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Interest Rate Futures Most Important Question Solution

The document provides information about a finance exam question regarding interest rate hedging using futures contracts. It asks the student to advise on taking a long or short position in 3-month futures contracts to hedge interest rate risk for a company borrowing £25 million. It also asks the student to evaluate if using forward rate agreements would provide lower interest costs than futures contracts. The student determines that selling futures contracts would benefit the company if rates rise, and calculates the gains and losses under different rate scenarios. The student also concludes that using forward rate agreements would result in higher interest costs than futures contracts for this company.

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Ashish Goel
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259 views3 pages

Interest Rate Futures Most Important Question Solution

The document provides information about a finance exam question regarding interest rate hedging using futures contracts. It asks the student to advise on taking a long or short position in 3-month futures contracts to hedge interest rate risk for a company borrowing £25 million. It also asks the student to evaluate if using forward rate agreements would provide lower interest costs than futures contracts. The student determines that selling futures contracts would benefit the company if rates rise, and calculates the gains and losses under different rate scenarios. The student also concludes that using forward rate agreements would result in higher interest costs than futures contracts for this company.

Uploaded by

Ashish Goel
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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QUESTION NO.1B Espaces plc is consumer electronics wholesaler. The business of the firm is highly seasonal in
nature. In 6 months of a year, firm has a huge cash deposits and especially near Christmas time and other 6
months firm cash crunch, leading to borrowing of money to cover up its exposures for running the business.
It is expected that firm shall borrow a sum of £25 million for the entire period of slack season in about 3 months.
The banker of the firm has given the following quotations for Forward Rate Agreement (FRA):
Spot 5.50% - 5.75%; 3 x 6 FRA 5.59% - 5.82%; 3 x 9 FRA 5.64% - 5.94%
3-month £50,000 future contract maturing in a period of 3 months is quoted at 94.15. You are required to:
(a)Advise the position to be taken in Future Market by the firm to hedge its interest rate risk and demonstrate how
3 months Future contract shall be useful for the firm, if later interest rate turns out to be (i)4.5% and (ii) 6.5%
(b)Evaluate whether the interest cost to Espace plc shall be less had it adopted the route of FRA instead of Future
Contract.
Note:- Ignore the time value of money in settlement amount for future contract.
Solution:
(a)(i)Since firm is a borrower it will like to off-set interest cost by profit on Future Contract. Accordingly, if interest
rate rises it will gain hence it should sell interest rate futures.
Amount of Borrowing Duration of Loan 25,000,000 6
No. of Contracts = x = x = 1000 Contracts
Contract Size 3 months 50,000 3
(ii)The final outcome in the given two scenarios shall be as follows:
If the interest rate turns out to be 4.5% If the interest rate turns out to be 6.5%
Future Course
Action:
Sell to open 94.15 94.15
Buy to close 95.50 (100 - 4.5) 93.50 (100 - 6.5)
Loss/ (Gain) 1.35% (0.65%)
Cash Payment
(Receipt) for £ 50,000 x 1000 x 1.35% x 3/12 £ 50,000 x 1000 x 0.65% x 3/12
Future = £1,68,750 = (£81,250)
Settlement
Interest for 6
months on £50 £ 25 million x 4.5% x ½ = £ 5,62,500 £ 25 million x 6.5% x ½ = £ 8,12,500
million at actual
rates £ 7,31,250 £ 7,31,250
7,31,250 12
Thus, the firm locked itself in interest rate x 100 x = 5.85%
25,000,000 6
(b)No, the interest cost shall not be less for Espace plc had it taken the route of FRA, as the 3 x 9 FRA contract are
available at 5.64% - 5.94% i.e. borrowing rate of 5.94%. Hence, the interest cost under this option shall be nearby
by 5.94% which is more than interest rate under Future contract rate of 5.85%.

QUESTION NO.2D In March 2020, XYZ Bank sold some 7% Interest Rate Futures underlying Notional 7.50%
Coupon Bonds. The exchange provides following details of eligible securities that can be delivered:
Security Quoted Price of Bonds Conversion Factor
7.96 GOI 2023 1037.40 1.0370
6.55 GOI 2025 926.40 0.9060
6.80 GOI 2029 877.50 0.9195

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Target 100% Marks & Career in
Finance With Crore Plus Salary
100% COVERS 25 YEARS INSTITUTE’S
RTP;MTP;PAST YEARS;PRACTICE MANUAL 2
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6.85 GOI 2026 972.30 0.9643


8.44 GOI 2027 1146.30 1.1734
8.85 GOI 2028 1201.70 1.2428
Recommend the Security that should be delivered by the XYZ Bank if Future Settlement Price is 1000.
Solution:
The XYZ Bank shall choose those CTD (Cheapest-to-Deliver) Bonds from the basket of deliverable Bonds which
gives maximum profit computed as follows:
Profit = Future Settlement Price x Conversion Factor – Quoted Spot Price of Deliverable Bond
Accordingly, the profit of each bond shall be computed as follows:
Security Future Settlement Conversion Quoted Price Profit
Price Factor (4) = of Bonds
(1) (2) (3) (2) x (3) (5) (6)
7.96 GOI 2023 1000 1.0370 1037.00 1037.40 - 0.40
6.55 GOI 2025 1000 0.9060 906.00 926.40 - 20.40
6.80 GOI 2029 1000 0.9195 919.50 877.50 42.00
6.85 GOI 2026 1000 0.9643 964.30 972.30 - 8.00
8.44 GOI 2027 1000 1.1734 1173.40 1146.30 27.10
8.85 GOI 2028 1000 1.2428 1242.80 1201.70 41.10
Decision: Since maximum profit to the Bank is in case of 6.80 GOI 2029, same should be opted for.

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he doesn't share his calendar with us. Enjoy surprises.

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