Index Futures

The investment manager of Moonstar Pensions Ltd is concerned that share prices will
fall over the next month and wishes to hedge against this using FTSE stock index
futures. The fund’s pension portfolio comprises investments, which have a market value
of CU 5 million on 1 June 20X3.

On 1 June 20x3 the following prices are observed:

The prevailing value (i.e. spot price) of the FTSE 100 index is 5,000
The quote for September FTSE 100 index futures is 4,980.
The face value of a FTSE 100 contract is CU10 per index point
On 30 June 20x3, the market value of the shares in the portfolio was CU 4.8 million.
The FTSE 100 index and the futures index both stood at 4,800 on that date.
Show the outcome of the hedge

Solution

1 June 20x3
Value of a contract 4,980 x 10 = CU 49,800
No of contracts 5,000,000 = 100.4 rounded to 100 contracts
49,800
On spot date
Sold 4,980
Spot rate 4,800
Gain 180
Value 180,000 (180 x100 x 10)

Gain/ Loss on Portfolio

Original 5,000,000
Now 4,800,000
Loss 200,000

The hedge is less than 100% efficient because of basis (i.e. the Index value on 1 st June
and the future prices are different) and the rounding of the number of contracts.
Interest Rate FRA

A bank has quoted the following rates for dealing in FRAs

Bid Offer

3v6 4.59 4.56

It is 24th March and your company wants to fix an interest rate for borrowing CU 1
million for three months from 24th June. What is the payment to be made on the FRA if
the company entered a 3 v 6 FRA with a bank, assuming that interest rates rise to
4.65% from their current level of 4.5%?

Also, show the effective rate of interest including the supporting calculations.

Solution:

Since the company will be borrowing in three months’ time and wished to hedge the
interest rate risk in the underlying transaction, it can buy (Bid) an FRA. This will mean
that in three months’ time, the company will pay the amount of FRA to the bank and the
bank will pay the company the spot rate.

24th March

Company buys FRA at 4.59%

24th June
Company pays bank 4.59%
Bank pays company 4.65% (spot rate)
Company receives (net) 0.06%
Amount 150 (0.06% x 1,000,000 x 3/12)
Interest on borrowings (11,625) (4.65% x 1,000,000 x 3/12)
Net Payment (11,475)
Effective rate of interest 11,475 x 12 % = 4.59%
1,000,000 3

Simple Interest Rate Future

It is 1 January, and a company has identified that it will need to borrow CU 10 million on
31st March for 6 months.

The spot rate on 1 January is 8% and March 3 month interest rate futures with a
contract size of CU 500,000 are trading at 91.
Demonstrate how futures can be used to hedge against interest rate rises. Assume that
at 31st March the spot rate of interest is 11% and the March interest rate futures price
has fallen to 89.

Solution

1st January
Sell future at 91
No of contracts 10,000,000 x 6 = 40 contracts
500,000 3

31st March
Sell 91
Spot 89
Gain 2%
Amount 100,000 (2% x 500,000 x 40 x 3/12)
Interest payment (550,000) (11% x 10,000,000 x 6/12)
Net payment (450,000)
Effective Rate 450,000 x 12 % = 9%
10,000,000 6

Interest Rate options

Panda Ltd wishes to borrow CU 4 million fixed rate in June for nine months and wishes
to protect itself against rates rising above 6.75%. It is 11 May and the spot rate is
currently 6%. The data is as follows:

SHORT CU OPTIONS

CU500,000

Strike price Calls Puts

June Sept Dec June Sept Dec
93.25 0.16 0.19 0.21 0.14 0.92 1.62
93.50 0.05 0.06 0.07 0.28 1.15 1.85
93.75 0.01 0.02 0.03 0.49 1.39 2.10

Panda negotiates the loan with the bank on 12 June (when the CU 4m loan rate is fixed
for the full nine months) and closes out the hedge.
What will be the outcome of the hedge and the effective loan rate if prices on 12 June
are as follows:

Closing prices

Case1 Case2
Spot price 7.4% 5.1%
Futures price 92.31 94.75

Solution

Since Panda is a borrower, it will buy a put option. Since the target interest rate is
6.75%, Panda can choose any of the strike price that will leave the interest rate on or
below 6.75%. The strike rate of 94.75% appears to be most optimal considering the
differential interest rate and premium.

