ACCA · Question 02 · Treasury and advanced risk management techniques

SECTION B - ADVISORY REPORT

This question is worth 25 marks.

FerrumForge PLC is a heavy steel manufacturing company. The board has recently approved the construction of a new, highly efficient blast furnace. To fund this, FerrumForge will need to borrow $50 million in exactly 6 months' time. The loan will be for a duration of 4 years.

The company's treasury team is highly concerned about the current macroeconomic environment, which suggests that interest rates will rise significantly over the next 6 months. FerrumForge can currently borrow at SOFR + 1.5%. The current SOFR is 4.2%.

The treasury team is considering two hedging strategies:
Strategy 1: An Interest Rate Swap.
Strategy 2: An Interest Rate Collar using Options on Interest Rate Futures.

Exhibit 1: Interest Rate Swap Market
FerrumForge's bank has offered a 4-year interest rate swap starting in 6 months.
The bank's swap quote is: Pay Fixed 4.8% / Receive SOFR.

Exhibit 2: Options on Interest Rate Futures
Standard contract size is $1,000,000. Tick size is 0.01% and tick value is $25.
Options expire in exactly 6 months.
Current futures price for the relevant contract is 95.50.

Strike Price | Call Premium (annualised %) | Put Premium (annualised %)
95.00 | 0.42 | 0.18
95.50 | 0.28 | 0.28
96.00 | 0.15 | 0.45

Assume that in 6 months' time, SOFR has risen to 5.5%, and the futures price has moved to 94.50.

REQUIREMENTS:

(a) Calculate the effective annual interest rate that FerrumForge will pay under BOTH Strategy 1 (Interest Rate Swap) and Strategy 2 (Interest Rate Collar, assuming the company wishes to cap its borrowing rate using the 95.00 strike and floor it using the 96.00 strike). Recommend the most appropriate strategy based on your calculations. (15 marks)

(b) Discuss the advantages and disadvantages of using Over-The-Counter (OTC) derivatives (such as the proposed interest rate swap) compared to exchange-traded derivatives (such as futures and options) for a heavy manufacturing firm like FerrumForge. (10 marks)