Derivatives & Treasury Management: Interest Rate and Currency Risk

This assignment solution focuses on derivatives and treasury management, addressing various aspects of interest rate and currency risk hedging. It covers interest rate options, swaps, and futures, analyzing the effectiveness of different hedging strategies. The solution includes calculations for currency forwards, money market hedges, and currency options, demonstrating how firms can mitigate financial risks associated with fluctuating exchange rates and interest rates. Specific scenarios are analyzed to determine optimal investment decisions and risk management techniques, providing a comprehensive understanding of derivative instruments in treasury management. The document also discusses the regulatory landscape impacting derivative markets since 2009, and the impact of these regulations.

DERIVATIVES AND TREASURY
MANAGEMENT

TABLE OF CONTENTS
Section 2...........................................................................................................................................2
Q3 Interest rate options..........................................................................................................2
Q.4 Interest rate swaps...........................................................................................................5
Q5 Interest rate futures...........................................................................................................5
Q 6 Currency Forwards and Money Market Hedge...............................................................6
Q7 Currency exchange...........................................................................................................7
Q.8 Currency options..............................................................................................................8

Section 2
Q3 Interest rate options
Hedge required on 21st March
Firm needs to buy call option in order to hedge its position. There are two concepts which
are known as call and put. Usually, call refers to the situation in which one buy a contract and
acquired a right to purchase something a specific rate. On other hand, put option refers to the
situation in which one buy a right to sale specific security at the specific price. In order to
determine the investment strategy it is very important to understand call and put option in
relation to interest. Interest rate derivative is the financial instrument whose value if fixed on the
basis of interest rate. It can be said that value of the option is linked to the interest rate which
may be related to the yield on 10 year treasury bonds. Call option in interest rate contract give an
individual a right not a liability to obtain benefit from hike in the interest rate. Contrary to this,
put option is one in which bearer have the right but not liability to obtain profit when interest rate
get declined.
Call option will be taken for making investment in same. This is because open interest is
high in same then in case of put. It can be seen that call open interest is 3362136 and same for
put is 773234. Open interest is the important concept which reflect the number of fresh contracts
that are opened or purchased by the investors. It can be seen from the table that open interest is
high in case of call then put. Hence, call option is selected for the firm.
(b)
Maximum
rate
Minimum
rate Premium
0.12 -0.12 0.08

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Computation of intrinsic value 1
Option Future
Intrinsic
value
Price 94.87 94.92 -0.05
Time value 0.13
Intrinsic value is -0.05 for option which means less return is earn on the option. Time value
is 0.13 which indicate value that remain after deducting intrinsic value from premium amount.
(d)
Cash inflow in future and option 1
Option Future
94.87 94
It can be seen that cash inflow and outflow for option and future is 94.87 and 94. This means
that investment in future is better for the firm.

Q.4 Interest rate swaps
New Jersey -fixed rate
New York- Floating-rate
Bank deal 0.90%
New Jersey= .90*9.25%
=0.08325
New York= 0.90+.75%
=.90675
Net rate= 0.90675-0.08325
=0.08325%
2%-.05%=1.5% differential rate
Differential rate - Expected bank rate= equal share
1.5%-.90%= .60%
NJ= 9.25-.60%= 8.65%
In the above interest rate swap agreement among the two countries are related with the
case in which the above countries' currency is same. The above contract is based on the fixed and
floating interest rate. The bank wants make deal at .90% that shows correctly in the above case
that both the parties will earn equal benefit rate of 8.65% by making this deal at 0.90%. The
equal share of .60% for both the entity that is new jersey and new York will earn .60% when the
bank deal at .90%.
It has been observed from the above calculations and case that this is one of the arbitrage
opportunities. It is covered interest arbitrage in which financial instrument or a kind of security is
bought by an investor in the currency value of foreign exchange to gain benefit and the foreign
exchange risk is hedged through the sale of forward contract. The interest’s rate are taken as
perfect as the significance of interest is in major part of these agreements. The main aspect of the
derivative market is reflects that the countries should have taken up this kind of the best project
which enhances their overall role in the derivative s as one of the important component in the
financial markets. The fixed and floating rate have different combinations that can be made that
totally depends on an organisation that selects as per their choice. The efficient quality of an
enterprise which will reflects in their overall business. It is recommended to an organisation to
select best appropriate projects to attract wide number of customers.

