# Hedging with Financial Derivatives

11) A bank added a bond to its portfolio. The bond has a duration of 12.3 years and cost $1,109. Just after buying the bond, the bank discovered that market interest rates are expected to rise from 8% to 8.75%. What is the expected change in the bond value?

5) Suppose that the pension you are managing is expecting an inflow of funds of $100 million next year and you want to make sure that you will earn the current interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this?

6) How would you use the options market to accomplish the same thing as in Problem 5? What the advantages and disadvantages of using an options contract rather than a futures contract?

11) If your company has a payment of 200 million euros due one year from now, how would you hedge the foreign exchange risk in this payment with 125,000 euros futures contracts?

13) Suppose that you company will be receiving 30 million euros six months from now and the euro is currently selling for 1 euro per dollar. If you want to hedge the foreign exchange risk in this payment, what kind of forward contract would you want to enter into?

23) A bank issues a $100,000 fixed-rate 30 year mortgage with a nominal annual rate of 4.5%. If the required rate drops to 4.0% immediately after the mortgage is issued, what is the impact on the value of the mortgage? Assume the bank hedged the position with a short position in two 10-year T-bond futures. The original price was 64 12/32 and expired at 67 16/32 on a $100,000 face value contract. What was the gain on the futures? What is the total impact on the bank?

24) A bank customer will be going to London in June to purchase 100,000 in new inventory. The current spot and futures exchange rates are as follows: The customer enters into a position in June futures to fully hedge her position. When June arrives, the actual exchange rate is $1.725 per pound. How much did she save?

4. Options Pricing Problem.

Answer the following question to be submitted to the Facilitator.

Calculate the call option value at the end of one period for a European call option with the following terms:

-The current price of the underlying asset = $80.

-The strike price = $75

-The one period, risk-free rate = 10%

-The price of the asset can go up or down 10% at the end of one period.

a. What is the fundamental or intrinsic value?

b. What is the time premium?

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Depreciation Methods

440) Wendy's boss wants to use straight-line depreciation for the new expansion project because he said it will give higher net income in earlier years and give him a larger bonus. The project will last 4 years and requires $1,700,000 of equipment. The company could use either straight line of the 3-year MACRS accelerated method. Under straight-line depreciation, the cost of the equipment would be depreciated evenly over its 4-year life (ignore the half-year convention for the straight-line method). The applicable MACRS depreciation rates are 33.33%, 44.45%, and 7.41%, as discussed in Appendix 13A. The company's WACC is 10%, and its tax rate is 40%.

a) What would the depreciation expense be each year under each method?

b) Which depreciation method would produce the higher NPV, and how much higher would it be?

c) Why might Wendy's boss prefer straight-line depreciation?

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#### Solution Preview

11) A bank added a bond to its portfolio. The bond has a duration of 12.3 years and cost $1,109. Just after buying the bond, the bank discovered that market interest rates are expected to rise from 8% to 8.75%. What is the expected change in the bond value?

Current interest rate 8.00%

New interest rate 8.75%

Current price $1,109.00

Bond Duration 12.3 years

Change in bond price ($94.73) Negative sign indicates decrease in price

∆P= −Duration*∆i/(1+i)*P

5) Suppose that the pension you are managing is expecting an inflow of funds of $100 million next year and you want to make sure that you will earn the current interest rate of 8% when you invest the incoming funds in long-term bonds. How would you use the futures market to do this?

"Buy long-term bond futures contract with one year expiry worth $100 millions.

No of contracts = $100,000,000/$100,000=1000

After one year we would be entitled to get a delivery of the long-term bonds at the price agreed today. This would ensure that we will get the desired current interest rate of 8%."

6) How would you use the options market to accomplish the same thing as in Problem 5? What the advantages and disadvantages of using an options contract rather than a futures contract?

"Buy call option on long-term bonds with a delivery date of one year from now and at a strike price which would result in 8% interest.

Advantage of using options: We are protected against the downside but if there is an opportunity for upside, with a call option we can enjoy that. Thus, we an earn an interest rate of more than 8% if interest rates go up. But we are protected if interest rates go down. With futures, we are locked at 8%. So neither a downside nor an upside.

Disadvantages of using ...

#### Solution Summary

The expert examines hedging with financial derivatives. The market interest rates are provided. Advantages and disadvantages are provided.

Discuss contingencies and how they are reported on financial statements. What conditions must be met before a contingency can be charged against income?

For each of the intended uses of the derivatives listed below, explain the accounting in fair value:

o Derivative designated as a hedge of the exposure to changes in the fair value of a recognized asset or liability to or firm commitment

o Derivative designated as a hedge of the exposure to variable cash flows of a forecasted transaction

o Derivative designated as a hedge of the foreign currency exposure of a net investment in a foreign operation

o Derivative not designated as a hedge