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Financial systems Case study


Case study: Another example
“Explain how a two-year bill facility that uses 90-day bills poses interest rate risk for the borrower. Describe FRAs, BAB futures and interest rate swaps and explain how they can be used to hedge the interest rate risk involved in a planned issue of BABs. Demonstrate how each hedge instrument establishes the company’s cost of funds.”
The essay component and the demonstration components of the case study will each be graded out of 5 marks. Illustration of the hedging demonstrations: Assume 90-day BABs with a face value of $100m are to be issued in mid December, that the current December BAB futures price is 95.00, the December one-year swap rate is 4.80% and the December spot rate turns out to be 4.50%, demonstrate the hedged interest rate outcomes in December using the three instruments: ? Proceeds from the spot 90-day bill market:

P=
?

$100m 1 + 0.045 × 90

= $98,902,587.73 365

Using a FRA:

Cash settlement to lender = Vmkt ? Vagreed = $100m 1 + 0.045 × 90 ? $100m 1 + 0.05 × 90

365 365 = $98,902,587.73 ? $98,782,138.02 = $120,449.71

? ? 365 F reffective = ? ? P + or ? Cash settlement ? 1? n ? ? ? $100m ? ? 365 =? ? 1? = 5.00% ? $98,902,587.73 ? $120,449.71 ? 90
? Using BAB futures: Sell 100 December BAB contracts:

It is clear from the question that the answer must be the forward rate; 5.0%

Vsell =

$100m 1 + 0.05 × 90

= $98,782,138.02 365

Close out in December: $100m Vbuy = = $98,902,587.73 1 + 0.045 × 90 365 Loss on futures = $98,782,138.02 - $98,902,587.73 = $120,449.71

Case study in the final exam: Another example, p. 2

$100 m ? ? 365 reffective = ? ? 1? = 5.00% ? $98,902,587.73 ? $120,449.71 ? 90
? Using an interest rate swap Calculate the nominal amount, Q:

It is clear from the question that the answer must be the forward rate; 5.0%

=

$100m 1 + 0.048 × 90

= 98,830,282.68 365

Cash settlement = Q(rFXD ? rFTG )

= $98,830,283.68 × (0.048 ? 0.045) × 90

90 365

365

= $73,107.33

Since the $73,107 is paid in March the present value of this amount (using the December spot rate of 4.50%) should be used to demonstrate the hedge:

PVcash settlement =

$73,107 1 + 0.045 × 90

= $72,305.04 365

$100 m ? ? 365 reffective = ? ? 1? = 4.80% ? $98,902,587.73 ? $72,305.04 ? 90

It is clear from the question that the answer must be the swap rate; 4.80%


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