Wardegul Co September / December 2017

Wardegul Co, a company based in the Eurozone, has expanded very rapidly over recent years by a combination of
acquiring subsidiaries in foreign countries and setting up its own operations abroad. Wardegul Co’s board has foun
increasingly difficult to monitor its activities and Wardegul Co’s support functions, including its treasury function, h
struggled to cope with a greatly increased workload. Wardegul Co’s board has decided to restructure the company
a regional basis, with regional boards and appropriate support functions. Managers in some of the larger countries
which Wardegul Co operates are unhappy with reorganisation on a regional basis, and believe that operations in th
countries should be given a large amount of autonomy and be supported by internal functions organised on a nati
basis.

Assume it is now 1 October 2017. The central treasury function has just received information about a future trans
by a newly-acquired subsidiary in Euria, where the local currency is the dinar (D). The subsidiary expects to receiv
D27,000,000 on 31 January 2018. It wants this money to be invested locally in Euria, most probably for five mon
until 30 June 2018.

Wardegul Co’s treasury team is aware that economic conditions in Euria are currently uncertain. The central bank
rate in Euria is currently 4·2% and the treasury team believes that it can invest funds in Euria at the central bank
rate less 30 basis points. However, treasury staff have seen predictions that the central bank base rate could incr
by up to 1·1% or fall by up to 0·6% between now and 31 January 2018.

Wardegul Co’s treasury staff normally hedge interest rate exposure by using whichever of the following products i
appropriate:
– Forward rate agreements (FRAs)
– Interest rate futures
– Options on interest rate futures

Treasury function guidelines emphasise the importance of mitigating the impact of adverse movements in interest
rates. However, they also allow staff to take into consideration upside risks associated with interest rate exposure
deciding which instrument to use.

A local bank in Euria, with which Wardegul Co has not dealt before, has offered the following FRA rates:
4–9: 5·02%
5–10: 5·10%

The treasury team has also obtained the following information about exchange traded Dinar futures and options:

Three-month D futures, D500,000 contract size

Prices are quoted in basis points at 100 – annual % yield:
December 2017: 94·84
March 2018: 94·78
June 2018: 94·66
Options on three-month D futures, D500,000 contract size, option premiums are in annual %
Calls Strike price Put
December March June December March June
0·417 0·545 0·678 94·25 0·071 0·094 0·155
0·078 0·098 0·160 95·25 0·393 0·529 0·664

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

Required:
(a) Recommend a hedging strategy for the D27,000,000 investment, based on the hedging choices which
treasury staff are considering, if interest rates increase by 1·1% or decrease by 0·6%. Support your answer
with appropriate calculations and discussion. (18 marks)

(b) Discuss the advantages of operating treasury activities through regional treasury functions compared with:
– Each country having a separate treasury function.
– Operating activities through a single global treasury function. (7 marks)
 Issue
Today's date
Deposit date
End date
FRA
Interest rate / LIBOR

Forward rate argreement (FRA)

FRA 5.02% (4-9) since the investment wil take place in four months' time for a period of five months.

Investment return (5.3%-0.3%)*D27m*5/12

Payment to bank (5.3%-5.02%)*27000000*5/12
Receipt from bank (5.02%-3.6%)*27000000*5/12
Net receipt
Effective interest rate

Interest rate futures

1 Buy now sell later
Go long in the futures market since hedge against a fall in interest rate.
Use March contract as the investment will be made on 31 January.

2 Number of contracts

3 Basis = (100 - interest rate) - future contract price

4 Unexpired basis

5 Net outcome of hedge

a Investment return (from FRA)

b Expected futures price (futures close out price)
c Loss on futures market (94.36-94.78)*500000*3/12*90
Profit on fututres market (96.06-94.78)*500000*3/12*90
Net receipt

6 Effective annual interest rate

Options on futures
1 Buy March call options as need to hedge against a fall in interest rates.
 If interest rates increase by 1.1% to 5.3%
2 Exercise price
3 Estimated futures price (from futures)
4 Exercise?
5 If yes, gain in basis points

6 Investment return (from FRA)

7 Gain on options
8 Premium
9 Net receipt
10 Effective annual interest rate

If interest rates decrease by 0.6% to 3.6%

2 Exercise price
3 Estimated futures price (from futures)
4 Exercise?
5 If yes, gain in basis points

6 Investment return (from FRA)

7 Gain on options
8 Premium (same as before)
9 Net receipt
10 Effective annual interest rate

Discussion
FRA The forward rate agreement gives the highest guaranteed return of 4.72%. If Wardegul Co wishes to have certain c
This assumes the bank of Wardegul is reliable and there is no risk of default.

Mixed If there is a risk of default due to economic uncertainty, the choice will be between futures and options as these are

Option The 95.25 option gives a better rate of 4.90% if interest rates increase, but a significantly lower rate of 4.01% if inte

Conclu Therefore, if Wardegul is risk averse, it will choose the forward rate agreement.
 Deposit / Investment Buy now sell later
1-Oct-17
31-Jan-18 Futures or Call Options: March contracts
30-Jun-18
4-9 5.02%
4.20%

ce in four months' time for a period of five months.

If interest rates increase by 1.1% to 5.3% If interest rates decrease by 0.6% to 3.6%
D D
562,500 371,250
-31,500
159,750
531,000 531,000
4.72% 4.72%

a fall in interest rate. Buy March futures

de on 31 January.

90 contracts

1.02

0.339999999999999

If interest rates increase by 1.1% to 5.3% If interest rates decrease by 0.6% to 3.6%
D D
562,500 371,250
94.36 96.06
-47,250
144,000
515,250 515,250

4.58% 4.58%

fall in interest rates.

 94.25 95.25
94.36 94.36
Yes No
11 0
D D
562,500 562,500
12375 0
-61,313 -11,025
513,563 551,475
4.57% 4.90%

94.25 95.25
96.06 96.06
Yes Yes
1.81 0.810000000000002
D D
371,250 371,250
203,625 91,125
-61,313 -11,025
513,563 451,350
4.57% 4.01%

ranteed return of 4.72%. If Wardegul Co wishes to have certain cash flows and is protecting against a fall in interest rates, it will most likel
there is no risk of default.

ainty, the choice will be between futures and options as these are guaranteed by the exchange.

erest rates increase, but a significantly lower rate of 4.01% if interest rate fall.

the forward rate agreement.

March
94.78 buy
 For deposit
Buy
Sell

Buy
Sell

t rates, it will most likely to choose the FRA.

Awan December 2013
Brandon September / December 2021