Assignment Questions

I. Peoples Federal Savings Bank

1. Should Peoples Federal Savings have hedged its September 1 savings certificate rollover?
Ans. Yes in principle — but only if the hedge design and liquidity planning matched the bank’s
constraints.

Reasoning:

 The bank had a classic maturity mismatch: long-duration fixed-rate mortgages funded by
short-term 3-month certificates. That exposes net interest cost to rising short rates — a
legitimate, common hedging motive. A hedge to protect the cost of the September 1 rollover
was therefore economically appropriate.

 However, the chosen instrument and implementation created two operational mismatches
that made the hedge impractical for Peoples in the realized scenario:

1. Margin-intensity / cash-flow mismatch- A short in T-bill futures produces daily

variation margin cash flows that can be large and occur well before the hedged cash
outcome (the September 1 roll). Peoples lacked either enough liquid reserves or
committed credit lines to comfortably fund large adverse daily margin calls. The case
shows that reality: large daily variation margin payments consumed liquidity.

2. No downside protection on mark-to-market- A short futures position benefits when

rates rise; but when rates fall the short produces large negative MTM which must be
paid daily. The hedge removed price risk at the rollover date but produced
unacceptable interim cash risk.

Conclusion: Hedging the risk was justifiable, but the implementation was flawed: they used a straight
short futures hedge without ensuring they could meet margin calls or without buying option
protection (caps/put options) or choosing a hedging size/timing that matched liquidity.

2. What would you have advised Mr. Myers to do on August 6?

Recommended action on Aug 6th:

1. Immediately reassess and reduce position size to match real liquidity — do not wait to be
caught by further margin calls. If liquidity is limited, reduce the 400-contract position to the
number the bank can maintain without threatening regulatory capital or operations. (Half-
size or some other tolerance level guided by a stress test is a defensible conservative move.)

2. Obtain liquidity first (if possible) — try to arrange (same day) a committed short-term credit
line or repo facility to cover foreseeable worst-case margin swings until the September
rollover. If this cannot be arranged quickly, shrink the hedge.

3. Consider switching to (or adding) protective options or collars — buying short-term interest-
rate call options (or caps) would have limited downside cash flows while leaving upside
hedge protection, albeit at a premium cost. If options were too expensive, a layered/rolling
futures hedge with smaller lots would reduce daily variation risk.
 4. If you expect rates to fall and the hedge would lose more cash than bank can bear, close or
materially reduce the futures position and accept the interest-rate exposure — better to
manage interest cost risk than risk insolvency via margin drains.

5. Stop trading/put hard limits — instruct brokers to notify and not to increase positions and to
execute only pre-approved instructions. Immediately set intraday monitoring and escalation.

Why: The bank already had $690k cash outflows and no demonstrated capacity to absorb further
large variation margin; preserving liquidity and regulatory capital must trump theoretical hedging
completeness.

3. How should Mr. Myers explain his futures losses to the board on August 27 th ?

Key communication points — factual, educational, and forward-looking:

1. Explain the economic intent and result

o “We hedged the September 1 rollover to protect the bank against rising 90-day T-bill
rates that would raise the cost of our 3-month savings certificates. The hedge would
have achieved that objective if rates had risen. Instead short-term rates fell during
June–August, producing mark-to-market losses on our short futures which required
daily cash variation margin payments.”

2. Quantify the cash flows clearly

o Initial margin posted: $1.0m.

o Variation margin paid prior to Aug 6: $690k.
o Variation margin during the vacation period: $1,830k.
o Additional required to close that day: $540k.
o Total cash outflows related to the futures position ≈ $3.06m (explain accounting
deferral separately).

3. Differentiate accounting recognition from economic result

o Under FHLBB accounting the bank can defer recognition of the net futures profit/loss
to match the hedged September obligation. Explain that the large MTM losses were
paper/temporary if the hedge was maintained and rates reverted; however, the cash
required to fund variation margin is real and reduced available liquidity — the board
must understand that accounting deferral doesn’t remove liquidity stress.

4. Explain what went wrong in execution

o The strategy failed operationally because we under-estimated the possible

magnitude and timing of variation margin calls and had insufficient committed
liquidity or alternative lower-cash strategies (options, smaller positions, collars).

5. Present corrective actions and governance fixes

o Immediate steps taken:

(a) position reduced/closed (state actual course if done),
(b) arranged internal limits on futures usage,
(c) required pre-approved credit lines for hedging,
(d) adopt written policy: stress test margin scenarios before any hedge, require sign-
 offs, and prefer instruments (e.g., swaps, caps) that align cash-flow profile with
liquidity.

o Suggest a stress-test demonstration showing how different rate paths produce

margin needs and how the new policy avoids recurrence.

