A closer look at

the case study

Week 12
Exam Preparations and open question session

Final exam
Part A comprises 15 multiple choice questions
worth one mark each
Part B comprises five questions worth five
marks each (25 in total)
Based on lectures/tutorials 6-11 (please note
that the question will be of a similar style to the
tutorial questions).

Part C is the case study (10 marks)

Three previous exam papers are available in
Course documents on UTSOnline
2

The Case Study

Describe a two-year bill facility that uses 90-day bills and
explain how it poses interest rate risk for the borrower.
Describe FRAs, BAB futures and interest rate swaps and
explain how these instruments can be used to hedge the
interest rate risk posed by the bill facility. Demonstrate how
each hedge instrument establishes the companys cost of funds
for the initial issue of the bills.
For the purposes of your demonstration, assume:
the two-year bill facility uses 90-day BABs with a face value of $10
million;
the facility is being organised in May for commencement in mid June
2015;
when the bill facility was being organised the June 2015 BAB futures
price was 95.55.;
the two-year swap rate in June is 4.50%pa
the 90-day spot rate was 4.65%pa in mid-June (the settlement date
for June 2015 futures)
the June FRA rate matches the relevant BAB futures rate

Bank accepted bills (BABs)

Companies use accepted bills as an
alternative source of debt to bank loans
acceptance improves the bills credit standing so that it
can be traded in the money market
six banks are designated as prime banks and the bills
they accepts (BABs) will trade at the same yield

Borrowers pay an acceptance fee to the

accepting bank, and enter a bill receivable
agreement
The amount of bill acceptance, and
particularly the amount of BABs sold in the
money market has fallen since the GFC

Bill acceptance arrangement

Note that while the BAB trades as an unsecured

instrument, the acceptor usually requires
security for the bill receivable agreement
5

Interest rate risk management

Bill
facility

For the borrower if rates increase (more than

expected), then each $P will fall, and the interest
payments required increase
For an investor, the future returns depend upon the
market yield, which is unknown
Both may prefer to lock-in the forward rate
rather than face the uncertainty of the future
spot rate

Hedging interest rate risk

Borrowers are
exposed to the
risk of unexpected
interest rate
increases
Specifically, the
risk that future
spot rates are
higher than
forward rates
There is also the
chance of upside
rates turning out
to be lower than
expected

Hedging with derivatives

A derivative contract establishes a forward

rate that can be used to hedge an interest
rate exposure

The forward rate is established through the

payment of a cash settlement

when the derivative contract is agreed neither

party knows if they will pay the cash
settlement or receive it because this depends
on the future spot rate
when spot rates are higher than expected, the
borrower is compensated by being paid the
cash settlement
when spot rates are lower than expected, the
lender is compensated by being paid the cash

The effects of hedging

For a
borrower

For a
lender

a forward rate hedges the

risk of higher than
expected rates

a forward rate hedges the

risk of lower than
expected rates

but eliminates the

chance of benefiting
from a lower than
expected rate

but eliminates the

chance of benefiting from
a higher than expected
rate
9

Forward rate agreements

An FRA is a contract with a bank that serves to
establish a forward interest rate for a specified
future date on a nominal principal for a set period
The FRA contract:
has no upfront cost
achieves the forward rate through the
payment (+ or -) of a cash settlement
calculated as the difference between a future
spot rate and the agreed forward rate
10

FRA contracts

We define a FRA by its starting and finishing

months
for example, a 1:4 FRA @ 5.00% sets a rate
of 5% for 3 months (90 days) starting in
one month
a strip of FRAs (e.g., 1:4, 4:7, 7:10 )
hedges a series of exposures such as from
a bill facility

11

FRA contracts
FRAs use standard documentation that
specify:
their settlement date
the term of the rate
the amount on which the rate applies
whether it is a borrowing or lending rate
the cash settlement equation - the equation
used with discount securities is:
Settlementbyborrower Vmarket Vagreed

1 (rmarket t) 1 (ragreed t)
12

The fine prints for the

calculations
For the purposes of your demonstration, assume:
the two-year bill facility uses 90-day BABs with a
face value of $10 million;
the facility is being organised in May for
commencement in mid June 2015;
when the bill facility was being organised the
June 2015 BAB futures price was 95.55.;
the two-year swap rate in June is 4.50%pa
the 90-day spot rate was 4.65%pa in mid-June
(the settlement date for June 2015 futures)
the June FRA rate matches the relevant BAB
futures rate

13

Hedging the case study example with a FRA

A company plans to issue $10m worth of 90day bills next month and enters a 1:4 FRA at
4.45%
Say next month the spot rate is 4.65%, the
Vmarket Vagreed
byborrower
cash Settlement
settlement
will be:

Settlement

1 (rmarket t) 1 (ragreed t)

$10m

$50m

1 0.0465 90
1 0.0445 90
365
365
9,886,642.20 9,891,464.89
$4,822.69
Paid to the
borrower

14

FRA borrowing example continued

The proceeds of the bill issue are given by the
first part of the cash settlement equation
The outcome of the payment by the borrower
next month is as follows:

diy
F
reffective
1

d
Pmarket / settlement

365
$10m

1
9,886,642.20 4,822.69 90
4.45%
the FRA
rate

the cash settlement

received increase the
proceeds from sale of
Bills

15

BAB futures contract can also be

used to hedge interest rate risk
The specifications of a BAB futures contract:
Contract unit:
A$1million

90-day BABs with a face value of

Price Quotation: 100.00 minus the annual % yield to 2 d.p.

