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 © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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 -2

Introduction • The asset-liability management tools we explore here are useful across a broad range of financial-service providers sensitive to the risk of changes in market interest rates • Many of the risk management tools in this chapter are not only used by financial firms to cover their own interest rate risk, but are also sold to customers who need risk protection and generate fee income for the providers • Most of the financial instruments in this chapter are derivatives ▫ They derive their value from the value and terms of underlying instruments Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -3

Uses of Derivative Contracts Among FDICInsured Banks • Due to their high exposure to various forms of risk, banks and their principal competitors are among the heaviest users of derivative contracts • These risk-hedging instruments allow a financial firm to protect its balance sheet and/or income and expense statement in case interest rates, currency prices, or other financial variables move against the hedger • Approximately 15 percent of all banks operating in the United States reportedly employ the use of derivatives to subdue risk in its various forms ▫ Today the bulk of trading in derivatives is centered in the very largest banks worldwide • Interest-rate risk is by far the most common target for derivatives, with foreign exchange (currency) risk running a distant second • The leading type of risk-hedging contracts are swaps, followed by financial futures and options Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -4

EXHIBIT 8 -1 Types of Derivative Contracts Used by Depository Institutions to Manage Different Types of Risk Exposure, 2010 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 Contracts: Promises of Future Security Trades at a Preset Price • In Chapter 7, we explored the nature of gaps between assets and liabilities that are exposed to interest rate risk • The preceding chapter developed one other measure of the difference between risk-exposed assets and liabilities – the leverage-adjusted duration gap 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: Promises of Future Security Trades at a Preset Price (continued) • A financial futures contract is an agreement reached today between a buyer and a seller that calls for delivery of a particular security in exchange for cash at some future date • Financial futures trade in futures markets and are usually accounted for as off-balance-sheet items on the financial statements of financial-service firms • Sellers of financial assets remove the assets from their balance sheet and account for the losses or gains on their income statements • Buyers of financial assets add the item purchased to their balance sheet • In cash markets, buyers and sellers exchange the financial asset for cash at the time the price is set • In futures markets buyers and sellers exchange a contract calling for delivery of the underlying financial asset at a specified date in the future Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -7

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • When the contract is created, neither buyer nor seller is making a purchase or sale at that point in time, only an agreement for the future • When an investor buys or sells futures contracts at a designated price, it must deposit an initial margin ▫ The initial margin is the investor’s equity in the position when he or she buys (or sells) the contract • Each trader’s account is marked-to-market ▫ When a trader’s equity position falls below the maintenance margin (the minimum specified by the exchange) the trader must deposit additional funds to the equity account to maintain his or her position, or the futures position is closed out within 24 hours ▫ The mark-to-market process takes place at the end of each trading day Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -8

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • Buyers of futures contracts ▫ 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 • Sellers of futures contracts ▫ 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

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • The financial futures markets are designed to shift the risk of interest-rate fluctuations from risk-averse investors, such as banks and insurance companies, to speculators willing to accept and possibly profit from such risks • Futures contracts are traded on organized exchanges ▫ For example, the Chicago Mercantile Exchange or the London Financial Futures Exchange • On the exchange floor, floor brokers execute orders received from the public to buy or sell these contacts at the best prices available Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -10

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • Futures contracts are also traded over the counter (OTC) ▫ Often less costly for traders ▫ These are most often called forward contracts • Forward contracts ▫ ▫ ▫ Generally more risky – counterparty risk and liquidity risk 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 -11

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • 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 -12

EXHIBIT 8– 2 Sample Market Prices for Interest-Rate Futures in Recent Years Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -13

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • 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 the 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 -14

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • 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 purchase price (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 -15

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • The three most typical interest-rate hedging problems financial firms face are 1. 2. 3. Protecting the value of securities and fixed-rate loans from losses due to rising interest rates Avoiding a rise in borrowing costs Avoiding a fall in the interest returns expected from loans and security holdings • Where the financial institution faces a positive interest-sensitive gap, it can protect against loss due to falling interest rates by covering the gap with a long hedge • If the institution is confronted with a negative interest-sensitive gap, it can avoid unacceptable losses from rising market interest rates by covering with a short hedge Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -16

