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7.3 Part D Bank Balance Sheet Item                             Amount         &n

7.3 Part D

Bank Balance Sheet

Item                             Amount            Duration       Interest Rate       

Cash-type Securities       $50m                1.2 year             2.25%

Commercial Loans          $100m             2.4 years           4.50%

Mortgages                     $350m             8.0 years           6.50%

Core Deposits                $270m             1.0 year             2.00%

Notes Payable                $180m             2.0 years           4.50%

3. Off-Balance sheet futures hedge (Use balance sheet information above, 8 points)

T-Bond futures contracts for the delivery of $100,000 face value are trading at 102-16, and have a duration of 9.50 years.

a. What is the total dollar price of each futures contract (PF)?

b. For this bank to achieve complete immunization, solve for F (total dollar value of futures contracts to immunize). Note: We don’t know the number of contracts yet or a specific interest rate change, so that information should not be used to solve for the dollar value F. Use only the information provided above to solve for F.

c. Using F from part b above, solve for the number of T-Bond futures contracts needed by this bank to hedge the interest rate risk (round to the nearest whole number of contracts).

Answers A-C below

The contract size for Treasury future is usually $100,000. Each contract trades in handles of $1,000,

but these handles are split into thirty-seconds, or increments of $31.25 ($1,000/32)

a)$ Price of Futures Contract = $102.5

b)$ Value of futures Contract = $100000+$2000+($1000*16/32) = $102500

c) 1000 Future Contracts

Please assist with D below

D. Explain in a full essay what risk this bank faces, what position this bank would take on the T-Bond futures contracts to hedge against the interest rate risk it faces, why it would take that position, and graph that position in a fully-labeled futures payoff diagram.

Solutions

Expert Solution

Risk Bank Faces: Interest rate Risk

Reason:

The price of an interest rate future moves inversely to the change in interest rates. If interest rates go down, the price of the interest rate future goes up and vice-versa.

Position to be taken:

Traders who have positions in long-term financial instruments that are sensitive to interest-rate changes can take offsetting, or hedged, positions using T-Bond futures. Because of the low margin requirements, a futures trader can hedge a $100,000 bond position for only $4,000 or less, which makes hedging very easy and cost-effective.

A hedger would sell a futures contract to offset interest-rate risk on bonds in his portfolio.

If interest rates rise, the price drop of his bond portfolio would be offset by a gain in the value of his short position in T-Bond futures contracts.

A hedge can be removed at any time: the long position can sell the T-Bond futures contract to close the position, and the short position can buy back the contract to retire it.


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