Global Master Funds Strategies for Managing Interest Rate Risk - Assignment Example

INTEREST RATE RISK Name: Course: Instructor: Institution: City: Date Introduction Interest rate risk ought to be overseen where variances in interest rate effect on the company’s productivity (Morey, &, Simpson, 2011). According to Howard, &, D’Antonio, (2009), in a company where the center operations are an option that is other than financial related administrations, such monetary risk ought to be overseen, so that the focus of the company is on giving the main products or administrations without presenting the business to various risks. Question 1 Effects of Interest Rate Risk on Interest rate risk of Global Master Fund emerges from the impacts of variances in the predominant levels of businesses interest rates on the fair value of the financial assets and future income or cash flows. The Global Master Fund holds cash equivalent and cash that expose the company to interest rate risk. In addition, the company can invest into different securities and trusts indirectly exposed to interest rate risk, as the invested security can earn investments in direct financial assets for example securities with fixed interest rates. The table below shows the sensitivity of Global Master Fund investment to variances in interest rate changes as at 31st December, 2014. This analysis is based on the assumption that the given interest rates will increase or decrease by 2%, other variables constant. It shows the predictions of future changes in interest rates in respect to past volatility of interest rates. At 31 December, had the investment rates rose or decreased by 2% with all different variables held constant, the rise or decline in operating profit and net financial assets attributable to security holders would add up to roughly; Table 1 Cash holding fund Balanced Fund Conservative Fund Global Equities Fund 2% change in interest rate movement 962,620 4,095,980 2,405,940 209,060 From table one above it is evident that a 2% interest rate will either increase or decrease the cash holding funds of Global Master Funds by $962620, balanced fund by $4095980, conservative fund by $2405940 and global equity fund by $209060. These in turn will either increase or decrease the company cash flow by $7673600 (total sum) Question 2 Global Master Fund’s Strategies for Managing Interest Rate Risk Hedging Hedging is the act of taking a position in one business to balance and offset against the risks embraced by accepting a position in an opposite or restricting business or speculation. Most companies hedge in order to reduce their exposure to various risks for example, credit risks, interest rate risks and market risks. There are various strategies used to hedge against various risks. Global Master Fund’s strategies for managing interest rate risks are as follows; Swap Agreements The Master Fund goes into different swap agreements including premium aggregate returns swaps, interest rate swaps, credit default swaps with financial institutions or brokers for speculation or investment reasons. A swap entails the trade by the Master Fund with an alternate party of their individual duties to pay or get cash streams, for example, an exchange of floating interest payments for fixed-rate interest payments. Swap agreements and comparable exchanges can be independently arranged and organized to incorporate presentation to an assortment of distinctive sorts of investment or business variables. Contingent upon their structures, swap agreements may reduce or increase the Master Fund's presentation to long-term or short-term investment rates, foreign currency values, corporate borrowing rates, mortgages securities. Therefore balancing the swap contract will help Global Master Fund control their interest related financial instruments. The Master Fund's capacity to benefit from such exchanges will likewise rely on upon the capacity of the financial institutions with which it goes into the exchanges to meet their commitments to the Master Fund. In the event that counterparty’s reliability declines, the estimation of the understanding would bring liability, conceivably bringing about losses. On the off chance that a default happens by the other party to such exchange, the Master Fund will have contractual remedies compliant with the agreements identified with the exchange, which may be constrained by appropriate law on account of a counterparty's indebtedness. In specific situations, suitable exchanges may not be accessible to the Master Fund, or the Master Fund may not be able to close out its position under such exchanges in the meantime, or at the same cost, as though it had bought tantamount traded on an open market securities. Interest Rate Swaps To cover for expected future fluctuations of interest rate risk by 2%, Global Mutual Fund decided to engage into 