Today is April 1st. A bank needs to borrow $100 million on May 15th by selling 90-day Eurodollar deposits. Bank’s Treasury desk is looking into derivatives contracts for hedging the bank’s risk and is interested in the June Eurodollar futures contract with a current price of 93.25 and a contract size of $1 million.
Explain the risk faced by the bank in the spot market and determine the futures position that the Treasury desk should take in order to hedge against the risk.
On May 15, LIBOR rate and the Eurodollar futures contract rate both are equal to 5 percent. Assuming that the Treasury desk constructs the hedge position you have identified in part (a), CALCULATE the hedged and unhedged effective cost of borrowing for your bank. EXPLAIN whether the hedge was a mistake.