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Question 2b

Lurgshall Co is a listed electronics company. Lurgshall Co has recently appointed a new chief executive, who has a number of plans to expand the company. The chief executive also plans to look carefully at the costs of all departments in Lurgshall Co’s head office, including the centralised treasury department.

The first major investment which the chief executive will oversee is an investment in facilities to produce applications-specific components. To finance the planned investment, it is likely that Lurgshall Co will have to borrow money. It is now 1 May. At present, it seems that Lurgshall Co will need to borrow $84 million on 1 September, for a period of six months, though both the amount and the period of borrowing are subject to some uncertainty. The treasurer plans to borrow the funds at a variable rate of LIBOR plus 50 basis points. LIBOR is currently 4·5% but is expected to rise by up to 0·6% between now and 1 September.

So far, the possibility of hedging a rise in LIBOR of 0·6% using a forward rate agreement or September $ futures has been investigated. The results of the calculations for these instruments were as follows:

4–10 Forward rate agreement from Birdam Bank: 5·38%

Three-month traded September $ futures: 5·36%

Lurgshall Co’s treasurer also wants to consider using options on futures to hedge loans.

Although Lurgshall Co has not previously used swaps for hedging purposes, the treasurer has asked Birdam Bank to find a counterparty for a potential swap arrangement.

Relevant information about options and swaps is as follows:

The current price for three-month $ September futures, $2 million contract size is 95·05. The price is quoted in basis points at 100 – annual % yield.

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

September calls Strike price September puts
0·132 95·25 0·411

It can be assumed that futures and options contracts are settled at the end of each month. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals. It can also be assumed that there is no basis risk and there are no margin requirements.

Birdam Bank has found a possible counterparty to enter into a swap with Lurgshall Co. The counterparty can borrow at an annual floating rate of LIBOR + 1·5% or a fixed rate of 6·1%. Birdam Bank has quoted Lurgshall Co a notional fixed rate of 5·6% for it to borrow. Birdam Bank would charge a fee of 10 basis points to each party individually to act as the intermediary of the swap. Both parties would share equally the potential gains from the swap contract.

Treasury staffing
Lurgshall Co’s new chief executive has made the following comments: ‘I understand that the treasury department has a number of day-to-day responsibilities, including investing surplus funds for the short-term liquidity management and hedging against currency and interest rates. However, these tasks could all be carried out by the junior, less experienced, members of the department. I do not see why the department needs to employ experienced, expensive staff, as it does not contribute to the strategic success of the company.’

(b) Discuss the advantages and disadvantages of using swaps as a means of hedging interest rate risk for Lurgshall Co. (5 marks)