Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities

SOLUTIONS MANUAL
Chapter Twenty-Three
Answers to Chapter 23
Questions:
1. The a!or "ifferences #etween futures an" forwar" contracts are$
i. %utures contracts are tra"e" in open e&changes in stan"ar"i'e" units( with fi&e" aturities.
%orwar" contracts are #ilateral agreeents #etween two counter parties. )ence( the* can #e
tailor-a"e to the #u*er+s satisfaction.
ii. %utures contracts are arke" to arket ever* "a* while forwar" contracts are not.
Conse,uentl*( "efault risk is higher for the latter.
iii. %utures contracts are rarel* "elivere". -nstea"( the* are close" out .reverse"/ prior to aturit*.
Deliver* usuall* takes place for ost forwar" contracts.
2. a. Sell forwar"
#. Bu* forwar"
c. Sell forwar"
". Sell forwar"
e. Sell forwar"
f. Bu* forwar"
3. 0 he"ge involves protecting the price of or return on an asset fro a"verse changes in price or
return in the arket. 0 naive he"ge usuall* involves the use of a "erivative instruent that has
the sae un"erl*ing asset as the asset #eing he"ge". Thus( if a change in the price of the cash
asset results in a gain( the sae change in arket value will cause the "erivative instruent to
generate a loss that offsets the gain in the cash asset.
1. a. 2ou are o#ligate" to take "eliver* of a 3144(444 face value 24-*ear Treasur* #on" at a
price of 356(444 at soe pre"eterine" later "ate.
#. This is a long he"ge( un"ertaken to protect the %- against falling interest rates.
c. 2ou lose 31(444( since *ou are o#lige" to pa* 356(444 although the current futures price is
onl* 351(444.
". 2ou gain 32(444 since *ou are o#lige" to pa* 356(444 while the current futures price is
357(444.
23-1
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
6. 0 icrohe"ge uses a "erivative contract such as a forwar" or futures contract to he"ge the risk
e&posure of a specific transaction( while a acrohe"ge is a he"ge of the "uration gap of the
entire #alance sheet. %-s that attept to anage their risk e&posure #* he"ging each #alance
sheet position will fin" that he"ging is e&cessivel* costl*( #ecause the use of a series of
icrohe"ges ignores the %-+s internal he"ges that are alrea"* on the #alance sheet. That is( if a
long-ter fi&e"-rate asset position is e&pose" to interest rate increases( there a* #e a atching
long-ter fi&e"-rate lia#ilit* position that also is e&pose" to interest rate "ecreases. 8utting on
two icrohe"ges to re"uce the risk e&posures of each of these positions fails to recogni'e that
the %- has alrea"* he"ge" uch of its risk #* taking atche" #alance sheet positions. The
efficienc* of the acrohe"ge is that it focuses onl* on those isatche" positions that are
can"i"ates for off-#alance-sheet he"ging activities.
9. Selective he"ging involves an e&plicit attept to not inii'e the risk on the #alance sheet.
0n %- a* choose to he"ge selectivel* in an attept to iprove profit perforance #* accepting
soe risk on the #alance sheet( or to ar#itrage profits #etween a spot asset+s price oveents
an" the price oveents of the futures price. This latter situation often occurs #ecause of
"ifferential changes in interest rates cause" in part #* cross-he"ging.
7. Basis risk is the lack of perfect correlation #etween changes in the *iel"s of the on-#alance-
sheet assets or lia#ilities an" changes in interest rates on the futures contracts. The reason for this
"ifference is that the cash assets an" the futures contracts are tra"e" in "ifferent arkets.
:. a. The %- can either .i/ #u* a call option( or .ii/ sell a put option on interest rate instruents(
such as T-#on"s( to generate positive cash flows in the event that interest rates "ecline.
#. 0n %- can use call options on T-#on"s to he"ge an un"erl*ing cash position that "ecrease in
value as interest rates "ecline. This woul" #e true if( in the case of a acrohe"ge( the %-;s
"uration gap were negative an" the repricing gap positive. -n the case of a icrohe"ge( the %-
can he"ge a single fi&e"-rate lia#ilit* against interest rate "eclines.
c. 0n %- is #etter off purchasing calls as oppose" to writing puts. This is for two reasons. %irst(
regulator* restrictions liit an %-;s a#ilit* to write <nake"= short options. Secon"( since the
potential positive cash inflow on the short put option is liite" to the si'e of the put preiu(
there a* #e insufficient cash inflow in the event of interest rate "eclines to offset the losses in
the un"erl*ing cash position.
