Question

In each of the following cases, identify what risk the manager of an FI faces and whether the risk should be hedged by buying a put or a call option.

a. A commercial bank holds three-month CDs in its liability portfolio.

b. An insurance company plans to buy bonds in two months.

c. A savings bank plans to sell Treasury securities it holds in its investment portfolio next month.

d. A U.S. bank lends to a French company with the loan payable in euros.

e. A mutual fund plans to sell its holding of stock in a British company.

f. A finance company has assets with a duration of six years and liabilities with a duration of 13 years.

Answer 1

a. He should buy a put option because if the rates rise, commercial deposit can be purchased at lower price and sold immediately after exercising the option.

b. He should buy call options that will allow him to purchase the bonds at the lower prices and these bonds purchased with options, can be sold immediately for a gain which can be applied against the lower yield realized in the market.

C. it should buy put option that allows the sale of the bonds at or near the current price.

D. Bank should buy put option because if the France currency will depreciate, the put option to sell Franck will minimise the loss.

E. It should buy a put to sell pound.

F. He should buy call option on interest bonds.