This page contains a suggested solution to a 2013 MCT exam question, together with extracts from an article that appeared in The Treasurer in February 2015.
With many thanks to Will Spinney and Kerry Attwell-Thomas for providing the suggested solution and other valued advice.
To become a good treasurer, you need deep financial understanding and analytical skills, along with the ability to communicate your expert advice to an audience of senior non-specialists.
A great way to improve your ability to explain financial matters is to apply your knowledge to real life scenarios. This is the unique strength of studying for the ACT’s higher level qualifications.
Higher level qualifications progress the knowledge, comprehension and application skills you have already learnt. The focus at this level is on analysis, synthesis, evaluation and effective communication.
This means looking at everything you already know from another perspective.
You learn to:
- Formulate, select and justify solutions
- Communicate effectively, in writing and in person, with colleagues, senior management and other stakeholders
- Confidently recommend action and change
Here is a 2013 MCT question which applies the strategic and tactical financial decision making skills you need to become a trusted adviser at the highest level.
- Your company has just negotiated a £100m 10-year LIBOR linked credit facility to fund a step increase in production capacity. The loan amortises in equal instalments from year 6 to year 10, as for similar loans in the past.
- The company’s policy for interest risk management in these circumstances is to swap to fixed at the outset in order to protect the project return, so the return has been calculated on the basis of hedging at the current 10-year swap rate.
- The finance director believes that interest rates will continue at the current low level for some time to come and therefore is in favour of postponing a fix for the new facility, contrary to past practice.
- Before sharing this belief with the chief executive the finance director seeks your advice, as treasurer, about how to implement his view without taking undue risk. Of particular concern is the need for a monitoring system to flag when action to hedge might be necessary.
- Current interest rate data:
- LIBOR: 3 months = 0.5%
- Swap rate: 10 year = 2.0%
- Would you support the finance director in their preference to postpone the hedge? Explain your decision.
The issue seems to be a simple decision around whether interest rates will rise over the period of the loan so that paying a lower floating interest rate now would be cheaper in the long run than fixing now for the period of the loan.
The magnitude of the difference is £1.5 million in years one to six, shrinking thereafter until year 10.
The issues around this question are, however, wider than this.
- Is this loan part of a larger portfolio of loans? If so, then it would seem that all of those are fixed and so having some floating rate debt would balance the risk better. The overall portfolio risk should be considered rather than the risk on an individual loan. It seems that there are other loans in the portfolio because of the prior policy on fixing.
- Loans are not usually identified with particular projects and it is overall capital structure that should be considered when evaluating projects. If the projects are non-recourse then different approaches may be required.
- Is company profitability affected by interest rates, which are usually set around the economy? If the economy does well, profitability might rise, thus offsetting any rise in cost on this loan and enjoying low cost at a time of low activity.
- What is the appetite for interest rate risk?
- Is the company at risk of breaching covenants so that paying a higher rate may risk a default in a loan? In the same vein are there short term pressures on earnings which should be considered (of course treasurers take a longer term view)?
- Is there any cash on the balance sheet, or might there be over the life of the loan which might attract interest at floating rates, thus offsetting any rises in rates?
When those questions are answered then the decision can be properly addressed.
Let’s suppose it comes down to a view on interest rates.
In theory, the two interest rates are economically equivalent, so that the market expects rates to rise beyond 2% over the life of the fix to exactly compensate between the two choices. Therefore any decision one way or the other hinges around whether you believe the market is right or wrong.
One question that could be posed to the finance director is ‘why do you know better than the market?’ Should anyone in the firm be speculating?
However, the market has not performed well with implied future interest rates over the last few years. The market has consistently predicted rises in interest rate rises which have not transpired. It might be reasonable to suppose that it is also wrong now.
We could consider interest rate options, but these will include a cost beyond interest and will depend on volatility. One possibility is to mimic an option approach, which would be to fix half of the loan. However, in that case, future action to fix more or less over time, should strictly be undertaken.
This is a delta hedging approach.
The finance director specifically asks about monitoring and monitoring resembles this delta hedging approach. It anticipates a choice of floating rate. Thus, suppose the yield curve mathematics shows that the market expects rates to rise to 0.75% after one year. So if rates rise to 0.75% before one year then a move should be made to fix, because the market is rising quicker than expected.
If on the other hand, rates have not risen that far by then, then floating was the right call.
This monitoring and possible changes to hedging are ongoing, difficult and expensive and should be considered in the overall costs of funding.
In conclusion, the wider context of the firm and perhaps peer group should be considered before a decision is taken.
However, all things being equal, a postponement of hedging or partial hedging with subsequent delta hedge adjustments is a preferred course.