Your company president is concerned about the effect of interest-rate changes on rate sensitive assets and liabilities.

You have presented an analysis of both the income and the duration gap of the firm and how this would result in changes in the market value of the bank's net worth. This presentation made it clear that the bank needs to hedge against an adverse change in the market value of net worth. Based on economic forecasts, it is most likely that interest rates will rise in the next six months.

As a result of the excellent work you presented to management regarding gap analysis, you have been called on again to present alternatives that will manage this inherent risk. You see this as a way to learn more about the key management concerns of banks and to hone a fine presentation. However, you are not sure about these "hedging" concepts, so you seek out professionals in the area and begin to focus entirely on how these tools work.

Your professional "coach" in this area is Mr. B. Smart. He has worked for many years setting up and managing hedging strategies. You are not intimidated by his experience, but you are interested in making a good first impression. With this in mind, you make a glossary for basic hedging methods, including forward contracts, interest-rate forward contracts, long position, short position, hedge, financial futures contract, arbitrage, micro hedge, macro hedge, cross hedge, hedge ratio, basis risk, stock market risk, and portfolio insurance.

Bob has asked you to bring your bank's current list of assets and liabilities to the study session to use in setting up both a micro and a macro hedge. A summary of your bank's position is as follows:

Total assets: $150 million

Duration gap: 2.20 years

Primary holdings of concern: $7 million in 6% Canada bonds selling at par that will mature in 5 years

$12 million in stocks with an average beta of 0.90

Your assignment after the first study session is to set up a micro hedge for the Canada bonds that will help the bank offset the adverse effect of interest-rate increases on the bonds being held and to set up a macro hedge that will minimize any negative effect on the market value of net worth when interest rates rise.

You gather information from the most recent financial press regarding Canada bond contracts with a maturity of about one year. Historical relationships between Canada bond futures contracts and Canada bonds indicate that the change in the value of the hedged asset relative to the futures contract would be about 1.3 and that interest rates on the hedged asset change on average for a given change in the interest rate on the futures contract by about 0.90. A 1% increase in interest rates results in a decline in value for Canada bonds of 8% of par.

11. Explain how the bank would make use of futures contracts to hedge foreign exchange rate risk if they anticipate a decrease in the value of the dollar relative to a foreign currency over the next six months.