Capital market practice questions. Question 1: Explain how STIR futures can be used to hedge the interest rate reset risk in the FRNs.

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Question 1: Explain how STIR futures can be used to hedge the interest rate reset risk in the FRNs.

As scenario, one of the concerns that the company has to face is the steady rise in short-term interest rates over the next three years. To hedge against rates rising, the company can sell future contracts as a STIR futures tool. The future to use can be the three-month interest rate future.

For example, the company can use LIFFE three - month sterling interest rate futures contract (ST3) as STIR futures tool.

The STIR futures Contract Specification:

Name of the contract

LIFFE three-month sterling interest rate

futures contract (ST3)

Unit of trading

£ 500,000

Delivery months

March, June, September, December, and two serial months, such that 26 delivery months are available for trading, with the nearest three delivery months being consecutive calendar months.

Last trading day

11:00, third Wednesday of the delivery month

Quotation

100.00 minus rate of interest (%)

Tick size

0.01 % on annual basis

Tick value

£ 12.5 (Tick value = 500000×0.0001×3/12 = £ 12.5)

Specifically, the company should sell