Financial Markets & Derivatives

Dununa Reverse Co, a comapny based in SADC region, has expanded very rapidly over recent years by a combination od acquiring subsidiaries in foreign countries and setting up its own operations abroad. Dununa Reverse Co's board has found it increasingly difficult to monitor its activities and Dununa reverse Co's support functions, including its treasury function, have struggled to cope with a greatly increased workload. Dununa Reverse Co's board has decided to restructure the company on a regional basis, with regional boards and appropriate support functions. Managers in some of the larger countries in which Dununa Reverse Co operates are unhappy with reorganization on a regional basis, and believe that operations in their countries should be given a large amount of autonomy and be supported by internal functions organized on a national basis. Assume it is now 1 July 2019. The central treasury function has just received information about a future transaction by a newly acquired subsidiary in Zambia, where the local currency is the Zambian Kwacha (K). The subsidiary expects to receive K27,000,000 on 31 October 2019. It wants this money to be invested locally in Zambia until 30 March 202. Dununa reverse Co's treasury team is aware that economic conditions in Zambia are currently uncertain. The Bank of Zambia (BOZ) base rate is currently 4.2% and the treasury team believes that it can invest funds in Zambia at the BOZ base rate less 30 basis points. However, treasury staff have seen predictions that the BOZ base rate could increase by up to 1.1% or fall by up to 0.6% between now and 31 October 2019. Dununa reverse Co's treasury staff normally hedge interest rate exposure by using whichever of the following products is most appropriate: - Forward rate agreements (FRAs) - Interest rate futures - Options on interest rate futures Treasury functions guidelines emphasise the importance of mitigating the impact of adverse movement in interest rates. However, they also allow staff to take into consideration upside risks associated with interest rates exposure when deciding which instrument to use. A local bank in Zambia, with which Dununa reverse Co has not dealt before, has offered the following FRA rates: Time Period (months) FRA rates 4 - 9 5.02% 5 - 10 5.10% The treasury team has also obtained the following information about exchange traded kwacha futures and options: Three-months (K) futures, K500,000 contract size price are quoted in basis points at 100 - annual % yield Dates Futures Price December 2017 94.84 March 2018 94.78 June 2018 94.66 Options on three-month (K) futures, K500,000 contract size, option premiums are annual % Call Options Price Options Exercise price December March June December March June 94.25 0.417 0.5545 0.678 0.071 0.094 0.155 95.25 0.078 0.098 0.160 0.393 0.529 0.664 It can be assumed that futures and options contracts are settled at the end of each month. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals. It can also be assumed that there is no basis risk and there are no margin requirements.

Required: a) Recommend a hedging strategy for K27,000,000 investment, based on the hedging choices which treasury staff are considering if interest rates increase by 1.1% or decrease by 0.6%. Support the answer with appropriate calculations and discussion.