Solution 11
Since the company is likely to suffer the loss of opportunity if the rates go down, it buys
the interest future contract. The number of contracts to be bought should be either 5 or 6
since the value of one contract is $ 1 million.
Suppose the company buys 6 contracts, and the rates after 3 months are as follows:
LIBOR: 8.3 percent
Interest rate future: 90.5
Thus, the loss of opportunity for the company due to fall in the rates is:
9 – 8.3 6
5.5 X -------- X 10 6 X ---- = $ 19,250
100 12
On the other hand, the gain on the future contracts is 6 X (90.5 – 90) X 100 X 25 = $
7,500
The net loss is $ (19,250 – 7,500) or $ 11,750
The loss is not covered fully because of the difference in basis as the fall in interest rate is
not totally reflected into the contract quotes, as also the amount to be covered is not in
exact multiples of the contract value of Euro-dollar rate future.
Illustration
Problem 12
A company is to borrow DM 2.5 million DM 2.5 million in December for 3 months. At
the moment (September), the December DM future is being quoted at 92.5. The market
rate of Euro-DM is 7.5 percent, which is likely to go up in months to come.
What should the company do? Assume that on 15 December, the DM future has fallen to
91.5 and the Euro-DM rates are 8.6 percent.
Solution 12
Since the DM borrowing rate is likely to go up between September and December, the
company will do well to sell DM future contracts to cover against interest rate risk.
The value of one Euro-DM future contract is DM 1 million while the sum to be hedged is
DM 2.5 million. So the company has to sell either 2 contracts or 3 contracts. Let us say,
it sells 3 of them.