25. Nicholas is responsible for the asset and liability management of JerseyBeech Bank, a small retail bank with USD 300 million in interest-bearing assets that yield approximately 70 bp above LIBOR. The duration of the interest-bearing assets is 2.5 years. Due to the recent financial turmoil, the bank seeks to reduce potential negative impacts on earnings from adverse moves in interest rates. Thus, the bank decides to hedge 50% of its interest rate exposures using Treasury bond futures. Nicholas decides to use September T-bond futures that trade at 106-22 and will mature in three months; the cheapest-to-deliver bond associated with this contract is a 7-year, 10% coupon, with a current duration of 5 years. At the maturity of the futures contract, the duration of the bank’s interest rate sensitive assets will not change; however, the duration of the cheapest-to-deliver bond will fall to 4.9. [source: FRM 2010 practice exam]

How many contracts should Nicholas buy or sell?

• a.  Buy 703 contracts.
• b.  Sell 703 contracts.
• c.  Buy 717 contracts.
• d.  Sell 717 contracts.

[my adds]

25.2 What is meant by cheapest-to-deliver (CTD)? Why does the CTD even exist; i.e., why is there not a single instrument that the short must deliver?
25.3 What other instruments could be employed to similarly achieve a duration-based hedge?
25.4 If interest rates rise, in which direction does the value of this hedge move?
25.5 After the trade, assume the bond yield jump up (increase) abruptly. Will the hedge likely require an adjustment? Tough bonus: what is the implication on the CTD bond?
25.6 Is this hedge a complete or perfect immunization against interest rate movements?

Answers:

• Here in forum

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