A bank has assets of $ 10 million earning an average yield of 5 percent with a weighted duration of 1.5 years. It has liabilities of $ 9 million paying an average rate of 1.5 percent with a weighted duration of 3.5 years. The bank wants to construct a macrohedge to reduce interest rate risk as much as possible, and plans to trade three-month Eurodollar futures currently trading at 2 percent.
a. Should the bank buy or sell Eurodollar futures?
b. How many futures contracts should the bank trade?
c. If cash interest rates rise an average of 1 percent and the Eurodollar futures rate rises by 1.10 percent, calculate how much the bank’s market value of equity will change and how much the bank would earn or lose on its futures position. Was this a successful hedge?