Three-month sterling interest-rate futures are quoted as follows on 30 August:
£500,000 points of 100%
Settlement price
September ......................... 91.50
December ......................... 91.70
March .............................. 91.90
Red Wheel plc expects to need to borrow £15m at floating rate in late December for three months and is concerned that interest rates will rise between August and December.
Assume: No transaction costs.
Required
a. Show a hedging strategy that Red Wheel could employ to reduce uncertainty.
b. What is the effective rate of interest payable by Red Wheel after taking account of the derivative transaction if three-month spot rates are 10 per cent in December? Show the gain on the derivative.
c. What is the effective rate of interest after taking account of the derivative transaction if three-month spot rates are 7 per cent in December? Show the loss on the derivative.