“Describe a two-year bill facility that uses 90-day bills and explain how it poses interest rate risk for the borrower. Describe FRAs, BAB futures and interest rate swaps and explain how they can be used to hedge the interest rate risk posed by the bill facility. Demonstrate how each hedge instrument establishes the company’s cost of funds for the initial issue of the bills.”

Describe a two-year bill facility that uses 90-day bills and explain how it poses interest rate risk for the borrower.

A bill is your promise to pay back a loan at a later date. The ADI provides an amount less than the face value (settlement price) of the bill. On a specific date (maturity date), the borrower has to pay back the settlement price plus interest.

A bill facility helps you manage cash flow more effectively by making payments only on the maturity of the bill. It also provides interest rate protection and flexibility. 

The borrower is subjected the fluctuations of the BBSW rate due the length of investment of 2 years with a 90 day bill rollover. This means that within a period of 90 days, a bill is established with a start date, maturity time, interest rate and amount. After the 90 day maturity, the bill rollover to the next period of 90 days with a rate that may have changed within that 90 day period. A rollover doesn’t pay out after maturity instead it allows the amount matured to be reinvested at a corresponding BBSW at the initial investment date.

Borrowers would prefer a decrease in the maturity interest rate due to the fact that it have to repay lower amounts of interest, decreasing cash outflow for the business.

Describe FRAs, BAB futures and interest rate swaps and explain how they can be used to hedge the interest rate risk posed by the bill facility.

Forward Rate Agreement (AFR) is OTC contract between contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date, the effective date. They are traded on the wholesale, primary market.

FRA have no upfront costs, allow clients to detail to own requirements, easy to arrange and pose little risk of default.

Once a derivative contract is established the borrower doesn’t know whether they will receive or pay a cash settlement. This will depend upon the fluctuation of the interest rate. A rate increase will mean a received cash settlement to offset the agreed rate and a decrease will mean compensation to the lender.

Bank accepted Bill (BAB) future are contracts that allow a hedge to be through an offsetting position. This position can either be through selling out or close position. The end result will be determined through the money market. It is important as it allows a real interest market to be established.

It means that on the agreed future settlement date the investor needs to supply the agreed amount an investors makes the prediction of a forward rate by entering into a contract. An increase in the yield will result in loss whilst a drop in the rate will result in a profit.

Cash settlement will depend on the movement of the interest rate. It is an agreement that Unlike FRA, BAB futures are standardised and are allowed to achieve price discovery by being traded on the secondary market. They also cost an acceptance fee that is charged by the lender.

Interest Rate Swaps is liquid financial derivative that allows an exchange of payments over an agreed time frame that are performed by swap dealers through OTC transactions and lack a secondary market

They provide a risk-transfer function that allows both hedging and speculation. It means that each party either pays a fixed or a floating rate.

If a rise in the rate occurs then the fixed rate payer as it will receive greater payments by the floating payer. Whilst a decrease in the rate will allow a floating rate payer to benefit.

Demonstrate how each hedge instrument establishes the company’s cost of funds for the initial issue of the bills.