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Hi John,
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
The futures deal is started ‘now’ and finished on the date that the loan starts.
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.
Thankyou John.
Your video made much more sense than the text book.
BPP are saying choose the future with an end date that most closely matches the end date of the loan. Doesn’t that contradict ACCA’s answer?
BPP also says that there is no basis risk (same thing as unexpired basis?) when a
contract is held to maturity. Doesnt that also contradict the ACCA answer given that there is an unexpired basis calculated despite the future closing before the loan end date?Thank you,
Dan
No – what BPP is correct.
When they say that you choose the future with the end date that most closely matches the end of the future, what they mean is that you choose the future with the end date that is soonest after the date of the transaction.
If a future is held to maturity, then on the last day of the future the basis (the difference between the futures price and the interest rate) will indeed be zero – i.e. no basis.
However since futures deals are normal closed off before the end date, there will be a basis (because it falls linearly to zero by the last day). The basis risk is the fact that although we assume that it falls linearly, in practice there is no reason that it should be linear.
Thank you. Why is the relevent date of transaction used the date the loan is taken out? isnt it the loan repayment date that we’re hedging for?
No – it is the date the loan starts. The reason is that once the loan starts, the interest rate is then fixed at whatever rate is quoted on that date.
So the risk we are trying to hedge is the risk of the interest rate changing between today and the date that the loan starts.
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Can someday kindly guide me how the 2/6 is derived, it was used to calculate the basis of 0.18, am so confused to what the 2 and 6 stands. What I thought contradicts with what Kaplan text got theirs on page 506. Some one pleas explain to me am stuck. It Dec 2011 Q2. Why they didn’t use 5 months duration of the month, where is 6 coming from???
The loan will start on 1 May, which is 4 months away from now (per the question).
We are using June futures, which finish at the end of June. So…..if 1 May is 4 months away, then end of June is 6 months away from now.
We assume that the basis falls linearly to zero over the life of the future. So….since the future will end in 6 months time, the basis will fall by 1/6 each month.
At the start of the loan, (1 May) there will then only be 2 months left until the end of the future (30 June) and so the basis will have fallen by 4 months at 1/6 each month. Or…..since there are only 2 months left, the basis remaining will be 2/6 of the current basis.
Hope that makes sense 🙂Is there any hint in the question, which suggest that regarding options calculations it is enough to calculate only % cost as in Alecto (bpp) or full calculations (using absolut amounts) is required as in Awan (bpp)?
I am away from home until tomorrow and I do not have the BPP Kit. Please ask again tomorrow and then I should be able to help you.
I repeat my question: Is there any hint in the question, which suggest that regarding options calculations it is enough to calculate only % cost as in Alecto (bpp) or full calculations (using absolut amounts) is required as in Awan (bpp)?
Sorry for the delay, but now I am back home 🙂
It doesn’t really matter which approach you use. As always in P4, the marks are for proving that you know how the various instruments (options etc) work, and then discussing the relative advantages/disadvantages.
Either approach would have got the marks in both of the questions.
Hello I have a question about why is it a sell future contract?
I know it is a silly question, and I do not have the problem of determining what kind of contract it is in any other question ive attempted except for this one for some reason. It is a borrowing, so wouldn’t that mean I am looking to buy Euros?
thanks
If you are borrowing money then you will be worried about the interest rate rising.
To ‘cancel’ (i.e. hedge against) changes in interest rates you will sell futures. This is because if interest rates rise, the futures price will fall. Therefore by selling futures now and then buying at a lower price on the date the loan starts you will make a profit to set against the extra interest payable.
You are not buying any foreign currency at all – you are borrowing money.
I really do suggest that you watch our free lectures on managing interest rate risk.
In this question shouldn’t the futures value when interest rate is increased by 0.5% be 96.2 (100-3.8) instead of 96.02 that is given in the examiner’s answer ?
No – the examiners answer is correct.
The futures price will not equal the equivalent interest rate because of the basis. The unexpired basis is 0.18 (the calculation is shown in the answer) and therefore the futures price will be 0.18 less than the equivalent interest rate.
I do suggest that you watch my lectures on the management of interest rate risk where all of this is explained.
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