Chapter Eight Risk Management Financial Futures Options Swaps

Chapter Eight Risk Management: Financial Futures, Options, Swaps, and Other Hedging Tools Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

8 -2 Key Topics • The Use of Derivatives • Financial Futures Contracts: Purpose and Mechanics • Short and Long Hedges • Interest-Rate Options: Types of Contracts and Mechanics • Interest-Rate Swaps • Regulations and Accounting Rules • Caps, Floors, and Collars Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -3 Derivatives A Derivative is Any Instrument or Contract that Derives its Value From Another Underlying Asset, Instrument, or Contract, Such as Treasury Bills and Bonds and Eurodollar Deposits Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -4 Managing Interest Rate Risk • Derivatives Used to Manage Interest Rate Risk ▫ Financial Futures Contracts ▫ Forward Rate Agreements ▫ Interest Rate Swaps ▫ Options on Interest Rates Interest Rate Caps Interest Rate Floors Interest Rate Collars Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -5 Financial Futures Contract • An Agreement Between a Buyer and a Seller Which Calls for the Delivery of a Particular Financial Asset at a Set Price at Some Future Date • Futures Markets ▫ The Organized Exchanges Where Futures Contracts are traded • Interest Rate Futures ▫ Where the Underlying Asset is an Interest. Bearing Security Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -6 Financial Futures Contracts IS Gap = IS Assets – IS 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -7 Background on Financial Futures • Buyers ▫ A buyer of a futures contract is said to be long futures ▫ Agrees to pay the underlying futures price or take delivery of the underlying asset ▫ Buyers gain when futures prices rise and lose when futures prices fall Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -8 Background on Financial Futures • Sellers ▫ A seller of a futures contract is said to be short futures ▫ Agrees to receive the underlying futures price or to deliver the underlying asset ▫ Sellers gain when futures prices fall and lose when futures prices rise Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -9 The Purpose of Financial Futures To Shift the Risk of Interest Rate Fluctuations from Risk-Averse Investors to Speculators Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -10 The World’s Leading Futures and Option Exchanges • Chicago Board of Trade (CBT) • Chicago Board Options Exchange • Singapore Exchange LTD. (SGX) • Chicago Mercantile Exchange (CME) Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e • Euronext. Liffe (Eurex) • Sydney Futures Exchange • Toronto Futures Exchange (TFE) • South African Futures Exchange (SAFEX) © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -11 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -12 Most Common Financial Futures Contracts • U. S. Treasury Bond Futures Contracts • Three-Month Eurodollar Time Deposit Futures Contract • 30 -Day Federal Funds Futures Contracts • One Month LIBOR Futures Contracts Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -13 Hedging with Futures Contracts Avoiding Higher Borrowing Costs and Declining Asset Values Use a Short Hedge: Sell Futures Contracts and then Purchase Similar Contracts Later Avoiding Lower Than Expected Yields from Loans and Securities Use a long Hedge: Buy Futures Contracts and then Sell Similar Contracts Later Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -14 Short Futures Hedge Process • Today – Contract is Sold Through an Exchange • Sometime in the Future – Contract is Purchased Through the Same Exchange • Results – The Two Contracts Are Cancelled Out by the Futures Clearinghouse • Gain or Loss is the Difference in the Price Purchased for (At the End) and Price Sold For (At the Beginning) Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -15 Long Futures Hedge Process • Today – Contract is Purchased Through an Exchange • Sometime in the Future – Contract is sold Through the Same Exchange • Results – The Two Contracts are Cancelled by the Clearinghouse • Gain or Loss is the Difference in the Price Purchase For (At the Beginning) and the Price Sold For (At the End) Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -16 Basis Risk The basis is the cash price of an asset minus the corresponding futures price for the same asset at a point in time ▫ For financial futures, the basis can be calculated as the futures rate minus the spot rate ▫ It may be positive or negative, depending on whether futures rates are above or below spot rates ▫ May swing widely in value far in advance of contract expiration Basis=Cash-market price (or interest rate) – futures market price (or interest rate) Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -17 Realized Return from Combining Cash and Futures Market Trading = Return Earned in the Cash Market +/- Profit or Loss from Futures Trading - Closing Basis Between Cash and Futures Market - Opening Basis Between Cash and Futures Market Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -18 Change in the Market Value of the Futures Contract Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -19 Change in the Market Value of the Futures Contract Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -20 Number of Futures Contracts Needed Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -21 Quick Quiz • What are financial futures contracts? Which financial institutions use futures and other derivatives for risk management? • How can financial futures help financial service firms deal with interest rate risk? • What futures transactions would most likely be used in a period of rising interest rates? Falling interest rates? Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -22 Interest Rate Option It Grants the Holder of the Option the Right but Not the Obligation to Buy or Sell Specific Financial Instruments at an Agreed Upon Price. Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -23 Types of Options • Put Option ▫ Gives the Holder of the Option the Right to Sell the Financial Instrument at a Set Price • Call Option ▫ Gives the Holder of the Option the Right to Purchase the Financial Instrument at a Set Price Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -24 Most Common Option Contracts Used By Banks • U. S. Treasury Bond Futures Options • Eurodollar Futures Option Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -25 Principal Uses of Option Contracts • 1. Protecting a security portfolio through the use of put options to insulate against falling security prices (rising interest rates); however, there is no delivery obligation under an option contract so the user can benefit from keeping his or her securities if interest rates fall and security prices rise • 2. Hedging against positive or negative gaps between interest-sensitive assets and interest- sensitive liabilities; for example, put options can be used to offset losses from a negative gap when interest rates rise, while call options can be used to offset a positive gap when interest rates fall. Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -26 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -27 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -28 Speculation vs. Hedging • With financial futures, risk often cannot be eliminated, only reduced. ▫ Traders normally assume basis risk in that the basis might change adversely between the time the hedge is initiated and closed • Perfect Hedge ▫ The gains (losses) from the futures position perfectly offset the losses (gains) on the spot position at each price Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -29 Federal Funds Options and Futures • Represents the Consensus Opinion Of the Likely Future Course of Market Interest Rates • Public Trading for Futures Contract Began at the CBOT in 1988 • Public Trading on Options Contracts Began in 2003 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -30 Regulations For Options and Future Contracts • OCC – Risk Management of Financial Derivatives: Comptrollers Handbook • FASB – Statement 133 – Accounting for Derivatives Instruments and Hedging Activities Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -31 Interest Rate Swap A Contract Between Two Parties to Exchange Interest Payments in an Effort to Save Money and Hedge Against Interest-Rate Risk Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -32 Interest –Rate Swap Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -33 Quality Swap • Borrower with Lower Credit Rating Pays Fixed Payments of Borrower with Higher Credit Rating • Borrower with Higher Credit Rating Pays Short-Term Floating Rate Payments of Borrower with Lower Credit Rating Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -34 Further… • Firms with a negative GAP can reduce risk by 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-interest payments in exchange for a fixed-rate receipt Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -35 Risks of Interest Rate Swaps • Substantial Brokerage Fees • Credit Risk ▫ The counterparty may default on the exchange of the interest payments ▫ Only the interest payment exchange is at risk, not the principal • Basis Risk ▫ A swap’s reference interest rates are not the same as those attached to all the assets and liabilities (LIBOR, bond rates, etc. ), so rates do not change exactly the same -> some risk remains • Interest Rate Risk Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -36 Netting The Swap Parties Only Swap the Net Difference Between the Interest Payments. This Reduces the Potential Damage if One Party Defaults on its Obligation Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -37 Currency Swap An Agreement Between Two Parties, Each Owing Funds to Other Contractors Denominated in Different Currencies, to Exchange the Needed Currencies with Each Other and Honor Their Respective Contracts. Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -38 Interest Rate Cap Protects the Holder from Rising Interest Rates. For an Up Front Fee Borrowers are Assured Their Loan Rate Will Not Rise Above the Cap Rate Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -39 Interest Rate Floor A Contract Setting the Lowest Interest Rate a Borrower is Allowed to Pay on a Flexible-Rate Loan Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -40 Interest Rate Collar A Contract Setting the Maximum and Minimum Interest Rates That May Be Assessed on a Flexible-Rate Loan. It Combines an Interest Rate Cap and Floor into One Contract. Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

8 -41 Quick Quiz • Explain what is involved in a put option? • What is a call option? • Suppose market interest rates were expected to rise. What type of option would normally be used? • If rates were expected to fall, what type of option would a financial institution’s manager be likely to employ? Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.