This content provides a practical, time-managed walkthrough of a complex AFM (Advanced Financial Management) hedging question, emphasizing efficient exam technique and strategic approaches to financial risk management.
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Now, the number one issue that students
face in AFM is their time management.
It's a really time pressured exam. You
got loads to do. So, what I've done is
I've recorded this video of me working
through a hedging question. Everyone
loves hedging, so it's a really good
topic to recap anyway. And I've worked
through it from start to finish in one
go. So, I've done it to time as if I
were doing it in the exam. Now, this
isn't going to be perfect. I've made
spelling mistakes. I could see them as I
was typing at times. And that's fine. I
want to replicate exactly what I do in
the exam. I wouldn't go back and change
those. I wouldn't worry about it. You've
just got to keep moving. It's really,
really up against it in terms of time.
Also, my answers are going to be way
shorter and more concise than the
examiner's answers. Have you seen the
examiner answers? Sometimes they're
massive. So, these huge model answers
they provide, they don't do those to
time. They're not done within the time
allocation. So, they're there to help
you and to advise and to give you more
knowledge, but they're not realistic as
to what you can achieve. So, I've done
it exactly as I would. So, look out for
like the length of my paragraphs. Look
at how I structure my answers. And
that's one of my biggest tips around
hedging questions in general is if if
you've got a good structure like I offer
my students. So, you can see when I'm
doing my options, you've got the set up
the hedge, arrange the hedge, result of
the hedge, I do a real step-by-step
approach. Same with the swap. I do
exactly the same thing. I do like
preferred or non-preferred, then you do
the savings, the target rate, and then
the swap. I've got step-by-step
approaches which make it so much quicker
and so much easier to pick up those
marks. So, enjoy the video and see how I
work through this question from start to
finish. Okay, so we got our little bit
exhibit lur shell. We've got some
hedging. Oh, it's a hedging question.
Okay, and chief execs views. No problem.
Right, start with the requirements. And
they want us to compare the results of
hedging 84 million. That number is going
to be important using the options and
the swap. Okay, that's what I got to do
with the results already obtained using
the forward rate agreement and futures.
So, I'm not going to have to do those
again. Comment on the results. Need to
make sure I discuss them. And it says
including how the interest rates will
work. 15 marks. Okay, I'm going to spend
30 minutes on that part. Four marks for
discussion. Got to remember to do that.
And then B, criticize the views of the
chief exec about the work carried out by
the Treasury and the staff required to
do this work. Five marks. Okay, fine.
And then I need to remember to do
conclusions, assumptions, and commercial
acumen. No problem. Okay, so I've got a
hedging question. Hedging 84. The fact
it says swap suggests it's going to be
interest rates. Let's have a quick read
of the exhibits. Tells us a bit about
the company. Lur shell listed
electronics. I'll try and use that if I
can. News chief exec. Number of plans to
expand. Okay. Costs. Okay. Centralized
treasury. We'll need that in part B
probably. First major investment. We're
going to oversee an investment in
facilities application specific
components. We're going to have to
borrow. Okay, that means we need a loan.
Let's have a look at the hedging
information. We're going to need this in
part a now the 1st of May. That's going
to be important. I might write that down
actually. So, let's just get my
spreadsheet set
out like so. Doesn't matter too much.
I'm just going to label it. So, we've
got part A. That's where all my calcs
were, wasn't
it? Um, so we is now the 1st of May. I'm
just going to make notes as I read it.
Need to borrow 84 million on the 1st of
September for a period of 6 months. Okay.
uh starting on
the 1st of
September, they can borrow at a variable
rate. So they plan to borrow at variable rate
rate
plus the base rate plus 50 basis points
which is 0.5%. So make a note of that.
That's the current rate. It's currently
4.5 but is expected to rise by up to 0.6%.