5. a. March >S Treasur* Bon" calls at 13944$ 3 66?91 or 33(:65.376 per 3144(444 contract
#. Dece#er 6 2r Treasur* @ote puts at 11564$ 3:?91 or 3653.764 per 3144(444 contract
c. Dece#er Auro"ollar calls at 5::764$ 72.76 percent or 37(276 per 31(444(444 contract
14. a. 1. The value of the call "ecreases( 2. the value of the call increases.
#. 1. The value of the put increases( 2. the value of the put increases.
23-2
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
11. 0 he"ge with futures contracts pro"uces s*etric gains an" losses with interest rate
increases an" "ecreases. That is( if the %- loses value on the #on" resulting fro an interest rate
increase( it en!o*s a gain on the futures contract to offset this loss. -f the %- gains value on the
#on" "ue to an interest rate "ecrease( a loss on the futures contract offsets this gain.
B* coparison( a he"ge with an option contract copletel* offsets losses #ut onl* partl*
offsets gains. That is( gains an" losses fro he"ging with options are no longer s*etric for
interest rate increases an" "ecreases. %or e&aple( if the %- loses value on the #on" "ue to an
interest rate increase( a gain on the options contract offsets the loss. )owever( if the %- gains
value on the #on" "ue to an interest rate "ecrease( the gain is offset onl* to the e&tent that the %-
loses the fi&e" option preiu .#ecause it never e&ercises the option/. Thus( the option he"ge
protects the %- against value losses when interest rates ove against the on-#alance-sheet
securities #ut( unlike futures he"ging( "oes not full* re"uce value gains when interest rates ove
in favor of on-#alance-sheet securities. Thus( an* %-s prefer option-t*pe contracts to
future?forwar" t*pe contracts.
12. Bhen he"ging interest rate risk e&posure( ost %-s utili'e financial futures options as
oppose" to options on cash instruents. The volue of activit* is uch larger in the futures
options arkets( there#* affor"ing the %- greater li,ui"it*. This a* #e a result of the regulator*
environent. %inancial futures options are regulate" #* the C%TC( while cash arket options are
regulate" #* the SAC. To the e&tent that the C%TC is perceive" #* %-s to #e less strict than its
SAC counterpart( this a* encourage activit* in the futures option arket. Moreover( the
availa#ilit* of options on cash instruents is constraine" #* the availa#ilit* of the un"erl*ing
instruent since option writers generall* prefer covere" option positions. Since there is no
liitation on the suppl* of futures( #ut there a* #e a liitation on the suppl* of cash
instruents( this encourages tra"ing in the futures options arket. Aven for high volue cash
arkets( such as the >.S. Treasur* arket( the alternative use of Treasuries for collateral .e.g.(
"iscount win"ow #orrowing/( li,ui"it*( an" financing .e.g.( repurchase agreeents/ a* liit
their availa#ilit* .increase the cost/ to the options writer. %inall*( the a""e" eleent of leverage
in the options futures contract also re"uces the cost of the contract.
13. a. The #ank faces the risk that interest rates will increase. The %- shoul" #u* a put option. -f
rates rise( the CDs can #e issue" onl* at a lower price. But( the increase in interest rates also
lowers the price of the securit* un"erl*ing the put option. Thus( the %- can purchase the
un"erl*ing securit* an" the gain fro the option e&ercise will offset the loss in value fro the
lower issue value of the CDs the %- e&periences in the spot arket.
#. The insurance copan* .-C/ is concerne" that interest rates will fall( an" thus the price of
the #on"s will rise. The -C shoul" #u* call options on #on"s. 0s rates fall( the un"erl*ing #on"
prices increase( #ut can #e #ought for less than the arket price #* e&ercising the call option.
The #on"s purchase" with the options can #e sol" ie"iatel* for a gain that can #e applie"
against the increase in the price of the #on"s #ought #* the -C in the spot arket an" hel" on the
#alance sheet. 0lternativel*( the #on"s #ought through the e&ercise of the call option can #e kept
an" place" in the -C+s portfolio if the* are the "esire" t*pe of asset.
