PFA

Ankur Bank specializes in providing short-term loans to both cor porate customers and retail customers. Its balance sheet shows to- tal assets of INR 184 billion and total liabilities and stockholder’s equity of INR 184 billion.

Assets (in INR million)

Cash and balances with the RBI     15790

Government securities                    14797

Loans and advances                        125841

Properties and fixed assets              27572

Total assets                                       184000

Liabilities (in INR million)

Due to banks                                                    9021

Due to non-bank customers                             163359

Bills payable                                                      714

Tax payable                                                       779

Total liabilities                                                   173873

Shareholder equity                                           10127

Total liabilities and equity                                  184000

The bank is concerned about changes in the interest rates and how these changes would affect the values of its assets and liabilities. Currently, the assets have duration of 6.45 years and the liabilities have a duration of 1.5 years. If the interest rate increases, the value of assets will decrease to an extent greater than the decrease in the value of liabilities. Therefore, the bank would like to adjust the duration of both the assets and liabilities to the same level of 3.8 years. The bank offers loans to corporations and individuals on a fixed

rate basis. However, the deposits are paid interests on a floating

rate basis. This again causes risk for the bank. Thus, the bank would.

like to convert the fixed-rate loans given to the customers into

floating-rate loans. The bank holds a large volume of government securities and would like to hedge the value of these securities in case the interest rate increases

In addition, the bank would like to enter the futures market whenever there are opportunities to enter into arbitrage transac tions and spread transactions.

Illustrate how the bank can accomplish these using futures

available in the market. On January 1, 2010, futures on 10-year 7% notional coupon government securities with March expiry are quoted at 93.65 93.82, and those with June expiry are quoted at 91.37-91.74. The March CTD futures have maturity on December 31, 2019, and a coupon of 8%; they are selling for INR 102.00.

The total value of government security investment is INR 14,797 million with a duration of 7.8 years. The interest-bearing deposits are worth INR 60,000 million with a duration of 3.2 years. The duration of the CTD bond for March futures is 5.62 years.

Discussion Questions

1.

Is there any arbitrage opportunity? Explain how the bank can

undertake arbitrage. Explain how the bank can enter into spread trading. If the quotes on January 12 are 93.72-93.99 for March futures and 92.04-92.40 for June futures, what would be the gain from 2

spread trading? The bank would like to hedge the portfolio of government securities using futures Explain how this can be accom plished using T-bond futures. The March futures quote on March 25 is 91.24-91.45. If the bank decided to close the posi tion on March 25, what will be the value of the hedged port folio? 3.

4.

The bank would like to keep the duration of its portfolio equal to that of the duration of its deposits using T-bond futures. Explain how it can be accomplished. What will be the value of the hedged portfolio on March 25