Activity1 : Interest Rate Risk Management Using Futures

| June 6, 2016

Activity1: Interest Rate Risk Management Using Futures

Fundamental Toys inc. is experiencing substantial growth. You receive an email from Bob.

Continuing growth of the company has required that we issue the company’s corporate debt soon. As you know, in 6 months we plan to issue $20 million worth of 20-year corporate bonds with a coupon of 9%, paid semiannually. Since this is our first large issue of longer term debt, I am concerned that the interest rates may drift higher over these months prior to the actual bond issuance. Could you come up with any suggestions as to how to protect us against a possible change in interest rates?

If you decide to use Treasury bond futures contracts, I think you could use the December futures settlement price of 97-19. Please consider calculating the outcomes of two possible scenarios:

1. When interest rates increase by 150 basis points.

2. When interest rates decrease by 150 basis points.

What’s needed from you:

1. Describe the main characteristics of the futures contracts Bob suggested in his reply (such as price of a standard contract, term to maturity, and semiannual coupon rate of a standard contract) and whether you have enough information for the assessment of the hedge.

2. Determine the implied semiannual yield on the futures contracts, given the price of 97-19. As a reminder, T-bond futures are $100,000 per contract, 20-year to maturity, 6% coupon, semiannual compounding.

3. For the purpose of this case, you may assume that there are no transaction costs to buy or sell any futures contracts. You would want to use either the Excel function called RATE or a financial calculator.

4. Determine how many contracts you would need to hedge the entire amount of the issuance of the bonds (please check Chapter 24, section 24.6) and what you should do — buy or sell? a.Number of contracts needed for the hedge

b. Value of the contracts in hedge

Hint: First convert the settlement value from 32s into decimals, then multiply by the value in Step 3 (a) above.

c. Determine implied annual yield using the data calculated in Step 2 and Excel function RATE.

5. Test your first scenario when interest rates increase by 150 basis points, as follows: a.Calculate the new interest rate on debt as the agreed-upon rate on actual bonds + 150 basis points;

b. Calculate the value of issuing the actual bonds at the new higher interest rate, using the new rate as your yield to maturity on the bonds and the agreed-upon rate as your coupon rate.

c. Determine the dollar value loss or savings from issuing debt at the new rate.

d. Calculate the new yield on the futures contract as the implied annual yield from Step 5(c) + 150 basis points.

e. Calculate the value of futures contracts at the new yield, using the Excel function PV, where your yield from Step 4 (d) and the coupon rate is the coupon on a standard futures contract.

f. Once you have determined the new value of the futures contracts in hedge in Step 4 (e), you can calculate the dollar change in value of the futures position as the difference between the value in Step 5(f).

g. The last element: the total dollar value change of the position will be the sum of the dollar values in Steps 4 (c) and 4 (f).

6. Please follow Step 4, but using the second scenario where interest rates are expected to decline by 150 basis points.


The end result should be the dollar value change of the position (5g) for 150 basis points and 150 basis points for 6. Support your answer by showing all the calculations, preferably in a worksheet.

Activity 2 Swaps

Here’s what I need from you:

Please disregard all the steps except for this one:

Put together an algebraic expression for the cost of the lender. If your algebraic expression is correct, you will realize that no calculations of the actual Libor rate are needed.

Example with the Prime rate: Prime+50 bp-3.75% +4% -Prime -20 = something like that, but, certainly with Libor.

Currency Exchange Risk Management Using Swaps

Bob is asking for an explanation. He has left you a note on your desk.

Offered a $20 million commercial loan priced using a 3month LIBOR index+100bp. After some preliminary research, using a money center bank’s swap trading desk and its traders’ connections, a possible deal has started taking shape. Another company would be willing to pay our company a floating rate payment priced at 3-month Libor+25bp, while our company would have an obligation to pay a fixed rate of 5.55% annualized, with quarterly settlements. I’m not overly concerned with the other party’s reasons for requiring these payments, so we don’t have to calculate the other party’s final cost. But we do need to remember that fixed-rate swap payments are made on a semiannual basis, based on 30/90/180/360 Accrual Year Fraction, while floating-rate side payments are being made on a quarterly basis, based on Actual/360 Accrual Year Fraction.

I’d like you to calculate what would be the ultimate cost of the loan to our company. For the purpose of this assignment you may ignore the carrying costs and the brokerage fees of the swap arrangement.


1.The basis of the ultimate cost of the payment to the lender to our company.

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