Page 234 - AFM Integrated Workbook STUDENT S18-J19

Chapter 11

Question 2

Astar Co is expecting to borrow $20 million for six months from 1 September.

The finance director has decided to use $1,000,000 3-month traded options
on interest rate futures contracts to hedge the risk.

Market information: Current annual interest rate is 4%.

September contracts. Option premiums are quoted in annual %:

Strike price Call Put

96.00 0.16 0.38

95.50 0.35 0.23

Assume that today is 31 May.

Required:

Calculate the result of the relevant options hedge, assuming that
interest rates have risen to 5% and the futures price has moved to 95.10
by 1 September.

Solution

Set up hedge

Call or put options? Buy put options, since we are borrowing

Number of contracts = (20,000,000/1,000,000) × 6/3 = 40

Which expiry date? September, since it expires soonest after the transaction
date of 1 September (and it is the only one given here!)

Which exercise price?

Strike price Rate Premium Total

96.00 4.00% 0.38% 4.38%

95.50 4.50% 0.23% 4.73%

222