- 15 Marks
FM – L2 – Q100 – Hedging with futures, Hedging with options
Firestone Ltd plans to borrow $5M and hedge interest rate risk using futures and options, calculating effective borrowing rates.
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
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