Page 14 - CIMA SCS Workbook August 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

EXERCISE 2

Email

To: Den Rice
From: Senior Manager
Subject: Interest Rate Hedging and Fake News

Interest Rate Risk

Interest rate risk is the risk of unexpected losses (or gains) arising as a consequence of movements
in interest rates. Exposure to interest rate risk arises from borrowing, investing (to earn interest)
or depositing cash.

Hedging is about making certain future cash flows, this helps a company plan; given the tough
operating conditions that FNG have experienced in recent times, it is important to plan well. For
FNG it is not just important to consider the interest rates on our loans, but also to make sure we
are considering the returns generated from any surplus cash we have.

FNG may use a mixture of internal and external hedging. Internal methods are arranged by FNG
itself whereas external methods would use a third party, often another bank. There can be
significant transaction costs associated with external techniques.

Internal methods

There are three methods of internal interest rate hedging.

One of the methods of internal hedging is smoothing, where FNG maintains a certain balance
between our fixed rate and floating rate borrowing. Based on your email, it appears this has been
the way FNG has hedged in recent times as our interest rates have stayed at very similar levels
over the last two years. The mixture of fixed and floating rate debt provides a natural hedge
against changes in interest rates. There will be less exposure to the adverse effects of each but
there will also be less exposure to any favourable movements in the interest rate.

Another option for internal hedging would be matching. FNG would match our assets and
liabilities to have a common interest rate (i.e. loan and investment both have fixed rates). Any
upside lost on a reduction in interest rates for debt would be matched by avoiding the downside
of interest rates going down on our investments.

The other internal method is netting where FNG would aggregate all positions, both assets and
liabilities, to determine our net exposure. As interest costs are usually higher than interest income
this would reduce our overall cost.

External methods

One method of external hedging is using forward rate agreements (FRA). This is a bespoke
method that would allow FNG to fix the interest rate that it would use in the future for a specific
amount on a date of our choosing. It would give complete certainty over the cost of their loan,
however it would take away upside potential, and it seems ideally we would like to keep some
floating rate loans.

KAPLAN PUBLISHING 73