Compute the dealer's expected carry income.

A dealer in government securities is considering buying $875,000,000 in 10-year U.S. Treasury notes and $1,425,000,000 in one-year U.S. Treasury bills. Current yields on the T-notes average 7.15 percent, while one-year T-bills yield average 3.28 percent. The dealer can currently borrow $2,300,000,000 through one-year repurchase agreements at an interest rate of 3.20 percent. Compute the dealer's expected carry income for one year in each of the following two scenarios.

A. The dealer purchases the T-notes and T-bills and finances them with the RP under the terms listed above.

B. Same as part A. above except that interest rates change to 7.30% on the T-notes, 5.40% on the T-bills and 5.55% on the RP, and the dealer must refinance the T-notes and T-bills purchase at the new RP rate.

Based on the above results, is it always good for the dealer when interest rates rise? How about when they fall? Please explain.

Hint: A spreadsheet can be most useful here. Perform the succession of calculations for the T-notes in one column; the succession of calculations for the T-bills in the next column; and the expenses from the RP in the third column. Then, compute the carry income from the appropriate columns where income and expenses have been computed for each scenario.