- 15 Marks
FM – L2 – Q100 – Hedging with futures, Hedging with options
Question
Firestone Ltd, a Nigerian company, needs to borrow in US dollars to fund its US operations, but the chief financial officer is concerned that interest rates may be volatile given the current US political and economic environment.
It is now March and Firestone intends to borrow $5 million for a period of three months commencing in September.
Futures and options quotes for 3-month US secured overnight financing rate (SOFRA) are given below. Assume that Firestone can borrow at the three-month SOFRA rate.
3 month SOFRA futures price – contract size = $1,000,000
| June | September |
|---|---|
| 93.55 | 93.28 |
Traded options on 3-month SOFRA futures – contract size = $1,000,000 (premiums quoted are annual rates)
| Strike | June (Calls) | September (Calls) | June (Puts) | September (Puts) |
|---|---|---|---|---|
| 93.25 | 0.437 | 0.543 | 0.083 | 0.187 |
| 93.50 | 0.276 | 0.387 | 0.168 | 0.282 |
| 93.75 | 0.163 | 0.263 | 0.302 | 0.407 |
Required:
a) Discuss the relevant considerations to be considered when deciding between futures and options to hedge the company’s interest rate risk. (5 marks)
b) Assume that in September 3 month SOFRA is 7% and at that point in time September futures are quoted at 93.96.
- Calculate the effective borrowing rate using a futures hedge
- Calculate the effective borrowing rate when hedging with options using each of the three available strike prices
Answer
a)
It may sound like an option would always be a better alternative than hedging with futures. However, an option’s flexibility comes at a price as the buyer of an option pays a premium which is paid regardless of whether an option is ultimately exercised. Whether an options hedge is the best alternative depends upon whether the flexibility it offers is desirable in the circumstances and thus worth the price of the premium. For example, if a hedger wishes to eliminate a certain interest rate exposure, a futures hedge is likely to be the cheaper alternative.
b)
Hedging with futures
Firestone’s intention is to borrow in September. Therefore, September contracts should be sold.
Number of futures contracts = $5m / $1m = 5 contracts
The results of this are as follows.
Futures position
Mar: Sell to open 5 @ 93.28
Sept: Settlement: buy 5 @ 92.96
Quote movement: Gain 0.32%
Profit 5 contracts × $1m × 0.32% × 3/12 = $4,000
Net position
Loan interest 7% × $5m × 3/12 = (87,500)
Profit in futures market = 4,000
Net cost of loan = (83,500)
Effective interest rate = 83,500 / 5,000,000 × 12/3 = 6.68%
Hedging with options
Firestone wishes to borrow in September and it is concerned that rates may rise, so, Firestone should buy September put options.
Number of option contracts = 5 (as above)
Option premium
93.255 × 0.187% × $1,000,000 × 3/12 = £2,337.50
93.505 × 0.282% × $1,000,000 × 3/12 = £3,525
93.755 × 0.407% × $1,000,000 × 3/12 = £5,087.50
Closing price of futures
92.96 as above
Options – gain from exercise
| Put option strike price | September futures price | Option exercised (strike above futures price) | Gain % | Option outcome (5 × $1,000,000 × 3/12 × gain%) |
|---|---|---|---|---|
| 93.25 | 92.96 | Yes | 0.29% | $3,625 |
| 93.50 | 92.96 | Yes | 0.54% | $6,750 |
| 93.75 | 92.96 | Yes | 0.79% | $9,875 |
Net position
| Strike | Loan interest | Option premium | Option gain | Net cost | Effective interest rate |
|---|---|---|---|---|---|
| 93.25 | (87,500) | (2,337.50) | 3,625 | (86,212.50) | 86,212.50 / 5,000,000 × 12/3 = 6.90% |
| 93.50 | (87,500) | (3,525) | 6,750 | (84,275) | 84,275 / 5,000,000 × 12/3 = 6.74% |
| 93.75 | (87,500) | (5,087.50) | 9,875 | (82,712.50) | 82,712.50 / 5,000,000 × 12/3 = 6.62% |
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