23-3
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
c. The thrift will incur a loss on the sale if rates rise an" the value of the #on"s falls. The
thrift shoul" #u* a put option on Treasur* securities that allows the sale of the #on"s at or near
the current price.
". The >.S. #ank will incur a loss on the loan if the "ollar appreciates .euros "epreciate/.
Thus( the #ank shoul" #u* a put to sell euros at or near the current e&change rate.
e. The utual fun" will incur a loss on the sale if the "ollar appreciates .Cs "epreciate/.
Thus( the fun" shoul" #u* a put to sell C at or near the current e&change rate.
f. The %- is concerne" that interest rates will fall( causing the value of the lia#ilities to rise
ore than the value of the assets which woul" cause the value of the e,uit* to "ecrease. Thus(
the finance copan* shoul" #u* a call option on #on"s.
11. -n the case of writing a call option( the anager is o#ligate" to sell the interest rate futures
contract to the call option #u*er at the price of 3111(444 per 3144(444 contract. -f the call option
#u*er chooses to e&ercise the option an" the call writer "oes not own the securit* at the tie of
e&ercise( he or she ust purchase it first. The call writer will have receive" 3:65.3: fro the
writing of the option.
16. a. The pension fun" anager is e&pose" to interest rate "eclines .price increases/.
#. This interest rate risk e&posure can #e he"ge" #* #u*ing call options on either financial
securities or financial futures.
19. 0 forwar" contract re,uires "eliver* or taking "eliver* of soe coo"it* or financial
securit* at a specifie" tie in the future at a price specifie" at the tie of origination. -n a swap(
each part* proises to "eliver an"?or receive a pre-specifie" series of pa*ents at specific
intervals over a specifie" tie hori'on. -n this wa*( a swap can #e consi"ere" to #e the sae as a
series of forwar" contracts.
17. The swap #u*er akes the fi&e"-rate pa*ents in an interest rate swap. The swap seller
akes the varia#le-rate pa*ent in the swap. This "istinction is #* convention.
1:. %irst( %-s reain ore likel* to fail #ecause of cre"it risk than either interest rate risk or %D
risk. Secon"( cre"it swaps allow for the aintenance of long-ter relationships without the %-
#earing the full e&posure to the cre"it risk of the custoer.
15. 0 total return swap involves swapping an o#ligation to pa* interest at a specifie" fi&e" or
floating rate for pa*ents representing the total return on a loan or a #on" of a specific aount.
The swap can #e "esigne" to cover an* change in value of the principal as well as !ust the
interest. This t*pe of swap often is use" when there is e&posure to a change in the cre"it risk of
the counterpart*.
23-1
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
24. The total return swap inclu"es an eleent of interest rate risk( while the pure cre"it swap has
strippe" this risk fro the contract. -n a pure cre"it swap( the len"er akes a fi&e" fee or
pa*ent preiu to the counterpart* in e&change for the potential coverage of an* loss "ue to a
specific #orrower "efaulting on a loan. The swap is not tie" to interest rate changes. The pure
cre"it swap is siilar in pa*off to a "igital "efault option with the e&ception that the preiu is
pai" over the life of the swap rather than at the initiation of the risk coverage as with the option.
21. The cre"it risk on a swap is lower than that of a loan for the following reasons$
a/ Swaps "o not involve the e&change of principal pa*ents. The* onl* involve the
swapping of interest pa*ents( so the ost a counterpart* can lose is the "ifference in
the interest pa*ents.
#/ -n ost cases( pa*ents are a"e through netting #* novation( which nets all pa*ents
with one counterpart*( further re"ucing the possi#ilit* of "efault.
c/ Swaps a"e #* parties with poor cre"it ratings are usuall* #acke" #* lines of cre"it(
effectivel* aking the collaterali'e" loans( an" further re"ucing their risks.
Probe!s:
1. a. -nterest plus principal e&pense on si&-onth CD E 31 & .1 F .496?2/ E 31(432(644
-nterest an" principal earne" on Swe"ish #on" E 31(444(444?4.1: E SGr6(666(666.69 &
.1F.476?2/ E SGr6(793(::5
-n "ollars if he"ge"$ SGr6(793(::5 & 4.1:14 E 31(413(291

Sprea" E .31(413(291 - 31(432(644/?31 E 314(791?31(444(444 E 1.4791H for si& onths( or
2.16H per *ear.
