Q: What mistakes do candidates make on this ACCA question?

Students frequently select the wrong spread rate (bid vs ask) for forward contracts. Another common error is forgetting to add the time value of money (interest) to the option premium when comparing it to the forward contract, which settles in 6 months. In part (b), students often forget to add the 150 basis points spread to the final effective interest rate.

Question 1

SECTION B: ADVISORY REPORT

This question is worth 25 marks.

Ceres Agri-Tech ('Ceres') is a highly innovative agricultural technology firm based in Asia, whose functional currency is the Asian Dollar (A$). Ceres exports advanced drone-based irrigation systems globally. The company has significant foreign currency receivables due in exactly six months:
- USD 18.5 million from customers in the United States.
- EUR 12.0 million from customers in the European Union.

Ceres' treasury department is evaluating whether to use forward contracts or over-the-counter (OTC) currency options to hedge these exposures.

EXHIBIT 1: Foreign Exchange Data
Current Spot Rates:
A$ / USD: 1.3520 - 1.3550
A$ / EUR: 1.5840 - 1.5880

Six-Month Forward Rates:
A$ / USD: 1.3610 - 1.3645
A$ / EUR: 1.5710 - 1.5760

OTC Currency Options (Premiums are payable upfront in A$):
USD Put Option (Strike A$ 1.3500 / USD): Premium A$ 0.025 per USD
EUR Put Option (Strike A$ 1.5800 / EUR): Premium A$ 0.032 per EUR

Assume Ceres can borrow in A$ at an interest rate of 6% per annum to fund the option premiums.

EXHIBIT 2: Interest Rate Hedging
Separately, Ceres needs to borrow A$ 50 million in six months' time for a period of 5 years to fund a new R&D facility. The loan will be at a variable rate of SOFR + 150 basis points. Ceres' Board is concerned about rising interest rates and wants to cap the SOFR exposure at 4.0%, but is willing to sell a floor at 2.0% to create an interest rate collar and reduce the premium cost.

REQUIREMENTS:

(a) Calculate the expected net A$ receipts in six months' time for both the USD and EUR receivables using:
(i) Forward contracts.
(ii) Currency options (assuming the options are exercised).
Recommend, with justification, which hedging method Ceres should adopt for each currency. (12 marks)

(b) Explain how the proposed interest rate collar will function if the SOFR rate in six months is either 5.5% or 1.5%. Calculate the effective annual interest rate Ceres will pay in both scenarios (ignoring the upfront premium cost of the collar). (8 marks)

(c) Discuss the strategic implications of operating the Ceres treasury department as a profit centre rather than a cost centre, particularly in the context of its aggressive use of derivative instruments. (5 marks)

Accepted Answer

1. For part (a), identify the correct forward rate (the lower rate when selling foreign currency). Calculate the forward receipts. Then calculate the option receipts by multiplying the strike price, calculating the premium, adding 6 months of interest to the premium, and subtracting it from the gross receipts. Compare the two. 2. For part (b), remember that the effective rate is the underlying loan rate minus cap receipts (if SOFR > cap) plus floor payments (if SOFR < floor). Don't forget to add the 150 bps spread to the final effective rate. 3. For part (c), contrast the risk profiles of cost vs profit centres, linking it back to Ceres' core business (agri-tech, not banking).

Question 2

What mistakes do candidates make on this ACCA question?

Accepted Answer

Students frequently select the wrong spread rate (bid vs ask) for forward contracts. Another common error is forgetting to add the time value of money (interest) to the option premium when comparing it to the forward contract, which settles in 6 months. In part (b), students often forget to add the 150 basis points spread to the final effective interest rate.

How to approach this question

Full Answer

Common mistakes

Practice the full ACCA AFM — Advanced Financial Management Practice Exam 4

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