Question

6. Pico plc has borrowed heavily in euros and is worried about increasing interest rates in the eurozone. The Finance Director suggests that Pico plc should sell futures on French bonds (known as OATs or Obligations Assimilables du Trésor). a. Explain why selling a futures contract on French bonds would reduce the effect of an increase in euro interest rates. b. Pico sells a futures contract on bonds for €1,010 calculate the daily payments and receipts on the futures contract given the following bond prices: Day 1 Day 2 Day 3 Day 4 Day 5 €1,010 €1,005 €1,001 €1,006 €1,009 c. Explain why the market insists on daily settlement. The Finance Director also offers two alternatives: d. One alternative is to engage in an interest rate swap. Explain how this might work. e. The other alternative is to purchase a PUT contract on euro denominated bonds. Calculate the net profit or loss per unit on a put option contract with a strike price of €1,008 with a premium of €4.00 for the following maturity prices: €985, €1,000, €1,015 and €1,020 f. Explain how the option contract in part e protects against interest rate rises and how this form of protection differs from the futures contract.

Answer 1

a]

Interest rates and bond prices are inversely related. That is, an increase in interest rates results in a fall in bond prices, and a decrease in interest rates results in a rise in bond prices. Bond prices and bond futures prices move together, because the underlying asset on the futures is the bond itself.

Thus, if the interest rates increase, the bond prices will fall, and the bond futures prices will fall. This will result in a profit to the seller of bond futures (short position on bond futures).  

The profit on short bond futures position will offset the increased interest rate expense

b]

Daily receipt / payment = previous day futures price - current futures price

We do this because the futures contract was sold (it is a short position). Hence, if the futures price falls, there is a receipt, and if the futures price rises, there is a payment

c]

Futures are highly leveraged derivative instruments. Each unit change in the price of futures has a leveraged, or multiplied effect on the profit/loss. For example, if a futures contract size is 100,000, each unit change in the price of futures has a 100,000 effect on the profit/loss.

Therefore, daily settlement is done so that in case of large price moves, there is adequate margin available in the accounts of position-holders who have a large loss. This ensures guarantee of settlement, reduces counterparty risk, and reduces the risk of the overall market (including investors, brokers and all counterparties)

d]

An interest rate swap can be entered where Pico Plc pays a fixed rate of interest and receives the floating interest rate. The cash inflows from the swap can be used to pay the loan, and a fixed rate of interest is paid to the swap counterparty. Thus, Pico Plc converts its floating rate loan into a fixed rate loan, reducing the loss in case of a rise in interest rates