Question 1

In October, a U.S. Company is expecting to receive funds in Euros in December from its European customers of 1,250,000 Euros, and wants to hedge against a fall in the value of the Euro relative to the U.S. dollar in December. At this time the spot exchange rate Euro is worth $1.114 USD. The CME Group currency future settle rate for a December Euro FX futures contacts is 1 Euro = $1.1231 USD, with each futures contract for 125,000 Euros per contract.
a. What position and how many contracts should the financial manager take to hedge against a rise in the Euro? Explain why. (Hint: # contracts = Amount of Euros Hedging / 125,000 Euros per contract; always take a position that will give you a futures gain to offset your spot loss in the event of what you want to hedge.)
b. Suppose later in December the spot rate for the Euro falls to $1.003 USD and the futures settle rate has falls to $ 1.011 USD. Calculate the spot opportunity loss or gain for the company and the futures gain or loss. What is the net hedging result?
c. What are the advantages and disadvantages of hedging with FX options on futures contracts instead?

Accepted Answer

A. Take a short position, so you'll make a futures gain if the value of the Euro falls to offset a Spot Loss if the Euro falls.
Number of Contracts___10 contracts___________
# Contracts = 1,250,000 Euros / 125,000 = 10 contracts
B. Spot Gain or Loss _($138,750)_ 
Futures Gain or Loss __$140,125_______
Net Hedging Result __$1,375___ (Futures Gain or Loss - Spot Gain or Loss)
Calculations:
Spot Loss = 1,250,000 Euros [$1.114 - $1.003] = Loss of $138,750
Futures Gain = 125,000 x 10 [$1.1231 - 1.011] = $140,125
C. Options if the FX rate goes the opposite way expected, you don't have to take the futures loss against the spot gain. Disadvantage: high premium cost at times.

Question 2

In October an insurance company portfolio manager has a stock portfolio of $950 million with a portfolio beta of 0.85. The manager is planning to sell the stocks in the portfolio in December to be able to pay out funds to policyholders, and is worried about a fall in the stock market. In October the CME Group offers a December S&P 500 futures contract with a settle price of 2155.50 ($250 multiplier for the contract).
a. What type of futures position should be taken to hedge against the stock market going down and how many future contracts are needed for this hedge?
b. Suppose in December the stock market (S&P500 index) falls by 10% and the S&P500 futures index falls by 10% as well, what is the portfolio manager's opportunity loss (gain) on his portfolio, and his futures gain (loss) and the net hedging result?

Accepted Answer

a. 
Type of Position __Short_Position to make a futures gain if stock prices go down.
# of Contracts___1499_ (Be sure to round up if >_ 0.50; round down if fraction of contracts is less than .50.)
Calculation: 
# contracts = ($950,000,000 x Beta .85 ) / (2155.50 x $250)
= $807,500,000/$538,875 = 1499 contracts
b. 
Spot Gain or Loss _ ($80,750,000)
Futures Gain or Loss _$80,777,362.50___
Net Hedging Result __$273,625________
Calculations:
Spot Loss = $950,000,000(.10 x .85) = ($80,750,000)
Futures Gain = 1499 contracts x [2155.50 - 2155.50(.90)] x $250
= $80,777,362.50

Question 3

A U.S. financial institution needs to pay 125,000 pounds sterling in 90 days. The current spot exchange rate is $1.75 per pound sterling at this time. The manager believes that the dollar is likely to depreciate relative to the British pound over the next several months. The firm decides to hedge with a long futures contract (amount per contract of 62,500 pounds) with a current futures rate of $1.80.
If 90 days later the spot rate is $1.90 per pound, and the futures contract exchange rate is $1.95, what is the net result of the hedge?

Accepted Answer

Spot Loss of $18,750 and futures gain of $18,750 and net hedging result of $0
Calculation: 
Loss on spot position = 125,000($1.75 - $1.90) = Loss of ($18,750)
Gain on futures = 125,000($1.95 - $1.80) = $18,750
Net Hedging Result = $0

Question 4

A firm would like to have debt with a floating rate since its assets have floating rates, but has a high variable rate of debt of LIBOR + 1% (for this problem LIBOR is currently 10%) and a lower cost for fixed debt of 9.5%.
A broker finds a counterparty for a liability swap that has a fixed rate of 12% and a floating rate of LIBOR + .25% for its debt.
The broker will charge a fee of 0.4%. The Swap will be set up so that each respective party will issue its lowest cost type of debt. Then the firm with the fixed rate debt financing will receive a cash inflow of LIBOR + 1% from the other party and will pay out a cash outflow of 10% to the other party.
What are respectively the effective rates paid by the firm and the counterparty with this liability swap and the advantage of the swap to each party?

