Reference no: EM133111145

Suppose a bank wishes to sell $150 million in new deposits next month. Interest rates today on comparable deposits stand at 8 percent but are expected to rise to 8.25 percent next month. Concerned about the possible rise in borrowing costs, management wishes to use a futures contract. What type of contract would you recommend? If the bank does not cover the interest rate risk involved, how much in lost potential profits could the bank experience? [Assume 360 days in a year]

[HINT 1: A futures contract is a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is taking on the obligation to buy the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide the underlying asset at the expiration date.] [HINT 2: A short hedge is structured to create profits from future transactions in order to offset losses experienced on a financial institution's balance sheet if the market interest rates rise. A long hedger offsets risk by buying financial futures contracts before the time new deposits are expected to flow in and interest rates are expected to decline. ]