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A business plans to borrow approximately $40 million in short-term funding through the issue of commercial paper in three months’ time.

A business plans to borrow approximately $40 million in short-term funding through the issue of commercial paper in three months’ time. The business does not have a view on what is likely to happen to interest rates over the next three months, but it would be very satisfied if it could obtain its funding at the current yield.

(a) Using the following data, show how 90-day bank-accepted bills futures contracts can be used to hedge the interest rate risk to which the business is exposed. Show the calculation and timing of all transactions and cash flows (ignore transaction costs and margin requirements). Today’s data:

(i) current commercial paper yields 6.00 per cent per annum

(ii) 90-day bank-accepted bills futures contract 93.75.

Data in three months:

(iii) commercial paper yields 7.00 per cent per annum

(iv) 90-day bank-accepted bills futures contract 93.25.

(b) What is the effective cost of funds achieved with this hedging strategy? What would the cost of funds have been had the hedge not been put in place? Explain your answer, showing your calculations. (LO 19.5)

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