FINANICIAL DERIVATIVES (HEDGING WITH KLIBOR)

Mr. Tan, the Treasurer of City Finance Bhd., has just determined that there will be a RM 180 million shortfall (negative gap) for City Finance Bhd. 3 months from now. That amount will have to be raised in the interbank market. Citys cost of funds is the KLIBOR rate. City has priced its medium/ longer term loans to yield a 2% spread (profit margin) based on expected 3-month rates. The loans are at fixed rate. Mr. Tan is however worried about the interest exposure. Assuming the following quotes are available now. 1-month KLIBOR 3-month KLIBOR = 6.8% = 7.0% Spot-month KLIBOR futures = 93.00 3-month KLIBOR futures = 92.00

a. What is the interest rate that Mr. Tan should aim to lock-in?

b. Outline the hedge strategy (specify clearly).

c. Assuming the spot 3-month KLIBOR is the higher by 1.5%, 3 months later, analyze the hedge, and proof that using your strategy, the intended interest rate or spread has indeed been locked-in.