#. @et interest incoe shoul" #e E .446 & 31(444(444 E 36(444
EI 31(432(644 F 36(444 E 31(437(644
EI SGr6(793(::5?31(437(644 E 6.669SGr for 1 >.S. "ollar or 34.1:?SGr
%or the sprea" to reain at 1H the spot an" the forwar" will have to #e the sae.
2. a. The 24-*ear :H coupon 3144(444 Treasur* #on" has a "uration of 14.252 *ears.
Discount
Tie A&ponent C% %actor 8JC% 8JC% & t
4.6 1 1(444 .5916 3(:19.2 1(523.1
1.4 2 1(444 .5219 3(95:.2 3(95:.2
1.6 3 1(444 .::54 3(669.4 6(331.4
2.4 1 1(444 .:61: 3(115.2 9(:3:.1
2.6 6 1(444 .:215 3(2:7.7 :(215.3
3.4 9 1(444 .7543 3(191.3 5(1:3.:
3.6 7 1(444 .7655 3(435.7 14(935.4
1.4 : 1(444 .7347 2(522.: 11(951.4
23-6
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
1.6 5 1(444 .7429 2(:14.3 12(917.4
6.4 14 1(444 .9769 2(742.3 13(611.4
6.6 11 1(444 .9159 2(65:.3 11(251.4
9.4 12 1(444 .9219 2(15:.1 11(554.4
9.6 13 1(444 .9449 2(142.3 16(916.4
7.4 11 1(444 .6776 2(345.5 19(195.4
7.6 16 1(444 .6663 2(221.1 19(96:.4
:.4 19 1(444 .6335 2(136.9 17(4:6.4
:.6 17 1(444 .6131 2(463.6 17(166.4
5.4 1: 1(444 .1539 1(571.6 17(771.4
5.6 15 1(444 .1719 1(:5:.9 1:(439.4
14.4 24 1(444 .1691 1(:26.6 1:(266.4
14.6 21 1(444 .13:: 1(766.3 1:(131.4
11.4 22 1(444 .1224 1(9:7.: 1:(699.4
11.6 23 1(444 .1476 1(922.5 1:(993.4
12.4 21 1(444 .3541 1(694.6 1:(729.4
12.6 26 1(444 .3761 1(644.6 1:(769.4
13.4 29 1(444 .3947 1(112.: 1:(769.4
13.6 27 1(444 .319: 1(3:7.3 1:(72:.4
11.4 2: 1(444 .3336 1(333.5 1:(976.4
11.6 25 1(444 .3247 1(2:2.9 1:(65:.4
16.4 34 1(444 .34:3 1(233.3 1:(155.4
16.6 31 1(444 .2596 1(1:6.: 1:(3:1.4
19.4 32 1(444 .2:61 1(114.2 1:(211.4
19.6 33 1(444 .2711 1(459.1 1:(554.4
17.4 31 1(444 .2939 1(461.2 17(522.4
17.6 36 1(444 .2631 1(413.7 17(735.4
1:.4 39 1(444 .2137 571.7 17(611.4
1:.6 37 1(444 .2313 537.2 17(33:.4
15.4 3: 1(444 .2263 541.1 17(122.4
15.6 35 1(444 .2199 :99.6 19(:59.4
24.4 14 141(444 .24:3 21(992.4 133(214.4
Su 144(444.44 1(425(244
Duration E 1(425(244?144(444 E 14.252
#. K8?8 E -D.KR?.1 F R//
EI K8 E -D.KR?.1 F R//8 E -14.252.4.4426?.1 F 4.41//3144(444 E -2(171.41
The price "ecline of the 3144(444 Treasur* #on" is 32(171.41
c. 0 #i"-ask ,uote of 141 - 13 E 3141 13?32 per 3144 face value. Since the Treasur* #on"
futures contracts are for 3144(444 face value( the ,uote" price is 3141(149.26.
3. The e&pecte" change in the spot position E -5.1 & ..41?1.47/ & 14(144(444 E -3513(916. This
woul" ean a price change fro 141 to 51.:9366 per 3144 face value. B* entering into a two
onth forwar" contract to sell a 314(444(444 of 16 *ear #on"s at 141( the %- will have he"ge" its
spot position.
