AAT L4 Cash & Treasury Management 3 — Questions and Answers
Question 1: Interest rate risk arises when:
- A business has no debt
- Changes in interest rates affect the cost of borrowing or the return on investments (Correct answer)
- A business's customers pay late
- Exchange rates change unexpectedly
Correct answer: Changes in interest rates affect the cost of borrowing or the return on investments
Interest rate risk is the exposure to changes in interest rates that affect the cost of variable-rate borrowings or the return on variable-rate investments; it can affect both the income statement (interest charges) and cash flow.
Question 2: An interest rate swap allows a company to:
- Convert a variable-rate loan to a fixed rate (or vice versa) by exchanging interest payments with a counterparty, while the principal is unchanged (Correct answer)
- Convert debt to equity
- Exchange currency obligations between two parties
- Eliminate credit risk on a loan
Correct answer: Convert a variable-rate loan to a fixed rate (or vice versa) by exchanging interest payments with a counterparty, while the principal is unchanged
An interest rate swap exchanges interest payment obligations — typically swapping a floating rate payment (e.g., SONIA + margin) for a fixed rate with a counterparty, effectively locking in a fixed interest cost without changing the underlying loan principal.
Question 3: Surplus short-term cash in a treasury function is typically invested in:
- Long-dated government bonds or equities
- Short-term, highly liquid, low-risk instruments such as money market funds, treasury bills, or short-term bank deposits (Correct answer)
- Real estate and infrastructure projects
- Unquoted venture capital funds
Correct answer: Short-term, highly liquid, low-risk instruments such as money market funds, treasury bills, or short-term bank deposits
Surplus short-term cash must be readily accessible and safe; treasury invests in liquid, low-risk instruments (money market funds, bank deposits, treasury bills) to earn a return without putting capital at risk or sacrificing liquidity.
Question 4: The 'matching principle' in working capital management means:
- Revenue is matched to expenses in the income statement
- Long-term assets are funded with long-term finance; short-term assets are funded with short-term finance (Correct answer)
- All cash inflows are matched against cash outflows daily
- Capital expenditure is matched against depreciation
Correct answer: Long-term assets are funded with long-term finance; short-term assets are funded with short-term finance
The matching principle aligns the nature of the funding with the nature of the asset: long-term (non-current) assets should be financed with long-term capital; current assets may be funded by current liabilities — avoiding liquidity mismatches.
Question 5: A foreign currency transaction exposure arises when:
- A business imports goods and invoices are in sterling
- A business has a transaction denominated in a foreign currency — the sterling value will change if exchange rates move before settlement (Correct answer)
- A business invests in foreign shares
- A business has an overseas subsidiary that must be consolidated
Correct answer: A business has a transaction denominated in a foreign currency — the sterling value will change if exchange rates move before settlement
Transaction exposure is the risk that exchange rate movements between the transaction date and the settlement date change the sterling value of a foreign currency receivable, payable, or commitment.
Question 6: Which of the following is an example of a natural hedge?
- Buying a forward exchange contract
- Matching revenues in euros with costs/purchases also denominated in euros — so exchange rate movements affect both sides equally (Correct answer)
- Taking out currency insurance
- Holding a bank account in a foreign currency as a speculative investment
Correct answer: Matching revenues in euros with costs/purchases also denominated in euros — so exchange rate movements affect both sides equally
A natural hedge exists when a business naturally offsets foreign currency revenues against foreign currency costs in the same currency — exchange rate movements affect both sides, reducing net currency exposure without the need for financial instruments.
AAT L4 Cash & Treasury Management 3
Interest rate risk arises when: