A company will need to borrow 8 million euros from the end of May. It is now January. The company is concerned about the risk of a rise in the euribor rate (the benchmark interest rate for the euro) and it wishes to hedge its position with futures.

The current spot euribor rate is 3.50% (for both three months and six months) and the current June euribor futures price is the same, 96.50?

The value of 1 tick for a euribor futures contract is €25 (€1,000,000 × 0.0001 × 3/12)?

Required:

(a) How should the company hedge its interest rate exposure if it plans to borrow the 8 million euros for (1) three months or (2) six months?

(b) Suppose that in May when the company borrows the 8 million euros, the three-month and six-month spot euribor rate is 4.25% and the June futures price is the same, 95.75 (100 - 4.25)? Calculate the effective annual interest rate that the company has secured with its futures hedge if it borrows the 8 million euros for (1) three months or (2) six months.