So I'll add that on. So I could write a
5.1. Okay. So they're my little notes
there. So they've currently explored
hedging using forward rate agreement or
futures. Okay. The result is there. So
the forwards would cost that and the
futures would cost that. So they've
already done that for me. I don't need
to do anything with those. Fine. Then
they also want to use options as it says
and then potentially swaps. So not
previously used swaps. That's something
we could discuss later. Um, and they
found a counterparty. Fine. Right. Here
are the options. We've got the current
price. Okay, that looks fairly standard.
We got September, so that's fine. We've
only got one strike price, which makes
life a little bit easier. Contract size
is 2 million. They're three month uh
options on futures, which is fine. And
it tells us there that futures and
options stuff each month. Basis
diminishes to zero. That means I'm going
to need to do that basis working and
then I can comment on that cuz it's in a
bit of assumption. There's no basis
risk. It can be assumed that there is no
basis risk. I need to challenge that.
And then this is all the information for
the swap. So we've got a counterparty as
always. Uh we got the central base rate
plus 1.5% or fixed. That's for the
counterparty. And for us they've quoted
us a fixed rate of
5.6. Fine. And we know that our variable
rate it told us was up the top, wasn't
it? And it tells us that we
um can do that up here. It told us where
has it gone? Oh, there we go. So, we
have a variable rate of the central base
rate plus 50 basis points. Fine. I'll
need that for the swap. And there's a
bank charge of 10 basis points. No
problem. I need to look out for that and
remember to do that at the end. And then
they're going to share equally the
potential gains from the swap. No
problems. Okay. Right. That's all fine.
We've got everything in there. Just have
a quick look at this one. We're going to
need this one for part B more, aren't
we? So, the new chief exec. So, this is
about the treasury department. Just
checking there's nothing in there that I
particularly need for part A. I'll come
back to that later. So, we need that for
that bit. I'm not going to worry too
much about it for now. Okay. So, we're
going to start by doing this. I'm just
going to remind myself of the
requirement one more time is compare the
results of hedging that using options
and the swap with the result already
obtained. So, I'm going to go straight
in with this. I'm just going to label
this as part A like so. Not too much I
need to do in part of in terms of
discussion initially, but I will get
this set up as part of my planning time.
So, I do allow myself 9 minutes to plan.
I'm currently just over 5 minutes in.
So, I'm doing well. So, part A, what
we're going to need to do is do a little
bit of an assumpt uh yeah, I'm going to
state a key assumption because we need
to be skeptical. So, I'm just going to
write down just remind myself
uh to do some key assumptions and then
we're going to compare uh the hedging
products and then I'm going to do a
say compare the results and comment on
the results like that and four marks for
discussion. So, I need to make sure I'm
doing that and again that will help me
to get that analysis and evaluation mark
as well. And the reason I did that
assumption, by the way, is because there
are skepticism marks. So, I'm just going
to put that there as well. So, for now,
I've just set up just more to remind me
when I answer part A, I'm going to need
those. And then I'll do part B. I'm
going to worry about that later. Um, and
myself 15 marks. So, 30 minutes I'm
going to give myself to do the
calculations. Okay. Right. I am all set
up. What I'm actually going to do is
just write
here. So, I have
got 30 minutes from now to do this. So,
I've got until 36 minutes to do this
one on the clock. That includes the
discussion. So, I'm just going to do
that again just as a quick reminder to
myself. Okay. Um, right. I didn't I
don't know why I wrote part A there. I
need to write options. There we go. Just
zoom in a little bit. So, we're going to
start with my options. And we've got all
the hedging information here that we need.
need.
Lovely. And for options, I always do the
same approach. So, I'm just going to do
uh my same approach as always. Start off
it. And that's going to be call or
put. Uh which expiry date do we need? Uh
which strike price or exercise price,
whatever you want to call it. And the
number of contracts. I actually put that
So, that'll be my setup. Then, I'm going
to arrange the hedge. So, that'll be my
step two. Always use this step-by-step
approach for my options questions. It's really
nice. And we'll do that. And don't
forget, we're going to need to pay a
premium because it's an options
question. So, I'm going to make a note
to myself to remind me to do that. And
then in step three, we do the result of the
the
hedge which will happen on the 1st of
September. So we do that. So there we
go. I've set up my almost little
template. And within the result, we're
going to have our
transaction. And then we'll have the
result of our options here. And a bit
further down, we'll have our total.
