GF510_Unit 4 Assignment 1_Andrews, Tradawnya

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Unit 4 Assignment 1 Tradawnya Andrews Purdue Global University GF510

Chapter 23 Question 6 Suppose an FI purchases a 20-year Treasury bond futures contract at 95. a. What is the FI’s obligation at the time the futures contract is purchased? The FI is obligated to purchase the futures contract at a preset price of $95,000 on a set date. b. If an FI purchases this contract, in what kind of hedge is it engaged? If the FI purchases the futures contract it is engaging in long-term hedging. c. Assume that the Treasury bond futures price falls to 94. What is the loss or gain? There will be a loss of $1,000. $95k - $94k. d. Assume that the Treasury bond futures price rises to 97. Mark to market the position. There will be a gain of $2,000. $97k - $95k. Chapter 24 Question 18 An FI has a $100 million portfolio of six-year Eurodollar bonds that have an 8 percent coupon. The bonds are trading at par and have a duration of five years. The FI wishes to hedge the portfolio with T-bond options that have a delta of −0.625. The underlying long-term Treasury bonds for the option have a duration of 10.1 years and trade at a market value of $96,157 per $100,000 of par value. Each put option has a premium of $3.25 per $100 of face value. A. How many bond put options are necessary to hedge the bond portfolio? N = duration x price / delta x duration2 x market value N = 5 x 1000,000,000 / .625 x 10.1 x 96,157 N = 500,000,000 / 606,991.06 N = 823.74 = 824

B. If interest rates increase 100 basis points, what is the expected gain or loss on the put option hedge? = N x delta x -D2 x B x R / (1 + R) = 824 x -.625 x -10.1 x 96,157 x .01 / (1 + .084) = 4,614,028 C. What is the expected change in market value on the bond portfolio? = -D x P x R / (1 + CR) = -5 x 1000,000,000 x .01 / (1 + .08) = -4,629,629.63 D. What is the total cost of placing the hedge? Total = contracts x total cost 824 x $3,250 = $2,678,000 E. Diagram the payoff possibilities. F. How far must interest rates move before the payoff on the hedge will exactly offset the cost of placing the hedge? = (price/contract x 1 + R) / (delta x D x market value) = (3250 x 1.084) / (.625 x 10.1 x 96,157) = .0058 = .58% G. How far must interest rates move before the gain on the bond portfolio will exactly offset the cost of placing the hedge? = (price/contract x N x 1 + CR) / (-D x P) = (3250 x 824 x 1.08) / (5 x 100,000,000)

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= - .0058 = -.58% H. Summarize the gain, loss, and cost conditions of the hedge on the bond portfolio in terms of changes in interest rates. An interest rate increase of .58% would decrease the value of the portfolio but a gain in the hedge would offset this. An interest rate decrease by -.58% would be a gain in value of the portfolio. Chapter 25 Question 4 An insurance company owns $50 million of floating-rate bonds yielding LIBOR plus 1 percent. These loans are financed with $50 million of fixed-rate guaranteed investment contracts (GICs) costing 10 percent. A bank has $50 million of auto loans with a fixed rate of 14 percent. The loans are financed with $50 million in CDs at a variable rate of LIBOR plus 4 percent. A. What is the risk exposure of the insurance company? The risk to the insurance company is dependent upon the assets on the balance sheet. Any changes in interest rates (increasing or decreasing) will have an effect on this. B. What is the risk exposure of the bank? The risk of the finance company is dependent upon increasing or decreasing interest rates on the liability side of the balance sheet. C. What would be the cash flow goals of each company if they were to enter into a swap arrangement? Finance companies would want to achieve a goal of switching their variable rate payments to fixed rate payments and the insurance company would want to achieve the opposite.

D. Which FI would be the buyer and which FI would be the seller in the swap? In this type of swap, the bank will be making fixed rate payments and therefore would be the buyer and the insurance company that is making the variable-rate payments would be the seller. E. Diagram the direction of the relevant cash flows for the swap arrangement. F. What are reasonable cash flow amounts, or relative interest rates, for each of the payment streams? Reasonable cash flow amounts will be determined by LIBOR, rates, and terms. Keep in mind that these rates can change.

References CFA Institute. (2024). Measuring and managing market risk. 2024 Curriculum Refresher. https://www.cfainstitute.org/en/membership/professional-development/refresher- readings/measuring-managing-market-risk CFI Team. (2016). Mark to market. Corporate Finance Institute. https://corporatefinanceinstitu te.com/resources/valuation/mark-to-market/ Risk Officer. (n.d.). Credit Risk. Risk Officer. https://www.risk-officer.com/Credit_Risk.htm S aunders, A. (2023). Financial Institutions Management: A Risk Management Approach (11th ed.). McGraw-Hill Higher Education (US). https://mbsdirect.vitalsource.com/books/97 81266403361

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