On 11 May
Strike price of 93.75
No of contracts (4,000,000 / 500,000) x 9/3 = 24 contracts
Premium: 0.49% x 24 x 500,000 x 3/12 = CU (14,700)

On 12 June Case 1 Case 2

Spot rate of interest 7.4% 5.1%
Sell at 93.75 93.75
Future Spot rate 92.31 94.75
Exercise Yes No
Gain 1.44% -
Amount 43,200 (1.44% x 24 x 500,000 x 3/12)
Interest Payment (222,000) (7.4% x 4,000,000 x 9/12)
(153,000) (5.1% x 4,000,000 x 9/12)
Premium (14,700) (14,700)
Net Payment (193,500) (167,700)
Effective Rate of Interest 6.45% (193,500 / 4,000,000 x 12/9 %)
5.59% (167,700 / 4,000,000 x 12/9 %)
Hedge effectiveness
Adverse movement in
Interest rate 19,500 (7.4% - 6.75%) x 4,000,000 x 9/12
Hedging gain 43,200
Hedge efficiency 221% 43,200 / 19,500%
Index Futures / Options

Financing overseas subsidiaries depends on four key factors – State those factors
briefly. What are the considerations while choosing a country for investment? What
measures need to be taken to prevent the exploitation of the country by Multi National
Corporation (MNC)?

You are currently acting in the treasurer capacity for a large UK business to manage its
surplus funds. For the last few years the UK and world economic outlooks have been
quite positive and the business has benefited from a major investment in equities and
holds a portfolio worth £30m.

Recently, however, these positive signs have reduced and there is now the fear of some
market volatility or even a short downturn or market correction over the next three
months. The long-term prospects for equities are still positive however and so you do
not wish to divest the share portfolio. However, you do wish to protect against a
downturn over the next three months.

The current level of the FTSE 100 index is 6000 and a three-month FTSE 100 index
futures contract is currently quoted at 6020. The price of futures is £10 per index point.

Options are also available on the FTSE 100 index with a strike price of 6000 and
maturity of three months.

A call option has a premium of 150 points and a put option has a premium of 130
points.

Requirements:

i) Describe how you could use the FTSE 100 index future to hedge any portfolio
losses arising over the next 3 months and illustrate the outcome if the index
either falls to 5800 or rises to 6200.
ii) Describe how options may be used to hedge exposure to any market correction
and illustrate the outcome if the index either falls to 5800 or rises to 6200.

Solution
Future Market
The Company will need to sell in future market at 6020
Contract value 6020 x 10 = 60,200
No of contracts 30,000,000 = 498.33 or 498
60,200
On spot date
 5,800 6,200
Sell 6,020 6,020
Gain / (Loss) 420 (180)
Value 2,091,600 (896,400)

When the index drops to 5,800, the Company makes a gain in the future market but is
expected to make a loss in the value of portfolio. This cannot be determined since the
portfolio on the spot date is not known. A reverse situation arises when the Company
makes a loss in the future market.

Options market

The Company will need to take a put at 6020

Contract value 6020 x 10 = 60,200
No of contracts 30,000,000 = 498.33 or 498
60,200
Premium: 498 x 10 x 130 = 647,400

On spot date
5,800 6,200
Sell 6,020 6,020
Exercise yes no
Gain / (Loss) 420
Value 2,091,600
Premium (647,400)
Net 1,444,200
When the index drops to 5,800, the Company makes a gain in the future market and
exercises the option but is expected to make a loss in the value of portfolio. This cannot
be determined since the portfolio on the spot date is not known. However, when the
Company makes a loss in the future market, the option is abandoned. The company will
be better off since the value of portfolio will increase.

