Assume that the United States just experienced a mild recession. As a result, interest rates have declined to their lowest levels in a decade. The U.S. interest rates appear to be influenced more by changes in the demand for funds than by changes in the supply of U.S. savings, because the savings rate does not change much regardless of economic con- ditions. The yield curve is currently flat. The federal budget deficit has improved lately and is not expected to rise substantially.

The federal government recently decided to reduce personal tax rates significantly for all tax brackets as well as corporate tax rates. The U.S. dollar has just recently weakened. Economies of other countries were somewhat stagnant but have improved in the past quarter. Your assignment is to recommend how various financial institutions should re- spond to the preceding information.

Questions

1. A savings institution holds 50 percent of its assets as long-term fixed-rate mortgages. Virtually all of its funds are in the form of short-term deposits. Which of the following strategies would be most appropriate for this institution?

• Use a fixed-for-floating swap.
• Use a swap of floating payments for fixed payments.
• Use a put option on interest rate futures contracts.
• Remain unhedged.

Defend your recommendation.

2. An insurance company maintains a large portfolio of U.S. stocks. Which of the fol- lowing would be more appropriate?

• Sell stock index futures contracts.
• Remain unhedged.

Defend your recommendation.

3. A pension fund maintains a large bond portfolio of U.S. bonds. Which of the fol- lowing would be most appropriate?

* Sell bond index futures.
* Buy bond index futures.
* Remain unhedged.

Defend your recommendation.

4. An international mutual fund sponsored by a U.S. securities firm consists of bonds evenly allocated across the United States and the United Kingdom. One of the portfo- lio managers has decided to hedge all the assets by selling futures on a popular U.S. bond index. The manager has stated that because the fund concentrates only on risk- free Treasury bonds, the only concern is interest rate risk. Assuming that interest rate risk is the only risk of concern, will the hedge described above be effective? Why or why not? Is there any other risk that deserves to be considered? If so, how would you hedge that risk?