Case Questions (in black) With Answers (in red)
(Students fill in the answers shown here in red.)

Question 1
Exhibit 1 shows selected Eurodollar interest-rate futures settlements taken from a base illustration at the CME web site. The CME illustration only provides the settlement yields for four dates.   In Exhibit 1 you will find an extended illustration with monthly yields so that it is possible to learn about margin settlements.  So that students are consistent in the main settlements, the calculation outcomes are provided for two rows in the table below.  Students are to compute the results for the two bottom rows.

• Assume that 30 futures contracts (that each have a $1 million notional) are purchased on Dec. 17 in order to lock in a loan profit for MarginWHEW Bank across the four quarters.

• Assume $25 per tick settlement factors that translate into $2,500 adjustment factors illustrated in the initial part of this case.

• Assume all contracts are settled at the dates shown in the first column of the above table.

• Assume that the Futures Margin Account can never fall below the minimum margin of $500.

• Assume no interest expense or revenue on the balance left in the Futures Margin Account.  This is a simplifying assumption for students dealing with more complex issues in this case.

• Although margin accounts are normally settled daily, the settlements in this case will only be on selected dates in order to simplify the illustration.

Fill in all contracted sales amounts (like a short sale for future delivery) shown in the last column of the above table and show how all of the three future contracted settlements are derived.  Note that the bank does not actually pay the huge price of 10 contracts.  This selling "settlement price" is an artificial selling price against which the eventual artificial purchase "settlement price" is subtracted at the day the sell-then-buy (BTS-Long) futures contracts are settled.  The net difference is added or subtracted each quarter to the margin balance of MarginWHEW Bank's customer account with the CME. 

Part A:
What are the December 17 artificial settlements (in total dollars) of all 30 futures contracts?

Hint:  The settlement for the first 10 contracts is shown as a guide for students.

$9,853,000 = [$1,000,000 - ($2,500)(5.88)][10 contracts] for 10 March 2000 contracts
$9,848,750 = [$1,000,000 - ($2,500)(6.05)][10 contracts] for 10 June 2000 contracts
$9,845,000 = [$1,000,000 - ($2,500)(6.20)][10 contracts] for 10 Sept. 2000 contracts

Part B:
What are the actual cash purchase amounts of all 30 futures contracts that must be paid by MarginWHEW Bank in cash on December 17, 1999?

$0 purchase amounts since there is no premium on futures contracts at the date of acquisition

Part C:
How much does MarginWHEW Bank have to deposit into the Futures Margin Account on December 17?

$500

Question 2
What are quarterly yields corresponding to the above annual yields?

For this part of the case, please adjust yields to quarterly rates using both the (90/360 yr) and (91/360 yr) adjustment factors. 

Question 3 
What is the hedged annual APR cost of refundings rate locked-in by the acquisition of the 30 BTS-Long futures contracts used to hedge the profit on the $10 million loan?  Compute this rate on both the (90/360 yr) quarterly factors and the (91/360 yr) factors.

Part A:
What is the locked-in annual rate using the (90/360 yr) factors derived in Question 3 above?

Part B:
What is the locked-in annual rate using the (91/360 yr) factors in Question 3 above?

Part C:
Your cost of refundings rates computed above translate into what hedged cost of refundings dollars for the entire year from December 17, 1999 to December 17, 2000?

$610,495 = (6.1049509%)($10,000,000) hedge cost using (90/360 yr) factors
$610,646 = (6.1064654%)($10,000,000) hedge cost using (91/360 yr) factors

Question 4
What is the hedged annual APR loan profit rate and aggregate dollars locked-in by the acquisition of the 30 BTS-Long futures contracts used to hedge the profit on the $10 million loan?   For this computation, ignore reinvestment opportunities on the $200,000 received each quarter on the note receivable of $10,000,000.

