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Financial Institutions Management A Risk Management Approach 6th Edition Anthony Saunders, Marcia Cornett - Solutions
1. What type of opportunities or obligations does the manager have?
1. In what direction must interest rates move to encourage the call buyer to exercise the option?
1. What is the delta of an option ( )?
1. 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
1. How many bond put options are necessary to hedge the bond portfolio?
1. If interest rates increase 100 basis points, what is the expected gain or loss on the put option hedge?
1. What is the expected change in market value on the bond portfolio?
1. What is the total cost of placing the hedge?
1. Diagram the payoff possibilities.
1. How far must interest rates move before the payoff on the hedge will exactly offset the cost of placing the hedge?
1. How far must interest rates move before the gain on the bond portfolio will exactly offset the cost of placing the hedge?
1. Summarize the gain, loss, and cost conditions of the hedge on the bond portfolio in terms of changes in interest rates.
1. Corporate Bank has $840 million of assets with a duration of 12 years and liabilities worth $720 million with a duration of seven years. Assets and liabilities are yielding 7.56 percent. The bank is concerned about preserving the value of its equity in the event of an increase in interest rates
1. What type of option should Corporate Bank use for the macrohedge?
1. How many options should be purchased?
1. What is the effect on the economic value of the equity if interest rates rise 50 basis points?
1. What will be the effect on the hedge if interest rates rise 50 basis points?
1. What will be the cost of the hedge if each option has a premium of $0.875?
1. Diagram the economic conditions of the hedge.
1. How much must interest rates move against the hedge for the increased value of the bank to offset the cost of the hedge?
1. How much must interest rates move in favor of the hedge, or against the balance sheet, before the payoff from the hedge will exactly cover the cost of the hedge?
1. Formulate a management decision rule regarding the implementation of the hedge.
1. An FI has a $200 million asset portfolio that has an average duration of 6.5 years. The average duration of its $160 million in liabilities is 4.5 years. Assets and liabilities are yielding 10 percent. The FI uses put options on T-bonds to hedge against unexpected interest rate increases. The
1. What is the modified duration of the T-bonds if the current level of interest rates is 10 percent?
1. How many put option contracts should the FI purchase to hedge its exposure against rising interest rates? The face value of the T-bonds is $100,000.
1. If interest rates increase 50 basis points, what will be the change in value of the equity of the FI?
1. What will be the change in value of the T-bond option hedge position?
1. If put options on T-bonds are selling at a premium of $1.25 per face value of$100, what is the total cost of hedging using options on T-bonds?
1. Diagram the spot market conditions of the equity and the option hedge.
1. What must be the change in interest rates before the change in value of the balance sheet (equity) will offset the cost of placing the hedge?
1. How much must interest rates change before the profit on the hedge will exactly cover the cost of placing the hedge?
1. Given your answer in part (g), what will be the net gain or loss to the FI?
1. A mutual fund plans to purchase $10 million of 20-year T-bonds in two months. The bonds are yielding 7.68 percent. These bonds have a duration of 11 years. The mutual fund is concerned about interest rates changing over the next four months and is considering a hedge with a two-month option on a
1. What type of option should the mutual fund purchase?
1. How many options should it purchase?
1. What is the cost of those options?
1. If rates change / 50 basis points, what will be the impact on the price of the desired T-bonds?
1. What will be the effect on the value of the hedge if rates change / 50 basis points?
1. Diagram the effects of the hedge and the spot market value of the desired T-bonds.
1. What must be the change in interest rates to cause the change in value of the purchased T-bonds to exactly offset the cost of placing the hedge?
1. An FI must make a single payment of 500,000 Swiss francs in six months at the maturity of a CD. The FI’s in-house analyst expects the spot price of the franc to remain stable at the current $0.80/Sf. But as a precaution, the analyst is concerned that it could rise as high as $0.85/Sf or fall
1. Should the analysts be worried about the dollar depreciating or appreciating?
1. If the FI decides to hedge using options, should the FI buy put or call options to hedge the CD payment? Why?
1. If futures are used to hedge, should the FI buy or sell Swiss franc futures to hedge the payment? Why?
1. What will be the net payment on the CD if the selected call or put options are used to hedge the payment? Assume the following three scenarios: the spot price in six months will be $0.75, $0.80, or $0.85/Sf. Also assume that the options will be exercised.
1. What will be the net payment if futures had been used to hedge the CD payment? Use the same three scenarios as in part (d).Which method of hedging is preferable after the fact?
1. An American insurance company issued $10 million of one-year, zero-coupon GICs (guaranteed investment contracts) denominated in Swiss francs at a rate of 5 percent. The insurance company holds no Sf-denominated assets and has neither bought nor sold francs in the foreign exchange market.
1. What is the insurance company’s net exposure in Swiss francs?
1. What is the insurance company’s risk exposure to foreign exchange rate fluctuations?
1. How can the insurance company use futures to hedge the risk exposure in part (b)? How can it use options to hedge?
1. If the strike price on Sf options is $0.6667/Sf and the spot exchange rate is$0.6452/Sf, what is the intrinsic value (on expiration) of a call option on Swiss francs? What is the intrinsic value (on expiration) of a Swiss franc put option? ( Note: Swiss franc futures options traded on the
1. If the June delivery call option premium is 0.32 cent per franc and the June delivery put option is 10.7 cents per franc, what is the dollar premium cost per contract? Assume that today’s date is April 15.
1. Why is the call option premium lower than the put option premium?
1. An FI has made a loan commitment of Sf10 million that is likely to be taken down in six months. The current spot exchange rate is $0.60/Sf.Is the FI exposed to the dollar depreciating or the dollar appreciating?Why?
