Consider the following questions:
1.)June Klein, CFA, manages a $100 million (market value) U.S. government bond portfolio for an institution. She anticipates a small parallel shift in the yield curve and wants to fully hedge the portfolio against any such change.
PORTFOLIO AND TREASURY BOND FUTURES CONTRACT CHARACTERISTICS
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Security
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Modified Duration
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Basis Point Value
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Conversion Factor for Cheapest to Deliver Bond
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Portfolio Value/ Future Contract Price
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Portfolio
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10 years
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$100,000.00
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Not Applicable
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$100,000,000
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U.S. Treasury bond futures contract
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8 years
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$75.32
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94-05
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a) Discuss two reasons for using futures rather than selling bonds to hedge a bond portfolio. No calculations required.
b) Formulate Klein's hedging strategy using only the futures contract shown. Calculate the number of futures contracts to implement the strategy. Show all calculations.
c) Determine how each of the following would change in value if interest rates increase by 10 basis points as anticipated. Show all calculations.
1. The original portfolio
2. The Treasury bond futures position
3. The newly hedged portfolio
d) State three reasons why Klein's hedging strategy might not fully protect the portfolio against interest rate risk.
e) Describe a zero-duration hedging strategy using only the government bond portfolio and options on U.S. Treasury bond futures contracts. No calculations required.
2.)As a relationship officer for a money-center commercial bank, one of your corporate accounts has just approached you about a one-year loan for $1,000,000. The customer would pay a quarterly interest expense based on the prevailing level of LIBOR at the beginning of each three-month period. As is the bank's convention on all such loans, the amount of the interest payment would then be paid at the end of the quarterly cycle when the new rate for the next cycle is determined. You observe the following LIBOR yield curve in the cash market:
90-day LIBOR 4.60%
180-day LIBOR 4.75
270-day LIBOR 5.00
360-day LIBOR 5.30
a) If 90-day LIBOR rises to the levels "predicted" by the implied forward rates, what will the dollar level of the bank's interest receipt be at the end of each quarter during the one-year loan period?
b) If the bank wanted to hedge its exposure to failing LIBOR on this loan commitment, describe the sequence of transactions in the futures markets it could undertake.
c) Assuming the yields inferred from the Eurodollar futures contract prices for the next three settlement periods are equal to the implied forward rates, calculate the annuity value that would leave the bank indifferent between making the floating-rate loan and hedging it in the futures market and making a one-year fixed-rate loan. Express this annuity value in both dollar and annual (360-day) percentage terms.
3.)Alex Andrew, who manages a $95 million large-capitalization U.S. equity portfolio, currently forecasts that equity markets will decline soon. Andrew prefers to avoid the transaction costs of making sales but wants to hedge $15 million of the portfolio's current value using S&P 500 futures.
Because Andrew realizes that his portfolio will not track the S&P 500 Index exactly, he performs a regression analysis on his actual portfolio returns versus the S&P futures returns over the past year. The regression analysis indicates a risk-minimizing beta of 0.88 with an R2 of 0.92.
Futures Contract Data
S&P 500 futures price 1,000
S&P 500 index 999
S&P 500 index multiplier 250
a) Calculate the number of futures contracts required to hedge $15 million of Andrew's portfolio, using the data shown. State whether the hedge is long or short. Show all calculations.
b) Identify two alternative methods (other than selling securities from the portfolio or using futures) that replicate the strategy in Part a. Contract each of these methods with the futures strategy.
4.) The treasurer of a middle market, import-export company has approached you for advice on how to best invest some of the firm's short-term cash balances. The company, which has been a client of the bank that employs you for a few years, has $250,000 that it is able to commit for a one-year holding period. The treasurer is currently considering two alternatives: (1) invest all the funds in a one-year U.S. Treasury bill offering a bond equivalent yield of 4.25 percent, and (2) invest all the funds in a Swiss government security over the same horizon, locking in the spot and forward currency exchanges in the FX market. A quick call to the bank's FX desk gives you the following two-way currency exchange quotes.
Swiss Francs per U.S. Dollar U.S. Dollar per Swiss Franc (CHF)
Spot 1.5035 0.6651
1-year CHF futures 0.6586
a.Calculate the one-year bond equivalent yield for the Swiss government security that would support the interest rate parity condition.
a) Assuming the actual yield on a one-year Swiss government bond is 5.50 percent, which strategy would leave the treasurer with the greatest return after one year?
b) Describe the transactions that an arbitrageur could use to take advantage of this apparent mispricing, and calculate what the profit would be for a $250,000 transaction.
5.) Bonita Singer is a hedge fund manager specializing in futures arbitrage involving stock index contracts. She is investigating potential trading opportunities in S&P 500 stock index futures to see if there are any inefficiencies that she can exploit. She knows that the S&P 500 stock index is currently trading at 1,100.
a) Assume that the Treasury yield curve is flat at 3.2 percent and the annualized dividend yield on the S&P index is 1.8 percent. Using the cost of carry model, demonstrate what the theoretical contract price should be for a futures position expiring six months from now.
b) Describe the set of transactions that Bonita would have to undertake to take advantage of an actual futures contract price that was (1) substantially higher or (2) substantially lower than the theoretical value you established in Part a.
c) Assuming that total round-trip arbitrage transaction costs are $20 for the set trades described in Part b, calculate the upper and lower bounds for the theoretical contract price such that arbitrage trading would not be profitable.