AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E3. The use of financial derivatives to hedge against interest rate risk

E3a. Interest rate collar 10 / 13

Question 2a -

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 %.

March Calls  
June   
September Strike March Puts
June
September
0.279 0.391 0.446 96.00 0.006 0.163 0.276
0.012 0.090 0.263 96.50 0.196 0.581 0.754

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:

Briefly discuss the main advantage and disadvantage of hedging interest rate risk using an interest rate collar instead of options. (4 marks)

Question 2b iii -

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 %.

March Calls  
June   
September Strike March Puts
June
September
0.279 0.391 0.446 96.00 0.006 0.163 0.276
0.012 0.090 0.263 96.50 0.196 0.581 0.754

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)