23-9
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
-f rates rise #* 1H an" the #on" value falls #* 3513(916( the %- can close out its forwar" position
#* receiving 141 for #on"s worth 51.:9366. The profit on the forwar" position will offset the
loss in the spot arket.
1. a. DL08 E D0 M k DN E 9 M .4.5/.1/ E 9 M 3.9 E 2.1 *ears
#. A&pecte" A E -DL08OR?.1 F R/P0 E -2.1.-4.41?1.14/3164 E 33.272 illion
c. A&pecte" A E -DL08OR?.1 F R/P0 E -2.1.4.41?1.14/3164 E -33.272.
". Solving for the ipact on the change in e,uit* un"er this assuption involves fin"ing the
ipact of the change in interest rates on each si"e of the #alance sheet( an" then "eterining the
"ifference in these values. The anal*sis is #ase" on the e,uation$
A&pecte" A E 0 - N
0 E -D0OR0?.1 F R0/P0 E -9O4.41?1.14P3164 E -3:.1:1: illion
an" N E -DNORN?.1 F RN/PN E -1O4.41?1.49P3136 E -36.4513 illion
Therefore( A E 0 - N E -3:.1:1: M .-36.4513/ E - 33.4:76 illion
6. a. The #ank shoul" sell futures contracts since an increase in interest rates woul" cause the
value of the e,uit* an" the futures contracts to "ecrease. But the #ank coul" #u* #ack the futures
contracts to reali'e a gain to offset the "ecrease" value of the e,uit*.
#. The nu#er of contracts to he"ge the #ank is$
contracts 396
356(444 & 14.3726
4 .4.5/1/316 .9
%
8 &
%
D
/0
N
kD
0
.D
%
@ =

=

=
c. %or an increase in rates of 144 #asis points( the change in the cash #alance sheet position
is$
A&pecte" A E -DL08OR?.1 F R/P0 E -2.1.4.41?1.14/3164 E -33(272(727.27. The change in
#on" value E
-14.3726.4.41?1.4:6256/356(444 E -35(475.11( an" the change in 396 contracts is -35(475.11 &
-396 E 33(313(5:9.26. Since the futures contracts were sol"( the* coul" #e repurchase" for a gain
of 33(313(5:9.26. The su of the two values is a net gain of 311(26:.5:.
%or a "ecrease in rates of 64 #asis points( the change in the cash #alance sheet position is$
A&pecte" A E -DL08OR?.1 F R/P0 E -2.1.-4.446?1.14/3164 E 31(939(393.91. The change in
each #on" value E -14.37266.-4.446?1.4:6256/356(444 E 31(635.71 an" the change in 396
contracts is 31(635.71 & -396 E
-31(969(553.13. Since the futures contracts were sol"( the* coul" #e repurchase" for a loss of
31(969(553.13. The su of the two values is a loss of 324(925.15.
". -f Treasur* #ill futures contracts are use"( the "uration of the un"erl*ing asset is 4.26
*ears( the face value of the contract is 31(444(444( an" the nu#er of contracts necessar* to
he"ge the #ank is$
23-7
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
contracts 1(195
3216(444
44 3394(444(4
35:4(444 & 4.26
4 .4.5/1/316 .9
%
8 &
%
D
/0
N
kD
0
.D
%
@ =

=

=

=
e. -n cases where a large nu#er of Treasur* #on"s are necessar* to he"ge the #alance sheet
with a acrohe"ge( the %- a* nee" to consi"er whether a sufficient nu#er of "elivera#le
Treasur* #on"s are availa#le. The nu#er of Treasur* #ill contracts necessar* to he"ge the
#alance sheet is greater than the nu#er of Treasur* #on"s( the #ill arket is uch "eeper an"
the availa#ilit* of sufficient "elivera#le securities shoul" #e less of a pro#le.
9. The nu#er of contracts necessar* to he"ge the #ank woul" increase to 357 contracts. This
can #e foun" #* "ivi"ing 3394(444(444 #* .14.3726 & 356(444 & 4.52/.
7. a. The utual fun" nee"s to enter into a contract to #u* Treasur* #on"s at 5:-21 in four
onths. The fun" anager fears a fall in interest rates .eaning the T-#on"+s price will increase/
an" #* #u*ing a futures contract( the profit fro a fall in rates will offset a loss in the spot arket
fro having to pa* ore for the securities.
