Question 8.P.3: What kind of futures or options hedges would be called for i...

a. Market interest rates are expected to increase and your financial firm’s asset-liability managers expect to liquidate a portion of their bond portfolio to meet customers’ demands for funds in the upcoming quarter.

Financial firm can expect a lower price when they sell their bond portfolio unless it uses short futures hedges in which contracts for government securities are first sold and then purchased at a profit as security prices fall provided interest rate really do rise as expected. A similar gain could be made using put options on government securities or on financial futures contracts.

b. Your financial firm has interest-sensitive assets of $79 million and interest-sensitive liabilities of $88 million over the next 30 days and market interest rates are expected to rise.

Financial firm interest-sensitive liabilities exceed its interest-sensitive assets by $9 million which means the firm will be open to losses if interest rates rise. The firm could sell financial futures contracts or use a put option on government securities or financial futures contracts approximately equal in dollar volume to the $9 million interest-sensitive gap to hedge their risk.

c. A survey of Tuskee Bank’s corporate loan customers this month (January) indicates that, on balance, this group of firms will need to draw $165 million from their credit lines in February and March, which is $65 million more than the bank’s management has forecasted and prepared for. The bank’s economist has predicted a significant increase in money market interest rates over the next 60 days.

The forecast of higher interest rates means the bank must borrow at a higher interest cost which, other things held equal, will lower its net interest margin. To offset the expected higher borrowing costs the bank’s management should consider a short sale of financial futures contracts or a put option approximately equal in volume to the additional loan demand. Either government securities or EuroCDs would be good instruments to consider using in the futures market or in the option market.

d. Monarch National Bank has interest-sensitive assets greater than interest sensitive liabilities
by $24 million. If interest rates fall (as suggested by data from the Federal Reserve Board) the
bank’s net interest margin may be squeezed due to the decrease in loan and security revenue.

Monarch National Bank has interest-sensitive assets greater than interest-sensitive liabilities by $24 million. If interest rates fall, the bank’s net interest margin will likely be squeezed due to the faster fall in interest income. Purchases of financial futures contracts followed by a subsequent sale or call options would probably help here.

e. Caufield Thrift Association finds that its assets have an average duration of 1.5 years and its liabilities have an average duration of 1.1 years. The ratio of liabilities to assets is .90. Interest rates are expected to increase by 50 basis points during the next six months.

Caufield Bank and Trust Company has asset duration of 1.5 years and liabilities duration of 1.1. A 50- basis point rise in money-market rates would reduce asset values relative to liabilities which mean its net worth would decline. The bank should consider short sales of government futures contracts or put options on these securities or on their related futures contracts.