Bay Street Bankcorp Case Study

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Bay Street BankCorp Case Study Questions

1. Identify the cash market risk exposure facing BSB in each particular phase of the minority lending project.

2. If BSB decides to hedge its market risk exposure in each phase of the minority lending project, what is the appropriate direction of the hedge (i.e., long or short position in the futures market) for each component of the project? How will the hedge position immunize the bank from loss if market interest rise or fall?

3. Given the three separate phases of the minority lending project and the information shown in Table 1, what is the best futures contract (i.e., the Treasury bond future, the Treasury bill future, or the Eurodollar future) that BSB should use to hedge interest rate risk related to each phase of the project?

4. Given the magnitude of BSB’s exposure to interest rate risk in the cash market at each phase of the minority lending project, what is the appropriate number of futures contracts the bank should buy or sell in order to immunize its exposure to interest rate risk?

5. Suppose interest rates increase over the course of the next year, so that one year from today the one-year rate on bank certificates of deposit stands at 5.5 percent, the yield on FNMA securities is 8 percent, and the yield on one-year Treasury bills is 5.6 percent. Given this increase in interest rates, the prices of the financial futures contracts described in Table 1 are: Treasury bond futures contract 119-24 Treasury bill futures contract 94.63 Eurodollar futures contract 93.05 Given this interest rate scenario one year from today, what is BSB’s net gain or loss on each of the three components of its minority leading program?

6. Refer once again to your answer in Question 5. Did the bank’s immunization strategy depend upon market interest rates rising over the course of the coming year, or is the bank’s profit position protected from both increases and decreases in the level of market interest rates? Explain your answer by demonstrating the bank’s net gain or loss on each of the three components of its minority lending program, assuming the market interest rates fall over the course of the coming year. In this case, assume that the following interest rates and futures contract prices are observed one year from today, and recalculate BSB’s net gain or loss on each component of the minority lending program: One-year Treasury security spot rate 4.3% One-year bank certificate of deposit rate 4.0% FNMA yield 5.5% Treasury bond futures contract price 124-03 Treasury bill futures contract price 95.93 Eurodollar futures contract price 97.91

7. The case mentions that BSB seeks to eliminate its exposure to risk by buying and/or selling financial futures contracts. In using these derivative financial securities, does the bank eliminate all of its exposure to risk, or just a portion of the total risk the firm faces? Does the introduction of financial futures within the bank create any additional risks for management to consider? If so, identify and explain these risks.

8. Examine the hedging strategy you developed for BSB in Question 2 through 4. Does this particular strategy represent a static or dynamic hedge? Given your answer to this question, comment on the risk that BSB faces in executing this strategy, and describe how the bank’s hedging technique might be improved to immunize the bank more effectively against changes in the the level of market interest rates.

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