FRM 5

Assignment
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 Strike Puts
December March June December March June
0·342 0·432 0·523 94·50 0·090 0·119 0·271
National 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.
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
Using options on futures
Need to hedge against a fall in interest rates, therefore buy call options. As before, Awan Co needs 32
March call option contracts ($48,000,000/$2,000,000 x 4 months/3 months).
If interest rates increase by 0·9% to 4·99%
Exercise price 94.50 95.00
Futures price 94.55 94.55
Exercise ? Yes No
Gain in basis points 5 0
Underlying investment return (from above) $766,400 $766,400
Gain on options (0·0005 x 2,000,000 x 3/12 x 32, 0) $8,000 $0
Premium
0·00432 x $2,000,000 x 3/12 x 32 $(69,120)
0·00121 x $2,000,000 x 3/12 x 32 $(19,360)
Net return $705,280 $747,040
Effective interest rate 4·41% 4·67%
If interest rates increase by 0·9% to 3.19%
Exercise price 94.50 95.00
Futures price 96.35 96.35
Exercise ? Yes Yes
Gain in basis points 185 135
Underlying investment return (from above) $478,400 $478,400

Gain on options
(0·0185 x 2,000,000 x 3/12 x 32) $296,000
(0·0135 x 2,000,000 x 3/12 x 32) $216,000
Premium
As above $(69,120)
As above $(19,360)
Net return $705,280 $675,040
Effective interest rate 4·41% 4.22%
Discussion
The FRA offer from Voblaka Bank gives a slightly higher return compared to the futures market; however,
Awan Co faces a credit risk with over-the-counter products like the FRA, where Voblaka Bank may default
on any money owing to Awan Co if interest rates should fall.
The March call option at the exercise price of 94•50 seems to fix the rate of return at 4•41%, which is lower
than the return on the futures market and should therefore be rejected. The March call option at the exercise
price of 95•00 gives a higher return compared to the FRA and the futures if interest rates increase, but does
not perform as well if the interest rates fall.
If Awan Co takes the view that it is more important to be protected against a likely fall in interest rates, then
that option should also be rejected. The choice between the FRA and the futures depends on Awan Co’s
attitude to risk and return, the FRA gives a small, higher return, but carries a credit risk. If the view is that the
credit risk is small and it is unlikely that Voblaka Bank will default on its obligation, then the FRA should be
chosen as the hedge instrument.

FRM 5

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FRM 5

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Assignment

Exercise price 94.50 95.00

Futures price 94.55 94.55

Gain in basis points 5 0

Underlying investment return (from above) $766,400 $766,400

Gain on options (0·0005 x 2,000,000 x 3/12 x 32, 0) $8,000 $0

0·00432 x $2,000,000 x 3/12 x 32 $(69,120)

0·00121 x $2,000,000 x 3/12 x 32 $(19,360)

Net return $705,280 $747,040

Effective interest rate 4·41% 4·67%

If interest rates increase by 0·9% to 3.19%

Exercise price 94.50 95.00

Futures price 96.35 96.35

Exercise ? Yes Yes

Gain in basis points 185 135

Underlying investment return (from above) $478,400 $478,400

(0·0185 x 2,000,000 x 3/12 x 32) $296,000

(0·0135 x 2,000,000 x 3/12 x 32) $216,000

Net return $705,280 $675,040

Effective interest rate 4·41% 4.22%

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