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -17

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • Basis Risk with a Short Hedge ▫ You are concerned about the interest-rate risk exposure for bonds in a financial institution’s securities portfolio ▫ You fear increasing interest rates that would decrease the value of those bonds ▫ You have a long position in the cash market ▫ To hedge this possible increase in market interest rates, you could take a short position in the 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

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • Basis Risk with a Short Hedge Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -19

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • Basis Risk with a Long Hedge ▫ If you have concerns about declining interest rates, you could create a long hedge ▫ To hedge the decrease in interest rates, you could take a long position in the futures market Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -20

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • The real risk the user faces from hedging with futures stems from the movement in basis that may occur over the life of a futures contract because cash and futures prices are not perfectly synchronized with each other • The sensitivity of the market price of a financial futures contract depends, in part, upon the duration of the security to be delivered under 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 -21

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • If we rewrite this equation slightly we get an expression for the gain or loss from the use of financial futures Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -22

EXHIBIT 8– 3 Trade-Off Diagrams for 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 -23

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • How many futures contracts does a financial firm need to cover a given size risk exposure? ▫ The objective is to offset the loss in net worth due to changes in market interest rates with gains from trades in the futures market Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -24

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) • If we set the change in net worth equal to the change in the futures position value, we can solve for the number of futures contracts needed to fully hedge a financial firm’s overall interest-rate risk exposure and protect its net worth Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -25

Interest-Rate Options • The interest-rate option grants a holder of securities the right to either 1. Place (put) those instruments with another investor at a prespecified exercise price before the option expires or 2. Take delivery of securities (call) from another investor at a prespecified price before the option’s expiration date • In the put option, the option writer must stand ready to accept delivery of securities from the option buyer if the latter requests • In the call option, the option writer must stand ready to deliver securities to the option buyer upon request • The fee that the buyer must pay for the privilege of being able to put securities to or call securities away from the option writer is known as the option premium Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -26

Interest-Rate Options (continued) • For standardized exchange-traded interest-rate options, the most activity occurs using options on futures, referred to as the futures options market • Most common option contracts used by banks ▫ U. S. Treasury Bond Futures Options ▫ Grant the options buyer the right to a short position (put) or a long position (call) involving one T-bond futures contract for each option ▫ Eurodollar Futures Option ▫ Give the buyer the right to deliver (put) or accept delivery (call) of one Eurodollar deposit futures contract for every option exercised • Exchange-traded futures options are generally set to expire in March, June, September, or December to conform to most futures contracts Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -27

EXHIBIT 8– 4 Futures Options Sample Prices Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -28

Interest-Rate Options (continued) • Most options today are used by money center banks • They appear to be directed at two principal uses 1. Protecting a security portfolio through the use of put options to insulate against falling security prices (rising interest rates) ▫ 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 interestsensitive 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 -29

EXHIBIT 8– 5 Payoff Diagrams for Put and Call Options Purchased by a Financial Institution Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -30

EXHIBIT 8– 6 Payoff Diagrams for Put and Call Options Written by a Financial Firm Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -31

Regulations and Accounting Rules for Bank Futures and Options Trading • Regulators expect a financial firm’s board of directors to provide oversight while senior management is responsible for the development of an appropriate risk-management system • The risk-management system is to be comprised of 1. 2. 3. Policies and procedures to control financial risk taking Risk measurement and reporting systems Independent oversight and control processes • The OCC requires the banks it supervises to measure and set limits with regards to nine different aspects of risk associated with derivatives ▫ These risks are strategic risk, reputation risk, price risk, interest rate risk, liquidity risk, foreign exchange risk, credit risk, transaction risk, and compliance risk Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -32

Regulations and Accounting Rules for Bank Futures and Options Trading (continued) • In 1998, the Financial Accounting Standards Board (FASB) introduced Statement 133 (FAS 133) ▫ “Accounting for Derivative Instruments and Hedging Activities” • FAS 133 requires that all derivatives be recorded on the balance sheet as assets or liabilities at their fair value ▫ With regard to interest rate risk, FAS 133 recognized two types of hedges: a fair value hedge and a cash flow hedge ▫ The objective of a fair value hedge is to offset losses due to changes in the value of an asset or liability ▫ Cash flow hedges try to reduce risk associated with future cash flows (interest on loans or interest payments on debt) Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -33

