1.   A bank has the following transactions with another bank.

-    A two-year forward contract on a foreign currency, currently worth £2 million, to buy foreign currency worth £50 million

-    A long position in a six-month option on the S&P 500 with the principal equal to £20 million and the current value equal to   £4 million

-    A two-year swap involving oil with the principal equal to £30 million and the current value of the swap equal to   –£5 million

Risk weights are as follows: 0% for cash and government bonds; 20% for claims on OECD banks; 50% for residential mortgages; 100% for corporate loans and corporate bonds

Add-on factors (% of principal)

(a)   Estimate the capital required under Basel I for this bank.

Assume the netting amendment does not apply.

[30 marks]

(b)   Re-estimate the capital required if the netting amendment in

Basel I ( 1995) applies. Discuss how the application of       netting amendment affects the amount of required capital.

[45 marks]

(c)   Suppose that this bank also has cash of £50 million and lends £50 million to a company. Re-estimate the capital required if the netting amendment applies. Discuss how your answer differs from the answer to question (b)

[25 marks]

(a)   Consider the following problem:

A corporation plans to issue £1 million of 5-year bonds in 3 months. At current yields, the bonds would have a modified duration of 4 years. The corporation desires to hedge their  interest rate exposure with 20-year T-bond futures which    have a modified duration of 9 years. Each futures contract  has a par value of £100,000 and currently sold at £90,000. The corporation estimates that the yield on 20-year bonds  changes by 1 basis points for every 1.5-basis-point move in the yield on 5-year bonds

(i)  How can the firm use this T-bond futures contract to  hedge the risk surrounding the yield at which it will be able to sell its bonds?

[20 marks]

(ii) Suppose that the yield on 20-year bonds actually            changes by 1 basis points for every 1-basis-point move  in the yield on 5-year bonds. Does the corporation have to review their decision on futures position? What should they do?

[30 marks]

(b)   The following information is the balance sheet of Bank A. All

interest rates are fixed and paid annually.