Risk Exposure Paper

A1. Cash Market Risk exposure: The market risk for BSB is due to the change in the interest rates during the 3 phases. These exposures are dependent on the phases:

Phase I: Bank obtains $ 5m from Fannie Mae and invests in T-bills at 5.1% interest rate. Assuming that the investment horizon is of 1 year,

​​$ 5,255,000

Now, decline in interest rates would reduce the bank revenue. For example, if the interest rate falls to 4.95%, the revenue received is $ 5,247,500, which is $ 7500 less than the above case.

Phase II: The bank obtains $ 25m in CD deposits and pays interest on them at 5.04%. Assuming a horizon of 1 year, the bank’s payment would be,

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A rise in interest rates would mean a rise in bank payments. For example, if the interest rate rises to 5.5%, the bank would have to make a payment of $ 26,375,000, which is $ 115,000 more than the above case.

Phase III: The bank originates $30m in new commercial mortgage loans at a fixed rate of 7.21%. Assuming an investment horizon of 1 year,

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A decline in interest rate would mean a decline in bank revenues. For example, suppose the interest rate declines to 7%, the investment value would decline to $ 32,000,000, which is $ 63,000 less.

A2-A4. The market risk phenomenon shows a similar trend for phase 1 and 3 and an opposite one in phase 2. The bank would use a long hedge to guarantee a desired yield in case interest rates decline in phases 1 and 3. The bank will use a short hedge to guarantee a desired yield in case interest rates rise in Phase 2.

Phase I: Long Hedge

Number of futures contracts = 5,000,000/100,000 = 50 contracts

T Bond Futures Hedge: On July 7, the investor purchases T bond futures contracts at 115-01. On December 29th, the investor sells T-bond futures contracts at 121-04.

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T Bill Futures Hedge: On July 7, the investor buys 94 1/100 worth of T-bill futures and sells them on December 29th at 95.13.

Eurodollar Deposits: On...