Okay. So that's my standard template.
Good to go to fill it in. So let's start
with call or put. Um, so it gives us
both calls and puts. So I do need to
decide. So in this one we're borrowing,
aren't we? It tells us that we are going
to be borrowing 84 million. It tells us
that at the top there. So borrowers sell
Britney Spears. That's my way of
remembering that. So borrow sell. And
remember sell is always put. If it was
buy, it would be a
call. So we need to put options. So that
would be my first point. So borrow sell
Britney Spears deposits buyers David
Beckham. So just checking. We're
definitely borrowing. Great. and they
need to sell futures. Therefore, we only
need put options. Um expiry date in this
one, it hasn't given us a choice.
They're only giving us options on
September futures. I'll write that just
to be clear, but that's fine, which is
fine because the loan is starting on the
1st of September. So, using September
ones is perfect. Right. Number of
contracts, 84 million is the amount
we're hedging. Each contract is 2
million. So, I need to do 84 over 2
million. But remember, this is for 6
months, isn't it? So this is a period of
6 months and each contract only lasts
for 3 months. So what I'm going to do
here is you do the amount we need to
hedge which is 84 divided by the
contract size which is 2 million times
by the number of months of the loan
which is six over the length of each
contract which is three. And that will
give me 84
contracts. And then the strike price is
95.25. So that's the rate that we can
use, which in other words, by the way, is
is uh
uh
4.75%. I quite like doing it as a
percentage. If you just do 100 minus
that, if I just do that like that, in
fact, there you go. 4.75% is the rate
that we're locking into. Brilliant. So,
we've set up the hedge. That's a good
start. So, we need to sell or we're
having put options. We're buying put
options in this case. We're obtaining
put options. And it's September 84
contracts at 95.25. 25. So I might just
write that down just to be clear. Need 84
options at uh stock post at
95.25. Right now we need to pay the
premium. Um so we've said we need put
options. So it's going to be this one on
the right, the
0.411. And these are annual percentages.
So as always with the premium, you're
just going to do the premium rate, which
is 0.44. 4 uh 4
411% times by the number of contracts
which is
84. Now I'm just going to type that in
rather than click on the cell because
you do need to round it. So it needs to
be 84. So it's the rate times the number
of contracts times the contract size
which is 2
million times by 3 over2. Remember each
contract only lasts for three months. So
I'm going to do that. Now because this
is a payment I am going to make it
negative. saves a cost and it's three
months because each contract only lasts
for three months, not six months here.
So there we go. That comes out as our premium.
premium.
Lovely. Now we're going to do the result
of the hedge on the 1st of September. So
the transaction that's as if we hadn't
hedged at all. So this will just be
whatever the rate is on the day and it
is going to be negative because they are
going to be paying it. Now it says in
the requirement, let's just go back. Let
me remind myself. Uh it says the result
of hedging. So what was the interest
that hedging a rise in the base rate of
0.6%. Okay, it's currently
4.5, but don't
forget we borrow at 0.5% above that. So
So we're going to do the 4.5% base rate
is going to go up by 0.6%. So that's
5.1, but then we borrow at 0.5% above
that, 50 basis points is
0.5%. So going to have all of that going
on. The rise and the fact that we borrow
50 basis points above times by the
amount that we're borrowing, which is 84
million. And then we're going to times
that by 6 over 12 because that's how
long our loan is lasting for. So we're
not dealing with contracts here. It's
going to be time 6 over 12. So that will
give me the amount of interest I'd have
to pay if we didn't hedge at all. Then
for the options now, because they are
put options, you're always going to sell
initially. So put and sell are best
friends. So we're always going to sell
initially and we're going to put in the
price that we said, which is
95.25. So that was the strike
price. Then we're going to buy them
back. We always close out these. I'm
going to buy them back at a price. I
don't know what that is. And as always,
we're given this little clue that we're
going to need to do a separate working.
