Jacob Bower has a liability that: has a principal balance of $100 million on June 30, 1998, accrues interest quarterly starting on June

Jacob Bower has a liability that:

• has a principal balance of $100 million on June 30, 1998,

• accrues interest quarterly starting on June 30, 1998,

• pays interest quarterly,

• has a one-year term to maturity, and

• calculates interest due based on 90-day LIBOR (the London Interbank Offered Rate).

Bower wishes to hedge his remaining interest payments against changes in interest rates. Bower has correctly calculated that he needs to sell (short) 300 Eurodollar futures contracts to accomplish the hedge. He is considering the alternative hedging strategies outlined in the following table.

a. Explain why strategy B is a more effective hedge than strategy A when the yield curve undergoes an instantaneous nonparallel shift.
b. Discuss an interest rate scenario in which strategy A would be superior to strategyB.

Initial Position (6/30/98) in 90-Day LIBOR Eurodollar Contracts Contract Month Strategy A (contracts) Strategy B (contracts) 100 100 100 300 September 1998 December 1998 March 1999