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Answers to End-of-Chapter Questions

1.

Because for any given price at expiration, a lower strike price means a higher profit for a call option
and a lower profit for a put option. A lower strike price makes a call option more desirable and raises
its premium and makes a put option less desirable and lowers its premium.

2.

It would swap interest on $5 million of variable-rate assets for the interest on $5 million of fixed-rate
assets, thereby eliminating its income GAP.

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Quantitative Problem

1.

You would like to enter into a contract which specifies that you will purchase $120 million of bonds
with an interest rate equal to the current interest rate six months from now.

2.

You would enter into a contract that specifies that you will sell the $25 million of 8s of 2015 at a
price of 110 one year from now.

3.

The futures price must fall to 101. Otherwise, arbitrageurs would buy the bond for 101, sell the future
contract at 102 and then deliver the bond, thereby making a risk-free profit of 1 point. This is such a
good deal that huge sales of the futures contract will result, driving down its price to 101 so that no
risk-free profits can be made.

4.

You have a loss of 6 points, or $6000, per contract.

5.

You would buy a $100 million worth, i.e. 1000 contracts, of long-term bond futures contract with an
expiration date of one year in the future. This means that you would be entitled to delivery of the
long-term bond at todays price so that the current rate would be locked in.

6.

You would buy $100 million worth (1000 contracts) of the call long-term bond option with a delivery
date of one year in the future and with a strike price that corresponds to a yield of 8%. This means
that you would have the option to buy the long bond with the 8% interest rate, thereby making sure
that you can earn the 8%. The disadvantage of the options contract is that you have to pay a premium
that you would not have to pay with a futures contract. The advantage of the options contract is that if
the interest rate rises and the bond price falls during the next year, you do not have to exercise the
option and so will be able to earn a higher rate than 8% when the funds come in next year, whereas
with the futures contract, you have to take delivery of the bond and will only earn 8%.

7.

The put option is out of the money because you would not want to take the option to sell the futures
at 95 when the price at expiration is 120. Since the premium is $4,000 and you did not exercise the
contract, your loss on the contract is $4,000.

8.

You have a profit of 1 point ($1000) when you exercise the contract, but you have paid a premium of
$1500 for the call option, so your net profit is $500, a loss of $500.

9.

Because an option has the feature of that you win big if the price has a large change in one direction
but dont lose big if the price has a large change in the other direction. More volatility of the price
means that on average you will have a larger profit because you are more likely to win big with either
a call or a put option and thus their premiums will be higher.

10. It would swap interest on $42 million of fixed-rate assets for the interest on $42 million of variablerate assets, thereby eliminating its income gap.
11. You would buy 200 million euros of futures March futures contracts. With a contract size of 125,000
euros you would buy 200 million/125,000 = 1600 contracts.
12. You would hedge the risk by buying 80 euro futures contracts that mature 3 months from now.

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175

13. You would want to enter into a contract in which you deliver 30 million euros six months from now
in exchange for U.S. $30 million.
14. A hedger takes a short position in five T-bill futures contracts at the price of 98 5 32 . Each contract is
for $100,000 principal. When the position is unraveled, the price is 95 12 32 . What is the gain/loss on
this transaction?
Solution: Gain/contract = (98 5 32 95 12 32) 1,000 = 2,781.25
Total gain = 2,781.25 5 = 13,906.25
15. A bank issues a $100,000 variable-rate, 30-year mortgage with a nominal annual rate of 4.5%. If the
required rate drops to 4.0% after the first six months, what is the impact on the interest income for the
first 12 months? Assume the bank hedged this risk with a short position in a 181-day T-bill future.
The original price was 97 26 32 and the final price was 98 1 32 on a $100,000 face value contract. Did
this work?
Solution: At 4.5%, the required payment is calculated as:
PV = 100,000, I = 4.5/12, N = 360, FV = 0
Compute PMT. PMT = 506.685
If rate remain at 4.5%, the mortgage balance after 12 months is:
PMT = 506.685, N = 348, I = 4.5/12, FV = 0
Compute PV. PV = 98,386.71, or $1,613.29 of the payments went toward principal.
The total payments = 506.685 12 = $6,080.22.
Interest income for the year is $6080.22 $1613.29 = $4,466.93
If rates drop to 4% for the last 6 months of the year:
First, calculate the interest for the first six months:
PMT = 506.685, N = 354, I = 4.5/12, FV = 0
Compute PV. PV = 99,202.38, or $797.62 of the payments went toward principal.
The total payments = 506.685 6 = $3,040.11.
Interest income for the year is $3040.11 $797.62 = $2,242.49 of interest income.
Next, calculate the interest for the last six months:
At 4.0%, the required payment is calculated as:
PV = 99,202.38, I = 4.0/12, N = 354, FV = 0
Compute PMT. PMT = 477.772
PMT = 477.772, N = 348, I = 4.0/12, N = 354, FV = 0
Compute PV. PV = 98,312.41, or $889.97 of the payments went toward principal.
The total payments = 477.772 6 = $2,866.63.
Interest income for the year is $2866.63 $889.97 = $1,976.66 of interest income.
Total interest income = $2,242.49 + $1,976.66 = $4,219.15
Interest income has fallen by $247.78, or 5.5%.
The gain on the T-bill future = (98 1/32 97 26/32) 1,000 = 218.75. This reduced the
loss in interest income to just $29!

