interest rate risk\nwonderworld co has a newly - acquired subsidiary in algeria, where the local currency is…

interest rate risk\nwonderworld co has a newly - acquired subsidiary in algeria, where the local currency is the dinar (d). the subsidiary expects to receive d27,000,000 and wants to invest the full amount. assume it is now 1 october 2017 and the subsidiary expects to receive the money on 31 january 2018. it wishes the money to be invested for five months until 30 june 2018.\ncurrently the central bank base rate in algeria is 4.2%, but wonderworld co’s treasury team has seen predictions that the central bank base rate could increase by up to 1.1% or fall by up to 0.6% between now and 31 january 2018. the treasury team believes that wonderworld co can invest funds at the central bank base rate less 30 basis points.\nthe treasury team normally hedge interest rate exposure by using whichever of the following products is most appropriate:\n- forward rate agreements (fras)\n- interest rate futures\n- options on interest rate futures\ntreasury function guidelines emphasize the importance of mitigating the impact of adverse movements in interest rates. however, they also allow staff to take into consideration upside risks associated with interest rate exposure when deciding which instrument to use.\na local bank in algeria, with which wonderworld co has not had any business relationship before, has offered the following fra rates:\n- 4 - 9: 5.02%\n- 5 - 10: 5.10%\nthe treasury team has also obtained the following information about exchange traded dinar futures and options:\nthree - month d futures, d500,000 contract size prices are quoted in basis points at 100 - annual % yield:\n| december 2017 | 94.84 |\n| march 2018 | 94.78 |\n| june 2018 | 94.66 |\noptions on three - month d futures, d500,000 contract size, option premiums are in annual %:\n| | call | | | put | | |\n| december | march | june | december | march | june |\n| 0.417 | 0.545 | 0.678 | 94.25 | 0.071 | 0.094 | 0.155 |\n| 0.078 | 0.098 | 0.160 | 95.25 | 0.393 | 0.529 | 0.664 |\nit can be assumed that futures and options contracts are settled at the end of each month. basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals. it can also be assumed that there is no basis risk and there are no margin requirements.\nrequirements:\nrecommend a hedging strategy for the d27,000,000 investment, based on the hedging choices which treasury staff are considering, if interest rates increase by 1.1% or decrease by 0.6%. support your answer with appropriate calculations and discussion.

interest rate risk\nwonderworld co has a newly - acquired subsidiary in algeria, where the local currency is the dinar (d). the subsidiary expects to receive d27,000,000 and wants to invest the full amount. assume it is now 1 october 2017 and the subsidiary expects to receive the money on 31 january 2018. it wishes the money to be invested for five months until 30 june 2018.\ncurrently the central bank base rate in algeria is 4.2%, but wonderworld co’s treasury team has seen predictions that the central bank base rate could increase by up to 1.1% or fall by up to 0.6% between now and 31 january 2018. the treasury team believes that wonderworld co can invest funds at the central bank base rate less 30 basis points.\nthe treasury team normally hedge interest rate exposure by using whichever of the following products is most appropriate:\n- forward rate agreements (fras)\n- interest rate futures\n- options on interest rate futures\ntreasury function guidelines emphasize the importance of mitigating the impact of adverse movements in interest rates. however, they also allow staff to take into consideration upside risks associated with interest rate exposure when deciding which instrument to use.\na local bank in algeria, with which wonderworld co has not had any business relationship before, has offered the following fra rates:\n- 4 - 9: 5.02%\n- 5 - 10: 5.10%\nthe treasury team has also obtained the following information about exchange traded dinar futures and options:\nthree - month d futures, d500,000 contract size prices are quoted in basis points at 100 - annual % yield:\n| december 2017 | 94.84 |\n| march 2018 | 94.78 |\n| june 2018 | 94.66 |\noptions on three - month d futures, d500,000 contract size, option premiums are in annual %:\n| | call | | | put | | |\n| december | march | june | december | march | june |\n| 0.417 | 0.545 | 0.678 | 94.25 | 0.071 | 0.094 | 0.155 |\n| 0.078 | 0.098 | 0.160 | 95.25 | 0.393 | 0.529 | 0.664 |\nit can be assumed that futures and options contracts are settled at the end of each month. basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals. it can also be assumed that there is no basis risk and there are no margin requirements.\nrequirements:\nrecommend a hedging strategy for the d27,000,000 investment, based on the hedging choices which treasury staff are considering, if interest rates increase by 1.1% or decrease by 0.6%. support your answer with appropriate calculations and discussion.

Answer

Explanation:

Step1: Calculate investment amount in contracts

The investment amount is D27,000,000 and the contract size is D500,000. So the number of contracts $n=\frac{27000000}{500000} = 54$ contracts.

Step2: Analyze interest - rate scenarios

Scenario 1: Interest rate increase by 1.1%

The current central - bank base rate is 4.2%. The new rate would be $4.2%+1.1% = 5.3%$. The rate at which the company can invest is $5.3% - 0.3%=5%$. For futures: The current December 2017 futures price is 94.84, which implies an annual yield of $100 - 94.84=5.16%$. If interest rates rise, the futures price will fall. For options: We need to consider call and put options. If interest rates rise, put options will be more relevant. The put option premium for December with a strike price of 94.25 is 0.071.

Scenario 2: Interest rate decrease by 0.6%

The new central - bank base rate would be $4.2% - 0.6%=3.6%$. The rate at which the company can invest is $3.6% - 0.3% = 3.3%$. For futures: The March 2018 futures price is 94.78, implying an annual yield of $100 - 94.78 = 5.22%$. If interest rates fall, the futures price will rise. For options: Call options will be more relevant. For example, the call option premium for March with a strike price of 95.25 is 0.098.

Step3: Evaluate hedging instruments

Forward Rate Agreements (FRAs)

The 4 - 9 FRA rate is 5.02% and the 5 - 10 FRA rate is 5.10%. If interest rates rise, the 4 - 9 FRA may lock in a relatively good rate. If interest rates fall, the company may miss out on potentially higher returns.

Interest Rate Futures

If interest rates rise, selling futures contracts can lock in a price. For example, selling 54 three - month D futures contracts. If interest rates fall, buying futures contracts can be considered. However, futures contracts obligate the company to transact at the agreed - upon price.

Options on Interest Rate Futures

Options give the company the right but not the obligation to transact. If interest rates rise, buying put options can protect against losses. If interest rates fall, buying call options can allow the company to benefit from lower rates.

Step4: Recommend a hedging strategy

A combination of options and futures can be used. For the interest rate increase scenario, sell 54 three - month D futures contracts and buy 54 put options on three - month D futures with an appropriate strike price (e.g., 94.25 for December) to limit downside risk while still having some flexibility. For the interest rate decrease scenario, buy 54 three - month D futures contracts and buy 54 call options on three - month D futures (e.g., with a strike price of 95.25 for March) to benefit from potential rate decreases while limiting losses.

Answer:

Recommend a combination of futures and options. For an interest rate increase, sell 54 three - month D futures contracts and buy 54 put options on three - month D futures with an appropriate strike price. For an interest rate decrease, buy 54 three - month D futures contracts and buy 54 call options on three - month D futures with an appropriate strike price.