Assume that Regions Savings Bank, a bank with $250 million in total assets, has determined that its leverage-adjusted duration GAP was 2.50. The board of directors is concerned that interest rates would soon be increasing substantially across the board; in fact, they wish to plan for a 1% increase in interest rates over the next year. The board has come to you to provide a short report of how the bank might approach this situation. Provide a summary of the choices for managing the bank's exposure to interest rate changes, both on and off the balance sheet. Include a discussion of how it might manage its exposure by using futures contracts, forward rate agreements, interest rate swaps, and options on T-bond futures. Be certain to describe the specifics of each hedging strategy (e.g., how many contracts or how large of a position, etc.). Current information on these contracts is as follows:
· 6-month T-bill futures contracts with a modified duration of 0.45 are currently available for $995,000 per contract.
· Forward rate agreements are being quoted at 6%.
· Seven-year swaps at 6% fixed against 6-month LIBOR are also available; the modified duration of comparable 7-year T-notes is 5.0.
· Put options on bond futures are available with a delta of = -0.45 with the modified duration of the underlying T-bonds at 4.8 at a price of $99,000 per bond.