Interest Rate Futures

The Corporate treasurer of Clieff decides on 31 December to hedge the interest rate
risk on the CU 6 million to be borrowed in three months’ time for six months by using
interest rate futures. Her expectation is that interest rates will increase from 13% by 2%
over the next three months.

The current price of March CU 3 month futures is 87.25. The standard contract size is
CU500,000.

1. Set out calculations of the effect of using the futures market to hedge against
movements in the interest rate:
a. If interest rates increase from 13% by 2% and the futures market price moves
by 2%
b. If interest rates increase by 13% by 2% and the futures market price moves
by 1.75%
c. If interest rates fall from 13% by 1.5% and the future market price moves by
1.25%
The time value of money, taxation and margin requirements can be ignored.

2. Calculate, for the situations above, whether the total cost of the loan after hedging
would have been lower with the futures hedge chosen by the treasurer or with an
interest rate guarantee, which she could have purchased at 13% for a premium of
0.25% of the size of loan to be guaranteed.

Again, the time value of money, taxation and margin requirements can be ignored.

Solution

On 31 December:
Since Clieff is a borrower, it will sell in futures market.
No of contracts (6,000,000 / 500,000) x 6/3 = 24 contracts

On 30 March Case 1 Case 2 Case 3

Spot rate of interest 15.0% 15.0% 11.50%
Sell at 87.25 87.25 87.25
Future Spot rate 85.25 85.50 88.50
Gain / (Loss) 2.00% 1.75% (1.25)%
Amount 60,000 52,500 (37,500)
Interest Payment (450,000) (450,000) (345,000)
Net Payment (390,000) (397,500) (382,500)
Effective Rate of Interest 13.00% 13.25% 12.75%

Hedge effectiveness
Adverse movement in First case
Interest rate (60,000) (60,000) 45,000 (2% x 6,000,000 x 6/12)
Hedging gain / (loss) 60,000 52,500 (37,500)

Hedge efficiency 100% 87.50% 83.33% (Hedge

loss/gain)/Interest loss/gain)

Buy Interest rate cap at 13%

On 30 March Case 1 Case 2 Case 3

Spot rate of interest 15.0% 15.0% 11.50%
Interest rate cap 13% 13% 13%
Bank gives 2% 2%
Amount 60,000 60,000
Interest Payment (450,000) (450,000) (345,000)
Guarantee fees (15,000) (15,000) (15,000)
Net amount (405,000) (405,000) (360,000)
Effective rate 13.5% 13.5% 12%

Interest Rate Futures and Options

The finance director of Plutocrat Ltd is concerned that interest rates could become
more volatile for many major trading countries following recent turmoil in credit
markets.

It is now 1 March and Plutocrat is expected to need to borrow BDT 12,000,000 for
a period of six months commencing in six months' time.

Futures and options quotes are given below. You may assume that the company
may borrow at the 3-month LIBOR rate.

LIFFE futures prices, BDT 500,000 contract size

June 94.54
September 94.28

LIFFE options on futures prices, BDT 500,000 contract size, premiums are
annual %

Exercise price Calls Puts

June September June September

94.25 0.437 0.543 0.083 0.187

94.50 0.276 0.387 0.168 0.282
94.75 0.163 0.263 0.302 0.407

3-month LIBOR is currently 5.5%.

Requirements:
(a) Discuss the relevant considerations when deciding between futures and
options to hedge the company's interest rate risk.
(b) Using the above information illustrate the possible results of hedging interest
rate risk using:
(i) Futures, and
(ii) Options.
hedges if interest rates in six months' time increase by 0.5% and the September future
is then trading at 93.97. Recommend which hedge should be selected.

Solution

Using Futures

1 March
Sell in future market at September quote 94.28
No of contracts 12,000,000 x 6 = 48 contracts
500,000 3

1 September
Sell at 94.28
Spot rate 93.97
Gain 0.31%
Amount 18,600
Interest payment (360,000) (6% of 12,000,000 x 6/12)
Net Outcome (341,400)
Effective Rate 341,400 x 12 = 5.69%
12,000,000 6

0.31% x 1 x 500000 x 3/12 = 387.50

31 x (.01% x 1 x 500000 x 3/12)
31 x 12.50
TICK

Using Options

The strike rate of 94.75% appears to be most optimal considering the differential
interest rate and premium. We will use two strike prices to validate this hypothesis.

