FINA 424 Commercial Banking

QUESTION 1

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• Use the quotes of Eurodollar futures contracts traded on the Chicago Mercantile Exchange as shown below to answer the following questions:

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	Open	High	Low	Settle	Chg	High	Lifetime	Low	Open Int
							High/Low
Eurodollar (CME)-$1,000,000; pts. of 100%
Jun 08	97.2725	97.2875	97.2025	97.2150	−.0520	98.2550	Low	91.6800	1,264,397
Jly 08	97.2150	97.2250	97.0900	97.1200	−.1150	98.1850		97.0300	13,725
Aug 08	97.1200	97.1200	96.9500	96.9850	−.2150	98.2200		96.9500	2,929
Sep 08	97.1600	97.1850	96.8300	96.8850	−.2850	98.3350		91.6800	1,453,920
Dec 08	96.9750	97.0050	96.5500	96.6050	−.3800	98.2650		91.5700	1,384,300
Mar 09	96.8850	96.9200	96.4000	96.4550	−.4400	98.1850		91.5750	1,229,271
Jun 09	96.6900	96.7350	96.2200	96.2600	−.4500	98.0000		91.3100	985,412
Sep 09	96.4600	96.4900	96.0200	96.0450	−.4200	97.7700		91.2600	817,642
Dec 09	96.1650	96.2000	95.7750	95.8000	−.3700	97.5050		91.1600	607,401
Mar 10	95.9500	95.9850	95.5900	95.6150	−.3350	97.2750		91.4850	474,017

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2. a. What is the annualized discount yield based on the “low” index price for the nearest
3. March contract?
6. b. If your financial firm took a short position at the high price for the day for 15 contracts,
7. what would be the dollar gain or loss at settlement on June 09?
10. c. If you deposited the initial required hedging margin in your equity account upon taking the position described in (b), what would be the marked-to-market value of your equity account at settlement?

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QUESTION 2

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• You hedged your financial firm’s exposure to declining interest rates by buying one September call on Treasury bond futures at the premium quoted on April 15 as referenced in Exhibit 8-4.

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a. How much did you pay for the call in dollars if you chose the strike price of 11000? (Remember that option premiums are quoted in 64ths.)

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b. Using the following information for trades taking place on June 10. If you sold the call on June 10, due to a change in circumstances, would you have reaped a profit or loss? Determine the amount of the profit or loss.

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US TREASURY BONDS (CBOT)
$100,000, pts & 64ths of 100 pct
	Calls			Puts
Strike Price	Jul	Sep	Dec	Jul	Sep		Dec
10900	—	5-15	—	0-06	0-58		1-61
11000	3-34	4-31	4-47	0-12	1-10		2-20
11100	2-44	3-51	—	0-22	1-30		2-46
11200	1-59	3-12	3-39	0-37	1-54		3-11
11300	1-19	2-40	—	0-61	2-18		—
11400	0-52	2-09	2-46	1-30	2-51		4-17
11500	0-31	1-47	2-22	2-09	3-25		4-57

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QUESTION 3

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1. By what amount will the market value of a Treasury bond futures contract change if interest rates rise from 5 to 5.25 percent? The underlying Treasury bond has a duration of 10.48 years and the Treasury bond futures contract is currently being quoted at 113-06. (Remember that Treasury bonds are quoted in 32nds.)

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QUESTION 4

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1. It is March and Cavalier Financial Services Corporation is concerned about what an increase in interest rates will do to the value of its bond portfolio. The portfolio currently has a market value of $101.1 million, and Cavalier’s management intends to liquidate $1.1 million in bonds in June to fund additional corporate loans. If interest rates increase to 6 percent, the bond will sell for $1 million with a loss of $100,000. Cavalier’s management sells 10 June Treasury bond contracts at 109-050 in March. Interest rates do increase, and in June Cavalier’s management offsets its position by buying ten June Treasury bond contracts at 100-030.

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a. What is the dollar gain/loss to Cavalier from the combined cash and futures market operations described above?

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b. What is the basis at the initiation of the hedge?

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c. What is the basis at the termination of the hedge?

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d. Illustrate how the dollar return is related to the change in the basis from initiation to termination.

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QUESTION 5

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1. You hedged your thrift institution’s exposure to declining interest rates by buying one December call on Eurodollar deposit futures at the premium quoted earlier on April 15 (see Exhibit 8-4).

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a. How much did you pay for the call in dollars if you chose the strike price of 972500?

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b. If December arrives and Eurodollar Deposit Futures have a settlement index at expiration of 96.50, what is your profit or loss? (Remember to include the premium paid for the call option.)

