Question

Question 4 20 pts A company approaches a bank and wants to deposit $7m from the bank starting in 175 days for 90 days. The bank sees the current market information as • 175 day continuously compounded rate is 3.8671%. • There is a Eurodollar futures contract expiring in 175 days with a price of 96.3491. The bank sets their deposit rate at 0.3% below fair. At what rate does the bank set its rate? % (solve to 4 decimal places and write 4.0025 to represent 4.0025%) From the bank's perspective what are the two cash flows on the deposit. Remember a positive number represents the bank receiving cash. Round your answer to the nearest penny (0.01) First Cash Flow Second Cash Flow What is the present value of this FRA from the bank's perspective? Round your answer to the nearest penny (0.01) The company agrees to deposit to the bank. The bank immediately hedges this transaction with the Eurodollar futures contract. What position do they enter? (type 5 for long five contracts and -5 for short five contracts)

Answer 1

Eurodollar (ED) futures contract is a 90 day contract (interest rate) after the expiration.

In the question ED future contract expiring in 175  days = 96.3491

Interest rate = 100 - 96.3491 = 3.6509%

This means that if a I buy an ED future contract right now, after 175 days, I will be able to invest my money at 3.6509% for a period of 90 days.

So if bank receives $7m after 175days for a period of 90days, the bank can go long on an ED future contract.

The bank will receive an interest of 3.6509% pa for a period of 90days.

(i) So bank will lend at the rate = 3.6509% - 0.3% = 3.3509%

Cash flow for deposit

First cash flow = +$7m (when it receives the money)

*Second cash flow = -$7m(1+3.3509%*90/360) = -$7.05864m

(interest paid for a period of 90 days on $7m)

(b) Value of FRA (forward rate agreement) from banks perspective

The bank has locked a margin of 0.3% after 175 days

Value of margin = 0.3% of $7m = 0.021m

Present value = $0.021m * e^(-3.8671%*175/360)

= 0.021*0.9813

=$0.0206073m

(c) 1 ED future contract is $1m

So bank will have to go long on +22 contracts