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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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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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2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin

Bank Management and Financial Services, 7/e

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?

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