrowing by buying a floor and selling a cap