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16. Laura, a bond portfolio manager, administers a $10 million portfolio. The portfolio currently has a
duration of 8.5 years. Laura wants to shorten the duration to 6 years using T-bill futures. T-bill
futures have a duration of 0.25 years and are trading at $975 (face value = $1,000). How is this
accomplished?
Solution: The average portfolio duration needs to be 6 years.
10,000,000 6 = (10,000,000 8.5) + (Y 0.25)
60,000,000 = 85,000,000 + (Y 0.25)
25,000,000 = Y 0.25
Y = 100,000,000
Laura must take a short position in $100,000,000 worth of T-bill futures. At the current
price, this requires 100,000,000/975 = 102,564 contracts.
17. Futures are available on 3-month T-bills with a contract size of $1 million. If you take a long position
at 96.22 and later sell the contracts at 96.87, how much would the total net gain or loss be on this
transaction?
Solution: Gain = (96.87 96.22) 10,000 = 6,500 per contract.
18. Chicago Bank and Trust has $100 million in assets and $83 million in liabilities. The duration of the
assets is 5.9 years, and the duration of the liabilities is 1.8 years. How many futures contracts does
this bank need to fully hedge itself against interest rate risk? The available Treasury bond futures
contracts have a duration of 10 years, a face value of $1,000,000, and are selling for $979,000.
Solution: This requires creating a DURgap = 0. Clearly, the duration of the assets exceeds the
duration of the liabilities, so the bank will take a short position, effectively increasing its
liabilities. Assume that the dollar amount of the position is Y.

DURgap = 5

83 + Y 83
Y

1.8 +
10 = 0
100
83 + Y
83 + Y

500 = 149.40 + 10Y


Y = 35.06, or a position in $35,060,000 futures.
At the current price, this requires 35,060,000/979,000 = 35.812 contracts, or 36.
19. A bank issues a $3 million commercial mortgage with a nominal APR of 8%. The loan is fully
amortized over 10 years requiring monthly payments. The bank plans on selling the loan after
2 months. If the required nominal APR increases by 45 basis points when the loan is sold, what
loss does the bank incur?
Solution: The mortgage requires monthly payments as follows:
PV = 3000000, I = 8/12, N = 120, FV = 0
Compute PMT. PMT = $36,398.28
After 2 months, the remaining balance is:
PMT = 36398.28, I = 8/12, N = 118, FV = 0
Compute PV. PV = 2,967,094.27
However, at the prevailing rate, the mortgage is sold for:
PMT = 36398.28, I = 8.45/12, N = 118, FV = 0
Compute PV. PV = 2,910,552.12, or at a loss of $56,542.15

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177

20. Assume the bank in the previous question partially hedges the mortgage by selling three 10-year
T-note futures contracts at a price of 100 20 32 . Each contract is for $1,000,000. After 2 months, the
futures contract has fallen in price to 98 24 32 . What was the gain or loss on the futures transaction?
Solution: On each contract, the gain is (100 20 32 98 24 32) 10, 000 = 18, 750
Total gain = 18,750 3 = 56,250
21. Springer Country Bank has assets totaling $180 million with a duration of 5 years, and liabilities
totaling $160 million with a duration of 2 years. Bank management expects interest rates to fall from
9% to 8.25% shortly. A T-bond futures contract is available for hedging. Its duration is 6.5 years and
is currently priced at 99 5 32 . How many contracts does Springer need to hedge against the expected
rate change? Assume each contract is has a face value of $1,000,000.
Solution: $180 million 5 = ($160 million 2) + (TB 6.5)
TB = 89,230,769
Since the current price is $991,562.50, this requires 90 contracts. They should take a short
position.
22. From the previous question, rates do indeed fall as expected, and the T-bond contract is priced at
103 5 32 . If Springer closes its futures position, what is the gain or loss? How well does this offset the
approximate change in equity value.

