A closer look at the case study

A closer look at the case studyWeek 12Exam Preparations and open question sessionFinal examPart A comprises 15 multiple choice questions worth one mark eachPart B comprises five questions worth five marks each (25 in total)Based on lectures/tutorials 6-11 (please note that the question will be of a similar style to the tutorial questions).Part C is the case study (10 marks)Three previous exam papers are available in Course documents on UTSOnline2The Case Study Describe a two-year bill facility that uses 90-day bills and explain how it poses interest rate risk for the borrower. Describe FRAs, BAB futures and interest rate swaps and explain how these instruments can be used to hedge the interest rate risk posed by the bill facility. Demonstrate how each hedge instrument establishes the companys cost of funds for the initial issue of the bills.For the purposes of your demonstration, assume:the two-year bill facility uses 90-day BABs with a face value of $10 million; the facility is being organised in May for commencement in mid June 2015; when the bill facility was being organised the June 2015 BAB futures price was 95.55.;the two-year swap rate in June is 4.50%pa the 90-day spot rate was 4.65%pa in mid-June (the settlement date for June 2015 futures) the June FRA rate matches the relevant BAB futures rate

3Bank accepted bills (BABs)Companies use accepted bills as an alternative source of debt to bank loansacceptance improves the bills credit standing so that it can be traded in the money marketsix banks are designated as prime banks and the bills they accepts (BABs) will trade at the same yieldBorrowers pay an acceptance fee to the accepting bank, and enter a bill receivable agreementThe amount of bill acceptance, and particularly the amount of BABs sold in the money market has fallen since the GFC4Bill acceptance arrangementNote that while the BAB trades as an unsecured instrument, the acceptor usually requires security for the bill receivable agreement

5Interest rate risk management6For the borrower if rates increase (more than expected), then each $P will fall, and the interest payments required increaseFor an investor, the future returns depend upon the market yield, which is unknownBoth may prefer to lock-in the forward rate rather than face the uncertainty of the future spot rate

Bill facilityHedging interest rate risk7Borrowers are exposed to the risk of unexpected interest rate increasesSpecifically, the risk that future spot rates are higher than forward ratesThere is also the chance of upside rates turning out to be lower than expected

Hedging with derivativesA derivative contract establishes a forward rate that can be used to hedge an interest rate exposureThe forward rate is established through the payment of a cash settlementwhen the derivative contract is agreed neither party knows if they will pay the cash settlement or receive it because this depends on the future spot ratewhen spot rates are higher than expected, the borrower is compensated by being paid the cash settlement when spot rates are lower than expected, the lender is compensated by being paid the cash settlement8The effects of hedging9Forward rate agreementsThe FRA contract:has no upfront costachieves the forward rate through the payment (+ or -) of a cash settlement calculated as the difference between a future spot rate and the agreed forward rate 10An FRA is a contract with a bank that serves to establish a forward interest rate for a specified future date on a nominal principal for a set period

FRA contractsWe define a FRA by its starting and finishing monthsfor example, a 1:4 FRA @ 5.00% sets a rate of 5% for 3 months (90 days) starting in one montha strip of FRAs (e.g., 1:4, 4:7, 7:10 ) hedges a series of exposures such as from a bill facility11

FRA contractsFRAs use standard documentation that specify:their settlement datethe term of the rate the amount on which the rate applieswhether it is a borrowing or lending ratethe cash settlement equation - the equation used with discount securities is:

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The fine prints for the calculationsFor the purposes of your demonstration, assume:the two-year bill facility uses 90-day BABs with a face value of $10 million; the facility is being organised in May for commencement in mid June 2015; when the bill facility was being organised the June 2015 BAB futures price was 95.55.;the two-year swap rate in June is 4.50%pa the 90-day spot rate was 4.65%pa in mid-June (the settlement date for June 2015 futures) the June FRA rate matches the relevant BAB futures rate

13Hedging the case study example with a FRAA company plans to issue $10m worth of 90-day bills next month and enters a 1:4 FRA at 4.45%Say next month the spot rate is 4.65%, the cash settlement will be:

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Paid to the borrower by the bank

FRA borrowing example continuedThe proceeds of the bill issue are given by the first part of the cash settlement equationThe outcome of the payment by the borrower next month is as follows:

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the FRA ratethe cash settlement received increase the proceeds from sale of BillsThe specifications of a BAB futures contract:

Contract unit: 90-day BABs with a face value of A$1millionPrice Quotation: 100.00 minus the annual % yield to 2 d.p. For example,

Contact months: March, June, September and December up to 5 years aheadSettlement day: The second Friday of the contract monthDeliverableBAB futures contract can also be used to hedge interest rate risk 16Long & short positionsFutures contracts can be traded before their settlement date allowing the traders to avoid the contracts obligations17cash settlementA trader can close-out their position at any time prior to the settlement dateEven most deliverable contracts are cash settledCash settlement overcomes the need for the futures market to arrange physical settlement18Note that: BAB futures price

BAB futures price

BAB price vs. BAB valuee.g., 95.= 100.00 yield and so represents 4.89%

19BAB futures as a hedge instrument for BorrowersIssuers of BABs are exposed to the risk of higher than expected ratesBAB futures can be used to create an offsetting position to hedge the exposure by:selling BAB futures nowclosing-out the futures position (by buying the same BAB futures) at the same time as the BABs are sold in the money marketThis generates a profit or loss that offsets the outcome in the money market20IllustrationSay a company plans to issue $10 mil in BABs in December. If it is now May, how can it hedge the risk of higher rates using BAB futures? June BAB futures are trading at 95.55It turns out the interest rate in June is 4.65% (and the futures price is 95.35)

Sells BABs @ 4.65%MayJuneSells 10 BABs futures @ 95.55 (4.45%)Buys 6 BABs futures @95.35 (4.65%)21The hedge paymentThe profit or loss on the futures contracts:

The proceeds from the sale of bills in the money market:

22Outcome of hedgeThe borrowers effective rate is the combination of the money market proceeds and futures market profit/loss:

profit from hedgeproceeds from bill issueforward rate23So what is a Swap?A fixed-for-floating interest rate swap is the exchange of interest payments based on a fixed-rate for interest payments based on a floating-rateSwaps perform the risk-transfer function and there are various forms to manage different risksThey are arranged by swap dealers on an OTC basis and lack a secondary market24Fixed-for-floating swapsThis is the main swap instrument and is also known as a plain vanilla swapIt enables a:

to become ato become aand a:25Swap paymentsThe swap does not change the borrowers debt obligations in any way they will:continue to make interest payments to their lender, andthe swap establishes an additional set of payment obligations that has the effect of changing the interest rate exposure of both parties. These swap payments are based on:the swap rate which is the fixed rate, andthe BBSW which is the floating interest rate26Using a swap to hedge interest rate risk Consider the interest payment in our case study example. The Bill facility with a face value of $10m that have been hedged with a one-year swap at 4.5%Assume the spot rate (BBSW) in June is 4.65%The swaps nominal (or hedged) amount is:

27So what happens in June?The bill proceeds at the start of the first quarter at 5.8% are:

The swap payment is:

28Paid to the fixed rate payer by the bank

The effective rate under a SwapThe borrower receives $9886642.20 at the start of the 90-day period, and must pay the $10mil face value less the swap cash settlement at the end of the periodThe effective rate can be calculated as follows:

29Contact datePriceYield

Mar94.455.55

Jun 94.375.63