Pico plc has borrowed heavily in euros and is worried about increasing interest rates in the eurozone.
Question:
Pico plc has borrowed heavily in euros and is worried about increasing interest rates in the eurozone. The Finance Director suggests that Pico
plc should sell futures on French bonds (known as OATs or Obligations Assimilables du Trsor).
a. Explain why selling a futures contract on French bonds would reduce the effect of an increase in euro interest rates. (3 marks)
b. Pico sells a futures contract on bonds for 1,010 calculate the daily payments and receipts on the futures contract given the following
bond prices:
Day 1 Day 2 Day 3 Day 4 Day 5
1,010 1,005 1,001 1,006 1,009
(4 marks)
c. Explain why the market insists on daily settlement. (3 marks)
The Finance Director also offers two alternatives:
d. One alternative is to engage in an interest rate swap. Explain how this might work. (4 marks)
e. The other alternative is to purchase a PUT contract on euro denominated bonds.
Calculate the net profit or loss per unit on a put option contract with a strike price of 1,008 with a premium of 4.00 for the following
maturity prices: 985, 1,000, 1,015 and 1,020 (8 marks)
f. Explain how the option contract in part e protects against interest rate rises and how this form of protection differs from the futures contract. (3 marks)