So, we're going to need to do a basis
working there to work out what that
rate's going to be. Now, I'm going to
clearly label this. So, I'm going to
leave a bit of space cuz I want to do my
total and stuff. I'll call it working
one basis working. And I'll underline it
so the markers can see that this is
where the numbers from. And then I'm
going to do my standard basis working
table which is where I put in the spot
rates. I put in the futures price and
then that gives me a basis. I'm then
going to put
date sorry transaction date first then
we put in the future expire date
next. Like
so. Okay. It's now the let's just remind
ourselves the 1st of May. So we'll call
that month
May. The transactions happening on the
1st of September. That's when we're
borrowing our money. So how many months
is that from there? I'm going to count
my fingers. So we got all of May, June,
July, August. So it's another four
months from
now. And then the futures expire at the
end of September.
So they are September is always at the
end of the month. So that'll be 30th of
now. Brilliant. Right. The current spot
rate is that's today's rate. It says the
base rate is currently 4.5%. Now I can
forget about
the fact that we borrow at 50 basis
points above that whenever I'm doing the
basis working. So I'm just doing 100
minus uh the current spot rate which is
4.5. So we're going to need to use the
futures price when we do this not the
option strike price or anything. That's
why they've given us the price of these
futures and it's
95.05. So that's the current futures
price is
95.05. Now you always do the spot rates
less futures. So basis is
0.45. Now we work out the unexpired
basis. Remember that's just going to
shrink down to zero over the next 5
months. So it's going from here to here.
And on the 1st of September, we're going
to have one month left. So you got four
and you got month five. So we're going
to have one month left. So it's going to
be one over five. That's the unexpired
basis times by that. That's how long is
going to be left on the 1st of
September. How much is going to be left
of that if you imagine it depreciating
down to zero. So that's our unexpired
basis. Now we're going to do in here is
put what the spot rate will be on the
1st of September. And remember we said
it's going to be 4.5% but it's rising up
by 0.6. So that's going to be 100 minus
the 5.1. Now I have to do
these in this format, not as
percentages, otherwise everything's
backwards. And then my futures price
will just be the balance. So
that minus that. So it's the difference
between those two. The balancing figure
is going to be my futures price, which is
is
94.81. So that was what goes into here.
So I can just reference that cell and
then we can see if we're going to
exercise it or not. Now, always make the
by negative. So I'm going to do sell
minus the
buy. So always take off the buy because
you're paying it. And it is positive
which means it's a gain. Uh so we need
to exercise the option. I need to
mention that cuz otherwise uh otherwise
mark. Now the gain as a percentage is
0.44. Um so the gain in total is going
to be that as a percentage. which I can
just put a percentage down there times
by the number of contracts which was 84
times by the contract size which was 2
million times by 3 over 12 because each
contract anything to do with contracts
is always three months not six there
it's always going to be three. If we do
that we end up with a number. So the
total is going to
be our transaction plus the
gain plus that premium. So remember to
deduct the premium, but because I made
it negative, it's going to be taken off.
And that gives me my total interest for
the options. Now, it's always good to
make that bold. So I'll just make that
bold just to show the
markers. And I can actually just while I'm
I'm
here, tidy up these slightly. I quite
like the little comma button there just
to put a comma in just to make it a bit
easier to see.
