QUESTION 4:

a. In 3 months you expect to buy $1 million of 90-day Treasury Bills (T.B.). Should you hedge if interest rates are expected to rise)? Explain. Current 90-day T.B. are selling at a discount yield of 8.2 and the current F.T.B. (90 day) due in 3 months has a discount yield of 8.68. Assume you hedge at the current F.T.B. discount yield, expecting to lock in this rate (unbiased expectations). If you end the hedge early in 2 months what would be the net effective purchase price if the spot 90-day T.B. discount yield is 10.2 and the F.T.B. (90-day) discount yield is 10.68? What is the $ hedging error? Explain your results.

b. Calculate the hedging error and the net effective purchase price in (a) if the spot 90-day T.B. dy is 7% and the F.T.B. (90-day) dy is 7% when you end the hedge in three months. Explain your results and compare them to your answer in (a).

c. Repeat part (a) but change the expected investment in April to be 90 day commercial paper (C.P.) instead of T.B.s. Current 90 day C.P. trades at 10.2% dy. This 2% premium over T.B.s represents the typical risk premium (for C.P. with respect to T.B.) you expect over the life of the hedge. Since there is no future C.P. market, you hedge with the same F.T.B. as in (a). What C.P. rate should you expect to lock in (assume unbiased expectations)? Calculate the hedge error and N.E.P.P. in 2 months if the 90 day C.P. dy is 9.69% and the (90 day) F.T.B. dy is 7.46%?