Phobos Interest Rate Hedging Mark Fielding-Pritchard mefielding.com1.

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Phobos Interest Rate Hedging Mark Fielding-Pritchard mefielding.com1

Phobos  Wants to borrow money, £30m  Loan taken out 1 March, for 4 months  Sell  March  (30m/0.5)x (4/3)= 80  On 1 January sell  On 1March buy back  Note. On 1 January Libor is 6%, therefore the price of a future should be 94. But it isn’t, it is 93.88, therefore we have basis risk of 0.12% (12 ticks) mefielding.com2

Phobos You need to calculate the decline in basis risk to get the value of the future on close out Basis risk1 Jan 12 basis points Basis risk1 Mar 4 basis points mefielding.com3

Phobos  So basis risk will be 3 basis points from LIBOR at 1 March for a March future  Implied interest is greater than LIBOR so future price will be below expected LIBORFuture Price 7% %94.96 mefielding.com4

Phobos mefielding.com5 LIBOR5% 7% (Additional)/ Saved Interest (100000) FutureSold Buy Loss 108 Sold Buy Gain 92 Gain/ Loss1.08% x £ x 3/12 x 80 (108 ticks x x 80= ) 0.92% x £ x 3/12 x 80 (92 ticks x x 80= 92000) Hedge Efficiency100000/108000= 92.6%92000/100000= 92%

Phobos- Options  Options are just options to buy or sell futures  With futures we sold 80 March so here we want 80 March puts  Which exercise price? And what is the premium cost? mefielding.com6 StrikeInterestPremium Therefore we buy on 1/1 80 March puts, premium cost 0.3% x x 3/12 x 80 = £30000 (30 x 12.5 x 80= £30000)

Phobos mefielding.com7 LIBOR5% 7% (Additional)/ Saved Interest (100000) FutureSold Buy Don’t exercise Sold Buy Gain 129 Gain/ LossPremium £ % x £ x 3/12 x 80= (129 ticks x x 80= )

Phobos mefielding.com8 LIBOR5% 7% (Additional)/ Saved Interest (100000) FutureGain of £ becomes net loss of £8000 Loss of £ reduced by gain of £92000 OptionGain of £ reduced by premium of £30000 Loss of £ becomes loss of £1000

Phobos  Potentially interest rates can rise and rise, UK 22%  Selling puts is risk without limits  Our numbers don’t include costs  SWAPS can build in risk for years  Basis risk means there are under/over hedged liabilities  Derivatives should not be used for speculating mefielding.com9