1.8935346% APR = 8.0000000% note receivable - 6.1064654% hedged cost of refundings  = hedged profit rate

Question 5 
What is the annual gross profit that MarginWHEW Bank anticipates after hedging the cost of refunding the 8.00% loan for 12 months?  Express your answer in dollars.

$189,353 = ($10,000,000)( 1.8935346%) if reinvestment of interest received on the loan is ignored

Question 6 
Why is the computation of the hedged profit on the loan less reliable than the computation of the hedged cost of refundings for that loan (assuming interest rate futures contract hedging)?

Question 7 
This question entails calculating the balance sheet asset or liability reported in the financial statements for the Futures Margin Account on February 29, 2000 for all the futures contracts acquired by MarginWHEW Bank on Dec. 17.  Assume that SFAS 133 and IAS 39 rules for adjusting derivative financial instruments to fair values apply in this instance. Use the hypothetical settlement prices given in Exhibit 2. 

This  $985,300 "settlement price" is an artificial selling price against which the eventual artificial purchase "settlement price" is subtracted at the day the sell-then-buy (BTS-Long) futures contracts are settled.  The net difference is added or subtracted each quarter to the customer's margin balance.

$1,550 = $985,300 selling amount  - $983,750 purchase amount on Feb 29 for one March 2000 BTS-Long futures contract
$15,500 = ($1,550)(10 contracts) = the balance sheet asset component on February 29 of the March 2000 futures contracts

This same answer can be computed quickly as follows using yield rates:
$15,500 = -(5.88 Dec. settlement - 6.50 Feb. 29 settlement)($2,500)(10 contracts) for March 2000 futures

The aggregate for all 30 contracts is derived below using Exhibit 1 data:

$15,500 = -(5.88 Mar 17 settlement - 6.50 Feb. 29 settlement)($2,500)(10 contracts) for March 2000 futures
$13,500 = -(6.05 June 17 settlement - 6.59 Feb. 29 settlement)($2,500)(10 contracts) for June 2000 futures
$12,250 = -(6.20 Sept 17 settlement - 6.69 Feb. 29 settlement)($2,500)(10 contracts) for Sept. 2000 futures

Question 8
First compute the cash settlement of the March 2000 futures on March 17, 1999.  Then compute the cash withdrawal of cash settlements from the Futures Margin Account according to MarginWHEW Bank policy.  What is the balance sheet asset or liability reported in the financial statements for the Futures Margin Account on March 17, 2000 for all the remaining futures contracts acquired by MarginWHEW Bank on Dec. 17? 

Part A:
What are the March 17 hypothetical settlement values for all the 30 contracts using Exhibit 1  and Exhibit 2 data?

Hint:  The settlement for the first 10 contracts is shown as a guide for students.

$28,500 = -(5.88 June 17 settlement - 7.02 March 17 settlement)($2,500)(10 contracts) for March 2000 futures
$25,750 = -(6.05 June 17 settlement - 7.08 March 17 settlement)($2,500)(10 contracts) for June 2000 futures
$23,750 = -(6.20 June 17 settlement - 7.15 March 17 settlement)($2,500)(10 contracts) for Sept. 2000 futures
$78,000

Part B:
What is the aggregate contribution of the above 30 hedge settlements toward fixing the profit on the 8.00%, one-year note receivable?

$78,000  = the aggregate profit caused by increases in LIBOR between December 17 and March 17.  To this we must add the initial $500 margin deposit such that the balance in the Futures Margin Account is $78,500 before withdrawing the March 2000 futures contracts settlements.

Part C:
FAS 133 requires that futures hedging profits be partitioned into the part that can be deferred in Other Comprehensive Income (OCI) versus the part that must be credited to current earnings.  The OCI portion is the amount attributable to changes in spot rates.  By way of illustration, this portion is derived below for the time period between December 17, 1999 and March 17, 2000 using Exhibit 2 spot rates as follows (recall that 10 out of 30 contracts expired on March 17 such that only 20 futures contracts remain):

(Change in Spot Rates)(Number of Contracts)($2,500)
-$63,500 = (5.75 - 7.02)(20 remaining contracts)($2,500)

How would the accumulated "profit" from the 30 contracts on March 17 be partitioned between OCI and retained earnings (or current earnings if the books have not been closed)?  Assume a zero discount rate for the moment since the more complicated task of discounting is taken up later on in the case.

