Interest Rate Risk Management
Hillside Pharmaceuticals is an Irish firm that manufactures generic drugs. 95% of its customers are in the Euro area.
It has recently completed construction of a new fabrication facility in Dublin, including a state of the art clean room. The total cost of construction and fit-out is €25 million. The business’ current turnover is close to €9 million.
The construction was funded by two loans. The first was a loan of €15 million from Bank of Ireland and the second is a loan of €10 million from Citibank. Each loan is 20 years maturity. That means it is repayable in 2041.
The Bank of Ireland loan has 6 month interest rollovers at a rate of EURIBOR+200 basis points. The Citibank loan also has 6 month interest rollovers at a rate of EURIBOR+175 basis points.
The following are the swap rates provided by AIB Bank for a business like Hillside.
|AIB Euro Swap Rates|
The Hillside finance director has also received an indicative price for interest rate caps of 25 basis points for each 50 basis points at which the strike price is out of the money. It increases by 20 basis points for each year the cap is in place.
The Treasury Policy prevents the business from hedging interest rate risk beyond 10 years.
Hillside’s finance director informs you that the business wants to minimise its interest costs, though she also says that the business has tight profit margins and strong competitors that compete on price.
How would you advise this business on its appropriate interest rate risk management strategy, based on the information provided above, their objectives, and your view on money market developments.
Academia Financial Services is a subsidiary of Academia International Education Services. The parent business has grown from a small start-up in Ireland to a substantial international business. Its key product is an online teaching platform that has disrupted online teaching and is now being used in most global universities to provide international education remotely and sustainably.
The financial services subsidiary was set up to manage the surplus cash generated by the business. The software has been rolled out at low cost. The bulk of the cost involves paying for outsourced technical support and online help in several languages offered from a call centre business in Dublin.
The finance director (FD) has asked for your advice in developing a strategy to manage the surplus cash. She explains to you that the business is very aggressive on earning as much from the cash as possible and it is frustrating that interest rates currently are negative and it is costing the business money to leave cash pile up in deposit accounts.
The FD says that she has landed into the role because she was involved at the start of the business and it has grown so fast that she has not been able to get familiar with the tools available to manage the interest rate risk. It is clear to her though that the risk is that interest rates fall even further .
The business has a cash surplus of close to €1 million, that will double over the next year. Management is actively looking for potential acquisitions that can be funded by its cash surplus and that will complement the technology it already has. Such an acquisition, after identification, due diligence, and negotiation will not be completed in the next 2 years.
Below are prevailing EURIBOR rates but the business is earning those less 25 basis points from its bank.
How would you advise the Finance Director to manage the cash surplus so that they maximise their interest income and protect from further declines in interest rates?
Foreign Exchange Risk Management
Joleen Ltd is a manufacturer of medical diagnostic devices based in Cork. Its primary customer is the National Health Service (NHS) in the UK, with whom it has an exclusive license to supply its devices. This contract accounts for approximately 90% of its turnover. The remaining 10% includes small private hospitals in Germany and France.
The NHS contract is worth £24 million and it receives equal instalments each month. These are regularly paid on the final Wednesday of each month in Sterling. The contract has recently been renewed for the next five years.
Joleen manufactures most of the components for the device at its plant in Cork. There is however a significant component that Joleen has outsourced to a manufacturer in Shenzhen. This supplier provides this component to several companies, including Joleen, and can produce it at less than half the cost at which Joleen could manufacture it. It is invoiced for this component in US dollars. It pays the supplier USD 1 million at the end of every second month. The next payment is due at the end of January.
The following are the current spot and forward points for EUR/GBP and EUR/USD.
Joleen have forward contracts in place for the next 3 months of Sterling receivables at an average rate of 0.8950. The Dollar payables have not been hedged.
You are asked to advise the Finance Director on an appropriate foreign exchange risk management strategy for the nest 12 months. She explains that the business is quite profitable and the objective of any strategy should be to mitigate the damage from substantial adverse movements in exchange rates.
The Finance Director is not convinced that Joleen should do any hedging at all. She thinks that, because there is so much uncertainty and nobody can predict the future, it may be easier and just as good for the business to trade spot each time it has FX receivables or payables.
She is also interested in whether you think there is anything the business could do to reduce the extent to which it relies on external foreign exchange hedging.
Melchester Rovers is an English Premier League football club. They have signed 3 deals to buy and sell new players in the next transfer window.
They have contracted to sign Killian Mbappé from Paris St Germain (PSG) in France for €150 million euros. This will be paid in stage payments. The first payment is €10 million at the end of June; then €80 million at the end of August; then €25 million when the player completes 25 matches for Melchester Rovers, which is estimated to be at the end of December. The balance is due at the end of March 2023.
The club has also contracted to buy Karim Benzema from Real Madrid in Spain. This deal will require two payments. The first is €35 million at the end of June and €20 million at the end of December 2022. Due to injury concerns with the player, if he has not played 15 matches by the end of December 2022 the second instalment will be only €5 million.
The club has agreed to loan its striker, Blackie Gray, to Beijing Sinobo Guoan in China for the 2022 Chinese Super League season, from late April to mid- November. The Chinese club will pay the loan fee in US Dollars. The fee is USD30 million and will be paid in two equal instalments. The first will be paid at the end of April 2022. The second instalment will only be paid at the end of November 2022 if the player scores at least 20 goals. If he scores less than 20 goals the second part of the fee will not be paid.
The following are the spot rate and forward points for GBP/USD and EUR/GBP.
You have received the following indicative premiums for a USD put option at a strike price of 1.20: end April 2022 3%; end November 2022 4%. Each one cent above GBP/USD 1.20 reduces the premium by 25 basis points to a minimum cost of 2%. Each one cent below GBP/USD 1.20 increases the premium by 25 basis points with no maximum.
You have received the following indicative premiums for a EUR call option at a strike price of EUR/GBP 0.9000: end of June 2%; end of August 2.5%; end of December 3%; end of March
2023 3.7%. Each one pence above EUR/GBP 0.8700 reduces the premium by 25 basis points to a minimum cost of 1.5%. Each one pence below EUR/GBP 0.8700 increases the premium by 25 basis points with no maximum.
You have been appointed Treasury Manager of Melchester Rovers. The objective for hedging foreign exchange exposure on player transfers is to achieve the best possible Sterling return. Based on your view of the markets and the objectives of the club, what strategy would you pursue?
Is there anything the club could do to remove or reduce its need to externally hedge foreign exchange exposure on these or subsequent transfers?