Now, as an annual percentage, just
because they gave us these as an annual
percentage, this is going to be a lot
easier if I convert this into
percentage. That's for 6 months. That's
the total cost over 6 months. So, I do
that times by 12 over six. That gives me
my annual interest. And then divide that
by the amount that we are hedging. I
don't really need the brackets, but I'll
put them in just in case, which is 84
million. That will give me it as a
percentage which comes out as
5.57%. So that gives me something. And
again, it's reassuring. Look, it's in
line with those, isn't it? It's quite
similar to these rates up here. Um so
that's good. Excellent. Right onto our
swap. I've got too much time to to dwell
on that and think about um what it means
and so on. We can worry about that
later. Onto the swap. So again,
step-by-step approach. First thing I'm
going to do is the preferred and
So I'm going to set up a little table
and we in this one we've got what we
called lurg shell and then we've got a
counterparty. Um so that's fine. So I
always set them like this. We're going
to have our preferred rates and then
we're going to have our non-preferred
rates and I'm going to put lurg shell
just call them lerg. And then we got our
counterparty. Now just thinking
logically it doesn't specify which is
the preferred and which is the
non-preferred rate which is fine not too
much of an issue. Lur Shell think and
they're worried that the rates are going
to go up. So, they're going to prefer to
fix, aren't they? If they think that
interest rates are going up and they are
borrowing money, they're going to prefer
to fix. So, that will be their preferred
rate, um, which is 5.6%. So, I'll put
that in there. And then their
non-preferred rate will just be the
other one. Now, that is their current
rate. So, the current rate is the
central base rate plus 50 basis points.
So I'll call the base rate B plus 50
basis points is
0.5%. Now the counterparty I then just
put because that's fixed I'll just put a
floating there. The counterparty was the
base rate plus 1.5%. So that's the base
rate plus
1.5%. And
then the non-preferred rate will be the
6.1. Add those together.
Um 1.5 plus 5.6 is 7.1, isn't it? So
that's going to be B plus 7.1% is the
total if they took out their preferred.
Add those two together. B + 0.5 + 6.1 is
B +
6.6%. Brilliant. Now the non-preferred
should always be cheaper. Otherwise,
there'd be no point in doing this. So if
we just check that again, if you got
that the wrong way round and you didn't
sort of clock that they'd prefer to fix,
it doesn't matter too much. you just
know that the non-preferred total will
always be the cheaper one. And if we do
that, they will save 0.5%, won't they,
in total by taking out the
non-preferred. Um, so that's the
total. So, we can then work out the
savings for each company. Remember, it
told us they'll share them equally.
Let's just check that that is the case,
which is fine. So,
0.5% divided by two. So, they're going
to save 0.245% each.
rates which are the preferred rates less
the saving. So for
lurg it's going to be the 5.6% minus
0.25% which is
is
5.35%. I'm doing that in my head but if
you want to be safe just do it like
that. You can just see it like that. And
then the
counterparty theirs is going to be B +
1.5% is their preferred rate. They take
off the saving of
0.25%. And that comes out as B plus
1.25% is going to be their their target
rate. Now I ignore the bank fees until
the end with my approach. So I am very
conscious that we need to take off a
bank fee of 10 basis points but we'll do
swap. So we're going to start by paying
the non-preferred to the bank. Then one
company will pay the other. So I'll
do lurg
whoops pays the
Lerg. And then that should end up with
the target
rate. Then once we got that, then we'll
take off the bank fee and that'll give
us our total cost. So I'm going to do
the bank fee
afterwards. And then I do uh
Lerg I might call them their proper name
Lerg Shaw for this one. Then we got the
counterparty like so. Again, this is my
standard template for doing an interest
rate swap. It works really well. So
we're going to pay their non-preferred
to the bank. That's the finance they
take out because it is cheaper in total.
So, we're going to use these rates. So,
whatever you put up there, we're just
going to put again here. I'm going to
make them negative because that makes it
a bit easier when you do your
swap. Now, I put the little apostrophe
there, by the way, cuz then it it just
formats it as text in the software. Just
avoids any weird formatting issues, but
it'll probably be all right if you
didn't. So, that's that. And then the
counterparty pay 6.1%. Um, so again I'm
6.1%. Right? Then I jump to the target
rate which is which are these numbers
here. So we know that L shell need to pay
pay
5.35%. And the counterparty needs to pay
uh B plus
1.25%. So this is what we're aiming for.
