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Question 8.P.13: A bank is considering the use of options to deal with a seri...

A bank is considering the use of options to deal with a serious funding cost problem. Deposit interest rates have been rising for six months, currently averaging 5 percent, and are expected to climb as high as 6.75 percent over the next 90 days. The bank plans to issue $60 million in new money market deposits in about 90 days. It can buy put or call options on 90 day Eurodollar time deposit futures contracts for a quoted premium of 31.00 or $775.00 for each million-dollar contract. The strike price is quoted as 950,000. We expect the futures to trade at an index of 935,000 within 90 days. What kind of option should the bank buy? What before tax profit could the bank earn for each option under the terms described?

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You are trying to protect the bank against rising interest rates, thus you want to buy a put option.

 

Profit on put: payout from settlement = (950,000-935,000) 15,000 basis points x $25 = $375,000

 

Net profit: $375,000 – $775 = $374,225

 

If the bank bought the call option, the value at settlement would be $0 and the bank would loose the call premium of $775.

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