25 interest rate swap contract of notional amount of $10000000 as evident in table 2 below. The Master Fund is highly exposed to interest rate hazard when there is an unfavorable change in the estimation of ventures because of adverse developments in the business investment rates. The Master Fund goes into investment rate swaps to ensure against such unfavorable movements in the interest rates. Investment rate swaps are contracts between two parties where a settled interest sum traded for a drifting interest sum in light of a predetermined principal parity. The installment streams generally netted against one another, with the distinction paid by one party to the next. The Master Fund's interest rate swap contracts are booked to end from 2015 through 2021. This also entails cross-currency interest swap. Options To cover for the 2% future increase or decrease in interest rate risk, it is evident from table 2 below that Global Master Fund has entered into 500 option contracts with a notional amount of $20,000. These are derivative financial instruments that give the purchaser, in return for a premium payment, the right, yet not the commitment, to either buy from (call option) or offer to (put option) the writer a predefined basic instrument at a predetermined cost at a predetermined date (Global Master Fund, L.P 2014). The Master Fund goes into trade exchanged and over-the-counter option contracts to meet the prerequisites of its venture activities. The Master Fund has assigned to the Investment Manager the obligation to screen the Master Fund's positions to decrease the danger of potential misfortune because of changes in interest rates worth or disappointment of counterparties to perform (Global Master Fund, L.P 2014). For trade exchanged options gets, the stock trade goes about as the counterparty to particular exchanges and thus, bears the risk of conveyance to and from counterparties of particular positions. At December 31, 2014, the reasonable estimation of options displayed in derivative contracts on the announcement of benefits, liabilities and accomplices' capital. Losses and gains are accounted for in net acknowledged pick up on speculations, derivative contracts and foreign monetary forms and net change in hidden misfortune on ventures, derivative contracts and foreign currencies on the announcement of operations.. Forwards and Futures As indicated in table 2 below, to cover future unexpected changes in the cash flows due to 2% interest rate risk, Global Mutual Fund has entered into 400 future contracts with a notional amount of $110,000 and 25 forward contracts with a notional amount of $500000. The Master Fund participates in future and forward contracts to hedge the estimation of the portfolio against unfavorable economic situations. Forwards and future contracts are duties either to buy or offer an assigned financial instrument, currency, item or an index at a predefined future date at a predetermined cost and settled in real money or an alternate monetary resource (Global Master Fund, L.P 2014). Futures are standardized trade exchanged contracts while forwards are separately exchanged over-the-counter contracts. After going into a future contract, the Master Fund is obliged to vow to the handle a measure of money or different resources, equivalent to a certain rate of the agreement sum (starting edge store). Ensuing installments, known as margin of variation, are made or got by the Master Fund every day, contingent upon the day to day variances in the reasonable estimation of the fundamental security. Future contracts have little credit hazard because the counterparties are future trades. Forward contracts bring about credit exposure to the counterparty. Forward and future contracts both result in presentation to market risks taking into account changes into foreign exchange rates, records, and securities' qualities underlying these instruments, in respect to contracted sums (Global Master Fund, L.P 2014). Furthermore, in light of low margin ordinarily needed in connection to notional contract sizes, a high level of influence may be normal of a future or forward exchanging account. Subsequently, a moderately little value development in a basic of a future or forward contract may bring about generous misfortunes to the Global Master Fund (Global Master Fund, L.P (2014). While forward contracts are largely subject to liquidity hazard, prospects exchanging may additionally be illiquid. Certain prospects trades do not allow exchanging specific future contracts at costs, that represent a variance in cost amid a solitary day's exchanging past certain set limits. In the event that costs vacillate amid a solitary day's exchanging past those limits, the Master Fund could be kept from instantly selling unfavorable positions and accordingly could be liable to generous misfortunes. At December 