1. People’s Car Professor André Farber Solvay Business School
Université Libre de Bruxelles

2. Data
September 30, 2005
PC planning to borrow €10m from end March 2006 until end June 2006.
The usual borrowing rate of the company was EURIBOR + 75bp.
How to hedge IR risk using the 3-month Euribor contract traded on LIFFE.
Size of one contract: €1m
Tick: €25
Underlying rate: 3-month Euribor rate (a simple interest rate).
Current quotation for the March contract was 97.69
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3. Euribor http://www.euribor.org/html/content/euribor_about.html
Euribor (Euro Interbank Offered Rate) is the benchmark rate of the large euro money market that has emerged since It is sponsored by the European Banking Federation (FBE), which represents the interests of banks in 24 Member States of the European Union and in Iceland, Norway and Switzerland and by the Financial Markets Association (ACI). Euribor is the rate at which euro interbank term deposits are offered by one prime bank to another prime bank and is published at a.m. CET for spot value (T+2). Euribor was first published on 30 December 1998 for value 4 January The choice of banks quoting for Euribor is based on market criteria. These banks are of first class credit standing. They have been selected to ensure that the diversity of the euro money market is adequately reflected, thereby making Euribor an efficient and representative benchmark. A strict Code of Conduct sets out rules covering, amongst other things:
the criteria used to determine which banks may belong to the panel of banks. the obligations of the Panel Banks. the tasks and the composition of the Steering Committee, which is responsible for overseeing Euribor. Reuters (formerly Moneyline Telerate) has been chosen as the screen service provider responsible for computing and publishing Euribor. Since its launch, Euribor has become a reality on the derivatives markets and is the underlying rate of many derivatives transactions, both OTC and exchange-traded.
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4. EURIBOR JANUARY OCTOBER 2008
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5. People's Car

6. EONIA
Eonia® (Euro OverNight Index Average) is the effective overnight reference rate for the euro. It is computed as a weighted average of all overnight unsecured lending transactions undertaken in the interbank market, initiated within the euro area by the contributing banks. Eonia® is computed with the help of the European Central Bank. The banks contributing to Eonia® are the same as the Panel Banks quoting for Euribor®. Since its launch, Eonia® is the underlying rate of numerous derivatives transactions.
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7. People's Car

8. Payoff on IRF Payoff (long) at maturity = ΔF ×100×Tick = ΔF ×100×€25
Why?
Long IRF: Receives Fix Rate Pays Floating Rate
Payoff (long) at maturity = €1,000,000 (R0 – rT) 0.25
Size of contract
Tenor = 3 months
As:
100R0 = 100 – = 2.31
R0 = 2.31%
Payoff (long) at maturity
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9. Comparison with FRA 0.25 T T*=T+0.25T
T*=T+0.25
Long FRA: Receives Floating Rate Pays Fix Rate
Payoff FRA at time T
Same as:
Payoff FRA at time T*
Short FRA
Long IRF
At time T : €1,000,000 (R0 – rT) 0.25
At time T* : €1,000,000 (RFRA – rT) 0.25
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10. (1) What position should PC take on the Euribor futures contract (long or short) and on how many contracts? Explain.
Short position on 10 IRF
Borrow Pays Euribor + 75 bp Short IRF Receives Euribor Pays R0
Total Pays R bp
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11. (2) Suppose that, one month later, the futures quote is 97. 00
(2) Suppose that, one month later, the futures quote is Calculate the gain (or loss) on one contract for PC.
Ft = 97.00
F0 = 97.69
ΔF = = - 69 bp
P/L on one contract for PC = - (-69 bp) €25 = €1,725
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12. (3) Suppose that at maturity, the 3-month Euribor rate is 3. 00%
(3) Suppose that at maturity, the 3-month Euribor rate is 3.00%. Verify the effectiveness of the hedge.
If rT = 3% : FT = ×3% = 97
Interest paid (ignoring spread)
€10,000,000 ×3%×0.25
- €75,000
Payoff Short 10 IRF
-10×(-69 bp)×€25
+€17,250
Total
-€57,750
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13. (4) Suppose now that the current six-month (March) and nine-month (June) Euro discount factors are and respectively. Would this create an arbitrage opportunity? Explain.
The 6×9 forward interest rate is:
So you could locking a borrowing rate of 2.31% using IRF and locking in a lending rate of 2.40% on the money market.
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14. Using FGBL
In 2002, PC had bought at par €250 million of OLO , a 5.50 percent coupon bond issued by the State of Belgium with maturity on September 28, The current clean price of the bond was
Wolfgang Beauzart was alarmed by rumors concerning a possible increase of interest rates. He had asked John to see how the bond could be hedged using the December 2005 Euro-BUND futures (FGBL). The contract size is €100,000n the notional coupon is 6% and maturities for the underlying bonds are 8.5 to 10.5 years. The quoted futures price is
John ran a regression of past price changes for the bond (ΔS) regressed on the futures price changes (ΔF) over the past month (using daily data – see Exhibit 1):
ΔS = 0.71 ΔF + ε R²= 0.35
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15. What is the Tick of the FGBL futures?
Size of contract = €100,000
Quoted price F = percentage of face value
Payoff (long)
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16. Long or short? How many contracts?
Remember:
N size of futures €100,000
M exposure €250,000,000
n # futures contract (Long >0, short <0)
S market price of bond
If ΔS = β ΔF
Short 1,782 contracts
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