Bank Management / Advanced Commercial Banking Exam 3

NAME: __________________________________________

Multiple Choice (15 questions, 30 points)

1. Financial derivatives can be used by FIs to manage

a. credit risk
b. interest rate risk
c. liquidity risk
d. foreign exchange risk
e. answers a, b, and d only

2. A futures contract
a. is a direct contract between two parties created to meet the specific needs of the parties
b. has more counterparty risk than a forward contract
c. are standardized because they are offered by and traded on an exchange
d. are used more frequently than swaps
e. none of the above

3. An agreement between a buyer and a seller to immediately exchange a specific asset for payment
of cash is a
a. forward contract
b. spot contract
c. futures contract
d. call option
e. put option

4. What entity assumes counterparty risk in a futures contract?

a. the exchange upon which the contracts are traded
b. the seller of the contract
c. the buyer of the contract
d. the Commodity Futures Trading Commission
e. the FDIC

5. Which of the following scenarios is an example of microhedging an asset-side portfolio risk?

a. An FI sells futures to lock in its cost of funds against rising rates
b. An FI sells futures to hedge its bond portfolio from a rise in rates
c. The FI uses derivatives to hedge its balance sheet duration gap
d. An FI writes options to fund a hedge position

6. The sensitivity of the price of a futures contract depends upon the duration of the deliverable asset
underlying the contract.
a. True
b. False

7. FIs may want to write options to increase fee income; in so doing they are serving as a
counterparty for other parties wanting to hedge balance sheet risks.
a. True
b. False

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Bank Management / Advanced Commercial Banking Exam 3

8. Writing a call option is a bullish strategy.

a. True
b. False

9. The potential loss to a long call position is limited to the premium paid.
a. True
b. False

10. The buyer of a bond put option

a. receives a premium in return for standing ready to sell the bond at the exercise price
b. receives a premium in return for standing ready to buy bonds at the exercise price
c. pays a premium for the right to sell the underlying bond at the exercise price
d. pays a premium for the right to buy the underlying bond at the exercise price
e. pays a premium for the obligation to sell the underlying bond at the exercise price

11. As interest rates increase the writer of a bond call option stands to make
a. limited gains
b. unlimited gains
c. limited losses
d. unlimited losses

12. Which of the following are good strategies to adopt when interest rates are expected to rise?
a. Sell futures
b. write puts
c. write calls
d. buy futures
e. a and c, only
f. b and d, only

13. Which of the following tells you the change in the option price for a $1 change in the underlying
bond?
a. open interest
b. volatility
c. time left in the contract
d. delta
e. theta

14. An FI issues (borrows) a $1 million, 18-month floating rate CD at LIBOR plus 125 basis points.
What is the FI’s net interest income (NII) exposure and how can it be hedged?
a. It’s NII is exposed to rate increases; short hedge by buying puts
b. It’s NII is exposed to rate increases; long hedge by buying calls
c. It’s NII is exposed to rate increases; short hedge by writing puts
d. It’s NII is exposed to rate decreases; long hedge by buying calls
e. It’s NII is exposed to rate decreases; short hedge by buying puts

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Bank Management / Advanced Commercial Banking Exam 3

Section I: Multiple Choice (40 points)

Hometown Bank makes a two-year fixed-rate loan to a customer. The bank funds the loan by
issuing a CD where the interest rate is tied to LIBOR and resets every six months. Answer the next
five questions based on this information.

15. Hometown Bank is accepting interest rate risk by making this loan.
a. True
b. False

16. Hometown Bank is exposed to falling interest rates.

c. True
d. False

17. Management at Hometown Bank wishes to hedge against the interest rate risk using derivatives
but has mandated that paying up-front premiums is unacceptable. The best choice for the bank
may be to:
a. buy a put option on a bond
b. buy a call option on a bond
c. short a Treasury futures contract
d. enter into a pay-floating receive-fixed swap

18. Suppose instead that management at Hometown Bank wishes to hedge the interest rate risk but
has mandated that any derivatives used must not limit the profitability upside (i.e. the potential
gain to the bank) should rates move in its favor. The best choice for the bank may be to:
a. buy a put option on a bond
b. buy a call option on a bond
c. short a Treasury futures contract
d. enter into a pay-fixed receive floating swap

19. Derivative contracts that have asymmetric payoffs are

a. futures, forwards, swaps
b. options
c. those that obligate the holder to deliver on the contract
d. all of the above
e. (a) and (c) only

