Interest Rate Risk Management (OTC Derivative)

Concept Problem 1:
Grades Ltd. enjoys a high credit rating, and is capable of raising term funds either at a fixed rate of
10% p.a., or at a floating rate of 40 basis points over MIBOR. Levels Ltd. Enjoys a relatively lower
credit rating, and is able to borrow either at 80 basis points over MIBOR, or at a fixed rate of 11%.
Levels Ltd wants to borrow at fixed rate whereas Grades would like to enjoy a floating rate.
Structure a swap arrangement such that Grades Gains 2/3rd of the total gain. Assume that there
are no intermediaries involved.
Concept Problem 2:
Consider Concept Problem 1. Assume that the interest rates applicable to Grade and Levels are
as under:
Grades Levels
Fixed interest 10.00% 10.5%
Floating rate MIBOR MIBOR + 0.8%
What action will follow if Grades apprehends that interest rates will harden while Levels believes
that increases rates will soften?
Concept Problem 3:
S & C Ltd., presently enjoys in a 3 –year team loan of Rs.500 lakhs, with two years of tenor
remaining. The loan is priced at 5% over 3 months away. S $ C apprehends that 3- months
MIBOR is likely to increase in future. It enters into an FRA with Bank-M arranging to pay, for 12
months, fixed rate of interest of 12% p.a. commencing next quarter. Compute and show SC’s loss
or gain under FRA, if on each interest – fixation date, MIBOR moves as under.
Quater1 Quater2 Quater3 Quater4
8.00% 8.50% 7.25% 6.75%

Concept Problem 4:
Mr. Albert buys a Sterling June IRF at 94. The futures price can move to 93.30 or it may shift to
94.70. Explain the implications, and compute the gain or loss on the contract.
Concept Problem 5:
Assume you are the CFO of X Ltd headquartered in UK. In three months’ time (say November),
your company needs to borrow GBP 5 million. Your company can currently borrow at 9% p.a. You
expect that interest rate may rise before November. The three month Sterling interest rate futures
for December is currently trading at 93.34.
Required: (a) Show how a future hedge can be set up. (b) Also illustrate the result of the hedge if
by November, the interest rise by 1% and future price falls by 1.00 or if the interest rate falls by
0.5% and futures price moves up by 0.48. Assume contract size if 500, 000 GBP.
Concept Problem 6:
London International Financial Futures Exchange
Sterling Short Term – Sterling Options
Contract Size: 500,000 – Points of 100***

Strike Price CALLS PUTS

Sep Dec Mar Sep Dec Mar
9400 0.21 0.32 0.41 0.06 0.22 0.41
9425 0.07 0.18 0.28 0.17 0.33 0.54
 9450 0.03 0.08 0.18 0.38 0.50 0.70
** Points of 100 means: trick size. Trick size on three month contract is 500, 000 x 0.01 x 3/12 =
12.50
The above quotes are in respect of an option to buy either a Call option (Right to buying interest
rate futures contract), or a Put option (Right Sell interest –Rate futures contract). The options are
available to buy or sell the 3 – month Sterling futures contract at strike prices varying between
9400 and 9450. A call option with a strike price of 9400 is merely an option to buy 3-month Sterling
futures at a price of 94.00 (implies an interest rate of 6%). Compute the net-Gain if you buy one
September contract call option at strike price 9425 and the interest rate moves to 5.75%
Concept Problem 7:
You are the CFO of a fast growing well rated Indian company. Your company is likely to enjoy a
temporary surplus of $8.20 million in March next year. This surplus is likely to last for four months.
You can place the funds in a short – term deposit for which the going rate is 6%. You also believe
that interest rates will go down. So you deem it appropriate to hedge in the market using either,
using IR – Futures IR options. Data available—
Three months Futures $ 1, 000,000 of 100% Quote on
November 1
Price
December 94.30
March 39.40
June 92.74
September 92.28

