International Financial Management 6th Edition by Sanjiv Eun, Cheol Resnick, Bruce Sabherwal

Exercise 6

George Johnson is considering a possible six-month $100 million LIBOR-based, floating-rate bank loan to fund a project at terms shown in the table below. Johnson fears a possible rise in the LIBOR rate by December and wants to use the December Eurodollar futures contract to hedge this risk. The contract expires December 20, 1999, has a US$ 1 million contract size, and a discount yield of 7.3 percent.
Johnson will ignore the cash flow implications of marking to market, initial margin requirements, and any timing mismatch between exchange-traded futures contract cash flows and the interest payments due in March.
Loan Terms
September 20, 1999December 20, 1999March 20, 2000
• Borrow $100 million at• Pay interest for first three• Pay back principal
September 20 LIBOR + 200monthsplus interest
basis points (bps)• Roll loan over at
• September 20 LIBOR = 7%December 20 LIBOR +
200 bps
LoanFirst loan payment (9%)Second payment
initiatedpayment (9%)paymentpayment payment
initiatedand futures contract expiresand principal

•••
9/20/9912/20/993/20/00
a. Formulate Johnson's September 20 floating-to-fixed-rate strategy using the Eurodollar future contracts discussed in the text above. Show that this strategy would result in a fixed-rate loan, assuming an increase in the LIBOR rate to 7.8 percent by December 20, which remains at 7.8 percent through March 20. Show all calculations.
Johnson is considering a 12-month loan as an alternative. This approach will result in two additional uncertain cash flows, as follows:
LoanFirstSecondThirdFourth
initiatedpayment (9%) paymentpayment payment
and
principal

•••••
9/20/9912/20/993/20/006/20/009/20/00
b. Describe the strip hedge that Johnson could use and explain how it hedges the 12-month loan (specify number of contracts). No calculations are needed.