1. A corporate financial manager for XYZ, Inc. is charged with investing the “cash” assets of the firm in riskless short-term government debt. The manager prefers 90-day (3-month) Eurodollar deposits because of their liquidity; however, at the moment she is worried that the 3-month rates which she can achieve 3 months from now will be less than she had an- ticipated. Therefore, she is contemplating hedging against a decline in rates.

   Below are quotes on Eurodollar spot rates at various maturities.

Quote

98.17 98.15 98.08 97.70

Maturity

90 days 180 days 270 days 360 days

1

1. (a) Calculate the relevant futures price (per $100 of face) and forward rate which the manager should be able to “lock in” in an equilibrium market. Show your work.

2. (b) Which side of the futures market should the manager take if she wishes to use this market to hedge against interest rates declining? Explain your answer.

3. (c) The current (i.e., what the manager believes she can execute at) market futures prices at various contract expiration dates of the three month Eurodollar futures contract are given below.

   Expiration

   90 days 180 days 270 days

   Given these data, how should the manager hedge (i.e., should she use the futures market, or should she use some other hedging method)? Show your work and be specific about all the transactions which the manager should execute today. Rather than this, what is an alternative hedging mechanism?

3. Assume the existence of a financial asset whose current (spot) price is St. This asset pays no dividends. A forward contract on this asset exists, with expiration at date T. The price of this forward contract today is Ft. The price of the spot asset (and therefore the forward contract) at expiration can be written as ST .

   1. (a) If I “buy” one forward contract today, what is the payoff on the forward contract at date T?

   2. (b) Write down the discounted value of the components of the payoff in part a. Set this discounted value equal to the amount of money which changes hands at the purchase of a forward contract, and solve for the forward price.

   3. (c) Examine your answer to part b. Is there any relation between dis- counted cash flow analysis and derivative pricing?