6. Conclude with the lesson

o Hedging is proper risk management only if the hedge instrument’s cash-flow profile
and worst-case requirements are acceptable to the institution. We will keep hedging
authority but under revised limits and liquidity controls.

II. Southeast Corporation

[Link] many September 1984 T-bond futures contracts should Lori Hiratani sell short to hedge
Southeast’s interest rate exposure?

Sol. Approach (DV01 method): match the DV01 (dollar value of a 1 bp move) of the cash issue with
the DV01 of futures contracts.

Calculations (DV01 arithmetic):

 DV01 of the cash issue = Notional × Duration × 0.0001

= 60,000,000 × 7.8 × 0.0001 = $46,800.00 per 1 bp on the issue.
 DV01 per futures contract (standard contract multiplier $100,000):
DV01_fut = Contract multiplier × Duration_fut × 0.0001
= 100,000 × 8.5 × 0.0001 = $85.00 per 1 bp (per one futures contract).
 Contracts to short = DV01_cash / DV01_fut = 46,800 / 85 = ≈ 550.588.

Sell short ≈ 551 September 1984 T-bond futures contracts.

2. What rate will Hiratani "lock in" by initiating this hedge?

Ans.

 By selling futures, the firm effectively locks the Treasury yield level embedded in futures. If the
market rate for the T-bond at the time of delivery is 12.88% (the level noted), she has essentially
locked that Treasury yield for the duration of the hedge — approximately 12.88% for comparison
purposes.

 Important caveat: The corporate borrowing rate will be the Treasury rate plus the corporate
spread (credit spread). The futures hedge locks the Treasury component; it does not lock the
corporate spread. So the actual all-in borrowing rate for Southeast when they issue will be Treasury
yield + the then prevailing spread for their Aa credits. The hedge therefore effectively locks the
Treasury portion of funding cost near 12.88% but not the spread component.

3. Does this hedging strategy eliminate Southeast’s exposure? If not, what risks remain?

Ans. Remaining risks:

1. Basis risk / CTD & conversion factor risk — delivery/options/cheapest-to-deliver differences

and conversion factors can create imperfect offset between bond issue value and futures.
Futures may be cash-settled or delivered into by CTD bond which may have different
duration/convexity than the new corporate bond.
 2. Credit spread risk — futures hedge treasuries only. If corporate spreads widen between
hedge initiation and issuance, the firm’s effective borrowing cost increases even if Treasury
yields are locked.

3. Duration & convexity mismatch — the futures hedge assumes linear DV01 matching;
convexity differences mean hedge may under/over-react for large rate moves.

4. Liquidity/rolling risk — if futures need to be rolled or closed prior to issuance, basis may
change.

5. Operational & margin risk — margin calls on futures require liquidity, though typically less
dramatic for longer-dated T-bond futures than short-dated bill futures. Still needs attention.

6. Model error/estimation risk — if the assumed durations are off, hedging quantity will be
incorrect.

Conclusion: The futures hedge is a sensible instrument to lock the Treasury component of borrowing
cost. It does not remove credit spread risk and other basis/matching risks — these must be managed
or accepted.

III. Alpha Investors

1. Should Peoples Federal Savings have hedged its September 1 savings certificate

rollover?

Contracts to short= β×Portfolio MV/F*Contract multiplier

If we assume (for illustration only) a standard futures multiplier $250 and suppose the futures index
level equals (example) 190 (you should use the actual Exhibit 3 number), then:

Contracts= 894 contracts

2. What risks can Jim eliminate by shorting S&P 500 stock index futures con-tracts? How effective
do you expect his hedge to be?

He can eliminate or reduce:

 Systematic (market) risk — shorting index futures neutralizes market beta exposure. If the
market falls, losses in the equities offset gains in the short futures and vice versa.

 Transaction costs & timing risk — using futures avoids trading out of many individual
positions, reducing trading commissions and market impact.

Residual risks remaining:

 Idiosyncratic risk — firm/stock-specific moves won’t be hedged by index futures. If Alpha’s

portfolio has stock-specific risk, that remains.

 Imperfect beta estimate — estimation error in beta (1.18) causes under/over-hedging.

 Tracking error / basis risk — dividend yield mismatch, sampling differences between the
portfolio and the S&P 500, and futures-cash basis during the quarter.

 Liquidity and margin risk — variation margin could require cash (but typically less severe
than T-bill futures).
  Time-variation in beta — if portfolio beta changes over the quarter, hedge effectiveness
declines.

effectiveness of Jim’s hedge using the methodology described in the Salomon

Brothers research report

3. What return can Jim expect to earn during the third quarter of 1985 assuming

he adopts your hedging strategy?

