Question
ABC Bank has assets of 550 million with a duration of 6 years, Liabilities of 500 million with a duration 4 years. Interest rates are
ABC Bank has assets of 550 million with a duration of 6 years, Liabilities of 500 million with a duration 4 years. Interest rates are expected to rise from 10 to 12 percent over the next six months.
1) Calculate the potential loss to ABCs net worth if the forecast of rising rates proves to be true.
2) Suppose the manager of ABC Bank wants to hedge this interest rate risk with T-bond futures contracts. The current futures price quote is 132.03125 per 100 of face value for the benchmark 19-year. The duration of the deliverable bond is 15.5 years. How many futures contracts will be needed? Should the manager buy or sell these contracts? Assume no basis risk. Verify that selling T-bond futures contracts will indeed hedge the FI against a sudden increase in interest rates from 10 to 12 percent, a 2 percent interest rate shock.
3) If the bank had hedged with Eurodollar futures contracts that had a market value of $98 per $100 of face value and a duration of 0.45, how many futures contracts would have been necessary to hedge fully the balance sheet?
4) How would your answer for part (3) change if the relationship of the price sensitivity of futures contracts to the price sensitivity of underlying bonds were br = 1.35?
5) Verify that selling T-bond futures contracts will indeed hedge the FI against a sudden increase in interest rates from 10 to 12 percent, a 2 percent interest rate shock. Assume the yield on the T-bond underlying the futures contract is 9.45 percent as the bank enters the hedge, and rates rise by 2.3 percent and a br of 1.35
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