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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...

      

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.

  

Answers


Kavungya
(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 by 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 by 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 guarantee 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 cash flow of the principal loan
The loan, interest rate and period of loans must be equal
Kavungya answered the question on April 19, 2021 at 13:54


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