Dollars Short –UD Options

Contract Size: 1, 000, 000 – Points of 100%**
Strike Price CALLS PUTS
Dec Mar June Dec Mar June
9425 0.27 0.09 0.12 0.22 0.94 1.63
9450 0.13 0.04 0.08 0.33 1.14 1.84
9475 0.05 0.02 0.05 0.50 1.37 2.06
Trick size. Trick size on three month contract is 1, 000, 000 x 0.01 x 3/12 = 25.00)
Show the ultimate results of hedging using interest rate futures and traded options under two
noted alternatives.
• Interest rates fall by 1.5%, but the Futures market moves by 80% of this amount.
• Interest rates rise by 2%, but the Futures market moves by 90% of this amount
Concept Problem 8:
Data as in Concept Problem 7. Create a collar for lending.
Concept Problem 9:
AACJJ Ltd wants to borrow £5, 000,000 for four months. Their need for a loan will arise two
months hence. Current interest rate is 14%. Interest Rate Guarantee for 14.25% costs 0.30%.
Interest rate may move to either 15% or may come down to 13% in the next two months. Decides.
 Interest Rate Risk Management (OTC Derivative_(Conceptual Questions)

SOLUTION 1:
Step 1: Identify the rates
Company Fixed Floating
Step 2: Compute the Net Differential
Grades 10% M + 0.4
Levels 11% M + 0.8 a. Fixed Rate differential 11% - 10% = 1%
b. Floating Rate differential 0.8% - 0.4% = 0.4%
c. Net (a – b)

Step 3: Split the gain in the ratio of 3:2

Grade picks 0.4% and levels get 0.2%.

Step 4: Lay the sequence of operations

Sequence Strong Company Sequence Weak Company

A (10.00) E (M + 0.8)
B 10.00 + 0.40 = 10.40 F (10.4)
C (M + 0.40) G M + 0.40
D -10.00 + 10.40- (M + 0.4) = M H - (M + 0.8) – (10.4) + M + 0.4 =
(10.8)
Note that strong Company effectively pays only MIBOR, instead of M + 0.4, whereas, the
Weak company effectively pays 10.8 instead of 11.0. Hence Strong Company has gained 0.4%
and the weak Company has gained 0.2%.

SOLUTION 2:
Step 1: Identify the rates

Company Fixed Floating

? Grades 10% MIBOR flat
Levels 10.5% M + 0.8

Step 2: Compute the differential

a. Fixed rate Differential = 10.5% - 10.0% = 0.5%
b. Floating Rate differential = MIBOR + 0.8 (-) MIBOR = 0.8
c. Net differential (b-a) = 0.3%
Note: Grades is the Stronger Company. It wants to go fixed rate. Change is floating rate
is greater than change in fixed rate. Hence swap is possible.
Step 3: Split the gain in the ratio of 2:1
Grades picks 0.2% and Levels gets 0.1%
Step 4: Lay the action for Strong Company
Sequence Strong Company Sequence Weak Company
A (M) E (10.5)%
B M + 0.2 F 10%
C (10)% G (M + 0.2)
D (9.8)% H (M + 0.7)
 Grades ends up paying 9.8% instead of 10% and that 0.2% represents its share of gain. Level
pays M + 0.7 instead of M + 0.8 and that 0.1% represents its share of gain.

Points to remember
• Instead rate swaps are off-balance sheet item. The motivation for swap is to save on
interest cost.
• Commitment to original lenders does not change.
• Helps restructure the debt portfolio.
• Easier than a refinancing arrangement (substituting low cost debt for high cost once)
• May contribute to arbitrage opportunities.
• Since the swap is a agreement, distinct from the original borrowing, the swap tenor
can be structured in any way such that it ends either along with or prior to or even
subsequent to maturity of the original borrowing. This leads to what may be called
the “unbounding” of the funding – decision from the payment – decision.
• The major players in the swap market are banks, medium and large six=zed company.

SOLUTION 3:
S & C Ltd., expecting an increase in interest rate. Hence it wants to move from floating rate
to fixed rate. We must computes its original and its revised obligation. If the original
obligation (MIBOR + 5%) is higher than the revised obligation, the bank will pay it the
difference. If the original obligation is less than the revised obligation S&C will have to pay
the difference to the Bank.

