Higher-level assessments such as the MCT obviously require far more in-depth detail and analysis in your responses than those that are enough at introductory and intermediate levels.
Let’s review a recent question that first appeared in an article in The Treasurer about how to structure an answer plan (see www.treasurers.org/qualifications-strategic-partner-and-mct). The earlier article set out a skeleton answer plan, around which a full response would be framed. This article will illustrate the level of detailed response wanted from candidates at the senior level.
The best guide to the expected detail in your exam answers is what a well-prepared candidate could reasonably be expected to produce:
The question is summarised below, to highlight the most important information needed to produce the suggested solution.
Your company has just negotiated a £100m, 10-year Libor-linked credit facility. The loan amortises in equal instalments from year six to year 10. The company’s policy is to swap to fixed at the outset to protect the return.
The FD favours postponing a fix. Your advice is required about whether and how to implement the FD’s 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 data:
Libor: Three months = 0.5%
Swap rate: 10 year = 2.0%
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 £1.5m in years one to six, shrinking thereafter until year 10.
The issues around this question are, however, wider than this.
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 FD is: “Why do you know better than the market?” Should anyone in the business be speculating?
But the market has not performed well with implied future interest rates over the last few years. The market has consistently predicted interest rate rises that 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. In that case, however, future action to fix more or less over time, should strictly be undertaken. This is a delta hedging approach.
The FD 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, 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 business, and perhaps peer group, should be considered before a decision is taken. But all things being equal, a postponement of hedging or partial hedging with subsequent delta hedge adjustments seems a preferred course.
That may not be realistic in practice, but write what you can in the time given. You will be able to pass with a less detailed answer, but obviously the more good points you can make, the better.
To answer well, you will need both detailed understanding gained through diligent study, and a lot of practice. Answering past exam papers against the clock is the best way to practise writing incisive and succinct answers, as well as confirming and improving your knowledge and understanding. Three steps are necessary for your success.
Download previous articles from this series and other useful study information from the Exam Tips area of the student site at study.treasurers.org/examtips
Note: With many thanks to Will Spinney and Kerry Attwell Thomas for providing the suggested solution and for their other valued advice on this article.
Doug Williamson is a finance tutor and coach, who enjoys your success
