Futures and options illustration

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Q4 June 2016 exam

Futures

Things to work out:

interest may rise from 4.3% to 5.1%

work out how much interest would be at 4.3%

$34m x 1/2 year x 4.3% = $731k

work out how much it would increase to if interest rate rises:

$34m x 1/2 year x 5.1% = $867k

therefore increase cost = $136k

work out the expected futures rate at the point of borrowing: 95.44

Ask yourself, if today's future rate is 95.84, which we sell at, as we are hedging against interest rate rises (therefore we buy at expected rate of 95.44), then what is the gain/loss in the futures market? 40 ticks gain. Therefore, gain of 68 contracts x 40 ticks @ $25/tick. Which creates an offset hedge of $63k which reduces the overall cost down to $63k from $136k.

Options

As we are selling futures, we therefore buy put options. Of which two choices are to sell at 95.50 and 96.00. Both create a gain of 6 ticks and 56 ticks and there both should be exercised.

gains on options are therefore:

1) 6 x $25 x 68 = $10.2k

2) 56 x $25 x 68 = $95.2k

and premium costs are:

1) 30.4 x 25 x 68 = $51.68k

2) 50.8 x 25 x 68 = $86.36k

Therefore gain to offset against increase in interest costs are:

1) $136k - 10.2 + 51.68 = $177.48 (don't exercise)

2) $136 - 95.2 + 86.36 = $127.16 (exercise).