Financial Futures and Interest Rate Options

Description

Bank managers are paid to manage risk. In many cases, it is appropriate to reduce a bank’s exposure to potentially adverse changes in interest rates. Different methods that banks can use to reduce interest rate risk include hedging with financial futures contracts, forward rate agreements, basic interest rate swap agreements, and interest rate caps and floors. Hedging is a transaction designed to reduce risk, or in some cases, eliminate it (Rose & Hudgins, 2013). The concept underlying hedging with futures is that a bank trades financial futures, such that losses or gains on its actual cash transactions due to interest rate changes are partially offset by gains or losses on its futures position. When choosing a forward or futures hedge over an option hedge, the hedger agrees to give up future gains and losses. Hedging can also be viewed as a transaction that attempts to establish the expected future price of an asset (Rose & Hudgins, 2013). A short (long) hedge establishes the expected future sales (purchase) price. Hedging should always be viewed as risk reducing, but not eliminating, thus requiring that the remaining risk be identified and monitored. Write a paper answering the following two questions: 1.) By what amount will the market value of a Treasury bond futures contract change if interest rates rise from 5% to 5.25%? 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.) 2.) 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?