Treasury Options

Treasury options can also be used to earn a net premium for buying and selling the treasury options; meanwhile, the buyer of treasury option will have the right that he can purchase, at the end of 60 days, a treasury note with the face value of $100 at an opted strike price. However, using this alternate hedging strategy, General Motor can reduce the interest expense by the net premium received for buying and selling the treasury options. Therefore, under this hedging strategy, if the value of a treasury note is higher than $98.40, then the use of treasury options will reduce the effective interest rate for General Motors to a maximum level of 7.88%. Meanwhile, if the value of Treasury note with the face value of $100 is lower than $98.40, then the use of Treasury note will lead to increased effective interest to maximum level of 7.92%.

However, current interest rate on the 5 years’ Treasury note is 6.625% and as per the forecast of banks long term interest rate is expected to be higher than the current rate of 6.625%, therefore, the value of Treasury note is expected to be lower than the exercise price, hence, the options on Treasury note is not an effective hedging strategy in order to reduce the interest rate expense.

Swaption

Another alternate for the hedging of interest rate exposure is the use of options of interest rate swaps. However, options of interest rate swaps give the holder of the option the right to exercise the option and enter into an arrangement for the swap of fixed interest rate with a floating interest rate. Further, General Motors have two swaption available, 2 by 5 swaption that is for 2 years and 3 by 5 swaption that is for 3 years. However, the use of 2 by 5 swaption will generate a premium of $3.56 million and the effective and as a result the effective interest rate would be 7.68%.

Alternatively, General Motors can use 3 by 5 swaption which will generate premium of $3.76 million and this alternate will bring the effective interest rate at 7.66%. Meanwhile, the spread for 6 months LIBOR will be 4.7% in case of 2 by 5 swaption and 4.82% in case of 3 by 5 swaption, additionally, the probability that swaption will result in losses is around 40% to 45%. However, the use of swaption can be beneficial but again the negative side of the swaption is that the use of the swaption will expose General Motors to the unlimited LIBOR rate of above 9.4% and 9.64%, therefore, swaption would not be a suitable hedging strategy.

Recommendation

Since General Motors ‘wants to reduce its interest expenses, meanwhile, it also wants to control the fluctuation in cash flows arising from the interest payments and the analysis of the above alternative hedging strategy shows that the only feasible option that will meet the objectives of General Motor is the do nothing option. Because this alternate will fix the interest rate payments and will protect the cash flows from fluctuation arising due to the changes in interest rates. However, the use of hedging alternative will achieve the objective of reducing the effective interest rate to some extent, but the use of hedge instruments will expose General Motors cash flows to variations and will lead to short term liquidity problems. Therefore, Stephan would be recommended not to use any of the hedging instruments and propose the issue of 5 year treasury notes for the sum of $400 million..............................

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