A multinational corporation is about to embark on a major financial restructurin

Question

A multinational corporation is about to embark on a major financial restructuring program. One critical stage will be the issuance of seven-year Eurobonds sometime within the next month. The CFO is concerned with recent instability in capital markets and with the particular event that the market yields rise prior to issuance, forcing the corporation to pay a higher coupon rate on the bonds. It is decided to hedge that risk by selling 10-year Treasury note futures contracts. Notice that this is a classic cross hedge wherein 10-year Treasury notes are used to manage the risk of 7-year Eurobonds.

            Describe the nature of the basis risk in the hedge. In particular what specific events with respect to the shape of the Treasury yield curve and the Eurobond spread over treasuries could render the hedge ineffective? In other words, under what circumstances would the hedge fail and make the corporation worse off?

Explanation / Answer

Answer: Nature of the Basis risk in the Hedge: The hedge is exposed to two types of basis risks.

(a) Changes in the shape of the yield curve.The company wishes to hedge seven year issue costs with a ten year contract, the hedge is exposed to changes in the relative level of interest rates between the seven and ten year maturities.

(b) Quality Spread over treasuries in the eurobond market.

There are two types of basis risk that this hedge is exposed to. The first is from changes in the shape of the yield curve. Since the company wishes to hedge a seven year issue's cost with a ten year contract, the hedge is exposed to changes in the relative level of interest rates between the seven and ten year maturities. Specifically, if the seven-year treasury rate rises more relative to the ten-year rate then the hedge will not completely neutralize the position and lose money for the firm. The second source of basis risk is from the quality spread over treasuries in the Eurobond market. Since the company will have to sell its bonds with a spread over the Treasury rate, changes in this spread will also effect the quality of the hedge. Specifically, increases in the spread will lead to losses for the firm.

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