March 1
Put option at September quote 94.50
No of contracts 12,000,000 x 6 = 48 contracts
500,000 3
Premium 0.282% x 48 x 500,000 x 3/12 = (16,920)
1 September
Sell at 94.50
Spot rate 93.97
Gain 0.53%
Amount 31,800
Interest payment (360,000) (6% of 12,000,000 x 6/12)
Premium (16,920)
Net Outcome (345,120)
Effective Rate 345,120 x 12 = 5.752%
12,000,000 6

Put option at September quote 94.75

No of contracts 12,000,000 x 6 = 48 contracts
500,000 3
Premium 0.407% x 48 x 500,000 x 3/12 = (24,420)

1 September
Sell at 94.75
Spot rate 93.97
Gain 0.78%
Amount 46,800
Interest payment (360,000) (6% of 12,000,000 x 6/12)
Premium (24,420)
Net Outcome (337,620)
Effective Rate 337,620 x 12 = 5.627%
12,000,000 6

Interest Rate Future and Options

It is September 20X9. Rutini’s corporate treasurer has identified the need to invest CU
20m for a three-month period commencing at the end of December. Current interest
rates are 3% per annum.

Three-month December CU interest rate futures are trading at 3.375%. Three month put
options with an exercise price of 3.375% cost CU500 per contract; calls of a similar
denomination cost CU 350 per contract, The contract size is CU 500,000.

Demonstrate the results of covering the treasurer’s exposure using

(i) Futures
(ii) Options
Under the following December spot interest rates

1. 3.25%
2. 3.375%
3. 3.5%

Ignore basis risk at end December for the purposes of this illustration

Solution

Since Rutini is an investor, they will buy in future market or have a call option

Futures

September 1

Buy at 96.625

No of contracts 20,000,000 / 500,000 = 40 contracts

December

Spot interest rates 3.25% 3.375% 3.5%

Buy 96.625 96.625 96.625

Future spot 96.750 96.625 96.500

Gain/ (Loss) 0.125% (0.125)%

Amount 6,250 ( 6,250)

Interest received 162,500 168,750 175,000

Net received 168,750 168,750 168,750

Effective Rate 3.375% 3.375% 3.375%

Options

September 1

Buy at 96.625 (Call option)

No of contracts 20,000,000 / 500,000 = 40 contracts

Premium: 40 x 350 = CU 14,000

December

Spot interest rates 3.25% 3.375% 3.5%

Buy 96.625 96.625 96.625

Future spot 96.750 96.625 96.200

Exercise Yes No No

Gain/ (Loss) 0.125%

Amount 6,250

Interest received 162,500 168,750 175,000

Premium (14,000) (14,000) (14,000)

Net received 154,750 154,750 161,000

Effective Rate 3.095% 3.095% 3.22%

Share Option

Rutini’s treasurer holds 2,000 shares, current market price CU 13 per share. He intends
to sell them in three months’ time, but is worried about their price volatility. The following
three-month options are available:

Exercise price Premium per share CU

12.00 0.50
13.00 1.00
14.00 1.50

Calculate the treasurer’s net receipt in three months’ time if he takes no hedging action
or if he employs each of the options:

Tabulate your results for the following three-month prices

CU10, CU11, CU12, CU13, CU14. CU15

One of Rutini’s directors believes that X Ltd’s share price will be exceptionally volatile
over the next three months. He buys

1,000 X Ltd call options exercise price CU13.00 premium 50p per share

1,000 X Ltd put options exercise price CU13.00 premium 50p per share
Calculate his profit under the following three-month share prices
CU11, CU12, CU13, CU14. CU15

Comment on your result

X Ltd shares: Pay offs (000s)

