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- 15 Marks
Question
You are the head of the treasury group of Top Flight Aviation (TFA), a Nigerian company. The company operates chartered international flights for the elites in the country.
It is now December 31, and TFA needs to borrow £60 million from a UK bank to finance a new air jet. The borrowing and the purchase will be in three months’ time, and the borrowing will be for a period of six months.
You have decided to hedge the relevant interest rate risk using interest rate futures. Your expectation is that interest rates will increase from 13% by 2% over the next three months.
In the month of March, the current price of Sterling 3-month futures is 87.25. The standard contract size is £500,000.
Required:
a. Set out calculations of the effect of using the futures market to hedge against movements in the interest rate if:
(i) Interest rates increase from 13% by 2% and the futures market price moves by 2%;
(ii) Interest rates increase from 13% by 2% and the futures market price moves by 1.75%;
(iii) Interest rates fall from 13% by 1.5% and the futures market price moves by 1.25%;
In each case, show the hedge efficiency. The time value of money, taxation, and margin requirements should be ignored.
b. Show, for the situations in (a) 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 the treasurer could have purchased at 13% for a premium of 0.25% of the size of the loan to be guaranteed.
The time value of money, taxation, and margin requirements should be ignored.
(Total: 15 Marks)
Answer
a) Note:
For each of the scenarios of interest rate movements given in the question, we need to identify the appropriate market price of the futures contracts. Generally, the movements in interest rates and futures prices should be in the same direction but not necessarily „one-on-one‟.
b) Interest rate guarantee (IRG)
Premium for the guarantee is: £60m × 0.25% = £150,000.
The guarantee would be used in cases (i) and (ii) because the actual rate (15%) is greater than the target rate (13%).
Then, total cost limiting interest rates to 13% is actual interest of £3,900,000 plus premium £150,000, that is, £4,050,000. This costs more than the futures contracts hedge in cases (i) and (ii). In case
(iii), the guarantee is not used because the prevailing interest rate of 11.5% is less than the guarantee rate of 13%.
Interest costs at 11.5% are:
This costs less than the futures hedge, reflecting the fact that declining to take up the interest rate option in the case of the guarantee, has allowed the company to take advantage of the lower interest rates in the cash market.
- Tags: Futures Contracts, Hedging, Interest Rate Futures, Loan financing
- Level: Level 3
- Uploader: Kofi