BAFN307 Financial Risk Management: Interest Rate Risk Case Study 2018

This case study solution addresses interest rate risk management using off-balance sheet instruments, specifically focusing on Austral Big Bank Limited. It involves calculating the duration of a future position, determining whether the bank should go short or long on futures contracts to establish a macro hedge, and calculating the number of contracts necessary to fully hedge the bank. The solution includes computations for duration, analysis of the impact of changing price sensitivity, and the final number of contracts required for complete hedging. The analysis leverages key financial concepts and formulas to provide a comprehensive risk management strategy for the bank. Desklib offers similar solved assignments and past papers for students.

FINANCIAL RISK MANAGEMENT
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(a) Face value of bond = $ 1,000
Coupon rate = 8% p.a.
Hence, annual coupon payment = (8/100)*1000 = $ 80
The above coupon payment would be derived till the time of maturity which is 20 years.
Also, at the time of maturity, there would be principal repayment to the extent of $1,000 and
hence the cash inflows from the 1st year till the end of 19th year would be $ 80 p.a. but the
corresponding inflow for the 20th year would be $ 1080.
In order to find the duration the following table would prove to be immensely useful
(Damodaran, 2015).
On the basis of the above output, duration = 9853.829/949.999 = 10.372 years.

(b) It is apparent that as the interest rate would increase, there would be a decline both in the
value of equity and also the future contract. The decrease in the future contract is apparent
from the above computations that have been performed. Thus, in the given scenario, the
appropriate approach would be to sell the future contracts or go short on the future contracts.
This would allow the purchasing of the future contracts at a later date when their price would
be lesser and the gains made on the future contract can serve as a mechanism to offset the
losses caused owing to decline in the equity value (Brealey, Myers and Allen, 2014).
(c) The objective is to highlight the contract requirement so as to ensure that the bank is fully
hedged. The relevant formula in this regards is indicated as follows (Damodaran, 2015).
In the above formula
NF = Number of future contracts required
DA = Duration of Assets
DL = Duration of Liabilities
DF = Duration of Future Contract
PF = Price of Future Contract
k = Price sensitivity of Futures to price sensitivity of bonds
A = Amount of Assets
The values for all the above inputs are available in the given case and are substituted as
indicated below.

Hence, based on the above computation it is apparent that the number of contracts required to
fully hedge the bank is 365.
(d) In the given case, there has been change of price sensitivity of Futures to price sensitivity
of bonds which earlier was 0.90 and has now increased to 0.92. As a result of this increase,
there would a decrease in the number of contracts required to hedge the bank completely as if
apparent from the above formula. The precise number of future contracts required for
hedging in this case can be estimated using the following computation (Parrino and Kidwell,
2014).
NF = -[(6-(0.92)4)*150,000,000]/(10.3725*95000) = -353 contracts
Hence, now the required contract amount has decreased by 12 to yield the answer as 353
contracts. Therefore as the price sensitivity factor tends to increase, the number of contracts
required to take a position for complete hedging tends to reduce.

References
Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 6th ed. New
York: McGraw-Hill Publications
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley,
John & Sons.
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications