Headging Strategy
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Part 1
Strategies for hedging the interest rate risk of the acquisition financing of Ђ10 million
Various alternatives: Effective interest rates
Using Deposits 8.67%
Delayed Cap
Strike prices:
5.80 % 7.62%
6.80% 8.04%
7.80% 8.66%
3. Interest swaps 7.08%
4. Swaptions 7.37%
Using Deposits (Alternative 1)
Bank deposit has some merits but not necessarily the best choice . In this alternative An 11-year loan of $10 million is negotiated between the bank and TSD, at the beginning of year 5, subsequently the amount is invested at money market rate for 12 months, thereby hedging the interest rate.
The main advantage in this alternative is the guarantee in regards to the availability of the fund needed from the bank. However, unlike under alternatives (e.g. Swap), in the event of a possible reduction in interest rate, there will be no profit for TSD another possible disadvantage associated to this is increases in debt ratio. The cost , when compared to swaps, is relatively higher.
Delayed Cap (Alternative 2)
In this alternative, the maximum interest costs are fixed from year 6 and it is not affected by possible decreases in interest rate. In the event of possible increase in interest rate, the option with the lowest strike price (in this case 5.8%) should be the best choice for TSD. The effective interest rate is 7.62%. The problem here is the fact that the bank may not be willing to extend the roll over loan at the beginning of year 6, there is no guarantee. It is therefore highly important that for TSD ensure that all the necessary conditions are well spelled out in order to prevent such risk.
Interest swaps (Alternative 3)
By definition, Swap mans a binding agreement between counterparts to exchange periodic Interest payments on some predetermined dollar principal, which is called the notional principal amount. For example, one party will pay fixed and receive variable.
Assuming that interest rate increases, a fixed interest rate can be established by using the short term and the long term swap together. This system would lead to reduced interest costs. A reversed swap can also be contracted with the bank and in the event of decrease in interest rate, it can be used to change the fixed interest rate into a floating rate.
Under this aternative, TSD will pay a premium of 1.6 % (6,8% – 5,2%). The premium will be spread over the years 6 till year 15, on basis of 10% (cost of capital) which is discounted interest. This implies that a total of 0.26%premium will be paid every year.
When TSD, gets the $10 million rollover loan in year 6, the euribor will be compensated by the 11-year swap. Since the loan is received on the basis of euribor +1%, it therefore implies that fixed interest rate of 1% will be added to 6.8% of the 11-year swap and this in addition to the premium (0.26%) would lead to an effective interest rate of 8.04%.
A reversed situation:
In the event of downward movement in interest rate, a reversed swap provides TSD with an opportunity to remain profitable. With a reversed swap at the beginning of year 6, the fixed interest rate can be reversed into a variable interest rate. TSD pays 3monthly euribor in exchange for 6.8% fixed interest rate. As earlier explained, a decrease in interest rate does not prevent TSD from becoming profitable. With the use of reverse swap, interest rates can easily be exchanged.
Swaptions (Alternative 4)
By definition, swaption means Options on interest rate swaps. The buyer of a swaption has the right to enter into an interest rate swap agreement by some