Special Class - Derivative - 001

Interest Rate FRA

A bank has quoted the following rates for dealing in FRAs

Bid Offer

3 v 6 4.59 4.56

It is 24^th March and your company wants to fix an interest rate for borrowing CU 1 million for three months from 24^th June. What is the payment to be made on the FRA if the company entered a 3 v 6 FRA with a bank, assuming that interest rates rise to 4.65% from their current level of 4.5%?

Interest Rate Futures

The Corporate treasurer of Clieff decides on 31 December to hedge the interest rate risk on the CU 6 million to be borrowed in three months’ time for six months by using interest rate futures. Her expectation is that interest rates will increase from 13% by 2% over the next three months.

The current price of March CU 3 month futures is 87.25. The standard contract size is CU500,000.

1. Set out calculations of the effect of using the futures market to hedge against movements in the interest rate:
   1. If interest rates increase from 13% by 2% and the futures market price moves by 2%
   2. If interest rates increase by 13% by 2% and the futures market price moves by 1.75%
   3. If interest rates fall from 13% by 1.5% and the future market price moves by 1.25%

The time value of money, taxation and margin requirements can be ignored.

2. Calculate, for the situations above, whether the total cost of the loan after hedging would have been lower with the futures hedge chosen by the treasurer or with an interest rate guarantee which she could have purchased at 13% for a premium of 0.25% of the size of loan to be guaranteed.

Again, the time value of money, taxation and margin requirements can be ignored.

Interest Rate Futures and Options

The finance director of Plutocrat Ltd is concerned that interest rates could become more volatile for many major trading countries following recent turmoil in credit markets.

It is now 1 March and Plutocrat is expected to need to borrow BDT 12,000,000 for a period of six months commencing in six months' time.

Futures and options quotes are given below. You may assume that the company may borrow at the 3-month LIBOR rate.

LIFFE futures prices, BDT 500,000 contract size

June 94.54

September 94.28

LIFFE options on futures prices, BDT 500,000 contract size, premiums are annual %

Exercise price Calls Puts

June September June September

94.25 0.437 0.543 0.083 0.187

94.50 0.276 0.387 0.168 0.282

94.75 0.163 0.263 0.302 0.407

3-month LIBOR is currently 5.5%.

Requirements:

(a) Discuss the relevant considerations when deciding between futures and options to hedge the company's interest rate risk. 5

(b) Using the above information illustrate the possible results of hedging interest rate risk using:

(i) Futures, and

(ii) Options.

hedges if interest rates in six months' time increase by 0.5% and the September future is then trading at 93.97. Recommend which hedge should be selected.

Interest Rate SWAP

Swapit Ltd has a high credit rating. It can borrow at 10% or variable at LIBOR + 0.3%. It would like to borrow variable.

Badcred Ltd has a lower credit rating. It can borrow fixed at 11% or variable at LIBOR + 0.5%. It would like to borrow fixed.

Requirement

Show how a swap arrangement would benefit both parties if Swapit were to borrow fixed, paying Badcred Ltd LIBOR, and Badcred Ltd were to borrow variable paying 10.1% fixed to Swapit Ltd.

Interest Rate Swap

Tista Cement Ltd. has a fixed rate loan of BDT 125 Million at 13%, which must be redeemed one year hence. The Company is considering an interest rate swap with Gomoti Steel Ltd., which has a floating rate loan of the same size at LIBOR plus 1%. If the swap goes ahead, Gomoti Ltd. will pay Tista Ltd. 12% and Tista Ltd. will pay Gomoti Ltd. LIBOR plus 1½%. Tista Ltd. could issue floating rate debt at LIBOR plus 2% and Gomoti Ltd. could issue fixed rate debt at 12½%.

There would be legal fees of 0.10% for each company on the amount of swap if the swap is made.

Requirement:

(i) Would the swap benefit Tista Ltd:

• if LIBOR is 11% for the next year.
• if LIBOR is 11% for the next four months, and 9.5% thereafter?

(ii) Could an alteration in the terms of the swap make it beneficial to both companies? Any benefit would be shared equally between them.

Currency Risk

American Adventures Ltd (AA) is a family owned company based in the UK. AA organises walking, cycling and climbing holidays in the United States of America for both British and American customers. AA has the following receipts and payments due in four months’ time:

Receipts due from American customers on 31 March 2015	$2.25 million
Payments due to American suppliers on 31 March 2015	$3.50 million

You work for Zeta Corporate Finance which has been asked to give advice to AA on hedging its exchange rate risk. You have available the following data on 30 November 2014:

Exchange rates:

Spot rate ($/£) 1.5154 - 1.5157

4-month forward contract premium ($/£) 0.0012 - 0.0011

March currency futures price (standard contract size £62,500): $1.5148/£

March traded sterling currency options (standard contract size £10,000):

The premiums are quoted in cents per £ and are payable up front.

