INTEGRATED MINI CASE

HEDGING INTEREST RATE RISK WITH FUTURES VERSUS OPTIONS VERSUS SWAPS

On January 4, 2015, an FI has the following balance sheet (rates 8 percent):

Assets

Liabilities/Equity

Assets

$450m

Liabilities

$396m

Asset duration

8 years

Liabilities duration

4 years

Equity

$54m

DGAP=[8-(396/450)4]=4.48 years > 0

The FI manager thinks rates will increase by 0.55 percent in the next three months. If this happens, the equity value will change by:

E = [8-(396/450m)(4)]450m (0.0055/1.08)=-$10,266,667

The FI manager will hedge this interest rate risk with either futures contracts, option contracts, or swap contracts.

If the FI uses futures, it will select June T-bonds to hedge. The duration on the T-bonds underlying the contract is 14.5 years, and the T-bond futures are selling at a price of $110,531.25 per $100, or $110,531.25. T-bond futures rates, currently 5 percent, are expected to increase by 0.75 percent over the next three months.

If the FI uses options, it will buy puts on 15-year T-bonds futures with a June maturity, an exercise price of 109, and an option premium of 36/64 percent. The spot price on the T-bond underlying the option is $115.78125 per $100 of face value. The duration on the T-bonds underlying the options is 14.5 years, and the delta of the put options is 0.85. Managers expect these T-bond rates to increase by 0.7 percent from 5.25 percent in the next three months.

If the FI uses swaps, a swap agent offers a swap involving D Fixed 8 years (based on the 15-year Treasury bond rate) and D Floating 1 year (based on Treasury bills).

If by April 4, 2015, balance sheet rates increase by 0.5 percent, futures rates by 0.7 percent and T-bond rates underlying the option contracts by 0.66 percent calculate the on- and off-balance sheet cash flows to the FI when using futures contracts, option contracts, and swap contracts as its hedge instrument.

If by April 4, 2015, balance sheet rates actually fall by 0.25 percent, futures rates fall by 0.35 percent, and T-bond rates underlying the option contract fall by 0.34 percent, calculate the on- and off-balance-sheet cash flows to the FI when using futures contracts, option contracts, and swap contracts as its hedge instrument.