1.A Japanese bank expects to lend 10 million to a Spanish firm. If negotiations are successful, the loan will be made one month from today. The terms of the loan have already been established: the Spanish firm is to pay a fixed rate of 5%; the term of the loan will be one year; interest and principal, in euros, will be repaid to the bank one year after the loan is made. The Japanese bank is interested in maximizing its yen-denominated wealth of its shareholders.

a. Clearly discuss the nature of the interest rate risk the Japanese bank faces.

b. Clearly state how the Japanese bank can use forward rate agreements to manage the interest rate risk it faces. Explain how the FRA will reduce the interest rate risk faced by the bank. Be as precise and thorough as you can, given the information provided.

c. Should the bank desire that the contract rate on the FRA be above or below 5%? Why?

For the next two questions, assume the bank enters an FRA to borrow in yen at a fixed rate:

d. Clearly discuss the nature of the foreign exchange rate risks the bank will face after the loan is actually made.

e. Given your response in part d, clearly state how the bank can use forward exchange contracts to manage the exchange rate risk it will face after the loan is actually made. Again, be as precise and thorough as you can, given the information provided. Explain how the forward exchange contract will reduce the exchange rate risk faced by the bank?

2.Your firm plans on issuing 10,000 pure discount (no-coupon) notes with two years to maturity. Each note has a face value of $1000. The current yield to maturity on two-year notes like these is 10% per annum. You believe that if the Eurodollar futures yield changes by 10 basis points, the change in the required rate of return (yield to maturity) on the notes will be 7 basis points. The mark-to-market cash flow is $25/basis point for Eurodollar futures, which means the gain or loss on one Eurodollar futures contract for one-basis-point interest rate movement is $25.

Use the principles of dollar equivalency method to compute the proper number of Eurodollar futures contracts to trade in order to hedge the planned issuance of the notes. Will you buy or sell futures contracts?