Accepted Answer

The answer of A firm would like to have debt...

Question 5

In October an insurance company portfolio manager has a stock portfolio of $950 million with a portfolio beta of 0.85. The manager is planning to sell the stocks in the portfolio in December to be able to pay out funds to policyholders, and is worried about a fall in the stock market. In October the CME Group offers a December S&P 500 futures contract with a settle price of 2155.50 ($250 multiplier for the contract).
a. What type of futures position should be taken to hedge against the stock market going down and how many future contracts are needed for this hedge?
[Hint: # contracts = {[Amount Hedged / Futures Index Price x Multiplier]} x Beta Portfolio]
b. Suppose in December the stock market (S&P500 index) falls by 10% and the S&P500 futures index falls by 10% as well.
What is the portfolio manager's opportunity loss (gain) on his portfolio, and his futures gain (loss) and the net hedging result?

Accepted Answer

The answer of In October an insurance company portfolio manager...

Question 6

The Cookie Creme Company (Party A) prefers to have fixed rate debt, but has a higher fixed rate of 5% annually, while its variable cost of debt is LIBOR + 1%, with LIBOR at this time at 3%. The Bright Window Company (Party B) would prefer to have variable rate debt, but its fixed rate for debt is 4% annually is lower than its variable rate debt of LIBOR + 1.50% (with LIBOR at this time at 3%).
The two parties agree to a 10-year swap for a given amount at a brokerage fee cost of 0.10% for each party for a given notational amount.
• Party A will continue to issue variable rate debt that costs LIBOR + 1% (currently 3%), and Party B will continue to issue fixed rate debt that costs 4%.
Swap of Partial payments:
• Party A will pay Party B cash flows based on the notational amount at a fixed rate of 4%.
• Party B will pay Party A cash flows based at a rate equal to LIBOR + 1% (Libor currently 4%)
a. What are the liability swap rates (effective rates on debt) that each party will in net be paying on their debt with this swap? 
(Hint: liability swap rate = dr % - pi% + po% + fee%) where dr is the firm's rate on the type of debt it is using; po% is the rate to be paid to the other party; pi is the rate to be received from the other party; and fee% is the brokerage rate for the swap.)
b. Given your answers in a., what is the financing advantage for each party?

Accepted Answer

The answer of The Cookie Creme Company (Party A) prefers...

Question 7

Give a brief overview of the different types of credit swaps including credit-lined notes, first to default swaps, and index swaps. What role did credit swaps play in the U.S. Subprime Crisis?

Accepted Answer

The answer of Give a brief overview of the different...

Question 8

What type of provisions did the U.S. Dodd-Frank Act of 2010 include to reduce risks associated with swaps?

Accepted Answer

The answer of What type of provisions did the U.S....

Question 9

Give a brief overview of weather derivatives.

Accepted Answer

The answer of Give a brief overview of weather derivatives....

Question 10

List the advantages and disadvantages of hedging with futures contracts versus hedging with respectively forwards contracts, options on futures contracts, and swaps.

Accepted Answer

The answer of List the advantages and disadvantages of hedging...

Question 11

To hedge against a spot loss with a rise in interest rates (i.e., a fall in bond prices), a short futures position should be taken, and to hedge against a fall in interest rates (i.e., a rise in bond prices) a long futures position should be taken.

Accepted Answer

A short futures position can help to offset losses in the spot market if interest rates rise and bond prices fall. Likewise, a long futures position can help to offset losses if interest rates fall and bond prices rise.

Question 12

Advantages of forward contracts include: (1) that they can be tailor-made for any amount, security, and time period; (2) that they are more liquid than futures contracts and are backed by a clearing house.

Accepted Answer

This statement is false. Futures contracts are generally more liquid than forward contracts and are also backed by a clearing house, providing for greater security. Forward contracts, on the other hand, are typically less standardized and less flexible in terms of their terms and conditions.

Question 13

A financial institution wants to hedge against a rise in interest rates (i.e. a fall in prices) for a money market portfolio that it holds of $20 million. The FI decides to hedge with Eurodollar Future Contracts, with a minimum contract of $ 1 million. The hedge ratio that will be used is .95.
How many futures contracts should the FI get, and what should the position be (long or short)?

Accepted Answer

# of contracts = [$20 million / $1 mil.] x .95 = 19 
Should get a short futures position to make a gain if T-bill prices fall (i.e. rates rise).

