The corporate treasury team of Four Seas Ltd. is debating whether risk management can create value for the company and if it can create value what strategy to adopt towards interest rate risk management. The companys financial projections show an expected cash deficit in three months time of $12 million, which will last for a period of approximately five months. Prime rate is currently 9% per year, and Four Seas can borrow at 0.5% over prime. The treasury team believes that inflation pressure in USA will soon force the Federal Reserve to raise USA interest rate by 2% per year, which could lead to a similar rise in Hong Kong interest rates. In Hong Kong, the economy is still recovering from the financial turmoil and representatives of industry are calling for interest rates to be cut by 1%.

The corporate treasury team believes that interest rate is more likely to rise than to fall. It is now 1 December.

HIBOR prices (1 December)

Futures

3-month HIBOR $5,000,000 (100.00 minus the yield)

December 91.45

March 91.30

One basis point equals to $125

Required:

What is the current expected interest cost for Four Seas? If the company wants to hedge the interest rate risk, what should it do?

Illustrate the results of hedging if by 1 March: (1) prime rate rise by 2%, futures price move by 1.8% or (2) prime rate fall by 2%, futures price move by 1.8%.