A company plans to borrow 500,000 in three months time for a period of three months but
Question:
A company plans to borrow £500,000 in three months’ time for a period of three months but expects the future interest rate to be higher than the current interest rate of 10 per cent. To hedge its position, it therefore sells one £500,000 interest rate contract at 90 (i.e. 100 − 10). Suppose that, after three months, the interest rate has gone up by 3 per cent and the contract price has moved by the same amount. The seller of the contract now buys a contract at 87 (i.e. 100 − 13), thereby closing out his position. The contract price movement in terms of ticks is 3/0.01 300 = ticks.
The profit compensates the company for the higher cost of borrowing £500,000 in three months’ time, which is £3,750 500 (500,000 × 0.03 × ¼). Because the contract price movement exactly matched the interest rate change, the company has exactly offset its higher borrowing cost and hence constructed a perfect hedge for its interest rate risk.
Step by Step Answer:
Corporate Finance Principles And Practice
ISBN: 9781292450940
9th Edition
Authors: Denzil Watson, Antony Head