Your colleague Nina Peter is also a risk manager at Arcku Asset management Plc and specialises in swaps. She has been temporarily assigned to your hedge fund to assist you.

Arcku Plc has outstanding bonds worth £200m, 5 year semi-annual pay, floating rate bonds with coupons rate equal to 180 day LIBOR + 50 basis points with an embedded call option. Arcku Plc is worried that interest rates may rise over the rest of tenor of the issue. This would increase the cost of debt financing and Arcku would like to hedge against this risk.

Nina Peter offers two solutions:

1. Arcku can call the bonds early, if LIBOR rises above 5% or,

2. Take a long position in a swaption with strike rate of 5% for the remaining 3 years.

The expected term structure of interest for the remaining tenor of the issue is as follows:

180 day LIBOR 4.5%

360 day LIBOR 5%

540 day LIBOR 5%

720 day LIBOR 5.6%

900 day LIBOR 6%

1080 day LIBOR 4.8%

Equity Portfolios:

The dividends received from stock holdings were previously re-invested into trending stocks in short-term sub-portfolio until the end of the financial year. Due to recent bleak outlook of the UK economy, Arcku Plc’s hedge fund has decided to re-invest the dividend income into foreign currency (Euros) instead, as the UK Pound has been and is expected to continue to lose value against the Euro. If the Pound depreciation against the Euro continues, Arcku expects earn positive returns from this strategy that would help ease up its cash shortages. Dividend income amounts to approximately 2.5% of size of equity portfolio, that is, £2.5 m every quarter.

Nina suggests that Arcku Plc should enter into currency swap for next 5 year to exchange the dividend income with another EU based hedge firm whose annual dividend income is the same as Arcku, when converted into Pounds. Given today’s exchange rate of £1 = € 0.85 any firm with dividend income of €/ £ (0. 85 x £2.5 m= € 2,125,000) should qualify.

If not swaps, Arcku’s may enter into a forward contract or a future contract or go long in currency option. Any method chosen must consider Arcku’s current cash shortage and require a minimum cash outflow over the next 2 to 3 months.

Currency portfolio:

In order to execute a currency hedge, Nina suggests it is important to determine what would be the correct spot price of the currency 3 months from now. Nina thinks that the Pound is likely to depreciate against the Euro, as the UK is expected to have a higher inflation rate compared to mainland Europe. The UK inflation expectation is at 4.5%, while the cost-of-living index for EU is expected to increase by 3% over the next 3 months. The spot exchange today is €0.85 = £1

Required:

Bonds:

(I) Discuss the possible benefits, costs and limitation of the 2 options presented by Nina.

(II) Determine the net settlement of Arcku from swaption?

(III) Comment on last swap settlement? Can this be avoided?

(IV) Derive the equation to show how can Arcku eliminate the uncertainty regarding FRN interest payments by using the swaption?

Equity:

(V) Critically valuate Nina’s statement regarding currency swap on equity dividends.

Consider all elements of the suggestion you may or may not agree with?

(VI) Assuming a currency swap is not feasible, is a long position in forward or future contract better, considering the cash shortage?

(VII) Determine the expected spot exchange 3 months from now. Are Nina expectations of currency movements, correct?