Deck 8: Hedging Interest Rate Risk With Derivatives

Question 1

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?

Answer 1

A. Take a short position, so you'll make a futures gain if the value of the Euro falls to offset a Spot Loss if the Euro falls.
Number of Contracts___10 contracts___________
# Contracts = 1,250,000 Euros / 125,000 = 10 contracts
B. Spot Gain or Loss _($138,750)_
Futures Gain or Loss __$140,125_______
Net Hedging Result __$1,375___ (Futures Gain or Loss - Spot Gain or Loss)
Calculations:
Spot Loss = 1,250,000 Euros [$1.114 - $1.003] = Loss of $138,750
Futures Gain = 125,000 x 10 [$1.1231 - 1.011] = $140,125
C. Options if the FX rate goes the opposite way expected, you don't have to take the futures loss against the spot gain. Disadvantage: high premium cost at times.

Question 2

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?
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?

Answer 2

a.
Type of Position __Short_Position to make a futures gain if stock prices go down.
# of Contracts___1499_ (Be sure to round up if >_ 0.50; round down if fraction of contracts is less than .50.)
Calculation:
# contracts = ($950,000,000 x Beta .85 ) / (2155.50 x $250)
= $807,500,000/$538,875 = 1499 contracts
b.
Spot Gain or Loss _ ($80,750,000)
Futures Gain or Loss _$80,777,362.50___
Net Hedging Result __$273,625________
Calculations:
Spot Loss = $950,000,000(.10 x .85) = ($80,750,000)
Futures Gain = 1499 contracts x [2155.50 - 2155.50(.90)] x $250
= $80,777,362.50

Question 3

A U.S. financial institution needs to pay 125,000 pounds sterling in 90 days. The current spot exchange rate is $1.75 per pound sterling at this time. The manager believes that the dollar is likely to depreciate relative to the British pound over the next several months. The firm decides to hedge with a long futures contract (amount per contract of 62,500 pounds) with a current futures rate of $1.80.
If 90 days later the spot rate is $1.90 per pound, and the futures contract exchange rate is $1.95, what is the net result of the hedge?

Answer 3

Spot Loss of $18,750 and futures gain of $18,750 and net hedging result of $0
Calculation:
Loss on spot position = 125,000($1.75 - $1.90) = Loss of ($18,750)
Gain on futures = 125,000($1.95 - $1.80) = $18,750
Net Hedging Result = $0

Question 4

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?

Question 5

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?

Question 6

The Cookie Creme Company (Party A) prefers to have fixed rate debt, but has a higher fixed rate of 5% annually, while its variable cost of debt is LIBOR + 1%, with LIBOR at this time at 3%. The Bright Window Company (Party B) would prefer to have variable rate debt, but its fixed rate for debt is 4% annually is lower than its variable rate debt of LIBOR + 1.50% (with LIBOR at this time at 3%).
The two parties agree to a 10-year swap for a given amount at a brokerage fee cost of 0.10% for each party for a given notational amount.
• Party A will continue to issue variable rate debt that costs LIBOR + 1% (currently 3%), and Party B will continue to issue fixed rate debt that costs 4%.
Swap of Partial payments:
• Party A will pay Party B cash flows based on the notational amount at a fixed rate of 4%.
• Party B will pay Party A cash flows based at a rate equal to LIBOR + 1% (Libor currently 4%)
a. What are the liability swap rates (effective rates on debt) that each party will in net be paying on their debt with this swap?
(Hint: liability swap rate = dr % - pi% + po% + fee%) where dr is the firm's rate on the type of debt it is using; po% is the rate to be paid to the other party; pi is the rate to be received from the other party; and fee% is the brokerage rate for the swap.)
b. Given your answers in a., what is the financing advantage for each party?

Question 7

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?

Question 8

What type of provisions did the U.S. Dodd-Frank Act of 2010 include to reduce risks associated with swaps?

