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

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:

Specifically, the company should sell n futures.

Number of futures to trade to establish hedge:

• Where:
• FVCP = Face Value of Cash Position
• NVFT = Notional amount underlying the future
• NV01 = Nominal Value of a Basis Point
• PV01  = Price Value of a Basis Point

As scenario, the company has issued £250,000,000 of Floating Rate Notes (FRNs) paying LIBOR plus 40 basis points. This FRN has three years to maturity and pays semi-annual coupons. A coupon is payable today, the next coupon has been set and is payable in 6 month time.

Therefore:

• FVCP = £250,000,000
• NVFT = £500,000
• NV01 of £500,000 six month deposit is £500,000 * [0.0001 * (180/360)] = £25
• PV01 of future is £12.5

The summary of market data:

r0 : the LIBOR interest rates of today

r1 : the LIBOR interest rates in six months

(assume that r0  r1)

The company expects that the short-term interest rates will rise steadily over the next three years. In that case, issuing FRNs today, it may suffer a loss if the rate acctually rises as its expectation.

After using the STIR futures tool:

• Loss in the spot market (the company is hit by the interest rate goes up) is:

250,000,000*[((r1+0.4)-( r0 + 0.4))/100]*6/12 =1,250,000*(r1 – r0)

• Gain in the futures market (the long position benefits from an decrease in futures price) is:

500 contracts × [(100.00 - r0) - (100.00 - r1)] ticks × 25 tick value = 1,250,000*(r1 – r0)

Therefore: Loss in the spot market = Gain in the futures market or another way to say is :

In conclusion, by using STIR futures, the company can hedge the interest rate reset risk in the FRN effectively.

Question 2: Explain how to use interest rate swaps to hedge the reset risk in the FRNs.

As scenario, the company has issued £250,000,000 of Floating Rate Notes (FRNs) paying LIBOR plus 40 basis points. This FRN has three years to maturity and pays semi-annual coupons. However, the company expect LIBOR to go up steadily over the next three years. Thus, it will suffer from interest rate reset risk.

The company can eliminate the reset risk by converting floating ...