REVIEW OF PILLARS1. Extending bank liabilities in an asset/liability frameworkQuestion framework on examHere 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 liabilityHe wants to target 3 y or 4 y4 y synthetic = 3 y + 1 y hedge or 2 y + 2 y hedgepick oneEXAMPLE1. HE will give us this infoCurrent liabilities/ current CDs1 y .502 y .753 y 1.004 y 1.55 y 22. He will tell us to  Create 4 year synthetic  have to do better then the 4 y of 1.53. Create implied forward yield current (settlement prices for Eurodollars futures contract)IFYCMarch 14 99.7 99.7 – 1.50 = .3Jun 14 99.6 .4Sept 14 99.55 .45Dec 14 99.40 .60Mar 15 99.20 .80Jun 15 99.00 1.0Sep 15 98.80 1.2Dec 15 98.50 1.5Mar 15 98. 24. Calculate SYNTHETIC 4 yrIFR 2 year = 1.5-SPOT LIBOR= .3Hedge/creep/convergence cost = 1.20+ 2 yr Cd  .75Synthetic 4 yr = 1.95BUT 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 dayswhat is hedge instrument/vehicle? How many days til maturity? 90 daysEurodollar future contract is 90 days720/90= 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 yrStrip vs. StackStrip  n numbers of contracts on each maturing contractsSo if yield curve shifts then you are okayStack 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 is 3.9Current 30 y mbs prices4.5  1044.0  1023.5  1003  99**use the mbs prices with highest price so use 4.0 as excess servicing for MBSWLMBSGross Note Rate4.54.5Normal servicing (fed requires this).25.25Guarantee fee0.25Net note rate (whats left over after costs)4.254.0Net required yield3.9 (Fannae Mae)0 (none for MBS)Excess servicing.35* 5 = 1.75102Par100101.75102What is .35 basis points worth if duration on new MBS’s is 5?.35 * 5 = 1.75How 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 6005/16/2014REVIEW OF PILLARS1. 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 CDs1 y .50 2 y .753 y 1.004 y 1.55 y 22. 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 = .3Jun 14 99.6 .4Sept 14 99.55 .45Dec 14 99.40 .60Mar 15 99.20 .80Jun 15 99.00 1.0Sep 15 98.80 1.2 Dec 15 98.50 1.5Mar 15 98. 24. Calculate SYNTHETIC 4 yr IFR 2 year = 1.5-SPOT LIBOR= .3Hedge/creep/convergence cost = 1.20 + 2 yr Cd  .75Synthetic 4 yr = 1.95BUT 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 okayStack 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 is 3.9 Current 30 y mbs prices4.5  1044.0  1023.5  1003  99 **use the mbs prices with highest price so use 4.0 as excess servicing for MBSWL MBSGross Note Rate 4.5 4.5Normal servicing (fed requires this) .25 .25Guarantee fee 0 .25Net note rate (whats left over after costs) 4.25 4.0Net required yield 3.9 (Fannae Mae) 0 (none for MBS) Excess servicing .35* 5 = 1.75 102 Par 100 101.75 102What is .35 basis points worth if duration on new MBS’s is 5? .35 * 5 = 1.75How 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