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QUESTION 6

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1. Your financial firm needs to borrow $500 million by selling time deposits with 180-day maturities. If interest rates on comparable deposits are currently at 3.5 percent, what is the cost of issuing these deposits? Suppose interest rates rise to 4.5 percent. What then will be the cost of these deposits? What position and types of futures contract could be used to deal with this cost increase?

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QUESTION 7

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1. What kind of futures or options hedges would be called for in the following situations?

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a. Market interest rates are expected to increase and your financial firm’s asset-liability managers expect to liquidate a portion of their bond portfolio to meet customers’ demands for funds in the upcoming quarter.

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b. Your financial firm has interest-sensitive assets of $79 million and interest-sensitive liabilities of $88 million over the next 30 days and market interest rates are expected to rise.

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c. A survey of Tuskee Bank’s corporate loan customers this month (January) indicates that on balance, this group of firms will need to draw $165 million from their credit lines in February and March, which is $65 million more than the bank’s management has forecasted and prepared for. The bank’s economist has predicted a significant increase in money market interest rates over the next 60 days.

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d. Monarch National Bank has interest-sensitive assets greater than interest-sensitive liabilities by $24 million. If interest rates fall (as suggested by data from the Federal Reserve Board) the bank’s net interest margin may be squeezed due to the decrease in loan and security revenue.

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e. Caufield Thrift Association finds that its assets have an average duration of 1.5 years and its liabilities have an average duration of 1.1 years. The ratio of liabilities to assets is .90. Interest rates are expected to increase by 50 basis points during the next six months.

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QUESTION 8

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1. A bank is considering the use of options to deal with a serious funding cost problem. Deposit interest rates have been rising for six months, currently averaging 5 percent, and are expected to climb as high as 6.75 percent over the next 90 days. The bank plans to issue $60 million in new money market deposits in about 90 days. It can buy put or call options on 90 day Eurodollar time deposit futures contracts for a quoted premium of 31.00 or $775.00 for each million-dollar contract. The strike price is quoted as 950,000. We expect the futures to trade at an index of 935,000 within 90 days. What kind of option should the bank buy? What before tax profit could the bank earn for each option under the terms described?

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QUESTION 9

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Suppose the management of the First National Bank of New York decides that it needs to expand its fee-income-generating services. Among the services the bank is considering adding to its service menu are investment banking, the brokering of mutual funds, stocks, bonds and annuities, sales of life and casualty insurance policies, and offering personal and commercial trust services.

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a. Based on what you read in this chapter, list as many potential advantagesas you can that might come to First National as a result of adding these services to its menu.

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b. What potential disadvantagesmight the bank encounter from selling these fee-generating services?

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c. Are there risksto the bank from developing and offering services such as these? If so, can you think of ways to lower the bank’s risk exposure from offering these new services?

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d. What might happen to the size and volatility of revenues, expenses, and profitability from selling fee-based services like those mentioned above

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QUESTION 11

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A commercial bank decides to expand its service menu to include the underwriting of new security offerings (i.e., investment banking) as well as offering traditional lending and deposit services. It discovers that the expected return and risk associated with these two sets of service offerings are as follows:

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Expected return—traditional services	3.50%
Expected return—security underwriting	10.75%
Standard deviation—traditional services	2.50%
Standard deviation—security underwriting	8.25%
Correlation of returns between two services	+0.25
Proportion of revenue—traditional services	70.00%
Proportion of revenue—security underwriting	30.00%

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Please calculate the effects of the new service on the banking company’s overall return and risk as captured by the bank’s standard deviation of returns.

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QUESTION 11

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Based on what you learned from reading this chapter and from studies you uncovered on the Web, which of the financial firms listed below are most likely to benefit from economies of scale or scope and which will probably not benefit significantly from these economies based on the information given?

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a. A new bank offering traditional banking services (principally deposits and loans) was chartered earlier this year, gaining $50 million in assets within the first six months.

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b. A community bank with about $250 million in assets provides traditional banking services but also operates a small trust department for the convenience of families and small businesses.

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c. A financial holding company (FHC) with about $2 billion in assets offers a full range of banking and investment services, giving customers access to a family of mutual funds.

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d. A bank holding company with just over $10 billion in assets also operates a security brokerage subsidiary, trading in stocks and bonds for its customers.

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e. A financial holding company (FHC) with $750 billion in assets controls a commercial bank, investment banking house, chain of insurance agency offices, and finance company and supplies commercial and consumer trust services through its recently expanded trust department.