Interest rate futures 3 / 13

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Question 2a ii

Awan Co is expecting to receive $48,000,000 on 1 February 2014, which will be invested until it is required for a large project on 1 June 2014. Due to uncertainty in the markets, the company is of the opinion that it is likely that interest rates will fluctuate significantly over the coming months, although it is difficult to predict whether they will increase or decrease.

Awan Co’s treasury team want to hedge the company against adverse movements in interest rates using one of the following derivative products:

Forward rate agreements (FRAs); 
Interest rate futures; or
Options on interest rate futures.

Awan Co can invest funds at the relevant inter-bank rate less 20 basis points. The current inter-bank rate is 4•09%. However, Awan Co is of the opinion that interest rates could increase or decrease by as much as 0•9% over the coming months.

The following information and quotes are provided from an appropriate exchange on $ futures and options. Margin requirements can be ignored.

Three-month $ futures, $2,000,000 contract size
Prices are quoted in basis points at 100 – annual % yield

December 2013: 94•80
March 2014: 94•76
June 2014: 94•69

Options on three-month $ futures, $2,000,000 contract size, option premiums are in annual %

calls
december
calls
march
calls
june
strikeputs
december
puts
march
puts
june
0.3420.4320.52394.500.0900.1190.271
0.0970.1210.28995.000.3120.4170.520

Voblaka Bank has offered the following FRA rates to Awan Co:

1–7: 4•37%
3–4: 4•78%
3–7: 4•82%
4–7: 4•87%

It can be assumed that settlement for the futures and options contracts is at the end of the month and that basis diminishes to zero at contract maturity at a constant rate, based on monthly time intervals. Assume that it is 1 November 2013 now and that there is no basis risk.

A member of Awan Co’s treasury team has suggested that if option contracts are purchased to hedge against the interest rate movements, then the number of contracts purchased should be determined by a hedge ratio based on the delta value of the option.

Required:

Based on the three hedging choices Awan Co is considering, recommend a hedging strategy for the $48,000,000 investment, if interest rates increase or decrease by 0•9%.

Support your answer with appropriate calculations and discussion. (19 marks)

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Question 2b i

Alecto Co, a large listed company based in Europe, is expecting to borrow €22,000,000 in four months’ time on 1 May 2012. It expects to make a full repayment of the borrowed amount nine months from now.

Currently there is some uncertainty in the markets, with higher than normal rates of inflation, but an expectation that the inflation level may soon come down. This has led some economists to predict a rise in interest rates and others suggesting an unchanged outlook or maybe even a small fall in interest rates over the next six months.

Although Alecto Co is of the opinion that it is equally likely that interest rates could increase or fall by 0•5% in four months, it wishes to protect itself from interest rate fluctuations by using derivatives.

The company can borrow at LIBOR plus 80 basis points and LIBOR is currently 3•3%. The company is considering using interest rate futures, options on interest rate futures or interest rate collars as possible hedging choices.

The following information and quotes from an appropriate exchange are provided on Euro futures and options. Margin requirements may be ignored.

Three month Euro futures, €1,000,000 contract, tick size 0•01% and tick value €25
March 96•27
June 96•16
September 95•90

Options on three month Euro futures, €1,000,000 contract, tick size 0•01% and tick value €25. Option premiums are in annual %.

MarchCalls  
June   
SeptemberStrikeMarchPuts
June
September
0.2790.3910.44696.000.0060.1630.276
0.0120.0900.26396.500.1960.5810.754

It can be assumed that settlement for both the futures and options contracts is at the end of the month. It can also be assumed that basis diminishes to zero at contract maturity at a constant rate and that time intervals can be counted in months.

Required:

Based on the three hedging choices Alecto Co is considering and assuming that the company does not face any basis risk, recommend a hedging strategy for the €22,000,000 loan. Support your recommendation with appropriate comments and relevant calculations in €. (17 marks)

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Question 2c

Alecto Co, a large listed company based in Europe, is expecting to borrow €22,000,000 in four months’ time on 1 May 2012. It expects to make a full repayment of the borrowed amount nine months from now.

Currently there is some uncertainty in the markets, with higher than normal rates of inflation, but an expectation that the inflation level may soon come down. This has led some economists to predict a rise in interest rates and others suggesting an unchanged outlook or maybe even a small fall in interest rates over the next six months.

Although Alecto Co is of the opinion that it is equally likely that interest rates could increase or fall by 0•5% in four months, it wishes to protect itself from interest rate fluctuations by using derivatives.

The company can borrow at LIBOR plus 80 basis points and LIBOR is currently 3•3%. The company is considering using interest rate futures, options on interest rate futures or interest rate collars as possible hedging choices.

The following information and quotes from an appropriate exchange are provided on Euro futures and options. Margin requirements may be ignored.

Three month Euro futures, €1,000,000 contract, tick size 0•01% and tick value €25
March 96•27
June 96•16
September 95•90

Options on three month Euro futures, €1,000,000 contract, tick size 0•01% and tick value €25. Option premiums are in annual %.

MarchCalls  
June   
SeptemberStrikeMarchPuts
June
September
0.2790.3910.44696.000.0060.1630.276
0.0120.0900.26396.500.1960.5810.754

It can be assumed that settlement for both the futures and options contracts is at the end of the month. It can also be assumed that basis diminishes to zero at contract maturity at a constant rate and that time intervals can be counted in months.

Required:

Explain what is meant by basis risk and how it would affect the recommendation made in part (b) above. (4 marks)

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