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.