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Question 2a iii

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
strike puts
december
puts
march
puts
june
0.342 0.432 0.523 94.50 0.090 0.119 0.271
0.097 0.121 0.289 95.00 0.312 0.417 0.520

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)