For example,
Contact months: March, June, September and December
up to 5 years ahead
Settlement day:

The second Friday of the contract month

Deliverable
16

Long & short positions

The buyer has
the long
position

this is the contractual obligation

to buy the contract item on the
settlement date at the agreed
price

The seller has

the short
position

they have contracted to sell to

the contracts holder on the
settlement date at the agreed
price

Futures contracts can be traded before their

settlement date allowing the traders to avoid
the contracts obligations

17

cash settlement
A trader can close-out their position at any time
prior to the settlement date
Even most deliverable contracts are cash
settled
Cash settlement overcomes the need for the
futures market to arrange physical settlement
18

BAB PRICE VS. BAB VALUE

Note that:

BAB futures
price

e.g., 95.
= 100.00 yield
and
so represents
4.89%

BAB futures
price

VBAB

F
1 rfwd t
1mil
90
1 0.0489 365

$988086.12

19

BAB futures as a hedge instrument for

Borrowers

Issuers of BABs are exposed to the risk of higher

than expected rates

BAB futures can be used to create an offsetting

position to hedge the exposure by:
i. selling BAB futures now
ii. closing-out the futures position (by buying
the same BAB futures) at the same time as
the BABs are sold in the money market
This generates a profit or loss that offsets the outcome in
the money market
20

Illustration

Say a company plans to issue $10 mil in BABs

in December. If it is now May, how can it
hedge the risk of higher rates using BAB
futures?
June BAB futures are trading at 95.55
It turns out the interest rate in June is
4.65% (and the futures
price is 95.35)
Sells BABs @ 4.65%
May

Sells 10 BABs
futures @ 95.55
(4.45%)

June

Buys 6 BABs futures

@95.35 (4.65%)
21

The hedge payment

1.

The profit or loss on the futures

contracts:
10*$1m.
10*$1m.
Vsell Vbuy

90 ) 1(0.0465 90 )
1(0.0445 365
365
$9,891,464.89 $9,886,642.20
Profit $4822.69

2.

The proceeds
from the sale of bills in the
$10m
moneyPmarket: 90 $9,886,642.20
1(0.0465 365)
22

Outcome of hedge
3.

The borrowers effective rate is the

combination of the money market
proceeds and futures market profit/loss:

365
$10m
reffective
1
$9,886,642.20 4,822.69 90

4.45%
forward rate

proceeds
from bill issue

profit from
hedge
23

So what is a Swap?
A swap is an exchange of payments over an
agreed period
A fixed-for-floating interest rate swap is the
exchange of interest payments based on a fixedrate for interest payments based on a floatingrate
Swaps perform the risk-transfer function and
there are various forms to manage different risks
They are arranged by swap dealers on an OTC
basis and lack a secondary market

24

Fixed-for-floating swaps
This is the main swap instrument and is also
known as a plain vanilla swap
It enables a:
to become
a

and a:
to become a
25

Swap payments
The swap does not change the borrowers debt
obligations in any way they will:
i.

continue to make interest payments to their

lender,
and

ii.

the swap establishes an additional set of

payment obligations that has the effect of
changing the interest rate exposure of both
parties. These swap payments are based on:
the swap rate which is the fixed rate, and
the BBSW which is the floating interest rate

26

Using a swap to hedge interest

rate risk
Consider the interest payment in our case
study example. The Bill facility with a face
value of $10m that have been hedged with a
one-year swap at 4.5%
Assume the spot rate (BBSW) in June is 4.65%
The swaps nominal (or hedged) amount is:
Q

F
$10m

$9,890,258.77
1 rswap 90365 1 0.045 90365

27

So what happens in June?

1.

The bill proceeds at the start of the first

quarter at 5.8% are:

P
2.

1 rBBSW 90365

$10m

1 0.045 90365

$9,886,642.20

The swap payment is:

CS Q rswap rBBSW 90365

98,890258.77 0.045 0.465 90365

$3658.04

Paid to the fixed

rate payer by the
bank

28

The effective rate under a Swap

The borrower receives $9886642.20 at the

start of the 90-day period, and must pay the
$10mil face value less the swap cash
settlement at the end of the period

3.

The effective rate can be calculated as

F swappayment

365
follows:

reffective
1

P
90

10m 3658.04 365

9,886,642.20 90
4.50%

29