Explain why the final outcome may not be a perfect hedge

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Reference no: EM133290981

Case: A business plans to borrow approximately $40 million in short-term funding through the issue of commercial paper in three months' time. The business does not have a view on what is likely to happen to interest rates over the next three months, but it would be very satisfied if it could obtain its funding at the current yield.

Using the following data:

Today's data:

i. current commercial paper yields 5.00 per cent per annum

ii. 90-day bank-accepted bills futures contract 94.75.

Data in three months:

iii. commercial paper yields 6.00 per cent per annum

iv. 90-day bank-accepted bills futures contract 94.25.

Required:

a) Show how 90-day bank-accepted bills futures contracts can be used to hedge the interest rate risk to which the business is exposed. Show the calculation and timing of all transactions and cash flows (ignore transaction costs and margin requirements)?

b) Explain why the final outcome may not be a perfect hedge. Provide a description of the risks that contribute to such an outcome?

Reference no: EM133290981

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