Case study: Another example

Explain how a two-year bill facility that uses 90-day bills poses interest rate risk for the
borrower. DescribeFRAs, BAB futures and interest rate swaps and explain how they can
be used to hedge the interest rate risk involved in a planned issue of BABs. Demonstrate
how each hedge instrument establishes the companys cost of funds.

Businesses often require funds for a longer term than the usual 90-day term of a bill and so
will be provided with a bill facility. This is an agreement to rollover bills on their maturity
date by issuing a replacement set of bills, however there is potential that borrowers will be
exposed to interest rate risk. Interest rate risk is basically the threat posed by unexpected
changes in interest rates, in other words, it can be defined as the uncertainty surrounding
expected returns on security, brought about by changes in interest rates. Given that a
borrower uses 90-day bills under a two-year bill facility, the bills will be rolled over seven
times so that the loan is repaid at the end of two years. This arrangement is a floating-rate
arrangement that exposes the borrower to the risk of an unexpected rise in interest rates that
will increase its cost of funds while not increasing its interest earned on the loan. The
borrower faces interest rate risk throughout the period of the facility because the amount
raised is determined by the spot rate each time the bills are issued. Should rates rise
unexpectedly, the borrower would have to pay the higher-than-expected interest rate. For
instance, should the spot 90-day rate be higher than the forward rate of the month, the
borrower will have to pay more for its funds.

The main method for managing interest rate risk is to use a derivative which is an instrument
that features a forward settlement (or maturity) date. It provides the hedger with a forward
rate that is based on the expected future interest rate. For the borrower it removes the risk of
having to pay a higher interest rate (than the forward rate). But the forward rate removes the
upside potential, thus, if the future spot interest rate is lower than the forward rate on the day
the funds are borrower, the borrower pays the forward rate. This means the borrower now
faces the risk of lower interest rates. Thus, the hedge (the forward rate) does not eliminate
risk absolutely, it changes the risk exposure. The instruments that serve to hedge an exposure
to future spot interest rates include FRAs, BAB futures and interest rate swaps. A hedge
instrument that establishes a forward rate is simultaneously establishing a hedged amount.
This amount is calculated with the forward rate. In most of these derivatives the contract is
settled with a cash settlement calculated as the difference in the hedged amount and the actual
proceeds from the issue of money market securities. Where the future spot rate on the
settlement date for the hedge contracts is higher than the forward rate, the derivative contract
is settled with a payment to the company that equals the difference in the hedged amount and
the actual proceeds from the issue of securities. The purpose of the cash settlement is to
compensate the borrower for paying a higher interest rate (than the forward rate) and so adds
to the proceeds, bringing them up to the amount that corresponds to the forward rate. The
hedge contract is referred to as locking in the forward rate because the borrowing is made at
the spot rate in the money market and the cash settlement adjusts the proceeds to match the
amount given by the forward rate.

A forward rate agreement (FRA) is an OTC contract with a bank that serves to establish a
forward interest rate for the specified future date on a nominal amount for a set period to
manage risk. FRAs are identified by their starting date and finishing date. They are arranged
with dealers, who earn their income from the spread between the forward rates they provide
Case study in the final exam: Another example, p. 2

borrowers and the rates they provide lenders. Usually the nominal amount is the face value of
the securities on which the interest rate risk is being hedged or the amount of a bank loan. A
cash settlement equation is used to calculate the payment on the basis that it is made by the
borrower. This occurs only when the market rate is less than the agreed rate (and so the
calculated amount is positive). When the market rate exceeds the agreed rate, the FRAs cash
settlement equation generates a negative payment and so it is paid to the borrower. The
generated cash settlement compensates borrowers when the spot borrowing rate exceeds the
forward rate and is added to the proceeds, bringing them up to the amount that corresponds to
the forward rate.

A BAB future contract is for a standard parcel of bills with a face value of $1 million. The
market arranges trading in 20 contracts each with a successive settlement date (March, June,
September and December). These dates identify when the bills in the contract will become
spot bills and so identify the starting date of the 90-day forward rate. Thus, deducting their
quotation price from 100 reveals the forward 90-day rate for each rate. Borrowers use BAB
futures to hedge their exposure to future movements in 90-day interest rates. A borrower who
pays a floating rate based on a 90-day BBSW is concerned about future interest rates being
higher than expected. They would sell BAB futures to establish a forward borrowing rate.
This means that borrowers would set their hedge at the markets bid price. The borrower
would hedge each of its exposures by taking short positions in the BAB futures market with
successive settlement dates. More precisely the borrower will take short futures positions,
which is equivalent to the selling of forward bills. When closed out each date exceed the
forward rate at which the short position was taken. This generates a loss for the borrower
should the spot rate on the settlement date be less than the contacts forward rate. It is
important to specify the number of contracts that would be sold to establish a hedge position
that matches the amount being borrowed. If the hedged amount were less than the borrowing
amount, the hedge position would not result in a cash settlement that would be sufficient to
lock in the forward rate for the bill issue.

