Bay Street BankCorp Case Study

1. Identify the cash market risk exposure facing BSB in each particular phase of the minority lending project.

2. If BSB decides to hedge its market risk exposure in each phase of the minority lending project, what is the appropriatedirection of the hedge (i.e., long or short position in the futures market) for each component of the project? How will the hedge position immunize the bank from loss if market interest rise or fall? 3. Given the three separate phases of the minority lending project and the information shown in Table 1, what is the best futures contract (i.e., the Treasury bond future, the Treasury bill future, or the Eurodollar future) that BSB should use to hedge interest rate risk related to each phase of the project? 4. Given the magnitude of BSB's exposure to interest rate risk in the cash market at each phase of the minority lending project, what is the appropriate number of futures contracts the bank should buy or sell in order to immunize its exposure to interest rate risk? 5. Suppose interest rates increase over the course of the next year, so that one year from today the one-year rate on bank certificates of deposit stands at 5.5 percent, the yield on FNMA securities is 8 percent, and the yield on one-year Treasury bills is 5.6 percent. Given this increase in interest rates, the prices of the financial futures contracts described in Table 1 are: Treasury bond futures contract 119-24 Treasury bill futures contract 94.63 Eurodollar futures contract 93.05 Given this interest rate scenario one year from today, what is BSB's net gain or loss on each of the three components of its minority leading program? 6. Refer once again to your answer in Question 5. Did the bank's immunization strategy depend upon market interest rates rising over the course of the coming year, or is the bank's profit position protected from both increases and decreases in the level of market interest rates? Explain your answer by demonstrating the bank's net gain or loss on each of the three components of its minority lending program, assuming the market interest rates fall over the course of the coming year. In this case, assume that the following interest rates and futures contract prices are observed one year from today, and recalculate BSB's net gain or loss on each component of the minority lending program: One-year Treasury security spot rate 4.3% One-year bank certificate of deposit rate 4.0% FNMA yield 5.5% Treasury bond futures contract price 124-03 Treasury bill futures contract price 95.93 Eurodollar futures contract price 97.91

7. The case mentions that BSB seeks to eliminate its exposure to risk by buying and/or selling financial futures contracts. In using these derivative financial securities, does the bank eliminate all of its exposure to risk, or just a portion of the total risk the firm faces? Does the introduction of financial futures within the bank create any additional risks for management to consider? If so, identify and explain these risks. 8. Examine the heding strategy you developed for BSB in Question 2 through 4. Does this particular strategy represent a static or dynamic hedge? Given your answer to this question, comment on the risk that BSB faces in executing this strategy, and describe how the bank's heding technique might be improved to immunize the bank more effectively against changes in the the level of market interest rates.

Bay Street Bankcorp Hedging Interest Rate Risk with Financial Futures Michael Wang, president of Bay Street Bankcorp, peered anxiously at the thick envelope sitting on his desk from the Federal National Mortgage Association. Michael realized the envelope contained Fannie Mae's response to his request that the agency invest $5 million in the fledgling bank over the next year to expand BSB's highly successful and innovative minority lending program. Taking a deep breath, Michael quickly tore open the envelope and scanned the cover letter. He read no further than the second paragraph to learn that the FNMA had approved his funding request. BSB would become only the seventh bank in the United States to receive equity capital from Fannie Mae; the bank now stood on the verge of an ambitious and innovative expansion plan. The plan was full of risks. But Michael, and now Fannie Mae, felt it was the right thing to do. Bay Street Bankcorp was chartered in 1991 and opened for business in a large, south western city with a substantial population of Asian, Hispanic, and African American resi dents. In a hotly competitive banking market, BSB grew quickly and confidently by offering a unique product mix tailored to the needs of first-generation Asian immigrants. The majority of the bank's common stock was owned by Taiwanese immigrants, and BSB's management team understood its basic business strategy well. As the bank gained experience in minority lending to small Vietnamese, Chinese, and