Question 1:

As a manager of a FI you consider implementing one of the following strategies: to use forward contracts to hedge interest rate risk or to use futures contracts for hedging interest rate risk. Your risk analytic predicts a significant negative shock to interest rates and relatively stable forecast yields. Durations for these strategies are the same.

a) Which strategy would you choose if current yield on bonds is the same as the current level of interest rates? Justify your answer.

b) If initially you can buy or sell as many futures as you want would you choose a different strategy in part a)?

Question 2:

You are developing a strategy to manage interest rate risk of your portfolio using options on a bond.

a) Explain how to use the Black-Scholes model for hedging during the period of crisis.

b) Now you need to consider changes in interest rates that will happen only at year end every year. You do not know if interest rates will go up or down, but it can change only by 1 per cent. Show how to hedge interest rate risks over the two-year period using a 6 per cent 10-year T-bond, which is priced at par, $1000 and call options on 100 thousand $ with a strike price of 105$ and intrinsic value $1000.

c) Using results from part b) compute an option premium if a discount factor is 4 per cent.

Question 3:

Suppose you consider implementing macrohedging with swaps for two different FIs. One financial institution is small, and another institution is big. Discuss how to implement the macrohedging strategies for these FIs.