$78,000  = the aggregate profit caused by increases in LIBOR between December 17 and March 17 is then partitioned as follows for the March 17, 2000  balance sheet:

($63,500) = the credit balance in OCI for the remaining 20 contracts 
($14,500)  = difference (($78,000) - ($63,500)) 
($78,000) = the aggregate profit derived above for March 17, 2000

Part C:
Following MarginWHEW Bank policy, the March 2000 futures are settled for cash and the settlement is withdrawn from the Futures Margin Account.  What is the revised balance in that account?

$25,750 = -(6.05 June 17 settlement - 7.08 March 17 settlement)($2,500)(10 contracts) for June 2000 futures
$23,750 = -(6.20 June 17 settlement - 7.15 March 17 settlement)($2,500)(10 contracts) for Sept. 2000 futures

$49,500  = the aggregate asset value caused by increases in LIBOR between December 17 and March 17.  To this we must add the initial $500 margin deposit such that the balance in the Futures Margin Accounting is $50,000 on March 17, 2000.

Question 9
What is the balance sheet asset or liability reported in the financial statements for the Futures Margin Account on March 31, 2000 for all the remaining futures contracts acquired by MarginWHEW Bank on Dec. 17. 

$50,500  = the aggregate asset value caused by increases in LIBOR between December 17 and March 31.

Hint:  Remember that cash withdrawals are not made at the end of any month since contracts are not settled at the end of any month.

Since none of the above 20 futures contracts have been settled for cash, there are no cash withdrawals from the Futures Margin Account on March 31, 2000 according to MarginWHEW Bank policy.  The Futures Margin Account thus has a balance of $50,500 plus the $500 initial margin deposit for a total debit balance of $51,000 on March 31 after marking-to-market.

After computing the aggregate interest expense with the aggregate hedging amount from all 30 interest rate futures contracts, discuss the impact of the hedge upon the refunding costs for the funds raised to carry the $10 million loan receivable.  In particular, comment as to whether the hedgings were "effective" in the context of SFAS 133.

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Hint:  Hedge "ineffectiveness" is defined in Bob Jensen's online glossary at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm.

Part A:
What are the cash settlements on March 17, June 17, and September 17 in Year 2000 for the 30 interest rate futures contracts acquired on December 17, 1999?   What is their aggregate contribution toward fixation of the profit on the 8.00% note receivable? 

The total settlements aggregate to $85,750 gain on the futures contracts.  MarginWHEW made money on its futures contract hedging because interest rates lifted higher and higher.

(Note the rising quarterly interest expenses!)

The main criteria are spelled out in Section 2 beginning in Paragraph 62 on Page 45 of SFAS 133.  The margin of convergence error is so small each quarter in this case, that ineffectiveness is not an issue.

The hedge was fairly effective in achieving a fixed refunding cost of approximately 6.038% for the year.  When interest rates steadily increased, the futures contract settlements cut the refunding costs back toward the expected $611,787 fixed cost.  The discrepancy between the 6.038 actual rate and the 6.1179% hedged rate is explained in the answer to the next question.

The following is a quotation from the section entitled "How to Get Started Trading CME Interest Rate Products:  Section Two:  CME Interest Rate Futures," at the CME web site.  In particular, try the online "how to"  link at http://www.cme.com/market/interest/howto/hedging.html . 

