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    Chapter Eight

    Risk Management: Financial Futures,

    Options, Swaps, and Other Hedging Tools in

    Asset-Liability Management

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    2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/IrwinBank Management and Financial Services, 7/e

    Key Topics

    The Use of Derivatives

    Financial Futures Contracts: Purpose and

    Mechanics Short and Long Hedges

    Interest-Rate Options: Types of Contractsand Mechanics

    Interest-Rate Swaps

    Regulations and Accounting Rules

    Caps, Floors, and Collars

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    Derivatives

    A Derivative is Any Instrument or

    Contract that Derives its Value FromAnother Underlying Asset, Instrument,or Contract, Such as Treasury Bills andBonds and Eurodollar Deposits

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    Managing Interest Rate Risk

    Derivatives Used to Manage Interest RateRisk

    Financial Futures Contracts

    Forward Rate Agreements

    Interest Rate Swaps

    Options on Interest Rates

    Interest Rate Caps

    Interest Rate Floors

    Interest Rate Collars

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    Financial Futures Contract

    An Agreement Between a Buyer and a SellerWhich Calls for the Delivery of a ParticularFinancial Asset at a Set Price at Some Future

    Date Futures Markets

    The Organized Exchanges Where FuturesContracts are traded

    Interest Rate Futures

    Where the Underlying Asset is an Interest-Bearing Security

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    Financial Futures Contracts

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    TA

    TL*D-DD LA

    IS Gap = IS AssetsIS Liabilities

    and

    Recall what happens when interest rates rise? Fall?

    One of the most popular methods for neutralizing these gap

    risks is to buy and sell financial futures contracts

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    Background on Financial Futures

    Buyers

    A buyer of a futures contract is said to belong futures

    Agrees to pay the underlying futures priceor take delivery of the underlying asset

    Buyers gain when futures prices rise andlose when futures prices fall

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    Background on Financial Futures

    Sellers

    A seller of a futures contract is said to be

    short futures

    Agrees to receive the underlying futuresprice or to deliver the underlying asset

    Sellers gain when futures prices fall andlose when futures prices rise

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    The Purpose of Financial Futures

    To Shift the Risk of Interest RateFluctuations from Risk-AverseInvestors to Speculators

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    The Worlds Leading Futures and OptionExchanges

    Chicago Board ofTrade (CBT)

    Chicago BoardOptions Exchange

    Singapore ExchangeLTD. (SGX)

    Chicago MercantileExchange (CME)

    Euronext.Liffe(Eurex)

    Sydney Futures

    Exchange Toronto Futures

    Exchange (TFE) South African

    Futures Exchange(SAFEX)

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    Futures vs. Forward Contracts

    Futures Contracts

    Traded on formal exchanges (CBOT, CME, etc.)

    Involve standardized instruments

    Positions require a daily marking to market

    Forward Contracts

    Terms are negotiated between parties

    Do not necessarily involve standardized assets Require no cash exchange until expiration

    No marking to market

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    Most Common Financial FuturesContracts

    U.S. Treasury Bond Futures Contracts

    Three-Month Eurodollar Time Deposit

    Futures Contract 30-Day Federal Funds Futures Contracts

    One Month LIBOR Futures Contracts

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    Hedging with Futures Contracts

    Avoiding HigherBorrowing Costs and

    Declining Asset Values

    Use a Short Hedge: SellFutures Contracts andthen Purchase Similar

    Contracts Later

    Avoiding Lower ThanExpected Yields fromLoans and Securities

    Use a long Hedge: BuyFutures Contracts and

    then Sell SimilarContracts Later

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    Short Futures Hedge Process

    Today Contract is Sold Through anExchange

    Sometime in the Future Contract isPurchased Through the Same Exchange

    Results The Two Contracts Are Cancelled

    Out by the Futures Clearinghouse

    Gain or Loss is the Difference in the PricePurchased for (At the End) and Price SoldFor (At the Beginning)

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    Long Futures Hedge Process

    Today Contract is Purchased Through anExchange

    Sometime in the Future Contract is soldThrough the Same Exchange

    Results The Two Contracts are Cancelledby the Clearinghouse

    Gain or Loss is the Difference in the PricePurchase For (At the Beginning) and thePrice Sold For (At the End)

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    Basis Risk

    The basis is the cash price of an asset minusthe corresponding futures price for thesame asset at a point in time

    For financial futures, the basis can be calculated asthe futures rate minus the spot rate

    It may be positive or negative, depending on whetherfutures rates are above or below spot rates

    May swing widely in value far in advance of contractexpiration

    Basis=Cash-market price (or interest rate) futures market price (or interest rate)

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    Realized Return from Combining Cashand Futures Market Trading

    = Return Earned in the Cash Market

    +/- Profit or Loss from Futures Trading

    -Closing Basis Between Cash and FuturesMarket

    -Opening Basis Between Cash and FuturesMarket

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    Change in the Market Value of theFutures Contract

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    Change in the Market Value of the

    Futures Contract

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    i)(1

    iNF-DFF 00t

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    Number of Futures Contracts

    Needed

    ContractFuturestheofPrice*D

    TA*)TA

    TL*D-(D

    F

    LA

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    Quick Quiz

    What are financial futures contracts? Whichfinancial institutions use futures and otherderivatives for risk management?

