Fin management materials / 11 P4AFM-Session14_j08

SESSION 14 – INTEREST RATE RISK MANAGEMENT

(c)

To reduce the cost of the hedge the company can build a “low cost cap”. This involves on 1 December buying puts (as above) and simultaneously selling calls. The premium paid when buying puts is offset to some degree by premium received from selling calls.

Assume Theakston decides to set a floor at 5%. It will sell calls at 95.00. If interest rates fall to 4% futures prices will be 96.00 (ignoring basis). The purchaser of the calls will exercise them against Theakston and demand to buy futures from Theakston at 95.00. So Theakston must sell futures at 95.00 after first buying at market price of 96.00, creating a loss of 1%. Interest on the loan is 4% plus 1% loss on futures - bringing Theakston up to the floor at 5%.

If Theakston sells calls at 95.00 the premium income will be 0.87% × £500,000 × 3/12 × 49 = £53.288

If Theakston decides to set a cap at 6% it buys 49 March puts at 94.00, paying a premium of £112,700 as per (b).

Hence Theakston has created an interest rate band between 5 and-6% i.e. a collar. Theakston will not suffer if base rises above 6% but will not benefit from falls below 5%.

The net premium cost is £112,700 - £53,288 = £59,412

Solution 2

(a)Swap agreement

The overall possible arbitrage saving is 1.45 – 0.75 = 0.70% (Real borrows fixed and swaps to floating; Ale borrows floating and swaps to fixed)

The bank requires 0.25% leaving an arbitrage gain of 0.45% to be shared between Real. and Ale.

(b)Designing the swap to split benefit equally

Tutorial note: There are an infinite combination of cash flows that will split the benefit equally. The answer below is just one possibility.

Real will pay its bank fixed rate 6.35%. Ale will pay its bank LIBOR + 1.35%. Under the swap Real will pay Ale variable rate interest and Ale will pay Real fixed interest.

Each company requires 0.7%/2 = 0.35% benefit from the swap (pre fees).

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SESSION 14 – INTEREST RATE RISK MANAGEMENT

Real could pay Ale LIBOR + 1.35%, bringing Ale’s net interest expense to zero. Ale can borrow fixed rate itself at 7.8%. With the swap it will pay 7.8%–0.35% = 7.45%. Hence Ale should pay Real 7.45% fixed.

The following table summarises the position of both parties:

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