Swaps can be treated as instruments that enable the management of interest rate risk. Most
types of swap contracts are arranged by swap dealers on an OTC basis. Among interest rate
swaps the most widely used contract is a fixed-for-floating rate swap, also known as a plain
vanilla swap. It is an exchange of payments on a nominal sum by two borrowers for an
agreed period. A plain vanilla swap enables a borrower to modify the pattern of its interest
payments. For example, it would convert a floating-rate borrowers interest payments into a
stream of fixed-rate payments. A plain vanilla swap also generates cash settlements but not
just for one settlement date; its cash settlements are made over the term of the swap. It serves
to offset the variation in the interest rate between the spot rate and the swap rate and so
establishes the swap rate (or the proceeds that would be generated by the swap rate). Where
both counterparties have entered the swap to hedge their interest rate risk they have done so
because their swap contract will change in value to counterbalance the impact of an
unexpected change in interest rates on the amount of their interest obligations. Borrowers that
have raised floating-rate funds through issuing 90-day BABs under a bill facility are exposed
to the risk of unexpected increases in the 90-day bill rate. They could enter a swap as the
fixed-rate payer to hedge the risk that 90-day interest rates will be higher than expected. The
swap locks in the borrowers interest rate at the swap rate. The swap can also be viewed as
locking in the amount of borrowed funds, which we refer to as hedged amount.


Case study in the final exam: Another example, p. 2

The essay component and the demonstration components of the case study will each be graded out of
5 marks.
I llustration of the hedging demonstrations:
Assume 90-day BABs with a face value of $100m are to be issued in mid December, that the current
December BAB futures price is 95.00, the December one-year swap rate is 4.80% and the December
spot rate turns out to be 4.50%, demonstrate the hedged interest rate outcomes in December using the
three instruments:

- Proceeds from the spot 90-day bill market:

73 . 587 , 902 , 98 $
365
90
045 . 0 1
100 $
=
+
=
m
P
- Using a FRA:

71 . 449 , 120 $ 02 . 138 , 782 , 98 $ 73 . 587 , 902 , 98 $
365
90
05 . 0 1
100 $
365
90
045 . 0 1
100 $
= =
+

+
=
=
m m
V V settlement Cash
agreed mkt lender to


% 00 . 5
90
365
1
71 . 449 , 120 $ 73 . 587 , 902 , 98 $
100 $
365
1
= |
.
|

\
|

=
|
|
.
|

\
|

+
=
m
n settlement Cash or P
F
r
effective


- Using BAB futures:

Sell 100 December BAB contracts:
02 . 138 , 782 , 98 $
365
90
05 . 0 1
100 $
=
+
=
m
V
sell


Close out in December:
73 . 587 , 902 , 98 $
365
90
045 . 0 1
100 $
=
+
=
m
V
buy


Loss on futures = $98,782,138.02 - $98,902,587.73 = $120,449.71

% 00 . 5
90
365
1
71 . 449 , 120 $ 73 . 587 , 902 , 98 $
100 $
= |
.
|

\
|

=
m
r
effective


- Using an interest rate swap

Calculate the nominal amount, Q: 68 . 282 , 830 , 98
365
90
048 . 0 1
100 $
=
+
=
m


It is clear from the
question that the
answer must be the
forward rate; 5.0%
It is clear from the
question that the
answer must be the
forward rate; 5.0%
Case study in the final exam: Another example, p. 2

( )
( ) 33 . 107 , 73 $
365
90
045 . 0 048 . 0 68 . 283 , 830 , 98 $
365
90
= =
=
FTG FXD
r r Q settlement Cash


Since the $73,107 is paid in March the present value of this amount (using the December spot
rate of 4.50%) should be used to demonstrate the hedge:

04 . 305 , 72 $
365
90
045 . 0 1
107 , 73 $
=
+
=
settlement cash
PV

% 80 . 4
90
365
1
04 . 305 , 72 $ 73 . 587 , 902 , 98 $
100 $
= |
.
|

\
|

=
m
r
effective


It is clear from the
question that the
answer must be the
swap rate; 4.80%