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In this question for part a), if you see the answer, for both futures and options interest rate hedging, they have just taken the long position and buying call options respectively. So what happens is that even if the interest rates are rising, they have taken buy futures now and sell later, thereby showing a loss. However, what I did while answering is that I showed how to get profits in both increase of 0.90% and decrease of 0.90% in interest rates by showing 2 seperate ways of doing it. (i.e- in case of rising interest rates, sell futures and buy later) and in case of falling interest rates (buy now and sell later). Is this fine? Or should I just assume one side only?
Also, can you just confirm whether my understanding of the overall question is correct or not.
We are expecting to receive $48,000,000 so in first instance, I assumed it to be a Foreign currency hedging question because we may need to hedge that receipt.
However, we are not concerned of that, what we care about in this question is the deposit rates which may increase or decrease AFTER we get the amount of $48,000,000 immediately then depositing it in a bank account and hence we want to do interest rate hedging.
Is this correct?
Thanks in advance
With regard to your first question, the whole point of using futures is to fix the net outcome (the actual interest plus or minus the gain or loss on the futures) – subject of course to the basis risk.
What you are suggesting is certainly not fine because you do not know in advance whether interest rates will increase or decrease – that is why there is risk in the first place.
So if you are depositing money then you will always buy call options – if interest rates fall then you lose on the interest but gain on the options, and vice versa.
Options are different in that if interest rates rise then you will simply not exercise the options.
I really do suggest that you watch my free lectures on interest rate risk management.
With regard to your second question, all that is asked in the question is to recommend a hedging strategy for the investment.
There is no requirement to hedge against exchange rate risk (and you do not even know what currency Awan works in – if they work in dollars then there is no exchange risk anyway 🙂 )
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