Medium2 marksMultiple Choice

Risk ManagementRisk managementInterest rate riskOptionsSection B

This question is part of a case study — click to read the full scenario(Case 26)

Section B - Case 3: Nexus Co

Nexus Co is a UK-based manufacturer of specialized robotics. The company exports to Europe and imports components from Japan. The home currency is the GBP (£).

Nexus Co is due to receive €500,000 from a European customer in 3 months.
Exchange rates available:
Spot rate (EUR/GBP): 1.1520 - 1.1560
3-month forward rate (EUR/GBP): 1.1450 - 1.1500

If Nexus Co uses a forward market hedge, what will be the guaranteed GBP receipt?

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ACCA · Question 29 · Risk Management

Section B - Case 3: Nexus Co

Nexus Co has a large floating-rate bank loan. The treasurer is concerned about rising interest rates but also wants to benefit if rates fall. To achieve this while minimizing upfront premium costs, the treasurer decides to use interest rate options to create a 'Collar'.

How is an interest rate collar constructed for a borrower?

Answer options:

Buy an interest rate cap and buy an interest rate floor.

Sell an interest rate cap and buy an interest rate floor.

Buy an interest rate cap and sell an interest rate floor.

Enter into a fixed-for-floating interest rate swap.

How to approach this question

Understand the mechanics of options. A borrower wants protection against rising rates (Cap). To make it cheaper, they sell an option they don't strictly need (Floor).

Full Answer

C.Buy an interest rate cap and sell an interest rate floor.✓ Correct

An interest rate collar is used to restrict interest rate fluctuations within a specific range. For a borrower: 1. They buy an interest rate CAP. This acts as a ceiling, protecting them if rates rise too high. 2. To offset the premium cost of buying the cap, they sell an interest rate FLOOR. This means if rates fall below the floor, they must pay the buyer of the floor, effectively setting a minimum interest rate they will pay. This creates a 'collar' where the interest rate will fluctuate between the floor and the cap.

Common mistakes

Selecting Option B, which is the correct strategy for an investor/depositor, not a borrower.

Question 28 All questions Question 30

Practice the full ACCA FM — Financial Management Practice Exam 2

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