Assume a corporation made a one-year loan at 10 percent with receipts of $1,000,

Question

Assume a corporation made a one-year loan at 10 percent with receipts of $1,000, the present value is $909.09. This loan is funded with 90-day CDs paying 8 percent. Lets say the date is September 15 and that you sell 13-week T-bill futures in December, March, and June as a hedge on the CDs.

Calculate the price of the T-bill futures contract using a 10 percent discount rate. There is no further interest rate change at this point.

Then........

1. What is the present value of the net receipts if interest rates rise 2 percent?

2. How does this change in net receipts compare with the result assuming no change in interest rates?

3. If interest rates declined rather than increased, what would be the effect on the balance sheet and futures hedge results?

4. How might the bank use an option on a futures contract to acheive the same result?

5. What are the advantages of using the option on a futures contract over a futures contract alone? What is the disadvantages of the options approach compared with using only a futures contract?

6. Finally, should the corporation seek to pair a hedge contract to each individual asset or liability on the balance sheet of first savings or should it seek to look at the big picture and hedge the overall risk of the balance sheet?

Explanation / Answer

Advantages of futures:
a) Get exposure to assets that would be cumbersome to hold otherwise. For example, you can't easily buy 40,000 bushels of corn and store it but you can buy the futures contract.
b) Have highly liquid investment in a less liquid underlier. For example, a bond futures contract is more liquid than the underlying treasury bond.
c) Massive leverage possibilities to make (or lose) money with small cash upfront.
d) Trade stuff with no counterparty risk (because there is a clearinghouse) when spot or forward trading would have multiple sources of counterparty risk (e.g., oil forwards have counterparty risk and oil futures don't)
e) According to Keynes you can earn economic rent by providing liquidity to hedgers.

Advantages of options:
a) Options allow you to bet on volatility increasing or decreasing not just price.
b) Options have asymmetric payoffs so you can make money trading options by specifying a price range that an underlier won't go to rather than specifying up or down.
c) Massive leverage possible
d) No counterparty risk in exchange traded options
e) Highly liquid markets in FX options, equity index options, futures options, some equity options, probably others.

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