Strike price Call premium Put premium

$1.56 1.04 6.15

Annual borrowing and depositing interest rates:

Sterling 4.70% - 3.50%

Dollar 3.51% - 2.25%

Requirement:

Assuming the spot exchange rate on 31 March 2015 will be $1.5150 – 1.5156/£ and that the sterling currency futures price will be $1.5153/£, calculate AA’s net sterling payment if it uses the following to hedge its foreign exchange risk:

• a forward contract
• currency futures
• a money market hedge
• currency options

Currency Risk

E Inc is a US-based business that is a major computer software provider to the defence industry.

In order to expand its business, the company has recently agreed, in principle, to buy a small computer software business based in France for €10·54 million from a French conglomerate. However, E Inc is concerned over certain legal and technical aspects of the software business. The two parties to the transaction have therefore agreed that the deal will be finalised and the purchase price will be paid in three months’ time, subject to the satisfactory outcome of a due diligence investigation by an independent firm of accountants.

In order to deal with foreign exchange risk associated with the purchase of the French business, the Corporate Treasurer of E Inc is considering the following choices:

1. The purchase of futures contracts, which will be sold in three months’ time in order to close the company’s position. The relevant euro futures contracts are currently priced at €1 = $0·9750. The futures contract size is €125,000 (and should be rounded to the nearest whole number of contracts). The tick value is $12·50 and one tick is 0·01 cents per €.
2. The purchase of an over-the-counter option at an exercise price of €1 = $0·9900 with a premium cost of $2 per €100.

The current spot rate is €1 = $0·9812.

The Corporate Treasurer of E Inc believes that one of two future scenarios may occur and is concerned with the effect of each scenario on the choices described above.

The two scenarios are:

• in three months’ time, the spot rate moves to €1 = $0·9998 and the futures price moves to €1 = $0·9860
• in three months’ time, the spot rate moves to €1 = $0·9660 and the futures price moves to €1 = $0·9580

Required:

1. Calculate the cost of the futures contract and the hedge efficiency under each scenario.

(b) Calculate the final outcome of the over-the-counter option under each scenario.

Comment on your findings in (a) and (b) above.

Comment on the appropriateness of each hedging instrument for E Inc.

compliance of all legal aspects of a liaison office in Bangladesh

The issue relating to compliance of all legal aspects of a liaison office in Bangladesh

1. Monthly requirements

1. Tax Deduction at Source (TDS):

As per provision of Section 48 of the ITO 1984 and clause no. 14 of the liaison permission form the BIDA, tax is deductible at source from some specified payments mentioned in the Ordinance. All sums deducted or collected in accordance with the Rules 13 of ITR 1984 shall be paid to the Government treasury within the following timeline:

Sl.	Time of deduction or collection	Date of payment to the credit of the Government
1.	in case of deduction or collection made in any month from July to May of a year	within two weeks from the end of the month in which the deduction or collection was made
2.	in case of deduction or collection made in any day from the first to the twentieth day of June of a year	within seven days from the date in which the deduction or collection was made
3.	in case of deduction or collection made in any other dates of the month of June of a year	The next following day in which the deduction or collection was made
4.	in case of deduction or collection in the last two working days of the month of June of a year	on the same day on which the deduction or collection was made

2. VAT Deduction at Source (VDS):

As per provision of Section 6 (4AA) of the VAT Act 1991, SRO No. 113-Law/2009/521-VAT dated 11 June 2009 and clause no. 14 of the liaison permission form the BIDA, VAT is deductible at source from some specified payments mentioned in the SRO. All sums deducted or collected in accordance with the VAT Act shall be paid to the credit of the Government within fifteen days from the date of such deduction or collection.

Consequences of failure to Deduct/Collect Tax at Source

As per provision of Section 57 of the Income Tax Ordinance (ITO) 1984 and Section 37 of the VAT Act 1991, if any body fails to deduct and deposit the TDS, the company would be treated as an assessee in default. The company has to pay the due tax along with penalty calculated at the rate of 2% per month of such unpaid tax for the period commencing on the date following the expiry of the due time of payment. The Deputy Commissioner of Taxes to whom the statement in respect of deduction or collection of tax is required to be submitted shall take necessary action for realization of tax along with penalty from the assessee in default.

3. Submitting of VAT challans:

As per VAT Act 1991, VAT challans (TR-6) to be submitted to the concerned circle within five days from the date of collection of Treasury challans.