Recall that the banker had expected to lock up funding at 6.1179%. In fact, funds were acquired at 6.038%, or approximately eight basis points lower. This discrepancy occurred because of less-than-perfect convergence between the cash refunding rates and the futures liquidation rates. If the bank had funded at exactly the same rate as the futures liquidation rate, the target would have been achieved. In this case, however, the actual funding over the term of the loan was, on average, one and one-third basis points lower than the futures liquidation rates. Put another way, these basis adjustments positively affected the performance.

The minimal difference between the target rate and the effective funding rate can be attributed to the fact that the refunding dates were quite close but not identical to the futures expiration dates. If the respective dates were further apart, the funding rates and the futures rates would not necessarily converge as closely as those used in the above example.

This example of a one-year loan funded with three-month deposits illustrates a negative interest rate "gap" that is, where shorter-term liabilities are funding a longer term asset, and rising interest rates will have an adverse impact. The same basic hedging approach can be followed to remedy an overall balance sheet maturity mismatch.

IAS 39 does not have OCI requirements comparable to the OCI requirements in SFAS 130 and SFAS 133. In England, the OCI reconciliation statement is called a "Struggle Statement." However, the IASC does not yet require OCI and Struggle Statements. You can read more about OCI under the definition of Other Comprehensive Income and Struggle Statements in http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm .

However, the distinction is a moot point since IAS 39 still requires that cash flow hedge gains and losses be deferred by in equity in an account other than retained earnings such that the net effect is still the same as FAS 133.

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The main advantage is that such contracts have no cost (premiums) at the date of acquisition.  If they steadily increase in value as illustrated in the MarginWHEW Bank Case, then there is never a cash outlay and the hedging cash rolls in for BTS-Long futures contracts as interest rates rise and futures prices decline..  It rolls in for STB-Short futures contracts as interest rates fall.

The huge disadvantage of such contracts is that they can be very risky and the level of risk is not fixed.  In the MarginOOPS Bank Case, the bank had to keep throwing money into the Futures Margin Account when interest rates plunged.   If they had continued to plunge, the loss could have become immense. 

The main advantage of options contracts in the place of futures contracts is that the risk is known and fixed at an amount equal to the initial level of investment in the purchase cost of the futures contracts. For example, when CapIT Bank purchased 25 put contracts for $53,125 on Dec. 17, the maximum harm done, no matter what happens in the trading markets,  is $53,125 from purchasing the futures contracts. In other hedging alternatives, such as interest rate forward/futures contracts, the initial investment are virtually zero, but the loss risk may soar with big changes in LIBOR. Futures and forward contracts expose the holder to enormous risks. Futures contract holders have no risks beyond the cost of the futures.  Acquisitions of hedging futures are quick and easy if satisfactory deals are traded on open exchange systems such as the Chicago Board of  Futures Exchange.

Interest rate swaps have the advantage of both having a low initial cost and fixed risk if a variable price of interest is swapped for a fixed price. The problem with interest rate swaps is that they are custom contracts in which counter parties to the swap must be located and dealt with in private or brokered negotiations. Also it is better if the swap periods coincide.

Hint: The terms "cash flow hedge" and "fair value hedge" have important distinctions in SFAS 133. You may find references to parts of that standard by looking up these terms in http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin .

Changes in futures contract values may not be placed in OCI under SFAS 133 rules unless the hedges are designated as cash flow hedges. The distinction is between cash flow hedges and fair value hedges is less important in IAS 39 rules since there is no OCI alternative for either type of hedge in IAS 39.

The major example of using futures contracts to hedge fair value is Example 1 beginning in Paragraph 105 on Page 59 of SFAS 133.

The Futures Margin Account is a cash equivalent much like other cash equivalents such as certificates of deposit.  Cash may be withdrawn at any time as long as the balance left in the Futures Margin Account does not fall below the margin limit.  Firms often leave a cushion in the account to cover downturns in value.   They probably would not leave as much cushion as was left by MarginOOPS Bank on various dates.

Answer:  Details of this answer are given in the 285wp.xls Excel workbook.