Interest-Rate Swaps • An interest-rate swap is a way to change a borrowing institution’s exposure to interest-rate fluctuations and achieve lower borrowing costs • Swap participants can convert from fixed to floating interest rates or from floating to fixed interest rates and more closely match the maturities of their liabilities to the maturities of their assets ▫ The most popular short-term, floating rates used in interest rate swaps today include the London Interbank Offered Rate (LIBOR) on Eurodollar deposits, Treasury bill and bond rates, the prime bank rate, the Federal funds rate, and interest rates on CDs issued by depository institutions Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -34

Interest-Rate Swaps (continued) • 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 • Reverse Swap ▫ A new swap agreement offsets the effects of an existing swap contract • “Swaptions” ▫ Options for one or both parties to make certain changes in the agreement, take out a new option, or cancel an existing swap agreement Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -35

EXHIBIT 8– 7 The 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 -36

Interest-Rate Swaps (continued) • The principal amount of the loans, usually called the notional amount, is not exchanged ▫ Only the net amount of interest due usually flows to one or the other party to the swap ▫ The swap itself normally will not show up on a swap participant’s balance sheet • Actual defaults are limited • If a swap partner is rated BBB or lower, it may be impossible to find a counterparty to agree to the swap ▫ Low-rated partner may be required to agree to a credit trigger clause • Basis risk and interest rate risk can be significant Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -37

Caps, Floors, and Collars • An interest-rate cap protects its holder against rising market interest rates ▫ In return for paying an up-front premium, borrowers are assured that institutions lending them money cannot increase their loan rate above the level of the cap ▫ Alternatively, the borrower may purchase an interest-rate cap from a third party, with that party promising to reimburse borrowers for any additional interest they owe their creditors beyond the cap Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -38

Caps, Floors, and Collars (continued) • Interest-Rate Cap Example ▫ A bank purchases a cap of 11 percent on its borrowings of $100 million in the Eurodollar market for one year ▫ Suppose interest rates in this market rise to 12 percent for the year ▫ The financial institution selling the cap will reimburse the bank purchasing the cap the additional 1 percent in interest Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -39

Caps, Floors, and Collars (continued) • Financial-service providers can also lose earnings in periods of falling interest rates, especially when rates on floating-rate loans decline • A lending institution can establish an interest-rate floor under its loans so that, no matter how far loan rates tumble, it is guaranteed some minimum rate of return Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -40

Caps, Floors, and Collars (continued) • Interest-Rate Floor Example ▫ Suppose a lender extends a $10 million floating-rate loan to one of its corporate customers for a year at prime insists on a minimum (floor) interest rate on this loan of 7 percent ▫ If the prime rate drops below the floor to 6 percent for one year, the customer will pay not only the 6 percent prime rate but also pay out an interest rebate to the lender of ▫ Assuming the borrower does not default, lender assured a minimum return of 7 percent on its loan Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -41

Caps, Floors, and Collars (continued) • Lending institutions and their borrowing customers also make heavy use of the interest-rate collar ▫ Combines in one agreement a rate floor and a rate cap • Interest-Rate Collar Example ▫ A customer who has just received a $100 million loan and asks for a collar on the loan’s prime rate between 11 percent and 7 percent ▫ The lender will pay its customer’s added interest cost if prime rises above 11 percent, while the customer reimburses the lender if prime drops below 7 percent ▫ The collar’s purchaser pays a premium for a rate cap while receiving a premium for accepting a rate floor ▫ The net premium paid for the collar can be positive or negative, depending upon the outlook for interest rates and the risk aversion of borrower and lender at the time of the agreement Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. 8 -42

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? • Explain what is involved in a put option. What is a call option? What is an option on a futures contract? • What is the purpose of an interest-rate swap? • How can financial-service providers make use of interest-rate caps, floors, and collars to generate revenue and help manage 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 -43