4. Filing of Monthly Deduction and Collection Statement:

As per provisions of Section 58 of The Income Tax Ordinance, 1984 and Rule 18 of The Income Tax Rules, 1984, every person who has deducted or collected any tax under this Chapter shall furnish, to the person from whom such deduction or collection has been made, a certificate of tax deduction or collection and furnish the same to the tax authority within two weeks following the month of deduction or collection.

5. Filing of Monthly Salary Statement of Local and Expatriate Employees:

As per provisions of Section 50 of The Income Tax Ordinance, 1984, and every Rule 21 of The Income Tax Rules, 1984, person responsible for payment under the head ‘Salaries’ shall furnish, to the person from whom such deduction or collection has been made, a certificate of tax deduction or collection and furnish the same to the tax authority within two weeks following the month of deduction or collection.

2. Quarterly requirements

Filing of Quarterly Statements:

As per Clause no. 10 of the liaison permission from the Bangladesh Investment Development Authority (BIDA) and Guidelines for Foreign Exchange Transactions, Volume-I

A quarterly return of receipt and expenditure out of remittance receipt from abroad shall have to be submitted to BIDA, Authorized bank and concerned tax office along with encashment certificates within one month after the end of the quarter.

3. Half-Yearly requirements

Filing of Withholding Income Tax Return:

As per provision of Section 75A of ITO 1984 and para 47 of Finance Act, 2016-

A liaison Office is required to file a half yearly return of withholding tax, by thirty-first January of the year in which the deduction or collection was made and thirty-first July of the next year following the year in which the deduction or collection was made in a prescribed form accompanied by a statement of tax deducted or collected at source.

The DCT may extend the return submission date up to 15 days.

4. Annual requirements

1. Preparation of Financial Statements and Auditor’s Report

As per Section 183 (3) of The Companies Act, 1994 and Section 75(2)(d) of The Income Tax Ordinance, 1984,

every liaison office should have its annual financial statements audited by a Chartered Accountant and submit the same to the concerned authorities including Registrar of Joint Stock Companies and Firms (RJSC).

2. Filing of Income Tax Return:

As per provision of Section 75 of Income Tax Ordinance 1984, clause no. 10 of the liaison permission form the BIDA- A liaison office is required to file Income Tax Return for every income year

As per Section 9 of the Finance Act 2015, the definition of income year has been changed to the period of twelve months commencing on the first day of July of the relevant income year. In this connection, the return is required to be filed on 31 December of each year.

However, as per the newly inserted proviso of Section 2(35)(g) of The Income Tax Ordinance, 1984 introduced vide Finance Act, 2016, the Deputy Commissioner of Taxes may allow a different financial year for a company which is a subsidiary or holding company of a parent company incorporated outside Bangladesh if such company requires to follow a different financial year for the purpose of consolidation of its accounts with the parent company.

3. Filing of Transfer Pricing Return:

As per provisions of Section 107EE of the Income Tax Ordinance, 1984, every person who has entered into an international transaction shall furnish, along with the return of income, a statement of international transactions in the form and manner as may be prescribed. This return shall be submitted within the fifteenth day of the seventh month following the end of the income year.

4. Filing of Annual Salary information:

As per provision of Section 108 of the ITO, 1984-

A liaison Office is required to file annual salary information for every income year as prescribed in Rule 23 of The Income Tax Rules, 1984. The return is required to be filed before the 1st day of September of each year.

5. Information regarding filing of return by employees:

As per provision of Section 108A of the ITO, 1984-

As per Any person responsible for making any payment which is an income of the payee classifiable under the head "Salaries", shall, by the thirtieth day of April of each year, furnish to such income tax authority and in such manner as may be prescribed.

6. Filling of Annual Information Return (if required by the tax authoritiy)

As per provision of Section 75B of ITO 1984-

The NBR may require any person or group of persons including a liaison Office to submit an Annual Information Return in a prescribed form.

5. Others

1. Issue relating to Electronic Document

According to the provision of Section 11 of Information Technology Act 2006, the liaison Office is required to keep all necessary documents in paper form (hard copy). According to the provision of the Companies Act 1994, all the documents along with the books of accounts must be kept for 12 years.

2. Recruitment of expatriate staff

The ratio of expatriate and Bangladesh employees must be 1:5.

3. List of documents/register required by Bangladesh Labor Act, 2006 (amended in 2013):

• Movement Register/Log Book
• Visitor Register
• Attendance Register
• Salary Register
• Leave Register
• Service Register
• Register of Workers and Supply of Tickets and Cards
• Other Registers on need basis

4. RJSC requirement:

• Financial Statements of LO and Parent Company.
• Summary and list of employees
• Any other reporting requirements i.e. Schedules and Forms by the authority.

5. Renewal of following permissions:

• Any other permissions i.e. BIDA, Trade Liense, ERC, IRC and Labour Registration – pleases renewal as per the concerned authority’s requirements.