Exam 8: Hedging Interest Rate Risk With Derivatives

A bank owns Eurodollar CDs with a current market value of $9,700,000 that will be sold to make loans three months from now, and wants to hedge against a rise in interest rates that would result in having to sell the Eurodollar CDs at a lower price. The bank takes a short position with 10 Eurodollar Futures Contracts (minimum contract $1 million) for a futures price of $9,810,000 based on the discount rate quoted. If three months later the new T-bill price is $9,680,000 for the sale of the T-bills by the bank, and the new Eurodollar CD futures price is $9,800,000, what is the net hedging result?

Weather derivatives based on temperature deviations above average benchmarks make use of specific indexes for average monthly and seasonal temperatures as one example for 15 U.S. and five different European cities, with index values set for instance, by Earth Satellite, the National Climate Data Center with variations based on specific indexes and deviations from a base temperature for cooling degree day and heading degree day indexes.

Which of the following financial risk management instruments to use for hedging requires both margin accounts and daily resettlement?

Advantages of options on futures contracts versus future contracts include a maximum loss on the options contract of the premium cost of the option, since an option doesn't have to be exercised if rates go the opposite way expected, allowing the spot gain not having to be offset by the futures loss.

If a portfolio manager is planning on purchasing stocks two months from now and anticipates a bull market over that time period, the appropriate hedging strategy would be:

A pension fund investment manager has a portfolio of stocks with A beta of .87. The value of the portfolio is $6,400,000 and the Mini S&P stock index futures contract settlement at this time is 1065 with a multiple of $50. How many contracts are needed to hedge the cash position (round to a whole number) against a potential fall in stock prices, and what futures position should be taken?

A firm would like to have debt with a floating rate since its assets have floating rates, but has a high variable rate of debt of LIBOR + 1% (for this problem LIBOR is currently 10%) and a lower cost for fixed debt of 9.5%. A broker finds a counterparty for a liability swap that has a fixed rate of 12% and a floating rate of LIBOR + .25% for its debt. The broker will charge a fee of 0.4%. The Swap will be set up so that each respective party will issue its lowest cost type of debt. Then the firm with the fixed rate debt financing will receive a cash inflow of LIBOR + 1% from the other party and will pay out a cash outflow of 10% to the other party. What are respectively the effective rates paid by the firm and the counterparty with this liability swap and the advantage of the swap to each party?

Under the Dodd-Frank Act a mandate was given for the regulation and greater transparency for Credit Default Swaps (CDS) markets and trade compliance, with a lack of transparency making it difficult to analyze the value of CDS and a huge size of the market creating great risks, particularly for CDS used for speculative bets.

List the advantages and disadvantages of hedging with futures contracts versus hedging with respectively forwards contracts, options on futures contracts, and swaps.

A financial institution wants to hedge against a rise in the price of 91 day T-bills (fall in rates) for a future $20 million T-bill purchase three months from now. The FI decides to hedge with Eurodollar Future Contracts, with a minimum contract of $ 1 million. The hedge ratio that will be used is .95. How many futures contracts should the FI get and what position, and what should the position be (long or short) and what is the net hedging result with the current discount rates and three month later discount rates given below where rates rose instead of fell in the future: Discount Rates Today: Spot T-bill Eurodollar Futures 0.34\% 1.00\% $\text { Discount Rate 3-months Later: }$ Spot T-bill Eurodollar Futures 0.44\% 1.10\%

Give a brief overview of the different types of credit swaps including credit-lined notes, first to default swaps, and index swaps. What role did credit swaps play in the U.S. Subprime Crisis?

A primary advantage of options on futures versus futures for hedging is that the maximum possible loss for options is the premium cost, since an option does not have to be exercised.

The British pound futures contract is for 62,500 pounds. The futures exchange rate today on the pound is $1.51 and later in 60 days goes up to $1.55. If you purchased futures contracts taking a long position to hedge against a rise in the British pound for a payment of 62,500 pounds in two months, how much would you gain or lose on the futures contract position?

If a firm is expecting to issue commercial paper in 90 days, and is worried about interest rates rising and having to issue the commercial paper at a higher rate (i.e. a lower price), what strategy should it use to hedge this risk?

A financial institution wants to hedge against a rise in interest rates (i.e. a fall in prices) for a money market portfolio that it holds of $20 million. The FI decides to hedge with Eurodollar Future Contracts, with a minimum contract of $ 1 million. The hedge ratio that will be used is .95. How many futures contracts should the FI get, and what should the position be (long or short)?

To hedge against a spot loss with a rise in interest rates (i.e., a fall in bond prices), a short futures position should be taken, and to hedge against a fall in interest rates (i.e., a rise in bond prices) a long futures position should be taken.

In October, a U.S. Company is expecting to receive funds in Euros in December from its European customers of 1,250,000 Euros, and wants to hedge against a fall in the value of the Euro relative to the U.S. dollar in December. At this time the spot exchange rate Euro is worth $1.114 USD. The CME Group currency future settle rate for a December Euro FX futures contacts is 1 Euro = $1.1231 USD, with each futures contract for 125,000 Euros per contract. a. What position and how many contracts should the financial manager take to hedge against a rise in the Euro? Explain why. (Hint: # contracts = Amount of Euros Hedging / 125,000 Euros per contract; always take a position that will give you a futures gain to offset your spot loss in the event of what you want to hedge.) b. Suppose later in December the spot rate for the Euro falls to $1.003 USD and the futures settle rate has falls to $ 1.011 USD. Calculate the spot opportunity loss or gain for the company and the futures gain or loss. What is the net hedging result? c. What are the advantages and disadvantages of hedging with FX options on futures contracts instead?

Advantages of a swap over futures and options for hedging are swaps can be tailor-made for a particular hedge for any amount and time period, and can be gotten out of easily.

In October an insurance company portfolio manager has a stock portfolio of $950 million with a portfolio beta of 0.85. The manager is planning to sell the stocks in the portfolio in December to be able to pay out funds to policyholders, and is worried about a fall in the stock market. In October the CME Group offers a December S&P 500 futures contract with a settle price of 2155.50 ($250 multiplier for the contract). a. What type of futures position should be taken to hedge against the stock market going down and how many future contracts are needed for this hedge? [Hint: # contracts = {[Amount Hedged / Futures Index Price x Multiplier]} x Beta Portfolio] b. Suppose in December the stock market (S&P500 index) falls by 10% and the S&P500 futures index falls by 10% as well. What is the portfolio manager's opportunity loss (gain) on his portfolio, and his futures gain (loss) and the net hedging result?

Advantages of forward contracts include: (1) that they can be tailor-made for any amount, security, and time period; (2) that they are more liquid than futures contracts and are backed by a clearing house.