Tutorial+chapter+23 solution PDF

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Tutorial chapter 23 1.

Long Bank has assets that consist mostly of 30-year mortgages and liabilities that are short-term time and demand deposits. Will an interest rate futures contract the bank buys add to or subtract from the bank’s risk?

The purchase of an interest rate futures contract will add to the risk of the bank. If rates increase in the market, the value of the bank’s assets will decrease more than the value of the liabilities. In addition, the value of the futures contract also will decrease. Thus the bank will suffer decreases in value both on and off the balance sheet. If the bank had sold the futures contract, the increase in rates would have allowed the futures position to reflect a gain that would offset (at least partially) the losses in value on the balance sheet. 2. In each of the following cases, indicate whether it would be appropriate for an FI to buy or sell a forward contract to hedge the appropriate risk. a. A commercial bank plans to issue CDs in three months. The bank should sell a forward contract to protect against an increase in interest rates. b. An insurance company plans to buy bonds in two months. The insurance company should buy a forward contract to protect against a decrease in interest rates. c. A thrift is going to sell Treasury securities next month. The thrift should sell a forward contract to protect against an increase in interest rates. d.A U.S. bank lends to a French company; the loan is payable in francs. The bank should sell francs forward to protect against a decrease in the value of the franc, or an increase in the value of the dollar. e. A finance company has assets with a duration of six years and liabilities with a duration of 13 years. The finance company should buy a forward contract to protect against decreasing interest rates that would cause the value of liabilities to increase more than the value of assets, thus causing a decrease in equity value. 3.

The duration of a 20-year, 8 percent coupon Treasury bond selling at par is 10.292 years. The bond’s interest is paid semiannually, and the bond qualifies for delivery against the Treasury bond futures contract.

a. What is the modified duration of this bond? The modified duration is 10.292/1.04 = 9.896 years. b. What is the impact on the Treasury bond price if market interest rates increase 50 bps? P = -MD(R)$100,000 = -9.896 x 0.005 x $100,000 = -$4,948.08. c. If you sold a Treasury bond futures contract at 95 and interest rates rose 50 basis points, what would be the change in the value of your futures position? P = - MD( R) P = - 9.8 96(0.005)$95,000 = - $4,700.70

d. If you purchased the bond at par and sold the futures contract, what would be the net value of your hedge after the increase in interest rates? Decrease in market value of the bond purchase Gain in value from the sale of futures contract Net gain or loss from hedge 4.

-$4,948.08 $4,700.70 -$247.38

What are the differences between a microhedge and a macrohedge for a FI? Why is it generally more efficient for FIs to employ a macrohedge than a series of microhedges?

A microhedge uses a derivative contract such as a forward or futures contract to hedge the risk exposure of a specific transaction, while a macrohedge is an attempt to hedge the duration gap of the entire balance sheet. FIs that attempt to manage their risk exposure by hedging each balance sheet position will find that hedging is excessively costly, because the use of a series of microhedges ignores the FI’s internal hedges that are already on the balance sheet. That is, if a long-term fixed-rate asset position is exposed to interest rate increases, there may be a matching long-term fixed-rate liability position that also is exposed to interest rate decreases. Putting on two microhedges to reduce the risk exposures of each of these positions fails to recognize that the FI has already hedged much of its risk by taking matched balance sheet positions. The efficiency of the macrohedge is that it focuses only on those mismatched positions that are candidates for off-balance-sheet hedging activities. 5.

What are the reasons an FI may choose to hedge selectively its portfolio?

Selective hedging involves an explicit attempt to not minimize the risk on the balance sheet. An FI may choose to hedge selectively in an attempt to improve profit performance by accepting some risk on the balance sheet, or to arbitrage profits between a spot asset’s price movements and the price movements of the futures price. This latter situation often occurs because of changes in basis caused in part by cross-hedging....