Taiwanese entrepreneurs, it started to reach out in the community to other minority groups. BSB opened a second office in 1993 in the barrio to serve the needs of the Hispanic com munity, and now planned a third office in the inner city to gain entry into the African Amer ican community. Over the course of its brief history, BSB succeeded by doing the little things that the mega-banks in town neglected. The bank's main office manager was an American-born de scendent of first-generation Chinese immigrants who was fluent in both Chinese and Viet oN 'T'"ho "h<>nlr'c NmntPr litPr:>tnrP Wll lllWliV<: l!Vllilahle in four different .. '""""'l.. ' i Case 2 Bay Street Bankcorp 795 More important, however, BSB understood the financial needs of its minority cus tomers better than any bank in town. The tiny bank aggressively extended business and mortgage credit to newly arrived immigrants who had virtually no credit references. BSB understood that immigrants lacked credit histories because they had limited access to fi nancial institutions in their home countries-not because they were poor credit risks. In fact, many first-generation immigrants arrived in the United States with large amounts of cash provided by extended family members and saved over many years abroad. The fam ily nest egg represented a down payment on the American dream for the immigrant family, and the opportunity to gain economic freedom in America. Unfortunately, the larger, well-established banks in town rejected many business loan applications from immigrant families because there was no established credit history avail able from these potential borrowers. Adept at understanding immigrant culture, BSB toq)c. the time to assess the character of its customers in other ways, and approved many loan ts competitors rejected. The bank quickly acquired a reputation among Asian and later His panic immigrants, and BSB grew rapidly in the shadows of the big, chrome-and-glass of fice towers in the central business district. By 1996, the bank's asset base had reached $150 million, and its penetration of the Asian and Hispanic markets was almost complete. Recognizing that the bank's unique ap proach in marketing financial services across various minority groups could be extended to the African American community, the bank proposed the establishment of a third branch of fice in the inner city. At the same time, BSB developed an aggressive, $30 million lending plan offering long-term, fixed-rate mortgage financing to black-owned business ventures. The plan would be financed by an innovative savings deposit program, attracting immi grants' savings by offering one-year certificates of deposit at 50 basis points above pre vailing market rates to qualifying families. BSB sought to raise $25 million from this program over the course of the year, and in combination with the bank's $5 million infu sion of equity capital, BSB could fund its $30 million minority loan program over the course of the next year. The plan looked excellent on paper. BSB was an SBA Preferred Lender, which meant the bank could originate SEA-guaranteed loans without the prior approval of SBA loan of ficers. The bank was also rated in the "outstanding" category under the Community Rein vestment Act, providing testimony to its exemplary record in minority lending within the local community. Finally, the bank was profitable, posting a respectable profit of $1.25 mil lion against an asset base approaching $150 million. On the downside, however, BSB was still a young, and very small, financial institution operating in a large and competitive marketplace. The institution was adequately capital ized with sufficient reserves for future credit losses, but Michael Wang understood that a few unexpected charge-offs might destroy the bank-and the businesses of its customers. Standing on the verge of a 20 percent expansion plan targeted to occur in only a year's time, Michael was clearly nervous. The bank had little room for error if the intended ex pansion was to succeed. At the same time, the community depended on the bank to provide innovative and flexible loans where other banks simply refused to tread. There must be a way, Michael thought to himself, to contain the plan's risks and give it the best possible chance for success. Michael realized that an unexpected change in market interest rates, coupled with the proposed commercial mortgage loan program, could destroy the projected profitability of the program. The bank's forecast called for stable interest rates over the next 12 months, and because of the small average size and unique features associated with individual credits to minority borrowers, securitizing the new commercial loans was out of the question. Each 796 Cases loan must be priced correctly for the bank to earn a profit. At the same time, each loan must carry a reasonable cost to give fledgling entrepreneurs the greatest