Alecto Co, a large listed company based in Europe, is expecting to borrow â¬22,000,000 in four monthsâ time on1 May 2013 It expects to make a full repayment of the borrowed amount nine months from now Assume it is 1January 2013 now Currently there is some uncertainty in the markets, with higher than normal rates of inflation, butan expectation that the inflation level may soon come down This has led some economists to predict a rise in interestrates and others suggesting an unchanged outlook or maybe even a small fall in interest rates over the next six monthsAlthough Alecto Co is of the opinion that it is equally likely that interest rates could increase or fall by 05% in fourmonths, it wishes to protect itself from interest rate fluctuations by using derivatives The company can borrow atLIBOR plus 80 basis points and LIBOR is currently 33% The company is considering using interest rate futures,options on interest rate futures or interest rate collars as possible hedging choicesThe following information and quotes from an appropriate exchange are provided on Euro futures and options Marginrequirements may be ignoredThree month Euro futures, â¬1,000,000 contract, tick size 001% and tick value â¬25March 9627June 9616September 9590Options on three month Euro futures, â¬1,000,000 contract, tick size 001% and tick value â¬25 Option premiums arein annual %Calls Strike PutsMarch June September March June September0279 0391 0446 9600 0006 0163 02760012 0090 0263 9650 0196 0581 0754It can be assumed that settlement for both the futures and options contracts is at the end of the month It can also beassumed that basis diminishes to zero at contract maturity at a constant rate and that time intervals can be counted inmonthsRequired:
(a) Briefly discuss the main advantage and disadvantage of hedging interest rate risk using an interest rate collarinstead of options (4 marks)
(b) Based on the three hedging choices Alecto Co is considering and assuming that the company does not faceany basis risk, recommend a hedging strategy for the â¬22,000,000 loan Support the recommendation withappropriate comments and relevant calculations in ⬠(17 marks)
(c) Explain what is meant by basis risk and how it would affect the recommendation made in part (b) above (4 marks) (25 marks)