    How can financial futures help financialservice firms deal with interest rate risk?

    What futures transactions would most likelybe used in a period of rising interest rates?Falling interest rates?

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    Interest Rate Option

    It Grants the Holder of the Option theRight but Not the Obligation to Buy orSell Specific Financial Instruments atan Agreed Upon Price.

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    Types of Options

    Put Option Gives the Holder of the Option the

    Right to Sell the Financial Instrumentat a Set Price

    Call Option

    Gives the Holder of the Option theRight to Purchase the FinancialInstrument at a Set Price

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    Most Common Option Contracts

    Used By Banks

    U.S. Treasury Bond Futures Options

    Eurodollar Futures Option

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    Principal Uses of Option Contracts

    1. Protecting a security portfolio through the use of putoptions to insulate against falling security prices (risinginterest rates); however, there is no delivery obligationunder an option contract so the user can benefit from

    keeping his or her securities if interest rates fall andsecurity prices rise

    2. Hedging against positive or negative gaps between

    interest-sensitive assets and interest- sensitiveliabilities; for example, put options can be used tooffset losses from a negative gap when interest ratesrise, while call options can be used to offset a positivegap when interest rates fall.

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    Speculation vs. Hedging

    With financial futures, risk often cannot beeliminated, only reduced.

    Traders normally assume basis risk in that

    the basis might change adversely betweenthe time the hedge is initiated and closed

    Perfect Hedge

    The gains (losses) from the futures positionperfectly offset the losses (gains) on the spotposition at each price

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    Federal Funds Options and Futures

    Represents the Consensus Opinion Of theLikely Future Course of Market InterestRates

    Public Trading for Futures Contract Beganat the CBOT in 1988

    Public Trading on Options Contracts Began

    in 2003

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    Regulations For Options and FutureContracts

    OCC Risk Management of FinancialDerivatives: Comptrollers Handbook

    FASB Statement 133 Accounting forDerivatives Instruments and HedgingActivities

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    Interest Rate Swap

    A Contract Between Two Parties toExchange Interest Payments in anEffort to Save Money and Hedge

    Against Interest-Rate Risk

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    Interest Rate Swap

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    Quality Swap

    Borrower with Lower Credit RatingPays Fixed Payments of Borrower with

    Higher Credit Rating Borrower with Higher Credit RatingPays Short-Term Floating Rate

    Payments of Borrower with LowerCredit Rating

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    Further

    Firms with a negative GAP can reduce riskby making a fixed-rate interest payment in

    exchange for a floating-rate interest receipt

    Firms with a positive GAP take the opposite

    position, by making floating-interestpayments in exchange for a fixed-ratereceipt

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    Risks of Interest Rate Swaps

    Substantial Brokerage Fees Credit Risk

    The counterparty may default on the exchange ofthe interest payments

    Only the interest payment exchange is at risk,not the principal

    Basis Risk A swaps reference interest rates are not the

    same as those attached to all the assets andliabilities (LIBOR, bond rates, etc.), so rates donot change exactly the same -> some riskremains

    Interest Rate Risk

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    Netting

    The Swap Parties Only Swap the NetDifference Between the InterestPayments. This Reduces the PotentialDamage if One Party Defaults on itsObligation

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    Currency Swap

    An Agreement Between Two Parties,

    Each Owing Funds to OtherContractors Denominated in DifferentCurrencies, to Exchange the NeededCurrencies with Each Other and Honor

    Their Respective Contracts.

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    Interest Rate Cap

    Protects the Holder from RisingInterest Rates. For an Up Front FeeBorrowers are Assured Their Loan RateWill Not Rise Above the Cap Rate

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    Interest Rate Floor

    A Contract Setting the Lowest InterestRate a Borrower is Allowed to Pay on aFlexible-Rate Loan

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    Interest Rate Collar

    A Contract Setting the Maximum andMinimum Interest Rates That May BeAssessed on a Flexible-Rate Loan. ItCombines an Interest Rate Cap andFloor into One Contract.

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    h ill i ll i h d

    McGraw-Hill/Irwin

    Quick Quiz

    Explain what is involved in a put option?

    What is a call option?

    Suppose market interest rates wereexpected to rise. What type of option wouldnormally be used?

    If rates were expected to fall, what type ofoption would a financial institutionsmanager be likely to employ?