opportunity to succeed. It was a delicate balancing act, and Michael needed a novel way to tip the scales in BSB's favor. Remembering an article herecently read in the financial press, he began to wonder if the bank might limit its risk exposure by using financial futures contracts. At first, the very thought of buying and selling derivative financial instruments was appalling; after all, derivatives had received so much negative publicity that Michael rejected them out-of-hand for BSB. Now, however, he was forced to rethink his position. The bank des- Table 1 Selected Interest Rate and Price Data Annualized Yields Futures Contract Prices I Treasurl Treasury Eurod r Date Bank CDs1 FNMA Yield2 Bonds Bills4 Depo its5 July? 5.28% 7.69% 115-01 94.01 94.60 July 14 5.19 7.54 114-15 94.96 94.53 July 21 5.22 8.00 110-23 94.73 94.28 July 28 5.24 7.96 110-30 94.78 94.32 August 4 5.24 7.98 109-31 94.71 94.24 August 11 5.24 7.97 109-21 94.75 94.26 August 18 5.25 8.07 109-19 94.57 94.07 August 25 5.23 8.03 110-24 94.72 94.22 September 1 5.24 7.82 112-24 94.81 94.28 September 8 5.20 7.67 113-10 94.82 94.27 September 15 5.19 7.60 114-24 94.94 94.40 September 22 5.14 7.74 113-10 94.86 94.29 September 29 5.21 7.82 112-31 94.72 94.17 October 6 5.23 7.64 115-00 94.89 94.24 October 13 5.29 7.65 115-23 94.89 94.23 October 20 5.24 7.58 116-31 94.93 94.35 October 27 5.28 7.62 115-30 94.99 94.37 November3 5.23 7.48 117-25 95.08 94.47 November 10 5.20 7.53 117-09 95.06 94.44 November 17 5.20 7.52 117-00 95.05 94.57 November 24 5.16 7.58 117-04 95.01 94.61 December 1 5.18 7.37 119-05 95.10 94.68 December 8 5.05 7.37 120-00 95.07 94.65 December 15 5.11 7.29 119-29 95.00 94.58 December 22 5.04 7.30 118-30 95.04 94.62 December29 5.04 7.21 121-04 95.13 94.66 Note: 1Annualized yields on commercial certificates of deposit represent primary new issues of 1-year negotiable CDs at rna- jar New York banks on deposits of $100,000 or more. 2 FNMA yields represent posted yields on 30-year mortgage commitments (priced at par) for delivery in 30 days to the Federal National Mortgage Association. 3Treasury bond futures prices are quoted in 1132 increments of par. Thus, 115-01 represents a price of 115 and 1/32 per- cent of par value. Contract yields are standardized using a 15-year, $100,000 par value, 8 percent coupon bond. Each futures contract represents $100,000 in face value securities. 4Treasury bill futures prices are quoted at a discount from face value in increments of 1!1ooth of 1 percent. Thus, 94.01 ronroC!ontc: nril"'o "f O.d. gnrf l/1nn nc.ri"'Ant nf fgra \/!:1\tt,::::lo r.nntr M \/iAirl rA t nrl:::trrli7Arlttsinn A 1-VP.Rr !t1 million f;qr:P. QUESTIONS Case 2 Bay Street Bankcorp 797 perately needed a tool to contain its interest rate risk. Flipping to the third section in The Wall Street Journal, Michael scanned prices of three popular, and widely traded, futures in struments that would be easy for BSB to acquire and understand: the Treasury bond futures contract traded on the Chicago Board of Trade, the Treasury bill future traded on the Chicago Mercantile Exchange, and the Eurodollar future traded on the Chicago Mercantile Exchange. Michael decided the time was right for a little research project. Scanning a few weeks of futures prices on the three instruments noted above, he compiled the information shown in Table 1. These futures contract price quotes represented contracts with an expiration date one year from the date of each published price. Given the bank's limited experience with hedging risk in the financial futures market, Michael decided to limit his hedging activity to this time frame. The minority lending project would involve three separate components over the c se of the coming year. First, BSB would receive $5 million in cash from Fannie Mae to cover the agency's equity investment in the bank. While these funds would eventually be invested in the minority loan program, the bank planned to invest the money temporarily in Treasury bills. Second, the bank would issue $25 million in new certificates of deposit within the next six months. Finally, the bank would originate $30 million in new commercial mort gage loans before the end of the 1996 fiscal year to complete the program. At the time of his analysis, the spot rate on one-year Treasury securities was 5.10 per cent, the spot rate on one-year bank certificates of deposit was 5.04 percent, and the bank's price for fixed-rate commercial mortgage loans was 7.21 percent. Michael used these rates in forecasting the profitability of the minority loan program over the course of the 1996 fis cal year, but he realized that BSB faced some sort of risk if market interest rates shifted from their current position. Scanning the numbers shown in Table 1, Michael set out to de termine just how these financial futures contracts might limit the bank's exposure to this risk, increasing the minority loan program's chances for success