The most significant transaction which Massie Co is due to undertake with a company outside the Armstrong Group in the next six months is that it is due to receive €25 million from Bardsley Co on 30 November. Massie Co’s treasury manager intends to invest this money for the six months until 31 May, when it will be used to fund some major capital expenditure. However, the treasury manager is concerned about changes in interest rates. Predictions in the media range from a 0·5% rise in interest rates to a 0·5% fall.

Because of the uncertainty, the treasury manager has decided to protect Massie Co by using derivatives. The treasury manager wishes to take advantage of favourable interest rate movements. Therefore she is considering options on interest rate futures or interest rate collars as possible methods of hedging, but not interest rate futures. Massie Co can invest at LIBOR minus 40 basis points and LIBOR is currently 3·6%.

The treasury manager has obtained the following information on Euro futures and options. She is ignoring margin requirements.

Three-month Euro futures, €1,000,000 contract, tick size 0·01% and tick value €25.

September        95·94
December         95·76
March         95·44

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

It can be assumed that settlement for the 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:
(b) Based on the choice of options on futures or collars which Massie Co is considering and assuming the company does not face any basis risk, recommend a hedging strategy for the €25 million receipt. Support your recommendations with appropriate comments and relevant calculations. (14 marks)