Interest Rate Risk 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 K27,000,00. Assume it is now 1 October 2017 and the subsidiary expects to receive the money on 31 January 2018. It wishes the money to be invested for five months until 30 June 2018. 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.