Question

rart Granger plc (Granger) is highly geared and is keen to manage its exposure to interest rate risk. A large portion of the company's borrowings is floating rate debt at LIBOR + 3% and Granger is considering hedging the interest rate to minimise risk. Granger's bank has offered the following hedging options: • A forward rate agreement (FRA) at 4% interest • A cap at 4% interest. There will be a premium cost of 1% per year for the cap. • The bank is prepared to buy a floor from Granger at 3.85% interest for a premium of 0.75% per annum. Assume that LIBOR is currently 0.75% but is expected to move to 1.25% shortly.

Answer 1

(i) No Hedge:

Current:

= LIBOR + 3% = 0.75% + 3% = 3.75%

Expected:

= LIBOR + 3% = 1.25% + 3% = 4,25%

(ii) FRA:

Current:

= FRA rate = 4% = 4%

Expected:

= FRA rate = 4% = 4%

(iii) Cap:

Cap is nothing but a European Call Option for the interest rate.

Therefore, maximum interest that we will pay is 4% and ONE TIME premium PAID will be 1%

Current:

= LIBOR + 3% = 0.75% + 3% = 3.75%

Effective Interest rate = 3.75%+1% = 4.75%

Expected:

= LIBOR + 3% = 1.25% + 3% = 4,25%

Effective Interest rate = 4%(maximum) +1% = 5%

(iv) Collar

Collar means BOTH Buying a Cap and Selling a Floor

Floor is nothing but a European Put Option for the interest rate.

In Collar, effective interest rate will be maximum 4% i.e. Cap AND minimum 3.85% i.e. Floor and ONE TIME premium PAID will be 1% and RECEIVED will be 0.75%

Current:

= LIBOR + 3% = 0.75% + 3% = 3.75%

Effective Interest rate = 3.85%(minimum) + 1% - 0.75 = 4.15%

Expected:

= LIBOR + 3% = 1.25% + 3% = 4,25%

Effective Interest rate = 4%(maximum) +1% - 0.75% = 4.25%

Therefore, BEST Alternative will be the one with LOWEST Effective Interest Rate i.e. FRA

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