GXJ Co, whose home currency is the dollar, wishes to borrow €12 million for a period of six months in three months’ time. The lending bank will fix the interest rate for the loan period at its prevailing lending interest rate when the loan is taken out. The finance director of GXJ Co believes this lending interest rate could be a minimum of 3·5% per year or a maximum of 5·5% per year. The uncertainty regarding the future interest rate is caused by the volatile state of the economy and impending elections which could lead to a change in political leadership and direction. Interest on the euro loan would be payable at the end of the loan period.
The finance director of GXJ Co would like to hedge the interest rate risk arising from the future loan and the company’s bank has offered a 3–9, 4·5%–3·5% forward rate agreement.
The finance director is also concerned about the foreign currency risk associated with the euro interest payment which would be due in nine months’ time.
The following exchange rates are available:
Required:
(a) Evaluate the proposed forward rate agreement as a way of managing the interest rate risk anticipated by GXJ Co. (3 marks)
(b) Analyse the foreign currency risk associated with the future interest payment of GXJ Co and briefly discuss ways that this risk might be hedged. (4 marks)
(c) Explain the nature of four-way equivalence in the relationship between spot exchange rates, forward exchange rates and future (expected) spot rates. (3 marks)