FIN 4324 Assignment 5

FIN 4324 Assignment 5 (Due date: Nov 30th)

1. A futures contract on Eurodollar deposits is currently selling at an interest yield of 4 percent, while yields on 3-month Eurodollar deposits currently stand at 4.60 percent. What is the basis for the Eurodollar futures contracts?

The basis for the Eurodollar future contracts is currently 60 basis points (4.60 percent − 4 percent).

2. Your financial firm needs to borrow $500 million by selling time deposits with 180-day

maturities. If interest rates on comparable deposits are currently at 3.5 percent, what is the

cost of issuing these deposits? Suppose interest rates rise to 4.5 percent. What then will be

the cost of these deposits? What position and types of futures contract could be used to deal

with this cost increase?

At a rate of 3.5 percent, the interest cost is:

$500 million × 0.035 × 30/360 = $8,750,000

At a rate of 4.5 percent, the interest cost would be:

$500 million × 0.045 × 30/360 = $11,250,000

A short hedge could be used based upon Eurodollar time deposits, Federal funds futures contracts, or LIBOR futures contract.

3. By what amount will the market value of a Treasury bond futures contract change if interest

rates rise from 5 to 5.25 percent? The underlying Treasury bond has a duration of 10.48

years and the Treasury bond futures contract is currently being quoted at 113-06.

(Remember that Treasury bonds are quoted in 32nds.)

Change in value of a T-bond futures contract=

4. Morning View National Bank reports that its assets have a duration of 7 years and its liabilities average 1.75 years in duration. To hedge this duration gap, management plans to employ Treasury bond futures, which are currently quoted at 112-170 and have a duration of 10.36 years. Morning View’s latest financial report shows total assets of $100 million and liabilities of $88 million. Approximately how many futures contracts will the bank need to cover its overall exposure?

Number of futures contracts needed = = 468.338

Therefore, the bank needs to sell approximately 468 contracts to hedge the duration gap.

5. You hedged your financial firm’s exposure to increasing interest rates by buying one

December put on Eurodollar deposit futures at the strike price 97.75 earlier on April 15. If

December arrives and Eurodollar deposit futures have a settlement index at expiration of

96.50, what is your payoff?

Payoff from the long position on put option: (97.75 − 96.5) = 1.25% or 125 basis points.

6. Suppose that Gwynn’s Island Savings Association has recently granted a loan of $2 million

to Oyster Farms at prime plus 0.5 percent for six months. In return for granting Oyster

Farms an interest-rate cap of 6.5 percent on its loan, this thrift has received from this

customer a floor rate on the loan of 5 percent. Suppose that, as the loan is about to start,

the prime rate declines to 4.25 percent and remains there for the duration of the loan. How

much (in dollars) will Oyster Farms have to pay in total interest on this six-month loan?

How much in interest rebates will Oyster Farms have to pay due to the fall in the prime

rate?

Total Interest Owed = Amount Borrowed × Interest Rate Charged × (Number Of Month/12)

= 2,000,000 * 0.05* (6/12) =50,000

Oyster will have to pay an interest rebate to Gwynn’s Island Savings Association of :

Interest Rebate = (Floor rate – Current loan interest rate) × Amount Borrowed × (# of month/12)

=(0.050 – 0.0475) * 2,000,000 * (6/12) = 2,500

7. A firm has entered into a 4-year, annual-pay, 6% plain vanilla interest rate swap with a notional principal value of $10,000,000. The firm is the fixed rate payer (i.e. the swap dealer is the floating rate payer) and the following spot rates are observed and expected over the next three years:

• 1-year LIBOR today = 5%.

• Expected 1-year LIBOR in a year = 6%.

•Expected 1-year LIBOR in two years = 7%.

Based solely on this information, what would be (1) the first net payment amount and (2) the direction (e.g. from the firm to the swap dealer or vice versa)?

Payment is based on the 1 year LIBOR today

hence, floating will pay 5%*10000000=$500000

fixed will pay 6%*10000000=$600000

So, net payment will be from fixed to floating of 600000-500000=$100000

As firm will pay fixed so firm will pay $100000 to the swap dealer

8. What does securitization of assets mean?

Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming it (or them) into a security.

9. What kinds of assets are most amenable to the securitization process?

The best types of assets to pool are high quality, fairly uniform loans, such as home mortgages or credit loans.

10. What advantages does securitization offer to the lending institutions?

Securitization gives lending institutions the opportunity to use their assets as sources of funds and, in particular, to remove lower-yielding assets from the balance sheet to be replaced with higher-yielding assets. The lending institution can create liquid assets out of illiquid, expensive-to-sell assets. Also, this helps diversify the lender’s credit risk exposure.