Question

You are the treasurer for a company and realize that you will require additional operating funds in three months for three months. Answer the following questions:

1. You are at risk to changes in interest rate. Describe how movements in interest rates might affect your company given this need.
2. There are many ways to mitigate your exposure to the above risk. Discuss two and the pros/cons of each.

You should answer these questions in a couple of short paragraphs.

Answer 1

Since, the company will be needing more funds in the future as per the treasurer and the change in interest rate is a key variable, the profitability of the company could be imacted a lot as with high interest expense, there would be more financing expenses recorded on the cash flow statement and thus will lead to lower revenues, lower cash flows and reduced share price.

Interest rate risk coud be avoided by :-

1. FRA - getting a forward contract which is an OTC contract by which you can fix the rate of Investment. You will be paying fixed payments but the other party like bank will be paying the interest rate prevailing in the market.

2. Futures - a future instrument is similar to FRA in which you fixed the rate today but its exchange traded.

Pros/Cons

1. FRA

CON - more risk since its traded over the counter.

PRO - Less premium payments than futures or any other exchange traded instrument and less regulation involved

2. FUTURES

CON - MORE premium charges since more intermediaries because of exchange

pro - less risk because of the clearing Corporation.

I hope this helps you.

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