20. A swap “price” is

a. the fixed interest rate set at the swap’s origination
b. the up-front swap premium paid by the swap buyer
c. the notional value of the swap
d. all of the above

21. The delta () of an option

a. ranges in absolute value between 0 and 1
b. is the change in the price of an option divided by the change in the price of the underlying
asset
c. is positive for call options and negative for put options
d. all of the above

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Bank Management / Advanced Commercial Banking Exam 3

22. An option that can be exercised profitably for the holder is said to be
a. in the money
b. out of the money
c. a tax liability
d. a speculative bet

23. All else equal, the speculative value of a call option on a bond is higher when
a. a long amount of time remains before the option expires
b. the price of the underlying bond is very volatile with a high standard deviation
c. the strike price is high relative to the spot price
d. all of the above
e. only (a) and (b)

24. Which option type allows the user to exercise the option any time prior to expiration?
a. American option
b. Bermudan option
c. European option
d. all of the above

25. A put option on a bond has a strike price of $99 and the market price of the bond right now is
$100. The premium on the option is $2.43. From this information we know that the speculative
value of the option is
a. $0
b. $0.43
c. $1.43
d. $2.43

26. Credit default swaps (CDS) on a pool of mortgage-backed securities

a. are similar to put options in that they have asymmetric payoffs.
b. differ from puts in that the payoff only occurs if there is a credit default on the securities.
c. were partly responsible for making the recent financial crisis more severe.
d. all of the above

27. Which of the following statements about swaps is not true?

a. Swaps are designed to have zero net present value at inception—the market’s best guess
is that the present values of the payments will net out.
b. Swaps take on positive value for the fixed-rate payer through time if actual interest rates
are below the expected (projected) rates.
c. Swaps are priced so that if the fixed-rate payer pays a higher rate than the floating rate
payer in the first reset period, the pattern is expected to reverse in future periods.
d. Swaps are convenient derivative instruments because they are equivalent to a series of
forward rate agreements on interest rates.

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Bank Management / Advanced Commercial Banking Exam 3

28. A bank makes a $5 million two-year fixed-rate loan at 8% to a customer and funds it with a series
of 6-month CDs where the interest rate equals the 6-month LIBOR. Given this position, we know
that
a. the bank is exposed to rising rates.
b. the bank can perfectly hedge its risk by entering into a pay-fixed receive-floating, 2-year
semi-annual swap with a notional value of $5 million where the floating rate leg is
indexed to 6-month LIBOR.
c. If the bank hedges its interest rate risk with a swap, it will effectively lock in its margin
on the 2-year loan.
d. all of the above

29. Which of the following best describes a macrohedge?

a. An FI hedges a risk position that is more than $1 million in notional value.
b. A hedge where the interest rate movements of the on-balance-sheet asset are identical to
the interest rate movements of the bond underlying the derivative.
c. A hedge on the entire economic value of equity risk of the FI.
d. A hedge that insulates an FI against losses from changes in inflation rates.

30. If it is more likely that the Fed will begin to raise rates soon, effective strategies for banks
exposed to rising rates would be to
a. increase their asset duration
b. increase their liability duration
c. implement pay-floating, receive fixed swaps.
d. all of the above

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Bank Management / Advanced Commercial Banking Exam 3

Problems (50 points)

1. A bank holds $15 million in corporate bonds with a duration of 2 years. The bank wants to hedge
the interest rate risk to this position by using options. The current market value of T-bonds
underlying the contract is $102.0 per $100 face value (one contract=$100,000 face value), and the
duration of the T-bonds is 4 years. The δ of the option is |0.6|.

a. (2 points) Is this a macro hedge or a micro hedge?

Microhedge

b. (3 points) Would they write or buy options? Calls or puts? WHY? (hint – they’re hedgers,
not speculators in this case)
Buy puts. When interest rates rise, the gains in put options will offset the value losses on the bonds.

c. (5 points) How many contracts will it use to fully hedge the risk?
𝐷∗𝑃
𝑁𝑜 =
|𝛿| ∗ 𝐷𝐹 ∗ 𝑃𝐹

2 ∗ 15,000,000
𝑁𝑜 = = 122.55 ≅ 122 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠
|0.6| ∗ 4 ∗ 102,000

d. (5 points) If interest rates rise by 1% (in other words, Δr/(1+r) = .01) calculate the
gain/loss to the corporate bond portfolio.
Δ𝑟
ΔP𝐵𝑜𝑛𝑑 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = −(𝐷𝐵 ∗ 𝑃 ∗ )
1+𝑟

