Question

Suppose that it is January, and your bank makes a $1 million loan with a one-year maturity and carries 4% fixed interest rate. The bank initially finances the loan by issuing a $1 million 3-month Eurodollar CD paying 2.5%. After the first three months, the bank expects to finance the loan by issuing another $1 million 3-month Eurodollar CD in April (assume the rate becomes 2.9%), and another $1 million 3-month Eurodollar CD in June (assume the rate becomes 2.4%), and another $1 million 3month Eurodollar CD in Sept. (assume the rate becomes 3.25%).

Suppose that you want to hedge the interest rate risk through options on financial futures. Your bank decides to buy one put option on each of the June, September, and December Eurodollar futures at 97.5 strike price. The option premium paid for June is .35; for September .75; and for December is 1.12.

Suppose also that on June, the Eurodollar future rate becomes 3.1% and the put option premium becomes .55. In Sept., the Eurodollar future rate becomes 2.8% and the put option premium becomes .45. In Dec., Eurodollar future rate becomes 4.3% and the put option premium becomes 1.95

You need to set-up a table that shows:

(1) profit and loss profile of your bank hedge operation;

(2) the effective average cost of your bank CD

Answer 1

1. Amount of Loan made by the Bank = $ 1,000,000 @ 4%

Hence Interest Receivable at the end of one year = $ 1,000,000*4%= $40,000

2. Euro Dollar CD Payments: (a+b+c+d) = $27,625

a) Cost of Euro Dollar CD issued in the month January for 3 months = $1,000,000*2.5%*3/12= $6250

b) Cost of Euro Dollar CD issued in the month April for 3 months = $1,000,000*2.9%*3/12= $7250

c) b) Cost of Euro Dollar CD issued in the month June for 3 months = $1,000,000*2.4%*3/12= $6000

d) Cost of Euro Dollar CD issued in the month September for 3 months = $1,000,000*3.25%*3/12= $8125

3) Profit and Loss on Hedge Operation = (e+f+g) = $.73*10,256 = $7487 (For a complete hedge, the bank will have to buy put option worth the exposure of $1,000,000, Since the strike price at which put option is bought is $97.5 and only one put option has been bought, no. of units in one put option = $1,000,000/$97.5 ~ 10,256)

e) Gain/Loss on June Put option bought @ $.35, Strike price 97.5 = .20$

Premium Paid on Buying = $.35

Maturity price at the end of 3 months (Price of June Put option in September) = $.55

Gain = $.55 - $.35 = .20$

f) September Put option bought @ $.75, Strike price $97.5 = .

Premium Paid on Buying = $.75

Maturity price at the end of 3 months (Price of June Put option in December) = .45

Loss = $.45 - $.75 = $-.30

g) December Put option bought @ $1.12, Strike price =97.5

Premium Paid on Buying = 1.12

Maturity price at the end of 3 months (Price of September Put option) = $1.95

Gain = $1.95 - $1.12 = $.83

Answer (1) = (3) $7487

Answer (2) = (2) - (3) = $20,138 (Cost of Euro Dollar CD net of gain from Hedge operation)