Module 5 Case Study answers FINC 3370

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Apr 3, 2024

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Module 5: Interest Rate Risk Management, Use of Derivatives Case 50 total points Please give complete answers on concepts. Don’t forget to write your name on the submitted answers. All answers must be HANDWRITTEN and legible and converted into a single file. Upload your completed case to the Case 5 dropbox on d2l. 1) Why would a bond with a yield higher than the coupon rate sell at a discount? Why would a bond with a yield lower than the coupon rate sell at a premium? (5 pts) Ans: If a bond pays the exact rate of interest (return) that an investor requires, it sells for the face value. So if it pays less interest (coupon rate) than investors require (yield) it is worth less than face value and if it pays more interest than investors require it is worth more than face value. 2) What is cross hedging? Why does it reduce a bank’s ability to perfectly hedge against price risk? (5 pts.) Ans: Cross hedging involves using futures contracts for one type of asset (like a T-Bond) to hedge the price risk of another type of asset (like a loan). While both of these are impacted by changing interest rates in the economy, they are not perfectly correlated due to risk, return and maturity differences and therefore would not perfectly hedge price risk. 3) Currently, interest rates in the economy are the lowest they have ever been. Based on this realization, what should banks do as far as their duration gap and funding gap? Support each answer with one explanatory sentence. (5 pts) Ans: If interest rates are expected to rise or stay the same (and not go any lower) than a bank would want to reduce the duration gap (since bigger duration gaps cause bigger decreases in asset values) by getting long-term maturity assets off their balance sheet. They would want to increase their funding gap (since bigger funding gaps cause bigger increases in NII when rates increase) to be in a position to profit when rates eventually go back up. 4) What are the two main types of interest rate risk faced by a bank and how is each measured? How are depository institutions’ balance sheets and income statements affected if rates increase and if they decrease (assume a positive funding GAP and a positive duration GAP)? (10 pts.) Ans: Reinvestment risk is the chance that interest rate decreases will cause periodic cash flows to be reinvested at a lower rate—this is measured by the funding gap. Price risk is the chance that rate increases will cause asset and equity values to go down and is measured by the duration gap. With a positive funding gap the NII on the income statement will go up with a rate increase and down with a rate decrease. With a positive duration gap the asset and equity values on the balance sheet will go down with a rate increase and up with a rate decrease.

5) What advantages are offered by futures hedges that are not provided by GAP management? Explain the differences between a macro hedge and a micro hedge. Which type is more realistic for most institutions? Why? How do accounting and regulatory standards affect hedging strategies? (10 pts) Ans: the advantages of using futures contracts is that the bank doesn’t have to restructure the balance sheet or negatively influence customers to reduce price risk. A macro hedge hedges the entire duration gap (the entire balance sheet) while a micro hedge hedges a specific asset. The macro hedge would be better because it is counteracting the price risk all at once. Accounting standards however provide better treatment for micro hedges by allowing the recording of gains/losses only after the position is closed while the macro hedge must update gains/losses before closing the position. 6) (15 pts) A bond with a yield to maturity of 3% and a coupon rate of 3% has 3 years remaining until maturity. Calculate the duration and the modified duration for this bond assuming annual interest payments and a par value of $1,000. Why is the duration of this bond higher than the 3-year 10% coupon bond yielding 10% we looked at in the notes that had a duration of 2.7 years? If the required market yield on this bond increases to 4%, what approximate per- cent change in the bond price would you have based on the modified duration? Ans: DUR = [(30/1.03) + (2*30/1.03 2 ) + (3*1030/1.03 3 )] / 1000 = 2.91 years Mod DUR = DUR/(1+y*) = 2.91/1.03 = 2.83 This bond has a higher duration because of the lower coupon payment (since the maturity is the same) because a lower coupon payment means more price risk. Approximate %  = -2.83 x 1% = -2.83%

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