Page 238 - AFM Integrated Workbook STUDENT S18-J19

Chapter 11

Question 3

Egrade Co is expecting to borrow $10 million for three months from 1 June.

The finance director has decided to set up a collar hedge, using $1,000,000 3-
month traded options on interest rate futures contracts.

Market information: Current annual interest rate is 5%.

June contracts. Option premiums are quoted in annual %:

Strike price Call Put

94.00 0.45 0.33

94.50 0.26 0.58

Assume that today is 31 March.

Required:

Calculate the result of the collar hedge, assuming that

(i) interest rates have risen to 8% and the futures price has moved to
91.90 by 1 June;

(ii) interest rates have fallen to 2% and the futures price has moved to
98.10 by 1 June.

Solution

Set up hedge

Call or put options? Buy put options, since we are borrowing (so sell call
options too to set up the collar)

Number of contracts = (10,000,000/1,000,000) × 3/3 = 10

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

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