[1-2] A treasurer of Company A expects to receive a cash inflow of $15 million in 90 days. The treasurer expects short-term interest rates to fall during the next 90 days. In order to hedge against this risk, the treasurer decides to use an FRA that expires in 90 days and is based on 90-day LIBOR. The FRA is quoted at 5%. At expiration, LIBOR is 4.5%. Assume that the notional principal amount on the contract is $15 million.

- Indicate whether the treasurer should take a long or short position to hedge interest rate risk.

- Calculate the gain or loss to Company A as a consequence of entering the FRA.

- 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?

- 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.)

- 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

1

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?

- 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?

- 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)?

[8-9] Consider a call option expiring in 90 days on 180-day LIBOR. The option buyer chooses an exercise rate of 5.5% and a notional principal of $10 million. On the expiration day, 180-day LIBOR is 6%.

- Is this option in-the-money or out-of-the-money?

- What is the payoff to the holder of the option?

- You received a quote of 97.67 on a 90-day Eurodollar futures contracts. Express this quote as a dollar price.