Quarter 1 Quarter 2 Quarter 3 Quarter 4

a. MIBOR =+ 5% 13.00% 13.50% 12.25% 11.75%
b. Rate under FRA 12.00% 12.00% 12.00% 12.00%
c. Difference 1.00% 1.50% 0.25% (0.25%)
d. Amount /Rs. [500 L x C x 1.25% 1.875% 0.3125 lakhs 0.3125 lakh
3/12]
e. Action Bank will pay Bank will pay Bank will pay SC will pay
SC SC SC Bank
Limitations of an FRA

(i) It is not standardized,

(ii) It is an agreement between two parties and not exchange traded
(iii) It involves a counter – party risk.

SOLUTION 4:

Buying at Rs.94 means that Albert can invest at 6% p.a. for three months, when the contract
matures.

A price change from rs.94 to Rs.93.30 indicates that the June interest rate would be 6.7%.

A price change to 94.70 indicates that the June interest rate would be 5.30%.

The size of sterling contract is 500, 000. One tick value is Pounds 12.50. [500, 00 x 0.01% x
3/12]
 Gain or Loss in the given scenario would emerge as under:

Scenario I Scenario II
Bought at (or Invested) 94.00 (6.0%) 94.00 (6.0%)
Closed out by sale 93.30 (6.7%) 94.70 (5.3%)
(Borrowed)
Tick movements (70 ticks) (6.7 – 6.0) 70 ticks
Value of one tick 12.50 12.50
Value of movement (875) 875
Net effect Loss Gain
reason Implies borrowing at 6.7% Implies borrowing at 5.3%
And lending at 6.00% and lending at 6%.
SOLUTION 5:

Part (a)

Borrowing for GBP 5 million, would mean 10 contracts (5, 000,000 / 500,000 = 10).

Target interest payable at current interest rate of 9% for 3 months is (5m x 9% x 3/12)
works out to 112, 500.

The hedge is set up selling 10 interest Rate Futures contract at the current price of 93.34.

Alternative I Alternative
II
Company borrows at 10.00% 8.50%
Actual interest paid (5m, 3 months) 125, 000 106, 250
Impact as a result of IRE
Sold 10 contracts at (at the time of initiating hedge) 93.34 93.34
Bought 10 contracts at (when closing out) 92.34 93.82
Gain 1.00 (0.48)
Total gain or loss on 10 contracts a tick value 12.50 12, 500 6, 000
Net Payment 112, 500 112, 250
Part (b)

Under Alternative 1, Gain or futures fully offsets the loss on actual movement in interest
(100% hedge), and the actual interest out flow is equal to the target payment.

Under Alternative 2, the actual interest paid at 112, 250 represents a gain on target
amount of 112, 500 by 250.

SOLUTION 6:

Step 1: Compute cost of premium for one contract

A September call means expiry month is September. Sterling Options means as option to buy
rates applicable to pounds Sterling.

Method 1: The Premium is given as 0.07. This means 0.07%.

The Cost is 0.07% x £500, 000 x 3/12 = 87.50

Method 2: 0.07 means 7 ticks. The value of one tick is given as 12.5.

This premium of 87.50 if for one contract.

Step 2: Evaluate possibilities

If the price on the expiry date is higher than 94.25 the contract can be exercised at a
profit if September 3 month Sterling futures contract price is higher than 94.25. For
Example, suppose the futures price moves to 94.75 because interest rates are falling, then
the option can be exercised. If the interest moves down to 5.25%, the futures price will rise.

Step 3: Determination loss or gain

Exercise the option to buy one futures contract 94.25

Close out by simultaneously selling out one futures contract. 94.75

Gain in ticks 50 ticks

Gain in terms of Value (50 x 12.50) 625.00

Less: Cost of option premium (87.50)

Net Gain 537.50

SOLUTION 7:

Part 1: Hedging Through IRF

Step 1: Compute target Interest earnings on % 8.20 million, for four months.

a) Current rate of 6% = 8, 200,000 x 6.0% x 4/12 = $164, 000

b) If interest rates falls by 1.5% to 4.5% = 8, 200,000 x 4.5% x 4/12 = $123,
000
c) If interest rates rises by 2% to 8% = 8, 200,000 x 8.0% x 4/12 = $218, 667

Step 2: Determination number of contracts

• Each contract is worth Rs.10, 00,000

• The contract period if for 3 months.
• The cash surplus period if for 4 months.
• What needs to be earned in 4 months has now to be earned in 3 months.
• Hence the number of contracts = 8, 200,000 x 10, 00,000 x 4/3 = 10.93 contracts say 11
contracts.

