5. Star Ltd needs to borrow in 2 weeks\' time by issuing a 90 day bank bill with

Question

5. Star Ltd needs to borrow in 2 weeks' time by issuing a 90 day bank bill with face value of Sim·Currently, the bank bill rate is 4.4%. The risk is that the bill rate would increase. The company then decided to protect itself by selling one BAB futures contract at 96(4%). During the next 2 weeks, the 90-day bill rate increased and the bill was issued at 5.5%. At this date, the BAB futures contract was priced at 95(5%) (10 marks) A. Calculate the dollars short fall in the physical market. B. How to use futures to hedge, and show your calculation. C. What is the difference between future and forward contracts? D. What are speculator and hedger?

Explanation / Answer

Fund needed : $1000000

So, borrow with 4.4% interest for 90 days.

But it raises to 5.5% by 90 days.

So, current liability = 100000*4.4% = 1044000

After 90 days the liability increases = 1000000*5.5% = 1055000

So, Loss on borrowing = 11000.

Foreseeing this, Star Ltd hedges by selling BAB future @ 4% discount.

So, it gets = 1000000/0.96 = 960000.

By the end of the period, the futures price was 95 .

1000000/0.95 = 950000.

In this contract Star Ltd gained 10000.

So, 11000 Less 10000 = 1000 loss.

The difference between "Future" and "Forward" is that the Future contracts are more

secure and organized, done through the regulatory agency and are binding on the

parties : while the Forward contracts are private contract entered into between two

parties, hence credit risk is involed. Also, they are unregulated.

The difference between Hedging and Speculation is that they are two different

strategies. The hedging involves taking an opposite position in the market to

mitigate the expected future loss.

The speculator takes the risk as it comes and do not take steps to curb the loss.

In the illustration, the star ltd has hedged its position. So, the actual loss that

would have happened (i.e., 11000) is reduced by 10000 and the actual loss is 1000.

The actual dollar short fall is 4.4/5.5 = 1.25%

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