Now we need to do the little swap in
between. Now I've put their lur pays the
counterparty. It doesn't matter which
way round these two go really, but I'm
going to say Lur pays the counterparty
something. Now, the easiest way probably
is just to cancel out that 6.1. So, I'm
going to make the counterparty receive
6.1%. Now, this this bit here you can do
loads of different ways. It doesn't
matter as long as both sides balance,
but I'm just going to make that them pay
them 6.1%. So, it comes out of there and
into there. You see that then just
cancels out nicely. So, then whatever
that is I can just put in here. So
So
now if they just pay
them B plus
1.25%. If you add up both sides that
will work. So if you add that together
it's B plus 6.6 is what they're paying.
But then they receive B plus 1.25 and
they end up paying that. Those two
cancel out. They pay that and they end
up with that. So both sides balance.
Again loads of ways of doing that.
That's just the way I like to do it.
It's easiest. Then we've got the bank
fee which is 10 basis points. And it
does say to each individual party,
doesn't it? So it's not
um between them. So we've got to pay 0.1%
0.1%
each. Let's copy and paste that. Save a
little bit of time. So the total
cost once you take that into account is
going to be
5.45% for Lergaw and for them going to
be B +
1.35%. So that is our answer. Make it bold.
bold.
Job done. So that there that 5.45% is
what I'm going to need to talk about.
Lovely. So that is my swap done. Worked
through that. Done all the steps.
Lovely. Now we've got a few minutes left
to do the discussion for this
part A that we're doing. So remember we
need to comment on our results and then
show all relevant calculations etc. Four
marks for discussion. But I also want to
do a bit of skepticism and also uh a
little conclusion. So I'm just going to
get jump into that now. Now quite a nice
thing when you're doing this is
to do a little summary.
Um just before I do that I'm just going
uh calculation is based
actually now by assuming that now do you
remember the phrasing they use in here?
I can just copy that. Uh basis
diminishes to zero contract maturity at constant
rate and there is no basis risk and no
margin requirements as well which is
something for the futures we could talk
This may not hold true in
reality. Um, which could or which would affect
affect
uh the cost of the
something like that. So talk about the
impact of it. I'm not just saying this
assume basis uh there's no basis risk.
Talking about the
impact that'll do right onto our hedging
products. So we can do a little what I
was saying a minute ago. We could do a
little summary. So the FRAS will cost us
uh 5.38%.
5.36%. Our
options, who can remember what that was?
I can't. Options were
were
5.57. So that's why it's really nice
having that as a percentage. Otherwise,
it's quite hard to compare it. And then
our swap, remember, we're looking for
Now, what I love to do in a question
like this when you're discussing your
hedging products is just go through them
one by one. So, it's discuss that four
marks. We've got four products. So, we
can pretty much just go through them,
but I do want to do a quick conclusion
at the end as well. So, I'm just going
to go through them one by one and say
what's sort of good and bad about them.
So, I'll just break up into subheadings
almost. So, the forward rate agreement,
FRAAS would um provide it's always good
um this is what I call a perfect
um however they
rate even if the
anymore. Does it say what the loan is
for? So, they wanted to expand the
company, didn't they? So, it said
they're investing in this
the so it's quite nice just to for
commercial acument just to link it to
the scenar. So, I've just done that.
Okay. Uh now futures, let's talk about
them. Uh, so these are the cheapest.
Worth saying that, isn't it? Remember
that's good because it's a loan. So
futures. Um, I'm going to be a little
bit skeptical here as well, you know,
because they just gave us that, didn't
they? So it just said, uh, they gave us
that there, but they said futures would
be 5.36. And it just says it has been investigated.
