Question

Choat and Sons Limited is a company based in reading in the south of england. The company specializes in the production of forklifts both for domestic market and for export mainly to the USA. Due to increased demand for the company's products, it has become necessary to expand its production facilities.

Choat and Sons Limited intends to borrow £1,500,000 in three months time for a period of three months but expects interest rates to rise above the current 6% to more than 11%. Management of the company is worried about the expected future interest rises and wants to insulate the company from interest rate risk.

Required;

1. Describe how Choat and Sons Limited can use short sterling interest rate futures contract to hedge against interest rate risk.

Answer 1

An interest rate future allows one of the party to the transaction to borrow the stipulated amount of money at the stipulated rate of interest at a stipulated future period of time. However, as they are derivative instruments, generally there is no actual exchange of this borrowed sum, but both the parties net their position by the means of one party paying to another, the difference it owes due to change in interest rates.

Accordingly, Choat and Sons Limited can get into a futures contract to borrow GBP1.5 million at the existing rate of interest @ 6%. The future should mature when the company actually wants to borrow money. At that point of time, if the interst rates are higher than 6%, the company will receive a sum equal to:

Net = Principal x (Spot interest rate - 6%)

If the interst rate is 11% at the maturity, the company will receive:

Net = GBP1.5 million x (11% - 6%)

Net = GBP1.5 million x 5%

Net = GBP 75,000

With this payoff received from the transaction, the company could easily borrow GBP1.5 million from the market @11% rate of interst. Of the interest liability of GBP165,000 (GBP1.5million x 11%), they can offset the gain of GBP75,000, essentially bringing down their interst liability to GBP90,000 or 6% of principal borrowed.