Interest rate risk Coca-Cola Amatil Limited is an active issuer of bonds in the corporate debt market and frequently

utilises bank loans as a means of financing. The companys use of debt financing is unsurprising as it raises capital for operations while allowing firms to take advantage of debt tax shields. However, the substantial use of such debt instruments (approximately $579.6 million in 2010) can greatly expose the company to interest rate risks. Interest rate risk refers to the risks that the value of a financial instrument or cashflows associated with the instrument would fluctuate due to changes in market interest rates (Coca-Cola Amatil 2010a p.74). It can arise in instances when the yield curve shifts or changes and when the cash rates are altered by the Reserve Bank. In the case of Coca-Cola, as long term debt is issued at fixed rates and borrowings are charged at variable rates, the company is highly susceptible to both fair value and cashflow interest rate risks. Fair value risk occurs when bonds issued by the company, albeit at fixed rates (coupons), fluctuate because of changes in the market interest rates (yields). Cashflow risk arises due to the variable rates on loans which cause interest expense to fluctuate. The use of exchange-traded interest rate derivatives can mitigate and hedge the risk of interest rate fluctuations. More specifically, the use of interest rate futures, options and swaps are two strategies that the company could employ to hedge the effects of interest rate risks. Part II Interest rate futures (IRF) are the first form of derivatives that CCA could explore to control for interest rate risks. Firstly, IRF can be used to hedge cashflow risk surrounding floating rate loans. The companys cash outflows for interest payments would increase should interest rates rise. Thus, an appropriate strategy would be to take up a short position in an IRF

contract. This is because when interest rates rise, the value of the futures contracts would go down. Thus, a short position would make money and is a useful hedging strategy. A specific contract the company could engage in would be the ASX 90 Day Bank Accepted Bill Futures traded on the ASX with a contract value of AUD$1 million; with the dollar value of the minimum price movement, or tick value that does not remain constant but changes with movements in the underlying interest rates1 (ASX Factsheet 2010). The advantage of this strategy is clearly the ability to lock-in interest rates on variable-rate loans. Should CCA have a view on how interest rates would change in the following months, they can either long or short the ASX 90 Day IRF to prevent interest expense from affecting cashflows. A limitation though is that because the contracts are settled daily, the timing of the cashflows from the hedge does not line up exactly with the timing of interest cashflows. Further, as final settlement in the futures contract happens before interest payments which are received 3 months later, the hedge would be less than perfect (Hull 2011a, p.140). Hence, not all risk with interest rates can be perfectly hedged due to timing issues. Another limitation is the requirement of having to maintain margin accounts with futures products. CCA would have to actively mark-to-market its cashflows that arise due to changes in futures prices (Boudreault 2010). Next, interest rate options include options on fixed-income securities and futures options, which are options on IRF contracts. Futures options gives the buyer the right to buy from or sell to the writer a designated futures contract at a designated price at any time during the life of the option (Fabozzi 2010, p.654). A strategy that CCA could employ to hedge interest rate risk would be to long put options on similar maturity IRF with strike prices closest to where the futures are trading, ensuring that the options are at-the-money (Boudreault 2010). CCA could utilise the ASX 90 Day Bank Bill Futures Options that are traded on the SFE. The
1

Refer to numerical example in Appendix II

advantage of using options to hedge against interest rate risk is that it can limit CCAs downside should the market move against predictions, while maintain exposure to limitless upside if the market is favourable. The limitation that comes to mind would be the option premium required for this hedge to take place. Similar to the IRFs example above, should 1 basis point of option premium equal to $25, implementing a hedge comprising over $100 million in loans would incur substantial costs. However, no further cashflows would be incurred until the option position is exited or exercised.

Appendix II ASX 90 Day Bank Accepted Bill Futures example Suppose CCA wanted to lock in an interest rate for a three-month period in June 2012, on a loan principal of $100 million. The current June 2012 90-day BAB quote is 96.25, implying that CCA would be able to lock in a 90-day borrowing rate of 100 96.25 or 3.75% per annum. As each contract is worth $1 million, CCA can hedge itself by shorting 100 futures contracts. Suppose that in June 2012, the 90-day BAB rate rises and turns out to be 4.25%. The final settlement in the contract would then be at a price of 95.75. We have assumed that a one-basis point move in the futures quote corresponds to $25 per contract. By going short, CCA would gain: (96.25 95.75) x 100 x 25 x 100 = $120,000 The actual interest expense on the 3 month loan is: 100,000,000 x 0.25 x 0.0425 = $1,062,500 CCAs interest expense would be higher than anticipated because rates rose above original futures rates. Net interest expense = -1,062,500 + 120,000 = ($937,500) CCAs expected interest expense = 100,000,000 x 0.0375 x 0.25 = $937,500 This proves that with CCA going short on an IRF contract, the effect of locking in an interest rate of 3.75% can be achieved even though the interest rate of the loan is variable.

References Hull, J. C. (2011a). Fundamentals of Futures and Options Markets. United States of America: Pearson Education. Bouderault, J. J. (2010). Hedging Borrowing Costs with Eurodollar Futures and Options [Online]. Available at: http://www.cmegroup.com/trading/interest-rates/files/IR(9 October

301_Hedging_Borrowing _Costs_with_ED_Futures_and_Options.pdf 2011)

Fabozzi, F. J. (2010). Bond markets, Analysis and strategies. United States of America: Pearson International ASX Limited (2010). ASX 90 Day Bank Accepted Bill Futures and Options [Online]. Available at: www.sfe.com.au/content/aboutsfe/brochures/008_a90dbb.pdf