Question 9

Give a brief overview of weather derivatives.

Question 10

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

Question 11

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.

Question 12

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.

Question 13

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)?

A) Long hedge with 19 futures contracts
B) Short hedge with 19 futures contracts
C) Long hedge with 20 futures contracts
D) Short hedge with 20 futures contracts

Question 14

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:
$\begin{array}{lc}\text { Spot T-bill } & \text { Eurodollar Futures } \\0.34 \% & 1.00 \%\end{array}$
$\text { Discount Rate 3-months Later: }$
$\begin{array}{lc}\text { Spot T-bill } & \text { Eurodollar Futures } \\0.44 \% & 1.10 \%\end{array}$

A) Short Hedge, 19 contracts, Net Hedging Result of ($250)
B) Long Hedge, 20 contracts, Net Hedging Result of $500
C) Long Hedge, 19 contracts, Net Hedging Result of $250
D) None of the Above

Question 15

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?

A) Net Hedging Gain of $10,000
B) Net Hedging Loss of $10,000
C) Net Hedging Gain of $20,000
D) Net Hedging Loss of $20,000

Question 16

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.

Question 17

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) 105 Short Position
B) 105 Long Position
C) 122 Short Position
D) 122 Long Position

Question 18

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) A long position in stock index futures
B) A short position in stock index futures
C) A put option on stock index futures
D) Two of the above

Question 19

A finance company with variable-rate assets and fixed-rate liabilities wants to do a swap to have a better maturity match and finds a counterparty with fixed-rate assets and variable-rate liabilities to do an asset swap. The amount of the swap is $100,000,000, and the finance company agrees to pay the counterparty a variable rate equal to LIBOR +4% each year while the counterparty will pay the finance company a fixed rate of 10%. At the time of the Swap, LIBOR was 6%, so no cash flows were exchanged. In year 2, LIBOR is 4%, what will be the cash exchange and to which party?

A) $200,000 cash flow to the finance company
B) $2 million cash flow to the finance company
C) $2 million cash flow to the counterparty

Question 20

Bank Five has fixed-rate bond costs of 8.25% and variable-rate bond costs of 6.5%. Bank Cinco has fixed-rate bond costs of 8.75% and variable-rate bond costs of 5.5%. The two parties would like to have the opposite types of cheaper financing. To lower the cost of funds, what should their liability swap be:

A) Bank Five issues variable-rate Bonds, and Bank Cinco issues fixed-rate bonds and the banks swap payments.
B) Bank Five issues fixed-rate bonds and Bank Cinco issues variable-rate bonds, and the banks swap payments.
C) The two banks arrange a foreign currency swap.

Question 21

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

A) Forwards Contracts
B) Futures Contracts
C) Swaps
D) Options

Question 22

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) Short futures hedge
B) Long futures hedge
C) No hedge

Question 23

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?

A) Gain of $417
B) Gain of $2,500
C) Loss of $2,500

Question 24

A financial manager will have surplus funds to invest in 60 days and is worried about having to pay a higher cost for T-bills if rates fall. What type of futures hedge should the manager use?

A) Long hedge to buy Eurodollar CDs
B) Short hedge to sell Eurodollar CDs
C) No hedge

Question 25

Key consideration for choosing a futures or forwards contract for hedging is that futures contacts are standardized contracts for large standardized amounts for hedging for specific delivery dates and particular types of hedging instruments, but futures contracts are very liquid and can be reversed at any time, while forwards contracts must be carried through and are not guaranteed by an exchange.

Question 26

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.

Question 27

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.

Question 28

In the U.S., for the third quarter of 2015, net credit exposure for
U.S. commercial banks and savings institutions for derivatives was $444.6 billion with a notational value for derivatives held of $192.2 trillion, with 76.9% of total derivative notational amounts interest rate derivatives, and 90.85% of banking industry notational amounts held by 4 large major U.S. commercial banks.

Question 29

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.

Question 30

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.