FM – L2 – Q100 – Hedging with futures, Hedging with options

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

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%