Question
In: Accounting
Your bank is a regular borrower in the Eurodollar market. On August 9, 2019, the head...
Your bank is a regular borrower in the Eurodollar market. On
August 9, 2019, the head of the funds management division decides
to hedge the bank’s
interest cost on a $10 million three-month Eurodollar issue
scheduled for November
2018. On August 9, the bank could issue $10 million in
three-month Eurodollars at
1.61 percent. The corresponding futures rates for three-month
Eurodollar futures contracts are 1.83 percent (December 2019), 2.01
percent (March 2020), and 2.38 (June 2020).
1. What is the bank’s specific cash market risk on August 9,
2018? Should the bank buy or sell Eurodollar futures to hedge its
borrowing costs? Explain how the hedge should work.
2. Which Eurodollar futures contract should the bank use?
Explain why it is best.
Assume that the bank takes the futures position that you
recommend in Question
1 above at the rate available on August 9, 2018. On November
6, 2018, the bank
issues $10 million in Eurodollars at 3.25 percent.
Coincidentally, it closes out
(reverses) its futures position when the futures rate on the
contract you chose
equals 3.33 percent. Calculate the profit or loss on the
futures trades, the opportunity
gain or loss in the cash market, and the effective return or
cost to the bank on
its Eurodollar issue.
3. Suppose instead that interest rates declined after August 9
and the bank actually
issued Eurodollars at 1.47 percent. Assuming it closed out its
futures position at
1.59 percent, calculate the same profit/loss and return/cost
components as above.
4. It is important to note that the prevailing futures rate at
the time a hedge is initiated
reflects consensus information regarding the future level of
cash market rates.
Explain conceptually why the effectiveness of hedging is
influenced by the accuracy
of the futures rate
Solutions
ekkarill92 answered 2 years agoRelated Solutions
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