Your firm needs to raise $100 million in funds. You can borrow short-term at a spread of 1% over LIBOR. Alternatively, you can issue 10-year, fixed-rate bonds at a spread of 2.50% over 10-year treasuries, which currently yield 7.60%. Current 10-year interest rate swaps are quoted at LIBOR versus the 8% fixed rate.
Management believes that the firm is currently "underrated" and that its credit rating is
b. Suppose the firm's credit rating does improve 3 years later. It can now borrow at a spread of 0.50% over treasuries, which now yield 9.10% for a 7-year maturity. Also, 7-year interest rate swaps are quoted at LIBOR versus 9.50%. How would you lock in your new credit quality for the next 7 years? What is your effective borrowing rate now?
Your utility company will need to buy 100,000 barrels of oil in 10 days, and it is worried about fuel costs. Suppose you go long 100 oil futures contracts, each for 1,000 barrels of oil, at the current futures price of $60 per barrel. Suppose futures prices change each day as follows.
a. What is the mark-to-market profit or loss (in dollars) that you will have on each date?
b. What is your total profit or loss after 10 days? Have you been protected against a rise in oil prices?
c. What is the largest cumulative loss you will experience over the 10-day period? In what case might this be a problem?