A US company has a subsidiary located in Africa. The subsidiary expects to receive 24,000,000 Kenyan shillings

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Question:

A US company has a subsidiary located in Africa. The subsidiary expects to receive 24,000,000 Kenyan shillings (KES) in the local currency on January 31, 20X4. It intends to invest the money for five months until June 30, 20X4.

The current central bank base rate is 4%. The companyis concerned that the base rate may increase or decrease between now and January 31, 20X4. The company believes it can invest funds at the central bank base rate minus 20 basis points.

The company is considering using the following products to hedge interest rate exposure.

A local bank inAfrica has offered the following Forward Rate Agreement:

4-9: 4.32%

4-5: 4.38%

1-6: 4.19%

5-10: 4.25%

Three-month interest rate futures, the contract size is 800,000 Kenyan shillings (KES). Prices are quoted in basis points at 100 - annual % yield.

December 20X3 95.15

March 20X4 94.80

June 20X4 94.51

September20X4 94.12

It can be assumed that futures contracts are settled at the end of the month. Basis can be assumed to diminish to zero at contract maturity at a constant rate. It is now October 1, 20X3.

Requirements

a) What are the relative merits of the mentioned hedging instruments?

b) Recommend a hedging strategy for the investment based on the hedging instruments that the company is considering, in the scenario of a 0.5% interest rate increase. Support your response with appropriate calculations and discussion.