Interest Rate Hedges (June 2005)

Assume that it is now 1 June. Your company expects to receive £7·1 million from a large order in five months’ time.
This will then be invested in high quality commercial paper for a period of four months, after which it will be used to
pay part of the company’s dividend. The company’s treasurer wishes to protect the short-term investment from
adverse movements in interest rates, by using futures or forward rate agreements (FRAs).
The current yield on high quality commercial paper is LIBOR + 0·60%.
LIFFE £500,000 3 month Sterling futures. £12·50 tick size.
September 96·25
December 96·60
Futures contracts mature at the month end. LIBOR is currently 4%.
FRA prices (%)
4 v 5 3·85 – 3·80
4 v 9 3·58 – 3·53
5 v 9 3·50 – 3·45
Required:
(a) Devise a futures hedge to protect the interest yield of the short-term investment, and estimate the expected
lock-in interest rate as a result of the hedge. (4 marks)
(b) Ignoring transactions costs, explain whether the futures or FRA hedge would provide the higher expected
interest rate from the short-term investment. (2 marks)
(c) If LIBOR fell by 0·5% during the next five months show the expected outcomes of each hedge in the cash
market, futures market and FRA market as appropriate. (6 marks)
(d) Explain why the futures market outcome might differ from the outcome in (c) above. (3 marks)

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When using FRA here, why isn’t the CRP of .6 added on to 3.5 (New Libor)?