So, you need to choose the futures that finish first after the date the loan starts.

The futures finish on the last day of March, June, September, or December.

In your question, since the loan starts on 1 May, you need to use June futures. (March futures would finish at the end of March which is not late enough). June futures can be dealt in at any time up to the end of June.

We don’t extend the future. It is just that when they calculate the profit or loss on the deal, they calculate it as though it is 3 months interest. Since the loan is for 5 months, we need protection against 5 months worth of interest change. We do this by dealing in more futures than the amount of the loan. 3 months profit on 5/3 x the amount of the loan, will be equivalent to 5 months worth of interest rate change on the whole loan.

I don’t know whether you have watched my lecture on interest rate futures, but it does go through the reason for 5/3 in detail.

Please could you give me a hand understanding which month’s futures should be used for a given loan date?

For example in this past paper question money is needed to be borrowed in four months time and paid back in nine months. The loan is required on 1 May but the future used in the ACCA answers is a June 3 month-contract ‘extented’ to 5 months.

I’m confused why:
1. A March contract isn’t used in part – it covers March-May so shouldn’t 1 month of such a contract be used to cover May?
2. The contract is ‘extended’ – the loan is needed for 5 months but the future only covers 3 months, so is multiplied by 5/3, why is the future relevent to the 2 months that don’t sit in its 3 months range?
3. As the loan extends into September, why isn’t 1 month of cover obtained from a September 3-month contract?

Thank you for your help.

DD

What you are expected to do is to simply state whether or not they company would achieve its objective. If they end up with a maximum of more than 6.6% then they have not, if less than 6.6% then they have

You would get a mark for stating that correctly as applied to your answer, whether or not your calculations were correct.

However, as the spot exchange rate changes (or with interest rate futures, as the interest rate changes) then so too will the futures price. However the spot and the futures prices are not the same, but the difference (the basis) will fall to zero by the last day of the future.

If the question tells you what the spot exchange rate (or the actual interest rate) is on the date of the transaction then we can calculate was the futures price will be on that day (we assume that the basis falls linearly to zero), and then you can show the end result in full.

However, if you are not told what the figures are at the date of the transaction, we can still estimate the net effect (because whatever the figures turn out to be at the date of the transaction, then movement in the spot rate and the futures price will differ by the change in the basis which we can calculate). This figure that we can calculate is called the lock-in rate and means that this will be the net effect of using futures, whatever happens.

Without numbers, the above may or not make sense. However, if you look at the revision questions for P4 on this website then you will find a full worked example (for both currency futures and interest rate futures) which goes through both ways (showing exactly what happens at the date of the transaction, and also calculating the lock-in rate).

Can you also explain why do need lock-in-rate in futures? do we need to find out lock-in rate on all future questions? It could be better if you can explain with a BPP revision kit question no. 78 (Polytot) only Futures calculation

can mail me mail me at alexjacob_18@yahoo. co.in or alex.jcb30@gmail.com

Regards….
Alex

If you still have problems applying this to the questions, then do ask again.

Type 2 is where the business risk stays the same, but the gearing changes. In this case we can discount the project at the return given by the ungeared (asset) beta, and then deal separately with the extra gearing (an APV approach).

Type three is where both risks change, and therefore we have to get the beta for the project by calculating the asset beta of a similar company and then continuing as per a type 2.

However…….don’t worry too much about learning the numbers of the types. The examiner does not seem to be interested in calling it a Type 1 or a Type 2 or a Type 3. The question usually gives information relating the business and gearing risks and then you follow the ‘rules’ without needing to describe which ‘type’ it is.

Hope that helps

The current LIBOR is 6%, which is equivalent to a futures price of 100 – 6 = 94.

The profit or loss when the contract is closed out is calculated on the difference between the futures prices. You do not have to use ticks (I never do!) – it is the difference in the futures price /400 x the contract size. (The reason for the 400 is that you divide by 100 because it is a percentage, and you divide by 4 because they are always 3 month futures i,e, 1/4 of a year).

If you watch my lecture on interest rate futures you will see how they calculate the profit or loss in detail.

However strictly the BS formulae only apply when there is a fixed date for exercising the option (a European option) and so we do not really have a choice but to assume it is exercised in 2 years time.
(Mind you, it would be a good point to mention in writing – it might get you a bonus mark ) )