ACCA AFM · Guided practice (Show me how)
Chapter 20: Interest Rate Risk Management (1)
Interest rate options: capping a borrowing rate with traded puts
It is 13 August. Soraya will borrow $5,600,000 for 8 months starting in September. She wants to protect against the reference rate rising above 5.75%. The reference rate is 5% today and Soraya pays that rate plus 1.4%.
Options on three-month dollar futures ($500,000 contracts), premiums in points of 100%:
| Strike | Call Sep | Call Dec | Call Mar | Put Sep | Put Dec | Put Mar |
|---|---|---|---|---|---|---|
| 94.25 | 0.18 | 0.08 | 0.04 | 0.19 | 0.83 | 1.42 |
| 94.50 | 0.10 | 0.04 | 0.01 | 0.21 | 1.24 | 1.68 |
| 94.75 | 0.03 | 0.01 | 0.01 | 0.48 | 1.48 | 1.92 |
Futures today: September 94.30, December 94.20, March 94.10. The contracts expire at the end of the named month. The loan is negotiated on 18 September, when the reference rate is 6.5%. There are 48 days from today to September expiry and 12 left at the loan date. Assume linear basis, round its unexpired amount and the estimated futures price to two decimals, use whole contracts and round loan interest to whole dollars before netting.
(a) Set up the options
Identify the option hedge and calculate its contract count and premium for the eight-month loan from 18 September.
(b) The futures price on 18 September
Calculate the estimated futures price on 18 September when the loan is negotiated.
(b) and (c) The outcome
Calculate the option result, net borrowing cost and effective annual rate for the eight-month loan from 18 September.
Opening this exercise…