Solution: DURgap = DURa DURl = 5 (160 /180) 2 = 3.22


A

Change in equity = 3.22 (0.0075/1.09) 180,000,000 = 3,990,826


Each T-bill contract is worth $1,031,562.50, or $92,840,625 for the 90 contracts. This
represents a loss of $3,609,856, which roughly offsets the gain in equity value.
Although it appears that the bank would have been better off doing nothing, there was no
guarantee that rates would not rise!
23. A bank issues a $100,000 fixed-rate, 30-year mortgage with a nominal annual rate of 4.5%. If the
required rate drops to 4.0% immediately after the mortgage is issued, what is the impact on the value
of the mortgage? Assume the bank hedged the position with a short position in two 10-year T-bond
futures. The original price was 64 12 32 and expired at 67 16 32 on a $100,000 face value contract. What
was the gain on the futures? What is the total impact on the bank?
Solution: At 4.5%, the required payment is calculated as:
PV = 100,000, I = 4.5/12, N = 360, FV = 0
Compute PMT. PMT = 506.685
In a 4.0% market, the value of the mortgage is:
PMT = 506.685, I = 4.0/12, N = 360, FV = 0
Compute PV. PV = 106,131.
The value of the mortgage has increased by $6,131, or 6.131%.
The gain on each futures contract is ( 67 16 32 64 12 32 ) 1,000 = $3,125. The total gain is
$6,250. However, depending on how this is handled, the loss in mortgage value will not
show on the balance sheet or income statement. However, the gain in futures will. This
could potentially create a tax liability, perhaps as high as several thousand dollars. The
exact treatment of the gain under current tax rules can be quite complicated and may
diminish the ability of the bank to properly hedge.

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24. The bank customer will be going to London in June to purchase 100,000 in new inventory. The
current spot and futures exchange rates are:
Exchange Rates
Dollars/Pound
Period
Spot
March
June
September
December

Rate
1.5342
1.6212
1.6901
1.7549
1.8416

The customer enters into a position in June futures to fully hedge her position. When June arrives, the
actual exchange rate is $1.725 per pound. How much did she save?
Solution: She paid an actual rate of $1.6901 per pound, or $169,010. Had she simply taken the spot
rate at the time, the cost would have been $172,500. She saved $3,490. Of course, the
actual rate could have been below $1.6901.
25. Consider a put contract on a T-bond with an exercise price of 10112 32 . The contract represents
$100,000 of bond principal, and had a premium of $750. The actual T-bond price falls to 98 16 32 at the
expiration. What is the gain/loss on the position?
Solution: The gain per contract is (10112 32 98 16 32) 1,000 = $2,875. If you include the premium
paid, the gain is $2,125 per contract.
26. Consider a put contract on a T-bond with an exercise price of 10112 32 . The contract represents
$100,000 of bond principal and has a premium of $750. The actual T-bond price is currently 100 1 32 .
How can you arbitrage this situation?
Solution: (1) Purchase the actual T-bond for $100,031.25
(2) Purchase the put option for $750.
(3) Exercise the option, and sell the T-bond for $101,375.
This represents a gain of $593.75. If all three steps can be done simultaneously, there is no
risk or capital involved.
27. A banker commits to a two-year $5,000,000 commercial loan and expects to fulfill the agreement in
30 days. The interest rate will be determined at that time. Currently, rates are 7.5% for such loans. To
hedge against rates falling, the banker buys a 30-days interest rate floor with floor rate of 7.5% on a
notional amount of $10,000,000. After 30 days, actual rates fall to 7.2%. What is the expected interest
income from the loan each year? How much did the option pay?
Solution: Assuming a simple interest commercial loan, the interest received each year will be
7.2% $5,000,000 = $360,000.
If rates had remained at 7.5%, the interest income would have been 7.5% 5,000,000 =
$375,000.
Since rates fell, the floor pays $10,000,000 (0.075 0.075) = $30,000. This makes up
from the lower interest ($15,000) in both years. Unfortunately, the entire gain will
probably have to be recognized this year.

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179

28. A trust manger for a $100,000,000 stock portfolio wants to minimize short-term downside risk using
Dow put options. The options expire in 60 days, have a strike price of 9,700, and a premium of $50.
The Dow is currently at 10,100. How many options should she use? Long or short? How much will
this cost? If the portfolio is perfectly correlated with the Dow, what is the portfolio value when the
option expires, including the premium paid?
Solution: The trust manager needs 100,000,000/10,100 = 9,901 contracts. This will cost $495,050.
The value of the portfolio as a function of the Down will look like:

29. A swap agreement calls for Durbin Industries to pay interest annually based on a rate of 1.5% over
the one-year T-bill rate, currently 6%. In return, Durbin receives interest at a rate of 6% on a fixedrate basis. The notional principal for the swap is $50,000. What is Durbins net interest for the year
from the agreement?
Solution: Durbin pays 7.5% $50,000 and receives 6% 50,000, or net, pays 1.5% 50,000 = $750.
30. North-Northwest Bank has a differential advantage in issuing variable-rate mortgages, but does not
want to interest income risk associated with such loans. The bank currently has a portfolio of
$25,000,000 mortgages with an APR of prime + 150 basis points, reset monthly. Prime is currently
4%. An investment bank has arranged for NNWB to swap into a fixed interest payment of 6.5% on a
notional amount of $25,000,000 in return for its variable interest income. If NNWB agrees to this,
what interest is received and given in the first month? What if prime suddenly increased 200 basis
points?
Solution: NNWB earns $25,000,000 (0.055/12) = $114,583.33. This is turned over to the
investment bank under the terms of the swap. In return, NNWB receives $25,000,000
(0.065/12) = $135,416.67.
If prime jumps 200 basis points, NNWB earns $25,000,000 (0.075/12) = $156,250. This
is turned over to the investment bank under the terms of the swap. In return, NNWB
receives $25,000,000 (0.065/12) = $135,416.67.

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