1. If it decides to hedge using Sf futures, should it buy or sell Sf futures?
1. If the spot rate six months from today is $0.64/Sf, what dollar amount is needed in six months if the loan is drawn?
1. A six-month Sf futures contract is available for $0.61/Sf. What is the net amount needed at the end of six months if the FI has hedged using the Sf10 million of futures contracts? Assume that futures prices are equal to spot prices at the time of payment, that is, at maturity.
1. If the FI decides to use options to hedge, should it purchase call or put options?
1. Call and put options with an exercise price of $0.61/Sf are selling for $0.02 and $0.03 per Sf, respectively. What would be the net amount needed by the FI at the end of six months if it had used options instead of futures to hedge this exposure?
1. What is a credit spread call option?
1. What is a digital default option?
1. Use the following information to price a three-year collar by purchasing an out-of-the-money cap and writing an in-the-money floor. Assume a binomial options pricing model with an equal probability of interest rates increasing 2 percent or decreasing 2 percent per year. Current rates are 4
1. An FI has purchased a $200 million cap (i.e., call options on interest rates) of 9 percent at a premium of 0.65 percent of face value. A$200 million floor (i.e., put options on interest rates) of 4 percent is also available at a premium of 0.69 percent of face value.If interest rates rise to 10
1. What amount of floors should the FI sell to compensate for its purchase of caps, given the above premiums?
1. Go to the Chicago Board Options Exchange Web site at www.cboe.com. Find the most recent data on 10-Year Treasury yield options (TNX) by clicking on “CBOE Daily Market Statistics” under “Data.” Clicking on the current date on the calendar at the top of the page will allow the user to
1. In Example 25–2, which of the two FIs has its liability costs fully hedged and which is only partially hedged? Explain your answer.
1. What are some nonstandard terms that might be encountered in an off-market swap?
1. In Example 25–3, what is the notional size of swap contracts if Dfixed 5 and swap contracts require payment every six months? ( N s $51,111,111)
1. Referring to Table 25–8 , suppose that the U.S. FI had agreed to make floating payments of LIBOR 1 percent instead of LIBOR 2 percent. What would its net payment have been to the U.K. FI over the four-year swap agreement?
1. Are swaps as risky as equivalent-sized loans?
1. Explain the similarity between a swap and a forward contract.Forwards, futures, and options contracts had been used by FIs to hedge risk for many years before swaps were invented. If FIs already had these hedging instruments, why did they need swaps?
1. 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 finance company has$50 million of auto loans with a fixed rate of 14 percent. The
1. What is the risk exposure of the insurance company?
1. What is the risk exposure of the finance company?
1. What would be the cash flow goals of each company if they were to enter into a swap arrangement?
1. Which FI would be the buyer and which FI would be the seller in the swap?
1. Diagram the direction of the relevant cash flows for the swap arrangement.
1. What are reasonable cash flow amounts, or relative interest rates, for each of the payment streams?
1. In a swap arrangement, the variable-rate swap cash flow streams often do not fully hedge the variable-rate cash flow streams from the balance sheet due to basis risk.
1. What are the possible sources of basis risk in an interest rate swap?
1. How could the failure to achieve a perfect hedge be realized by the swap buyer?
1. How could the failure to achieve a perfect hedge be realized by the swap seller?
1. A commercial bank has $200 million of floating-rate loans yielding the T-bill rate plus 2 percent. These loans are financed with $200 million of fixed-rate deposits costing 9 percent. A savings bank has $200 million of mortgages with a fixed rate of 13 percent. They are financed with $200
1. Discuss the type of interest rate risk each FI faces.
1. Propose a swap that would result in each FI having the same type of asset and liability cash flows.
1. Show that this swap would be acceptable to both parties.
1. What are some of the practical difficulties in arranging this swap?
1. Bank 1 can issue five-year CDs at an annual rate of 11 percent fixed or at a variable rate of LIBOR plus 2 percent. Bank 2 can issue five-year CDs at an annual rate of 13 percent fixed or at a variable rate of LIBOR plus 3 percent.
1. Is a mutually beneficial swap possible between the two banks?
1. Where is the comparative advantage of the two banks?
1. What is the quality spread in the fixed versus variable interest rates for the two FIs?
1. What is an example of a feasible swap?
1. First Bank can issue one-year floating-rate CDs at prime plus 1 percent or fixed-rate CDs at 12.5 percent. Second Bank can issue one-year floating-rate CDs at prime plus 0.5 percent or fixed-rate CDs at 11.0 percent.
1. What is a feasible swap with all the benefits going to First Bank?
1. What is a feasible swap with all the benefits going to Second Bank?Diagram each situation.
1. What factors will determine the final swap arrangement?
1. Two multinational FIs enter their respective debt markets to issue $100 million of two-year notes. FI A can borrow at a fixed annual rate of 11 percent or a floating rate of LIBOR plus 50 basis points, repriced at the end of the year. FI B can borrow at a fixed annual rate of 10 percent or a
1. If FI A is a positive duration gap insurance company and FI B is a money market mutual fund, in what market(s) should each firm borrow to reduce its interest rate risk exposure?
1. In which debt market does FI A have a comparative advantage over FI B?Although FI A is riskier than FI B and therefore must pay a higher rate in both the fixed-rate and floating-rate markets, there are possible gains to trade. Set up a swap to exploit FI A’s comparative advantage over FI
1. The gains from the swap can be apportioned between FI A and FI B through negotiation. What terms of swap would give all the gains to FI A? What terms of swap would give all the gains to FI B?
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