#. The nu#er of contracts can #e "eterine" #* using the following e,uation$
contracts 9.::
35:(764 Q :.6
31:1(264 Q 12
%
8 Q
%
D
8 Q D
%
@ = = =
Roun"ing this up to the nearest whole nu#er is 7.4 contracts.
c. -n this case the value of #r E 1.12( an" the nu#er of contracts is 9.::?1.12 E 9.11
contracts. This a* #e a"!uste" "ownwar" to 9 contracts.
". Rne reason for the "ifference in price sensitivit* is that the futures contracts an" the cash
assets are tra"e" in "ifferent arkets.
:. a. The "uration gap is 14 - .:94?564/.2/ E :.15 *ears.
#. The %- is e&pose" to interest rate increases. The arket value of e,uit* will "ecrease if
interest rates increase.
c. The %- can he"ge its interest rate risk #* selling future or forwar" contracts.
". A E - :.15.564(444/..41/ E -377(:44
e. % E -5.59(444/..41/ E -3:(914 per futures contract. Since the acrohe"ge is a short
he"ge( this will #e a profit of 3:(914 per contract.
f. To acrohe"ge( the Treasur* #on" futures position shoul" *iel" a profit e,ual to the loss in
e,uit* value .for an* given increase in interest rates/. Thus( the nu#er of futures contracts ust
#e sufficient to offset the 377(:44 loss in e,uit* value. This will necessitate the sale of
377(:44?:(914 E 5.446 contracts. Roun"ing "own( to construct a acrohe"ge re,uires the %- to
sell 5 Treasur* #on" futures contracts.
23-:
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
5. -n pro#le :( we assue" that #asis risk "i" not e&ist. That allowe" us to assert that the
percentage change in interest rates .R?.1FR// woul" #e the sae for #oth the futures an" the
un"erl*ing cash positions. -f there is #asis risk( then .R?.1FR// is not necessaril* e,ual to .Rf?
.1FRf//. -f the %- wants to full* he"ge its interest rate risk e&posure in an environent with #asis
risk( the re,uire" nu#er of futures contracts ust reflect the "isparit* in volatilities #etween the
futures an" cash arkets.
a. -f br E 4.5( then$
contracts 14 E
/..54/ .5/.59(444
44/ :.15.564(4
E
#r &
%
8 &
%
D
0 /
N
kD -
0
.D
E
@
%

#. #r E 4.54 eans that the iplie" rate on the "elivera#le #on" in the futures arket oves #*
4.5 percent for ever* 1 percent change in "iscounte" spot rates .R?.1FR//.
c. -f br E 4.5 then the percentage change in cash arket rates e&cee"s the percentage change in
futures arket rates. Since futures prices are less sensitive to interest rate shocks than cash
prices( the %- ust use ore futures contracts to generate sufficient cash flows to offset the cash
flows on its #alance sheet position.
14.
contracts 272:
3142(969 & 5
214 .4.:76/1/3 .11
%
8 &
%
D
/0
N
kD
0
.D
%
@ =

=

=
11. a.
ts :21contrac :23.71
&359(167 4.926&14.1
(444 6&3144(444
&D&B S
D&8
p
@ = = =
#. 0 3144(444 24-*ear( eight percent #on" selling at 359(167 iplies a *iel" of :.1 percent.
8 E @p & p E :21 & .-4.926/ & .-14.1/ & 359(167 & 4.41?1.4:1 E 31(911(42: gain
c. B E -6 & 3144(444(444 & .41?1.4: E -31(925(934
" 8 E :21 & 3(264 E :21 & .-4.926/ & .-14.1/ & 359(167 & R ?1.4:1
Solving for the change in interest rates gives
R E .33(264 & 1.4:1/?.4.926 & 14.1 & 359(167/ E 4.446:41 or .6: percent.
e. B E 3(264 & :21 E -6 & 3144(444(444 & R ?1.4:
0gain solving for R E .33(264 & :21 & 1.4:/?.6 & 3144(444(444/ E -.4467:16 or -.6:
percent.
12. a. The "uration gap for the #ank is O12 M .724?:14/7P E 9. Therefore( the #ank is concerne"
that interest rates a* increase( an" it shoul" purchase put options. 0s rates rise( the value of the
#on"s un"erl*ing the put options will fall( #ut the* will #e putta#le at the higher put option
e&ercise price.
