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ACCA Strategic Professional · Advanced Financial Management · The use of financial derivatives to hedge against interest rate risk

A treasurer wants to hedge a $5 million, 3-month loan starting in 5 months using three-month futures (contract size $1 million) that expire in 3 months and 6 months. Which choice is most appropriate?

Sell 5 contracts of the 6-month expiry. The hedger should pick the contract expiring on or just after the date the loan begins, so the 3-month contract would expire too early. A borrower sells futures, and five contracts cover $5 million for a three-month loan.

  1. ASell 5 contracts of the 3-month expiry, as it is closest to the start of the loan
  2. BBuy 5 contracts of the 6-month expiry
  3. CSell 5 contracts of the 6-month expiry, as the contract should expire at or just after the date the loan startsCorrect
  4. DSell 10 contracts of the 6-month expiry

Explanation

Choose the expiry on or immediately after the date the exposure begins, so the 6-month contract. A borrower sells futures. The loan period equals the contract period so 5 contracts are needed. Doubling to 10 would only apply for a 6-month loan.

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