31, 2014, the reasonable estimation of prospects and forward contracts displayed in derivative contracts on the announcement of assets, liabilities and accomplices' capital. Gains and losses accounted for in net acknowledged investments, derivative contracts, foreign currencies, and net change in undiscovered loss on speculations, subsidiary contracts and foreign currencies on the announcement of operations. Warranties As indicated in the table 2 below, Global Master Fund engaged in 700 warranty contracts as a measure to help cover for the 2% interest rate risk associated with cash holding, balanced fund, conservative fund and global equities fund. The Master Fund may get warrants from its interest in an equity or debt of an organization. The warrants furnish the Master Fund with risk exposure and potential increases upon equity rise about the venture's offer cost. The estimation of a warrant has two properties: intrinsic value and time value. A warrant has a restricted life and lapses on a certain date. As time to the lapse date of a warrant approaches, the time estimation of a warrant will decrease. Moreover, if the price of the stock underlying the warrant reduces in value, the intrinsic value of the warrant will reduce. Further, if the cost of the stock underlying the warrant does not surpass the strike cost of the warrant on the close date, the warrant will lapse worthless. Accordingly, there is the potential for the Master Fund to lose its whole interest in a warrant. For example as at December 31, 2014, based on the notional amounts and number of contracts, the volume of the Master Fund’s derivatives were as follows; Table 2 Long exposure Short exposure Underlying risk Notional amount Number of contracts Notional amount Number of contracts Commodity price Future contracts $ 1110000 400 - - Credit Credit default swaps 10000000 2 10000000 3 Equity price Future contracts 500000 300 500000 2 Call option 20000 500 20000 5 Warranties 10000 700 - - Total return swaps - - 1000 3 Forex rate Forward contracts 10000000 25 100 80 Interest rate Interest rate swap 10000000 30 - - Recommendations Based on the information below, Global Master Fund should use covered call option to hedge against interest risk. Description No. of contracts Expiration Date Exercise Price Shares subject to call Fair Value Call Options Common Stock Allied Manufacturing corporation(premium to be received $20000 10000 June-2015 $25 10000 $95456 Financial XYZ Financial Bank.(premium to be received $10000 5000 Nov.-2015 $30 5000 $43678 ABC Bank(premium to be received $80000 7000 Aug.-2015 $45 7000 $90856 Total Financial $134544 Total Call Option $230000 Covered Call Option An alternative strategy that Global Master Fund should use to hedge interest rate risk is covered call, which essentially includes writing a call for stock effectively claimed. On the off chance that the call is unexercised, then the call writer keeps the premium, however holds the stock, for which he can at present get dividends. On the off chance that the call is exercised out, then the call writer gets the exercise price for his stock notwithstanding the premium, yet he foregoes the stock benefit over the strike price. On the off chance that the call is unexercised, then more calls can be written for later expiration months, earning more cash while holding the stock. Global Master Fund expects a 2% interest rate fluctuation. Therefore, it should consider entering into covered call option contract with the three companies outlined above. Firstly, with Allied Manufacturing company (10000 contracts, represents also total amount of shares to be bought and sold), with an exercise price of $25. If exercised, Global Master Fund will receive a premium of $20000. Secondly, it should enter into a covered call option contract (5000 contracts, represents also the total amount of shares to be bought and sold) with XYZ Financial bank, with an exercise price of $30. If exercised, Global Master Fund will receive a premium of $10000. Lastly, it should contract with ABC bank (7000 contracts, represents also total amount of shares to be bought and sold) at an exercise price of $45, which when exercised Global Master Fund will receive a premium of $80000. The total expected premium when the covered call option is exercised will be $230000. Therefore, this premium will be enough to cover the expected 2% fluctuation in the interest rates. References Global Master Fund, L.P (2014).Financial statements. Retrieved from at http//www.kmpg.com Howard, C. &, D’Antonio, L. (2009). A Risk-Return Measure of Hedging Effectiveness, Journal of Financial and Quantitative Analysis, 22(3): 377-381 Morey, M. &, Simpson, M. (2011) To Hedge or not to Hedge: the performance of simple strategies for hedging foreign exchange risk. Journal of Multinational Financial Management,11:213-223 Read More