Question 14

A financial institution wants to hedge against a rise in the price of 91 day T-bills (fall in rates) for a future $20 million T-bill purchase three months from now. The FI decides to hedge with Eurodollar Future Contracts, with a minimum contract of $ 1 million. The hedge ratio that will be used is .95.
How many futures contracts should the FI get and what position, and what should the position be (long or short) and what is the net hedging result with the current discount rates and three month later discount rates given below where rates rose instead of fell in the future:
Discount Rates Today:
$\begin{array}{lc}
\text { Spot T-bill } & \text { Eurodollar Futures } \
0.34 \% & 1.00 \%
\end{array}$
$\text { Discount Rate 3-months Later: }$ 
$\begin{array}{lc}
\text { Spot T-bill } & \text { Eurodollar Futures } \
0.44 \% & 1.10 \%
\end{array}$

Accepted Answer

The correct answer is C. The FI should get 19 futures contracts and take a long position. The net hedging result is $250.The hedge ratio is .95, so the FI needs to get 19 futures contracts to hedge against the $20 million T-bill purchase. The FI should take a long position in the futures contracts because it is hedging against a rise in the price of T-bills (fall in rates).The current discount rate for spot T-bills is 0.34%, and the current discount rate for Eurodollar futures is 1.00%. Three months later, the discount rate for spot T-bills is 0.44%, and the discount rate for Eurodollar futures is 1.10%.The change in the discount rate for spot T-bills is 0.10%, and the change in the discount rate for Eurodollar futures is 0.10%. The FI will lose $10,000 on the T-bill purchase, but it will gain $10,250 on the futures contracts. The net hedging result is $250.

Question 15

A bank owns Eurodollar CDs with a current market value of $9,700,000 that will be sold to make loans three months from now, and wants to hedge against a rise in interest rates that would result in having to sell the Eurodollar CDs at a lower price. The bank takes a short position with 10 Eurodollar Futures Contracts (minimum contract $1 million) for a futures price of $9,810,000 based on the discount rate quoted. If three months later the new T-bill price is $9,680,000 for the sale of the T-bills by the bank, and the new Eurodollar CD futures price is $9,800,000, what is the net hedging result?

Accepted Answer

Spot Loss = $9,700,000 - $9,680,000 = ($20,000) 
Futures Gain = $9,810,000 - $9,800,000 = $10,000 
($20,000) - ($10,000) =$10,000 Net Hedging Loss = $10,000

Question 16

Advantages of options on futures contracts versus future contracts include a maximum loss on the options contract of the premium cost of the option, since an option doesn't have to be exercised if rates go the opposite way expected, allowing the spot gain not having to be offset by the futures loss.

Accepted Answer

This statement is true. Options on futures contracts do have the advantage of a maximum loss being limited to the premium cost of the option, whereas futures contracts can result in unlimited losses. Additionally, options offer flexibility in allowing the buyer to choose whether or not to exercise the option, based on market conditions, whereas futures contracts require the buyer to follow through with the contract regardless of market movements.

Question 17

A pension fund investment manager has a portfolio of stocks with
A beta of .87. The value of the portfolio is $6,400,000 and the Mini S&P stock index futures contract settlement at this time is 1065 with a multiple of $50. How many contracts are needed to hedge the cash position (round to a whole number) against a potential fall in stock prices, and what futures position should be taken?

Accepted Answer

No. Contracts = {$6,400,000/(1065 x $50)) x .87 = 105 contracts 
Short Position to make a futures gain if stock prices fall.

Question 18

If a portfolio manager is planning on purchasing stocks two months from now and anticipates a bull market over that time period, the appropriate hedging strategy would be:

Accepted Answer

To make a gain on a futures contract if stock prices go up, a long position should be taken to offset the spot opportunity loss of having to pay more for stocks if prices rise.

Question 19

A finance company with variable-rate assets and fixed-rate liabilities wants to do a swap to have a better maturity match and finds a counterparty with fixed-rate assets and variable-rate liabilities to do an asset swap. The amount of the swap is $100,000,000, and the finance company agrees to pay the counterparty a variable rate equal to LIBOR +4% each year while the counterparty will pay the finance company a fixed rate of 10%. At the time of the Swap, LIBOR was 6%, so no cash flows were exchanged. In year 2, LIBOR is 4%, what will be the cash exchange and to which party?

Accepted Answer

The finance company is receiving a fixed rate of 10% and paying out LIBOR + 4%, which for year 2 is 8%, so the finance company will be receiving the 2% difference x $100 million = $2 million

Question 20

Bank Five has fixed-rate bond costs of 8.25% and variable-rate bond costs of 6.5%. Bank Cinco has fixed-rate bond costs of 8.75% and variable-rate bond costs of 5.5%. The two parties would like to have the opposite types of cheaper financing. To lower the cost of funds, what should their liability swap be:

Accepted Answer

The bank with the cheaper fixed-rate cost would issue fixed-rate bonds, and the bank with the cheaper variable rate cost would issue variable-rate bonds, and the two banks would swap payments.

Quiz 8: Hedging Interest Rate Risk With Derivatives