#. The #on"s un"erl*ing the put options have a arket value of 3141(631.26. Thus(
23-5
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
s contract or11(761 11(763.76
41(631.26 .1&:.17&31
(444 9&3:14(444
B & D & S
DL08&0
p
@ = = =
c. The change in e,uit* value is
KA E MDL08&0&.R?.1FR// E -9.3:14(444(444/..446?1.4769/ E -323(12:(7:1.
". 8 E @p. TT & D & B & R?.1FR// E 11(761 & .1 & :.17 & 3141(631.26 & 4.446?1.4769 E
323(125(1:6 gain
e. Net A E 312(545(764( an" solve the e,uation in part .c/ a#ove for R. Then
R E 312(545(764&1.4769?.3:14(444(444&.-9// E -4.442766 or -4.2766 percent.
f. >se the e,uation in part ."/ a#ove an" solve for R. Then(

R E .312(545(764 Q 1.4769/?O11(761 Q .1 Q :.17 Q 3141(631.26P E 4.442766 or 4.2766
percent.
13. a. MD E D?.1F.14/ E 7?1.14 E 9.3939 *ears
#.
B D& & S
0 P&
DN
k -
D0
O
E
@p E O9.6 - 1.6..:4/P & 3244(444(444?O.-.3/ & .-7.4/ & .59(444/P E 2(:79.5: or
2(:77 contracts
c. The change in e,uit* value is
KA E MDL08 & 0 & .R?.1FR// E -2.5.3244(444(444/..446?1.14/ E -32(939(391
". 8 E @p.TT & D & B & R?.1ER// E 2(:77 & .3 & 7 & 359(444 & 4.446?.1.14/ E 32(939(37:
gain
e. Net A E 33(659(264( an" solve the e,uation in part .c/ a#ove for R. Then
R E 33(659(264 & 1.14?.3244(444(444 & -2.5/ E -4.449:2 or -4.9: percent.
f. >se the e,uation in part ."/ a#ove an" solve for R. Then
R E 33(659(264?O2(:77 & .-.3/ & .-9.3939/ & 359(444P E 4.449:2 or 4.9: percent.
11. a. The utual fun" is concerne" a#out interest rates falling which woul" ipl* that #on"
prices woul" increase. Therefore( the %- shoul" #u* call options to guarantee a certain purchase
price.
#.
s option call 237 or 239.76
264 .6&5&3143(
(444 11&314(444
B & D & S
0 &
D
E
@C
= =
c. The ,uote for T-#on" options is 1-26( or 1 26?91 E1.354926 per 3144 face value. This
converts to 31(354.926 per 3144(444 option contract. The total cost of the he"ge is 237 &
31(354.926 E 3325(67:.126.
23-14
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
". %or a rate increase( the B E -11 & 314(444(444 & .4.446/?1.479: E -3614(773. -f rates
"ecrease( the value of the #on"s will increase #* 3614(773.
e. -f rates "ecrease( the value of the un"erl*ing #on"s( an" thus the option value( increases.
C E @c. & .-D/ & B & R?.1FR// E 237 & 4.6 & .-5/ & 3143(264&.-4.446?.1.479:// E 3611(312.
This occurs #ecause the %- can #u* the #on"s at the e&ercise price an" sell the at the higher
arket price. -f rates rise( the options will e&pire without value #ecause the #on"s will #e price"
lower in the arket.
16. The finance copan* will pa* a fi&e" rate( while the insurance copan* pa*s a N-BRR
#ase" rate. Rne such feasi#le swap woul" #e for the insurance copan* to pa* the finance
copan* N-BRR F 2.6H an" the finance copan* to pa* the insurance copan* 12H. The
insurance copan* woul" receive .N-BRR F .41/ -.14 F .12 - .N-BRR F .426/ E .446( while the
finance copan* receives .11 - .N-BRR F .41/ F .N-BRR F .426/ - .12 E .446. Thus the swap
protects #oth copanies fro interest rate risk an" allows the to ake a profit of 64 #asis
points.
19. a. The coercial #ank is at risk for a "rop in rates that woul" lower interest incoe( while
the savings association is at risk of an interest rate increase( thus raising the cost of fun"s.