Step 3: Decide on Buy or Sell

Since there is an anticipation of fall in interest rate contract are BOUGHT. 11$ Futures
contracts for March at 93.40 are bought.

Step 4: Evaluate position at the end of March

Alternative I Alternative II
Interest rate moves to 4.5% 8.00%
Price of futures contract moves by 80% of 1.5% 90% of 2%
Price of futures contract will be 94.60 91.60
 Sell 11 contract at 94.60 91.60
Bought 11 contract at 93.40 93.40
Gain or Loss per contract in TICKS 120 ticks 180 ticks
Value per tick $25 $25
Gain or (loss) per contract (G/L) 3000 (4500)
For 11 contracts (G/L x 11) 33, 000 49, 500
Actual interest received at 123, 000 218, 667
(Interest rate X 82, 00,000 X 3/12)
Total Net receipt 156, 000 196, 167
Target receipt at 6% 164, 000 164, 000
Hedge Efficiency. 95% 103%
Under Alternative 1 as against the target of 164000, we have achieved Rs.156, 000. This
gives a ratio of 95% which is called hedge efficiency. Similarly under Alternative 2, the
hedge efficiency turns out to be 103%.

Part -2 Hedging through Exchange Traded options

Step 1: Compute target Interest earnings on $8.20 million, for four months.

Same as per Step 1 shown in Part 2, Target income is $164, 000

Step 2: Determine the best call option, if exercised, by finding the minimum of strike price
plus premium.

Strike Price Premium in ticks Total

9425 9 9434
945 4 9454
9475 2 9477
Choose – CALL Option 1 March Options at 94.25 at cost of 9 ticks.
Step 3: Buy 11 contracts. For details see Step 2 and 3 above

Step 4: Evaluate position, at the end of March

Alternative I Alternative II
Interest rate moves to 4.5% 8.00%
Price of futures contract moves by 80% of 1.5% = 1.2 90% of 2% = 1.80
Price of futures contract will be 93.4 + 1.2 = 94.60 93.40 – 1.80 = 91.60
Sell at 94.60 91.60
Bought at 94.25 94.25
Gain in TICKS 35 ticks Not exercised
Premium in tick 9 ticks 9 ticks
Net cost or Gain Gain of 26 ticks Cost of 9 ticks
$ $
Value of Net Cost or Gain 25 x 11x 26 25 x 11 x 9
7, 150 (, 475)
Actual interest received st 123, 000 218, 667
Total Net receipt 130, 150 216, 192
Target receipt at 6% 164, 000 164, 000
Hedge Efficiency. 79% 131%
SOLUTION 8:

We can create a Collar for lending by March call options at 9475 and selling
March put options at 9425. The net receipt would be the value of 92 ticks (being
the difference between premium received at 94 ticks for selling put options at 94
ticks, and buying calls at2 ticks) per contract for 11 contracts.

Alternative I Alternative II
Interest rate moves to 4.5% 8.00%
Price of futures contract moves by 94.60 9160
Exercise option to buy at 9475? NO NO
Will the put at 9325 be exercised? NO YES
Since put options gas been sold, we -- 9425
must buy from the other party
Sell at the market --- 9160
Loss (265)
Net Premium 92 92
Net gain or Loss 92 (173)
Value of gain for 11 contracts 25, 300 47,575
Actual interest received at 123, 000 218,667
Total net receipt 148, 300 171,092
Target receipt at 6% 164, 000 164,000
Collars give a result mid –way between Futures and Options.

SOLUTION 9:

An IRG is in nature of an Interest Rate Option.

By Paying a premium for this guarantee at 0.30 on £ 5, 000,000 i.e. £15, 000, the
company isable to limit the interest liability to 14.25% on £5, 000,000 (£712, 500).

If the interest rate moves above 14.25%, the guarantee facility will be availed of,
and if theinterest rate falls below 13.95%, the IRG will not be used