ΔP𝐵𝑜𝑛𝑑 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = −(2 ∗ $15𝑚 ∗ .01) = −$300,000

e. (5 points) If interest rates rise by 1% (in other words, Δr/(1+r) = .01) calculate the
gain/loss to the options position.
ΔrF
Δ𝑂 = No ∗ Δ𝑃𝑜 = 𝑁𝑜 ∗ 𝛿 ∗ (−𝐷𝐹 𝑃𝐹 ) ∗ ( )
1 + rF

Δ𝑂 = 122 ∗ −0.6 ∗ (−4 ∗ 102,000) ∗ .01 = 298,656

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Bank Management / Advanced Commercial Banking Exam 3

2. An FI has a $200 million asset portfolio with an average duration of 3.4 years. The average
duration of its $180 million in liabilities is 2.2 years. It uses futures on T-bonds to hedge interest
rate risk. The market value of T-bonds is $99 per $100 face value (T-bond contracts are $100,000
face value) and the duration of T-bonds is 3 years.

a. (2 points) Is this a macro hedge or a micro hedge?

Macrohedge

b. (3 points) Will FI long or short futures contracts? WHY?

Its duration gap is positive, so it is exposed to equity losses when rates rise, therefore it should short the
T-Bond futures.

c. (5 points) How many contracts will the FI use to hedge against unwelcome changes in
interest rates?
𝐿
(𝐷𝐴 − 𝐴 ∗ 𝐷𝐿 ) ∗ 𝐴
𝑁𝐹 =
𝐷𝐹 ∗ 𝑃𝐹

180
(3.4 − 200 ∗ 2.2) ∗ $200,000,000
𝑁𝐹 = = 956.23 ≅ 956 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠
3 ∗ $99,000

d. (5 points) If interest rates fall by 1% (that is, Δr/(1+r) = -.01) what is the gain/loss to the
FI’s equity?
Δ𝐸 = −(𝐷𝐴 − 𝐿/𝐴 ∗ 𝐷𝐿 ) ∗ 𝐴 ∗ Δ𝑟/(1 + 𝑟)

180
Δ𝐸 = − (3.4 − ∗ 2.2 ) ∗ $200,000,000 ∗ −.01 = $2,840,000
200

e. (5 points) If interest rates fall by 1% (that is, Δr/(1+r) = -.01) what is the gain/loss to the
futures position?

Δ𝐹 = −[−𝐷𝐹 /(1 + 𝑟𝐹 ) ∗ 𝑁𝐹 ∗ 𝑃𝐹 ∗ ΔrF ]

Δ𝐹 = −[−3 ∗ 956 ∗ $99,000 ∗ −.01] = −$2,839,320

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Bank Management / Advanced Commercial Banking Exam 3

Part II: Problem Solving Questions (60 points)

1) (+15) Bank management wishes to enter into a pay-fixed receive-floating swap with a counterparty.
The key features of the swap are these:

Notional value $1 million

Maturity 3 years
Payment frequency Annual
Reset frequency Annual
Floating rate payer One-Year LIBOR
Fixed rate payer ???

a) Use the table below with the given forward rates to calculate the present value of the floating rate
cash flows.

Year Rate Pmt Discount factor PV of Payment

1 2.50% 25000 0.9756 24390.00
2 2.40% 24000 0.9527 22864.80
3 1.90% 19000 0.9349 17763.10
Total ---- ---- ---- 65017.90

b) Calculate the discounted notional value of the fixed cash flows.

Year Rate Pmt Discount factor PV of Payment

1 R 1000000R 0.9756 975,600.00 R
2 R 1000000R 0.9527 952,700.00 R
3 R 1000000R 0.9349 934,900.00 R
Total --- --- --- 2,863,200.00 R

c) Calculate the price (fixed interest rate) of the swap.

𝑃𝑉𝐹𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠ℎ 𝐹𝐿𝑜𝑤𝑠
𝐹𝑖𝑥𝑒𝑑 𝑅𝑎𝑡𝑒 =
𝑃𝑉𝐹𝑖𝑥𝑒𝑑 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠

65,017.90
𝐹𝑖𝑥𝑒𝑑 𝑅𝑎𝑡𝑒 = = 2.27%
2,863,200

d) Circle one: If the actual interest rate rises above 2.5% right after the inception of the swap and
stays that high for the next two years, who comes out ahead?

