1. The treasurer of a small bank has borrowed funds for 2 months at an interest rate of 0.6% and has lent funds for 6 months at 2%. The treasurer borrowed and lent 2 million dollars in t₀.

a. Represent the exposure on cash flow diagrams. Be specific on the size of the cash flows in each period.

b. To cover his exposure created by the mismatch of maturities, the dealer signs a forward loan. Calculate this treasurers break-even forward rate on interest, assuming no other costs. How much would he need to borrow forward? How much would he need to pay in t₂ at the break-even rate?

c. Assume that instead, the treasurer decides to wait 1 month and take a spot loan then. To cover his exposure, the treasurer signs a 2x6 FRA. (i) Use cash flow diagrams to show how this achieves his goal. (ii) What is the settlement amount in the FRA if the forward rate is 1.95%, the Libor rate on settlement date is 1.5%? (iii) Now that you know the Libor rate, use it to determine the exact outflows and inflows in t₂.

Calculate the total profits of the small bank after covering the mismatch.