Ans. If Jim fully hedges market exposure by shorting the appropriate number of futures, his expected
return over the quarter (ignoring active stock selection alpha) will be roughly:

 Return ≈ portfolio alpha + financing/interest on collateral − cost of carry (dividends).

 In practice, if the portfolio has no alpha (zero stock-selection alpha), a perfectly hedged
position will earn the cash return on the collateral he posts to cover margin (e.g., T-bill rate
on margin balance) minus any financing cost if he borrows to meet margin. If the broker pays
interest on margin cash at close to the 3-month T-bill rate, expect roughly that rate pro-rated
for the quarter.

 Additionally, dividend differences between the portfolio and the index matter: short index
futures requires synthetic handling of dividends; the portfolio receives dividends while the
futures position’s cost of carry accounts for expected dividends.

IV. Auto Star

1. If you were Rob Rough, what advice would you give to Edith Cooper?

Short, prioritized recommendations (you’re Rob Rough giving advice):

1. Do not naïvely cross-hedge prime-based liabilities with T-bill futures unless you’ve quantified
historical correlation and tested worst-case basis. Prime vs T-bill correlation is high but not
perfect (see case Exhibit 2 scatterplots). That imperfection creates basis risk and potential
margin exposure.

2. Prefer swaps or floating-rate instruments that more closely match prime-based liabilities.
Interest-rate swaps or FRAs tied to prime or short-term bank indexes are superior because
they can be structured to match the company’s actual contract reset mechanics.

3. If futures are the only available market instrument:

o Use a partial hedge sized for liquidity tolerance (not a full 1:1 hedge).

o Use options/caps to avoid unlimited margin calls (caps allow protection above a
strike in exchange for premium).

o Maintain committed liquidity (credit lines) to meet margin calls.

4. Stress-test margin scenarios to see the worst daily variation margin and ensure the company
can meet the calls without endangering operations.
 5. If credit is unavailable, do not enter the futures trade. The single biggest danger in the case is
lack of financing for variation margin — that risk can be fatal.

6. Hedge governance — limit sizes, require board/treasurer sign-off, document counterparty &
margin procedures.

Bottom line: cross-hedge only with strong analytics and a plan for margin financing; otherwise use
swaps or options that better match the exposure and cash-flow tolerance.

V. Stock Index Futures Arbitrage

1. What is the theoretical price of the MMI March ’86 futures contract?

Using the T-bill financing rate (6.8%) and assuming a small dividend yield, the theoretical price is
about 313.51, virtually the same as 313.55. So the mispricing is negligible.

2. Assume that Jim is subject to a $5,000,000 position limit. What position should he take to
exploit the mispricing of the March ’86 MMI futures?

 If Fobs>F* by more than financing + transactions costs, standard cash-and-carry arbitrage:

short futures and buy the basket of the underlying stocks (financed by borrowing). If
Fobs<F*, do reverse: buy futures and short the underlying.
 In this case, observed futures (313.55) ≈ theoretical (≈313.51), so no profitable arbitrage
after costs. If you compute a small positive mispricing you must compare it to transaction,
borrowing, and execution costs — likely not profitable.

3. What rate of return can Jim expect to earn on his position?

 Approx annualized return ≈ |Fobs-F*|/(F*.T)

 Using the numbers with q=0, return is ≈0.018% annualized — negligible and consumed by
trading costs and bid-ask spreads.
 If you finance at 8.0% instead of 6.8% or if dividends >0, that will change the sign/direction
of any tiny mispricing.

4. Who, in addition to securities dealers, would you expect to engage in index-futures arbitrage?

Proprietary program traders, hedge funds, statistical arbitrage desks, market-making desks, and
institutional traders seeking pure carry/arbitrage profits. Also large securities dealers and pension
funds that can do basket trades and financing cheaply.

5. Why do index futures often trade at a premium or discount to their theoretical values? How do
you expect the pricing efficiency of broader market index futures, like the S&P 500, to compare to
the pricing of MMI futures?

Reasons for premium/discount:

 Dividend yield of the underlying index (reduces forward price).

 Financing rate / cost of carry — firms borrowing at higher rates reduce arbitrage profits.

 Transaction costs and shorting costs for the underlying basket.

  Index construction and sampling — MMI is price-weighted (only 20 stocks) and less liquid;
S&P 500 is broad market, capitalization-weighted, and more liquid.

 Supply/demand, short squeezes, temporary imbalances and differences in margin/position

limits.

Efficiency expectation: S&P 500 futures are generally more efficient (tighter basis, smaller and rarer
mispricings) than a smaller, price-weighted MMI because S&P futures are far more liquid, widely
traded, and have many market participants who arbitrage small mispricings quickly. MMI futures
(smaller, fewer participants) can exhibit larger, more persistent basis deviations.