Strategy CU10 CU11 CU12 CU13 CU14 CU15

No cover 20 22 24 26 28 30

CU 12 per option 23 23 23 25 27 29

CU13 per option 24 24 24 24 26 28

CU14 per option 25 25 25 25 25 27

The suitability of the strategy depends upon the treasurer’s attitude to risk and the
profitability of each share price. The higher the exercise price of the option the greater
the protection given, but the smaller the participation in the favourable price movements

Rutini’s director

Three month share Profit / Loss on call Profit / Loss on put Net Pay Off CU
price CU
CU CU

11 (500) 1,500 1,000

12 (500) 500 0

13 (500) (500) (1,000)

14 500 (500) 0

15 1,500 (500) 1,000

Interest Rate SWAP

Swapit Ltd has a high credit rating. It can borrow at 10% or variable at LIBOR + 0.3%. It
would like to borrow variable.

Badcred Ltd has a lower credit rating. It can borrow fixed at 11% or variable at LIBOR +
0.5%. It would like to borrow fixed.

Requirement

Show how a swap arrangement would benefit both parties if Swapit were to borrow
fixed, paying Badcred Ltd LIBOR, and Badcred Ltd were to borrow variable paying
10.1% fixed to Swapit Ltd.

Swapit Badcred Total

Preferred option (LIBOR + 0.3%) (11%) (LIBOR + 11.3%)
Could borrow (10%) (LIBOR + 0.5%) (LIBOR + 10.5%)
Difference shared equally 0.4% 0.4% 0.8%
Effective Rate (LIBOR – 0.1%) (10.6%)

Normal Swap
Borrow at (10%) (LIBOR + 0.5%)
Swap variable (LIBOR + 0.5%) LIBOR + 0.5%
Swap fixed 10.6% (10.6%)

Swap mechanism
Borrow at (10%) (LIBOR + 0.5%)
Swap variable (LIBOR) LIBOR
Swap Fixed 10.1% (10.1%)

Interest Rate Swap

Tista Cement Ltd. has a fixed rate loan of BDT 125 Million at 13%, which must be
redeemed one year hence. The Company is considering an interest rate swap with
Gomoti Steel Ltd., which has a floating rate loan of the same size at LIBOR plus 1%. If
the swap goes ahead, Gomoti Ltd. will pay Tista Ltd. 12% and Tista Ltd. will pay Gomoti
Ltd. LIBOR plus 1½%. Tista Ltd. could issue floating rate debt at LIBOR plus 2% and
Gomoti Ltd. could issue fixed rate debt at 12½%.

There would be legal fees of 0.10% for each company on the amount of swap if the
swap is made.

Requirement:
(i) Would the swap benefit Tista Ltd:
 if LIBOR is 11% for the next year.
  if LIBOR is 11% for the next four months, and 9.5% thereafter?

(ii) Could an alteration in the terms of the swap make it beneficial to both companies?
Any benefit would be shared equally between them.

Tista Limited

Tk 000

Current cost 13% of 125m (16,250)

LIBOR at 11%

Net cost (12.5%) +12% + (13%) 13.5% of 125m (16,875)

Legal cost 0.10% of 125m (125)

Net cost (17,000)

LIBOR at 10% Tk 000

Net cost (11.5%) +12% + (13%) 12.5% of 125m (15,625)

Legal cost 0.10% of 125m (125)

Net cost (15,750)

The swap is profitable if LIBOR is 11% for the next four months, and 9.5% thereafter.

Borrowing position

Tista Gomoti Total

Current borrowing (13%) (LIBOR + 1%) (LIBOR + 14% )

With Swap (LIBOR + 1.5%) (12%) (LIBOR + 13.5%)

Gain shared equally 0.25% 0.25% 0.5%

New borrowing (LIBOR + 2%) (12.5%) (LIBOR + 14.5%)

Net gain* 0.15% 0.15%

Effective Cost (LIBOR + 1.85%) (12.35%)

* Gross gain of 0.5% shared equally less 0.10% legal costs