Q5 Interest rate futures
(a)
There is heavy risk on investment because debt is will be paid at LIBOR+3.5% at floating
interest rate. If interest rate will decline then it means that cost of debt is high. In order to hedge
same investment is made in options which is call at 97.90.
(b)
Return matrix 1
market rate Future Difference
1 3.50% 2.10% 1.40%
2 3.50% 2.20% 1.30%
3 3.50% 2.300% 1.20%
4 3.50% 2.400% 1.10%
5 3.50% 2.500% 1.00%
6 3.50% 2.600% 0.90%
7 3.50% 2.700% 0.80%
8 3.50% 2.800% 0.70%
9 3.50% 2.900% 0.60%
10 3.50% 3.000% 0.50%
11 3.50% 3.100% 0.40%
12 3.50% 3.200% 0.30%
13 3.50% 3.300% 0.20%
14 3.50% 3.400% 0.10%
15 3.50% 3.500% 0.00%
16 3.50% 3.600% -0.10%
17 3.50% 3.700% -0.20%
18 3.50% 3.800% -0.30%
19 3.50% 3.900% -0.40%
20 3.50% 4.000% -0.50%
21 3.50% 4.100% -0.60%
22 3.50% 4.200% -0.70%
23 3.50% 4.300% -0.80%

24 3.50% 4.400% -0.90%
25 3.50% 4.500% -1.00%
26 3.50% 4.600% -1.10%
27 3.50% 4.700% -1.20%
28 3.50% 4.800% -1.30%
It will be better to make investment in the sixth day of the month which is June month.
Q 6 Currency Forwards and Money Market Hedge
(a)
Calculation of alternatives 1
Sales & receipts 2500000
Purchase payable 250000
Exchange rate of USD-EUR
1.5540-
1.5550
3 month forward exchange rate
1.5510-
1.5550
USA UK
Annual interest rate for 3 months borrowing 1% 3%
Annual interest rate for 3 months lending (investment) 0.50% 2.50%
Difference 2250000
(a) 2356255.066
(b) 2423003.906
Present value concept is used to measure value of the currency whose formula is FV=
P*(1+r)^n. Value of cash flow is high in case of second alternative and due to this reason it is
selected for investment purpose. It can be said that investment will be made in the money market
instruments to get better value on investment.
Q7 Currency exchange
(a)

The main problem that firm facing is that it will receive cash of 1500 million in June. It is
possible that by that time exchange rate may change inversely which lead to reduction in the
receipt of cash flows. In order to hedge investment will be made in the fixed interest rate futures.
Value of future 1
Euro 1.4707
Spread 0.0012
USD 1.4719
Cash flow 1500
Value of futures 2207.85
Future exchange rate will be 1.47 Euro and due to spread its rate in USD is 1.4719. Hence, cash
flow value 1500 is multiplied by exchange rate and in this way value of future contract is
computed.
(b)
Cash flow when interest rate is fixed at price are $1.81/£1
June Fixed interest rate
1 1.81
2 1.81
3 1.81
4 1.81
5 1.81
6 1.81
7 1.81
8 1.81
9 1.81
10 1.81
11 1.81
12 1.81
13 1.81
14 1.81
15 1.81

16 1.81
17 1.81
18 1.81
19 1.81
20 1.81
21 1.81
22 1.81
23 1.81
24 1.81
25 1.81
26 1.81
27 1.81
28 1.81
29 1.81
30 1.81
Projections are made about the cash flow on the basis of specific exchange rate. The value of
cash flow in the fixed interest rate future will be 2715.
Q.8 Currency options
1 euro= 72.84
Spot rate= 10.55-10.60/1 euro
Premium= 1 million euro
Bank sell 1500 million at 10.45/1euro
a) Government wins contract and spot rate price in six months 11.5/1 euro
=1500*11.5/72.84*6/12
=118.41 million + 1 million
=119.41 million
b) Government wins contract and spot rate price in six months 7.5/1 euro
= 1500*7.5/72.84*6/12

=77.24 million+1 million euro
=78.24 million
c) Government does not win the contract and spot rate price in six months 7.5/1 euro
=1500*7.5/72.84*6/12
=77.24 million
d) Government does not win the contract and spot rate price in six months 11.5/1 euro
= 1500*11.5/72.84*6/12
=118.41 million
From the above calculations it has been observed that the above forward contract has
been on the contingent basis which is depended on the happening and non-happening of an
event. The extra premium is added in the cash flow for selecting the contract and vice versa. The
value of Euro is been taken as 72.84 by converting them into Indian rupees. The cash flows have
determined to move ahead in the business to show their ability in order attract wide number of
customers and shareholders as this is the basic quality an organisation should adopts the
organisation cam increasing their existing capabilities by increasing the overall scope of an
organisation which should play importantly role in business context. The different business
expansion will help an organisation in order to take relevant business decisions to support the
enterprise and take their basic responsibilities on them in order to move ahead without any
trouble.