Page 239 - AFM Integrated Workbook STUDENT S18-J19

Hedging interest rate risk

Which exercise prices?

The put option (cap) needs to correspond to the higher interest rate and the
call (floor) must correspond to the lower.

i.e. use puts at 94.00 and calls at 94.50 here.

Contact the exchange: We need to buy 10 June put options at a strike price of
94.00, and simultaneously sell 10 June call options at a strike price of 94.50.

Net premium payable is (0.33% - 0.26%) x 10 x $1m x 3/12 = $1,750

Result of hedge

On 1 June – assume interest rate is 8% and futures price is 91.90:

Transaction: $
Interest $10m × 8% × 3/12 (200,000)

Futures /options mkt:
31 March – Put/Sell? 94.00

1 June – Buy 91.90
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Exercise: Gain 2.10% 52,500
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(× 10 contracts × $1m × 3/12)

31 March – Call/Buy? 94.50
1 June – Sell 91.90

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Gain to counterparty? Do not exercise –

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Premium (see above) (1,750)

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Net (149,250)

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Effective annual interest rate 5.97%

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