#. Rne feasi#le swap woul" #e for the #ank to sen" the savings association .T-#ill F 1H/(
while the savings association sen"s the #ank a fi&e" pa*ent of 5H.
c. Bith this swap( the #ank receives .T-#ill F .42/ -.45 F.45 - .T-#ill F .41/ E .41( the
savings association receives .13- .T-#ill F .43/ F .T-#ill F .41/ - .45 E .42. Aach %- has locke" in
a profita#le sprea" in the returns fro its assets an" the cost of its lia#ilities.
". -t is possi#le that the floating rate asset ight not #e tie" to the sae rate as the floating
rate lia#ilit*. This woul" result in #asis risk. 0lso( if the ortgages are aorti'ing( the interest
pa*ents on the ortgages woul" not atch those on an* nonaorti'ing securit*.
17. a. A& ante( this is a profita#le transaction since the sprea" is 2H. The 2H sprea" on 3144
illion .164 illion/ is 32 illion. Converte" into British poun"s at the spot e&change rate(
this *iel"s an annual e&pecte" cash flow of 3 illion. The cash flows are as follows$
Auro"ollar CD British Noan
t Cash Rutflow .>.S.3/ ./ Cash -nflow ./ Sprea" ./
1 7 14.6 13.6 3
2 7 14.6 13.6 3
3 147 194.6 193.6 3
)owever( this sprea" will #e re"uce" or eliinate" if the poun" "epreciates relative to the >.S.
"ollar. That is( if it takes ore poun"s to purchase >.S. "ollars( it will #e ore costl* for the
#ank to repa* the Auro"ollar CD using British poun" loan procee"s. The British #ank will
un"ertake a short currenc* he"ge if it wants to protect itself against e&change rate risk e&posure.
23-11
Chapter 23 - Managing Risk off the Balance Sheet with Derivative Securities
#. A&pecte" future e&change rates are$
An" of *ear 1$ 1.96?>.S.3
An" of *ear 2$ 1.:16?>.S.3
An" of *ear 3$ 2.44?>.S.3
Auro"ollar CD British Noan
t Cash Rutflow.>.S.3/ ./ Cash -nflow ./ Sprea" ./
1 7 11.66 13.6 1.56
2 7 12.74 13.6 .:4
3 147 211.4 193.6 .64.6/
c. t Cash %low Swap 8a*ents @et Swap Cash %low Total Cash %low
./ ./ ./
1 11.66o 14.64 1.46 3
2 12.746 14.64 2.24 3
3 211.444 194.64 63.644 3
-n the last colun( the cash flows of the un"erl*ing cash position .in part #/ are a""e" to the cash
flows fro the swap he"ge. That is( at the en" of the first *ear( the sprea" on the loan versus the
CD is C1.56. The swap generates a net cash flow of C1.46 for a total en" of *ear 1 sprea" of
C3 illion. 0t the en" of *ear 2( the C.756 loan versus CD sprea" plus the C2.246 net swap
cash flow e,uals C3. 0t the en" of *ear 3( the C64.6 loss on the loan-CD position is offset #*
the C63.6 gain on the swap for a total cash flow of C3. Therefore( the he"ge" position locks in
the annual 2H sprea".
1:. a. There is a feasi#le swap #ecause of the coparative a"vantage inherent in the two sets of
#orrowing rates.
#. Bank 1 has a coparative a"vantage in the fi&e" rate arket an" Bank 2 has a
coparative a"vantage in the floating rates since the "ifference in the floating rate CDs is 1H(
while the "ifference in the fi&e" rates is 2H.
c. There is ore than one feasi#le swap( #ut one such swap woul" #e the following$
Bank 1 pa*s Bank 2 N-BRR F 3.6H( while Bank 2 pa*s Bank 1 13H.
@ow Bank 1 can issue fi&e" rate CDs at 11H( pa* N-BRR F 3.6H( an" receive 13H.
@et cost E -.11 - .N-BRR F .436/ F .13 E -.11 - N-BRR - .436 F .13 E -N-BRR - .416
-.N-BRR F 1.6H/ which is less than its current varia#le rate pa*ent.
Bank 2 can issue floating rate CDs at .N-BRR F 3H/( pa* 13H( an" receive .N-BRR F 3.6H/. -ts
net cost is 12.6H which is less than its current fi&e" pa*ent.
23-12