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 performance bond requirements, and any timing mismatch between exchange-traded futures contract cash flows and the interest payments due in March.
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:
b. Describe the strip hedge that Johnson could use and explain how it hedges the 12-month loan (specify number of contracts.) No calculations areneeded.