FIXED RATE PAYER FLOATING RATE PAYER

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Bank Management / Advanced Commercial Banking Exam 3

2) (+15) A bank holds $75 million in long-term corporate securities with an average duration of 3.1
years. The bank wishes to perfectly hedge against the interest rate risk by using options. The current
market value of T-bonds underlying the contract is $104.3 per $100 face value (one
contract=$100,000 face value), and the duration of the T-bonds is 5 years. The δ of the option is |0.7|.

a) Which side of the option contract (call/put) should the bank enter into?
Put

b) How many contracts should it purchase to fully hedge the interest rate risk?
𝐷∗𝑃
𝑁𝑜 =
|𝛿| ∗ 𝐷𝐹 ∗ 𝑃𝐹

3.1 ∗ 75,000,000
𝑁𝑜 = = 635.899 ≅ 636 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠
|0.7| ∗ 5 ∗ 104,300

c) If interest rates rise by 1% (proportionally), calculate the gain/loss to the net position of the FI
given the change in the price of the corporate bonds.
Δ𝑟
ΔP𝐵𝑜𝑛𝑑 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = −(𝐷𝐵 ∗ 𝑃 ∗ )
1+𝑟

ΔP𝐵𝑜𝑛𝑑 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = −(3.1 ∗ $75𝑚 ∗ .01) = −$2,325,000

d) If interest rates rise by 1% (proportionally) calculate the gain/loss in the value of the option
position.
ΔrF
Δ𝑂 = No ∗ Δ𝑃𝑜 = 𝑁𝑜 ∗ 𝛿 ∗ (−𝐷𝐹 𝑃𝐹 ) ∗ ( )
1 + rF

Δ𝑂 = 636 ∗ −0.7 ∗ (−5 ∗ 104,300) ∗ .01 = $2,321,718

3) (+15) An FI has a $300 million asset portfolio with an average duration of 5.2 years. The average
duration of its $240 million in liabilities is 3.4 years. It uses options on T-bonds to hedge against
unfavorable changes in interest rates. The  of the options is |0.3|, and the average duration of T-
bonds is 7.5 years. The current market value of the T-bonds is $98 per $100. (Each T-bond contract
is for $100,000 face value.)

a) Should the FI purchase put or call options? ____________________

Put

b) How many option contracts should the FI purchase to hedge against unfavorable changes in
interest rates?
𝐿
(𝐷𝐴 − 𝐴 𝐷𝐿 ) 𝐴
𝑁𝑜 =
|𝛿|𝐷𝐹 𝑃𝐹

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Bank Management / Advanced Commercial Banking Exam 3

240
(5.2 − 300 3.4) $300,000,000
𝑁𝑜 = = 3,374.15 ≅ 3,375 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠
|0.3| ∗ 7.5 ∗ $98,000
4) (+15) An FI has a $500 million asset portfolio with an average duration of 1.2 years. The average
duration of its $460 million in liabilities is 3.8 years. The bank wishes to hedge against the interest
rate risk in the futures market. The current price of a Eurodollar bond underlying the futures contract
is $101.50 per $100. Each contract is for a face value of $1,000,000. The duration of the Eurodollar
bonds is 4 years.

a) Which side of the futures contract (short/long) should the bank enter into?
Its duration gap is negative, so it is exposed to equity losses when rates fall, therefore it should long the
Eurodollar Bond futures.

b) How many contracts should it purchase or short to fully hedge the interest rate risk?

𝐿
(𝐷𝐴 − 𝐴 ∗ 𝐷𝐿 ) ∗ 𝐴
𝑁𝐹 =
𝐷𝐹 ∗ 𝑃𝐹

460
(1.2 − ∗ 3.8) ∗ $500,000,000
𝑁𝐹 = 500 = 282.759 ≅ 282 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠
4 ∗ $1,015,000

c) If interest rates fall by 1% (proportionally), calculate the gain/loss to the FI’s economic value of
equity.
Δ𝐸 = −(𝐷𝐴 − 𝐿/𝐴 ∗ 𝐷𝐿 ) ∗ 𝐴 ∗ Δ𝑟/(1 + 𝑟)

460
Δ𝐸 = − (1.2 − ∗ 3.8 ) ∗ $500,000,000 ∗ −.01 = −$11,480,000
500

d) If interest rates fall by 1% (proportionally), calculate the gain/loss to the FI's futures position.

Δ𝐹 = −𝐷𝐹 /(1 + 𝑟𝐹 ) ∗ 𝑁𝐹 ∗ 𝑃𝐹 ∗ ΔrF

Δ𝐹 = −4 ∗ 282 ∗ $1,015,000 ∗ −.01 = $11,449,200

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