ACCA AFM Syllabus E. Treasury And Advanced Risk Management Techniques - Options on interest rate futures - calculation - Past Papers ^{8 / 13}

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)

For a number of years Daikon Co has been using forward rate agreements to manage its exposure to interest rate fluctuations. Recently its chief executive officer (CEO) attended a talk on using exchange-traded derivative products to manage risks. She wants to find out by how much the extra cost of the borrowing detailed below can be reduced, when using interest rate futures, options on interest rate futures, and a collar on the options, to manage the interest rate risk. She asks that detailed calculations for each of the three derivative products be provided and a reasoned recommendation to be made.

Daikon Co is expecting to borrow $34,000,000 in five months’ time. It expects to make a full repayment of the borrowed amount in 11 months’ time. Assume it is 1 June 2015 today. Daikon Co can borrow funds at LIBOR plus 70 basis points. LIBOR is currently 3·6%, but Daikon Co expects that interest rates may increase by as much as 80 basis points in five months’ time.

The following information and quotes from an appropriate exchange are provided on LIBOR-based $ futures and options.

Three-month $ December futures are currently quoted at 95·84. The contract size is $1,000,000, the tick size is 0·01% and the tick value is $25.

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

Initial assumptions
It can be assumed that settlement for both the futures and options contracts is at the end of the month; that basis diminishes to zero at a constant rate until the contract matures and time intervals can be counted in months; that margin requirements may be ignored; and that if the options are in-the-money, they will exercised at the end of the hedge instead of being sold.

Further issues
In the talk, the CEO was informed of the following issues:

(i) Futures contracts will be marked-to-market daily. The CEO wondered what the impact of this would be if 50 futures contracts were bought at 95·84 on 1 June and 30 futures contracts were sold at 95·61 on 3 June, based on the $ December futures contract given above. The closing settlement prices are given below for four days:

(ii) Daikon Co will need to deposit funds into a margin account with a broker for each contract they have opened, and this margin will need to be adjusted when the contracts are marked-to-market daily.

(iii) It is unlikely that option contracts will be exercised at the end of the hedge period unless they have reached expiry. Instead, they more likely to be sold and the positions closed.

Required:
(a) Based on the three hedging choices available to Daikon Co and the initial assumptions given above, draft a response to the chief executive officer’s (CEO) request made in the first paragraph of the question. (15 marks)

For a number of years Daikon Co has been using forward rate agreements to manage its exposure to interest rate fluctuations. Recently its chief executive officer (CEO) attended a talk on using exchange-traded derivative products to manage risks. She wants to find out by how much the extra cost of the borrowing detailed below can be reduced, when using interest rate futures, options on interest rate futures, and a collar on the options, to manage the interest rate risk. She asks that detailed calculations for each of the three derivative products be provided and a reasoned recommendation to be made.

Daikon Co is expecting to borrow $34,000,000 in five months’ time. It expects to make a full repayment of the borrowed amount in 11 months’ time. Assume it is 1 June 2015 today. Daikon Co can borrow funds at LIBOR plus 70 basis points. LIBOR is currently 3·6%, but Daikon Co expects that interest rates may increase by as much as 80 basis points in five months’ time.

The following information and quotes from an appropriate exchange are provided on LIBOR-based $ futures and options.

Three-month $ December futures are currently quoted at 95·84. The contract size is $1,000,000, the tick size is 0·01% and the tick value is $25.

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

Initial assumptions
It can be assumed that settlement for both the futures and options contracts is at the end of the month; that basis diminishes to zero at a constant rate until the contract matures and time intervals can be counted in months; that margin requirements may be ignored; and that if the options are in-the-money, they will exercised at the end of the hedge instead of being sold.

Further issues
In the talk, the CEO was informed of the following issues:

(i) Futures contracts will be marked-to-market daily. The CEO wondered what the impact of this would be if 50 futures contracts were bought at 95·84 on 1 June and 30 futures contracts were sold at 95·61 on 3 June, based on the $ December futures contract given above. The closing settlement prices are given below for four days:

(ii) Daikon Co will need to deposit funds into a margin account with a broker for each contract they have opened, and this margin will need to be adjusted when the contracts are marked-to-market daily.

(iii) It is unlikely that option contracts will be exercised at the end of the hedge period unless they have reached expiry. Instead, they more likely to be sold and the positions closed.

Required:
(b) Discuss the impact on Daikon Co of each of the three further issues given above. As part of the discussion, include the calculations of the daily impact of the mark-to-market closing prices on the transactions specified by the CEO. (10 marks)

Keshi Co is a large multinational company with a number of international subsidiary companies. A centralised treasury department manages Keshi Co and its subsidiaries’ borrowing requirements, cash surplus investment and financial risk management. Financial risk is normally managed using conventional derivative products such as forwards, futures, options and swaps.

Assume it is 1 December 2014 today and Keshi Co is expecting to borrow $18,000,000 on 1 February 2015 for a period of seven months. It can either borrow the funds at a variable rate of LIBOR plus 40 basis points or a fixed rate of 5·5%. LIBOR is currently 3·8% but Keshi Co feels that this could increase or decrease by 0·5% over the coming months due to increasing uncertainty in the markets.

The treasury department is considering whether or not to hedge the $18,000,000, using either exchange-traded March options or over-the-counter swaps offered by Rozu Bank.

The following information and quotes for $ March options are provided from an appropriate exchange. The options are based on three-month $ futures, $1,000,000 contract size and option premiums are in annual %.

Option prices are quoted in basis points at 100 minus the annual % yield and settlement of the options contracts is at the end of March 2015. The current basis on the March futures price is 44 points; and it is expected to be 33 points on 1 January 2015, 22 points on 1 February 2015 and 11 points on 1 March 2015.

Rozu Bank has offered Keshi Co a swap on a counterparty variable rate of LIBOR plus 30 basis points or a fixed rate of 4·6%, where Keshi Co receives 70% of any benefits accruing from undertaking the swap, prior to any bank charges. Rozu Bank will charge Keshi Co 10 basis points for the swap.

Keshi Co’s chief executive officer believes that a centralised treasury department is necessary in order to increase shareholder value, but Keshi Co’s new chief financial officer (CFO) thinks that having decentralised treasury departments operating across the subsidiary companies could be more beneficial. The CFO thinks that this is particularly relevant to the situation which Suisen Co, a company owned by Keshi Co, is facing.

Suisen Co operates in a country where most companies conduct business activities based on Islamic finance principles. It produces confectionery products including chocolates. It wants to use Salam contracts instead of commodity futures contracts to hedge its exposure to price fluctuations of cocoa. Salam contracts involve a commodity which is sold based on currently agreed prices, quantity and quality. Full payment is received by the seller immediately, for an agreed delivery to be made in the future.

Required:
(a) Based on the two hedging choices Keshi Co is considering, recommend a hedging strategy for the $18,000,000 borrowing. Support your answer with appropriate calculations and discussion. (15 marks)

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 %

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)

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 %.

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)