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)

SECTION B: ADVISORY REPORT AeroTurbine Inc (AT) is a US-based developer of offshore wind farms. The company's base currency is the US Dollar ($). AT has recently signed a contract to purchase specialized turbine blades from a European manufacturer. The payment of €50 million is due in exactly six months. AT's Treasury department is concerned about the volatility of the EUR/USD exchange rate and is considering hedging the exposure. The treasury is currently operated as a cost center, but the CFO is considering transitioning it to a profit center. Foreign Exchange Data: Current Spot Rate ($/€): 1.1520 - 1.1540 Six-month Forward Rate ($/€): 1.1610 - 1.1635 Currency Options (Over-the-Counter): AT's bank has offered a six-month European call option to buy Euros at a strike price of $1.1600/€ for a premium of $0.025 per Euro. The premium is payable immediately. Interest Rates (Annualized): US Dollar: Borrowing 4.5%, Investing 2.5% Euro: Borrowing 3.0%, Investing 1.0% REQUIREMENTS: (a) Calculate the expected US Dollar ($) cost of the €50 million payable in six months using: (i) A Forward Exchange Contract. (ii) A Money Market Hedge. (iii) The Over-the-Counter (OTC) Currency Option (assume the option is exercised if the spot rate in six months is $1.1800/€, and calculate the total cost including the future value of the premium). (12 marks) (b) Based on your calculations in part (a), recommend the most appropriate hedging strategy for AeroTurbine Inc, discussing the advantages and disadvantages of the currency option compared to the forward contract. (6 marks) (c) Discuss the implications, benefits, and risks of transitioning AeroTurbine's treasury function from a cost center to a profit center. (7 marks)

SECTION B: ADVISORY REPORT This question is based on the Heavy Manufacturing and Aerospace sector. AeroForge Ltd is a specialized manufacturer of aerospace components. The company has recently secured a major contract to supply landing gear for a new commercial airliner. To finance the expansion of its manufacturing plant, AeroForge will take out a $50 million loan in exactly 6 months' time. The loan will be for a period of 5 years, with interest payable annually at a floating rate of SOFR + 1.8%. The current Secured Overnight Financing Rate (SOFR) is 4.0%. The Treasury team at AeroForge is highly concerned that interest rates will rise over the next 6 months, severely impacting the profitability of the new contract. The company's bank has offered the following hedging instruments: 1. Interest Rate Swap: AeroForge can enter into a swap starting in 6 months. The bank is quoting a swap rate where AeroForge pays a fixed rate of 4.5% and receives SOFR. 2. Interest Rate Options (Collar): AeroForge can purchase an interest rate cap at a strike rate of 4.8% for a premium of 0.6% (payable upfront). To offset this cost, AeroForge can sell an interest rate floor at a strike rate of 3.5% for a premium of 0.4% (receivable upfront). Assume that in 6 months' time, SOFR could either rise to 5.5% or fall to 3.0%. Requirements: (a) Calculate the effective annual interest rate that AeroForge will pay under BOTH the Interest Rate Swap and the Interest Rate Collar, under the two scenarios where SOFR in 6 months is 5.5% and 3.0%. (15 marks) (b) Discuss the advantages and disadvantages of using an Interest Rate Collar compared to a Swap in this scenario. Furthermore, briefly discuss whether AeroForge's treasury department should operate as a cost center or a profit center. (10 marks)

SECTION B: ADVISORY REPORT This question is worth 25 marks. CeresAgri is a multinational agricultural technology (AgriTech) firm based in the United States. The company has recently expanded its operations into Brazil and has committed to purchasing specialized drone and sensor equipment from a local Brazilian manufacturer. CeresAgri must make a payment of BRL 150 million (Brazilian Real) in exactly six months. The central treasury team is concerned about the recent volatility of the BRL against the US Dollar (USD) and wishes to hedge this exposure. EXHIBIT 1: Foreign Exchange Data Current Spot Rate: BRL 5.0500 - 5.0650 / USD Six-month Forward Rate: BRL 5.1200 - 5.1450 / USD Currency Options (Over-The-Counter): CeresAgri's bank has offered a six-month OTC currency option to buy BRL 150 million at a strike price of BRL 5.1000 / USD. The premium for this option is USD 450,000, payable immediately. Money Market Rates (Annualized): US Dollar (USD): Borrowing 4.5%, Deposit 3.0% Brazilian Real (BRL): Borrowing 11.0%, Deposit 9.0% EXHIBIT 2: Interest Rate Exposure In addition to the FX exposure, CeresAgri recently took out a USD 50 million floating-rate loan to fund a new R&D facility. The loan has a 4-year maturity, and interest is payable semi-annually at SOFR + 2.0%. The treasury team is worried that SOFR (Secured Overnight Financing Rate) will rise over the next four years. A bank has offered CeresAgri an interest rate swap where CeresAgri would pay a fixed rate of 3.8% and receive SOFR. REQUIREMENTS: (a) Evaluate the following hedging strategies for the BRL 150 million payment, calculating the expected USD cost for each: (i) Forward Exchange Contract (ii) Money Market Hedge (iii) OTC Currency Option (assuming the spot rate in six months is BRL 5.0000 / USD and BRL 5.2000 / USD). Recommend the most appropriate hedging strategy for CeresAgri. (14 marks) (b) Explain how the proposed interest rate swap would function to hedge CeresAgri's USD 50 million loan. Calculate the effective annual interest rate CeresAgri will pay if they enter into the swap. (6 marks) (c) Discuss the advantages and disadvantages of CeresAgri managing its foreign exchange and interest rate risks through a centralized treasury function rather than allowing regional subsidiaries to manage their own risks. (5 marks)