Question $4(20$ marks$)$

It is now the ${31}^{st}$ of January. The treasurer of $F$ Company is reviewing funding requirements

and has identified the need to borrow $$30$ million for a period of $4$ months at the end of March.

HIBOR is currently $3\%$ per year, and F Company can borrow at HIBOR $+1\mathrm{.}5\%.$

The treasurer approaches a bank that can offer Forward Rate Agreement $($FRA$)$ with the

following specifications:

Another bank approaches the treasurer suggesting the company may consider using interest

rate cap to hedge the interest rate risk and offers the following option contracts:

Options

$3-$month HIBOR $$5,000,000$

One basis point equals $$125$

The treasurer has made the following comment: "Interest rate risk is the risk of increase in

interest cost of borrowing fund when interest rate increase."

A member of the Board of Directors has made the following comment: "Risk management is

beneficial to the firm and shareholders, it can help the firm maintain the optimal capital

budget over time."

Required:

a$.$ Estimate the resulting interest cost of hedging using the appropriate FRA contract if

HIBOR $(1)$ increase by $2\%,(2)$ decrease by $2\%$ at the end of March.

$(6$ marks$)$

b$.$ Estimate the resulting interest cost of hedging using interest rate cap if HIBOR $(1)$

increase by $2\%,(2)$ decrease by $2\%$ at the end of March.

$(8$ marks$)$

c$.$ Discuss the validity of the comments made by the treasurer and the member of the

Board of Directors.

$(6$ marks$)$