05 16 2014 REVIEW OF PILLARS 1 Extending bank liabilities in an asset liability framework Question framework on exam o Here is the return on assets in the investment portfolio for a bank ROA The current CD rates for 6 month 1 y 2 y 3 y are What do you recommend he does Create synthetic 1 y or 2 y or create 1 y or 2 y CD Lower yield better for the bank so if current 4 y cd is 4 and you can create synthetic for 3 then you save bank 1 Create synthetic that is cheaper then existing liability He wants to target 3 y or 4 y 4 y synthetic 3 y 1 y hedge or 2 y 2 y hedge pick one EXAMPLE 1 HE will give us this info Current liabilities current CDs 1 y 50 2 y 75 3 y 1 00 4 y 1 5 5 y 2 2 He will tell us to Create 4 year synthetic have to do better then the 4 y of 1 5 3 Create implied forward yield current settlement prices for Eurodollars futures contract IFYC March 14 99 7 99 7 1 50 3 Jun 14 99 6 4 Sept 14 99 55 45 Dec 14 99 40 60 Mar 15 99 20 80 Jun 15 99 00 1 0 Sep 15 98 80 1 2 Dec 15 98 50 1 5 Mar 15 98 2 4 Calculate SYNTHETIC 4 yr IFR 2 year 1 5 SPOT LIBOR 3 Hedge creep convergence cost 1 20 2 yr Cd 75 Synthetic 4 yr 1 95 BUT DON T DO THE SYNTHETIC 4 yr because the 4 yr CD is 1 5 So synthetic 4 yr rate 4 yr CD rate more expensive for the bank What is hedge ratio 2 year cd maturity 360 2 720 days what is hedge instrument vehicle How many days til maturity 90 days Eurodollar future contract is 90 days 720 90 8 1 short 8 futures contracts to 1 CD so on 100m synthetic how many millions of euro futures contracts will he have to short 100 8 800 contracts you have to short to hedge a 100 mil 2 year CD futures yield always converges to spot similar to what you pay for put option but hedge cost is estimated to 1 2 what if basis widens or narrows Affects true cost synthetic 4 yr if you issue 2 year 2 years from now then this is a synthetic 4 yr Strip vs Stack Strip n numbers of contracts on each maturing contracts So if yield curve shifts then you are okay Stack 2 How to maximize proceeds to bank whole loans or securitize MBS and sell in secondary market Given The 30 yr rate to the homebuyer is 4 5 The 60 day whole loan rate use the mbs prices with highest price so use 4 0 as excess servicing for is 3 9 Current 30 y mbs prices 4 5 104 4 0 102 3 5 100 3 99 MBS Gross Note Rate Normal servicing fed requires this Guarantee fee WL 4 5 25 0 Net note rate whats 4 25 left over after costs MBS 4 5 25 25 4 0 102 102 Net required yield 3 9 Fannae Mae 0 none for MBS Excess servicing 35 5 1 75 Par 100 101 75 What is 35 basis points worth if duration on new MBS s is 5 35 5 1 75 How to protect value of newly originally mortgage from going down on an optimal way Think about straddle strangle calendar spreads puy at the money put and sell out of the money call SPREAD buy 60 05 16 2014 05 16 2014