Question

# 3. . Mod. 5: Hedging with Interest Rate Futures (Chapter 8, pp. 191 to 193). [Hints:...

3. . Mod. 5: Hedging with Interest Rate Futures (Chapter 8, pp. 191 to 193).

[Hints: \$ Price for T-bills and Eurodollar Futures:

\$ Price = \$ Amount {1 – [(d x n)/360]}

where d = discount yield as a fraction; n = maturity, usually 90 days]

In March, a bank short-term investment manager has \$1 million in 90 day T-bills on its balance sheet that it plans to sell in June for liquidity purposes, and is worried about interest rates rising (i.e. prices falling) in the next few months, which would cause the value of the T-bills to fall. The current (spot) discount yield is 1.10% (i.e. a Discount % price of 98.90%) for a 90-day T-bill.

1. What is the price for the \$ 1 million of T-bills in dollars?

T-bill Price in Dollars = \$1,000,000 × {1- (0.011 × 90/360)} = \$997,250_

On the CME Group website, a June Eurodollar Futures contract gives a price of 98.10% (i.e., a discount yield of 1.90%) for a \$1 million, 90 day Eurodollar Futures contract.

1. What is the contract price for the Eurodollar Futures Contract in dollars?

Eurodollar Futures Price in Dollars _\$981,000 = \$1000000*98.10%____

What type of Eurodollar futures contract should be purchased (long or short)? Explain why.

Long or Short _Long_    Why?__the future contract is at a discount__

1. Suppose in June the T-bill discount yield goes up by 20 basis points to 1.30%, and the Eurodollar Futures yield goes up by 25 basis points to 2.15%, what is the new dollar price for the 1 mil. T-bills, and what is the new contract dollar price for the Eurodollar Futures Contract?

New T-bill Price in Dollars _______________

New Eurodollar Futures Price in Dollars ____________

1. What is the loss or gain for respectively the T-bills and the Eurodollar Futures contract? What is the net hedging result?

T-bill Position Loss _____Eurodollar Futures Gain_________

Net Hedging Result __________________

(a) Since you have invested in a T-bill with discount yield of 1.1% pa for 90 days. If interest rate rise after buying the T-bill the investment manager will make a loss. Therefore to hedge, the investment manager should go short on futures contract, ie the interest rate increases, the eurodollar futures price decreases, and the short position in futures contract gains money.

(a)New T-bill price = \$1,000,000*(1-1.3%*90/360) =\$996,750

(b) Eurodollar future quotation = 100% - 2.15% = 97.85%

Eurodollar futures price =\$1,000,000*97.85% = \$978,500

T-bill position loss = \$996,750 - \$997250 = -\$500

Gain Eurodollar futures = \$981,000 - \$978,500 = \$2500

Net hedging result = \$2500 -\$500 = \$2000 (gain)