Consider a financial institution (FI) with the following balance sheet structure. Assets Liabilities 10-year deep discount bond 1,000,000 Equity 300,000 6-year deep discount bond 700,000 The current level of interest rates is 5% and analysts have forecasted an increase in interest rates by 100bp over the next 12 months. The duration of a deliverable bond in the futures market is 7 years, while the price per contract is 95,000. Assuming that the management has decided to use the futures market to hedge its interest rate risk exposure, answer the following: b)Under what balance sheet structure do FIs sell or buy interest rate futures? Explain c) Under what interest rate environment and balance sheet structure do FI use caps and floors to hedge their interest rate exposure? d) Consider a 8% cap and a 3% floor with premium 0.5% and maturity one year. Construct a strategy to hedge a $2m IRR exposure while minimizing the cost of hedging. What is this strategy called?

e) if interest rated by the end of the year rise to 10% what is the net payoff? what if rated fall to 2%? Draw the strategy net payoff graph for the full range of IR values