Measuring and Managing Interest Rate Risk Week 9

Measuring and Managing Interest Rate Risk Week 9 – October 19, 2005 J. K. Dietrich - FBE 524 - Fall, 2005

Interest rate risk u Future interest rates will affect value of all assets and liabilities, both real and financial assets and financial liabilities u No one knows future interest rates – Predictions of econometric models and the Lucas critique – Supply and demand factors (e. g. bond calendar) reflect expectations used in planning – Rational expectations and market rates J. K. Dietrich - FBE 524 - Fall, 2005

Interest Rate Risk u Interest rates change constantly – Each element of rates change: real rate, inflation premium, term premium, and risk premium – Market participants have varying degrees of sensitivity to changes in components of rates u One way to view interest-rate risk is in terms of balance sheet risk J. K. Dietrich - FBE 524 - Fall, 2005

Balance Sheet Risk Real Assets Inventories Equipment Plant Land Financial Assets Receivables Money Bonds Stock J. K. Dietrich - FBE 524 - Fall, 2005 Liabilities and Equity Financial Liabilities Payables Short-term notes Mortgages Bonds Preferred stock Common Stock Increasing duration Assets

Hedging Balance Sheet Risk u Hedging on balance sheet – Matching duration of assets and liabilities: Weighted average asset duration = Weighted average liability duration – Changing duration of assets and/or liabilities through swaps – Floating rate securities with short re-pricing intervals have short durations u Hedging off balance sheet – Futures, forward contracts, and options J. K. Dietrich - FBE 524 - Fall, 2005

Swaps u Exchange of future cash flows based on movement of some asset or price – Interest rates – Exchange rates – Commodity prices or other contingencies u Swaps are all over-the-counter contracts u Two contracting entities are called counterparties u Financial institution can take both sides J. K. Dietrich - FBE 524 - Fall, 2005

Swap example J. K. Dietrich - FBE 524 - Fall, 2005

Interest Rate Swap: Plain vanilla, LIBOR@5. 5% 1/2 5% fixed Company A (receive floating) $2. 75 mm $2. 5 mm 1/2 6 -month LIBOR Notional Amount $100 mm J. K. Dietrich - FBE 524 - Fall, 2005 Company B (receive fixed)

Definition of Derivatives u Derivatives are contracts – Commit parties to certain actions/payments in the future – The payment/action depends on outcomes of pre-specified events in the future u In most cases, the major cash flow or costly action will or may occur in the future, not in the present u Contracts can be standardized or negotiated J. K. Dietrich - FBE 524 - Fall, 2005

Types of Derivative Contracts u Three basic types of contracts – Futures or forwards – Options – Swaps u Many basic underlying assets – Commodities – Currencies – Financial assets like fixed incomes or residual claims J. K. Dietrich - FBE 524 - Fall, 2005

Derivatives = Value Derived from Prices of Other Assets u Stock market or equity price, commodity price, exchange and interest rate derivatives u Swaps, forwards and futures, options, and swap-options (or swaptions) u Traded and over-the-counter derivatives u Derivative are a zero-sum game u Credit risk in derivatives is performance risk, notional value risk J. K. Dietrich - FBE 524 - Fall, 2005

Exposure to Risk u. A general term to describe a firm’s exposure to a particular risk (e. g. a commodity price) is to classify the exposure as long or short u Long exposure means that the firm will benefit from increases in prices or values u Short exposure means that the firm will benefit from decreases in prices or values J. K. Dietrich - FBE 524 - Fall, 2005

Long Exposure u. A firm (or individual) is long if at the time of the risk assessment if it has or will have an asset or commodity. As examples – The firm owns assets, as in inventories of raw materials or finished goods – The firm produces a commodity or product, as in an agribusiness raising wheat or livestock – The firm will take possession in the future or a commodity or an asset – The firm has bought a commodity or asset J. K. Dietrich - FBE 524 - Fall, 2005

Short Exposure u. A firm (or individual) is short if at the time of the risk assessment if it needs or will need an asset or commodity. As examples – The firm is planning or has promised to deliver raw materials or finished goods – The firm uses a commodity or product in production as inputs, like steel or lumber – The firm will have possession in the future or a commodity or an asset it does not need or needs to sell – The firm has sold a commodity or asset and must deliver J. K. Dietrich - FBE 524 - Fall, 2005

Exposure to Risks J. K. Dietrich - FBE 524 - Fall, 2005

Examples of Exposure u Farmer with wheat is long wheat u Honey Baked Ham is short pork before Easter selling season u Treasurer with excess cash in three months is short investments u Company needing cash in nine months is long financial assets (its liabilities are others’ assets) to sell J. K. Dietrich - FBE 524 - Fall, 2005

Price Exposure in a Diagram Profit Long 0 Loss P 0 Short J. K. Dietrich - FBE 524 - Fall, 2005

Futures Contracts u Wall Street Journal tables u Standardized contracts – Quantity and quality – Delivery date – Last trading date – Deliverables u Clearing house is counter-party u Margin requirements, mark to market J. K. Dietrich - FBE 524 - Fall, 2005

Forward vs. Futures Contracts u Bilateral contract (usually with a financial firm as counter-party) u Terms are tailor made to needs of client, not standardized u No exchange of cash until maturity of contract u Over-the-counter market not as liquid as organized exchange J. K. Dietrich - FBE 524 - Fall, 2005

Managing Risk with Futures u Offset price or interest rate risk with contract which moves in opposite direction u “Cross diagonally in the box” u Identify contract with price or interest rate which moves as close as possible with the price or interest rate exposure u Imperfect correlation is basis risk u Not using futures or forwards can be speculation J. K. Dietrich - FBE 524 - Fall, 2005

Corporation Planning to Borrow Hedging Honey-Baked Plan Now J. K. Dietrich - FBE 524 - Fall, 2005 Honey-Baked Hedge Borrowing Hedge

Options (Definition) u An option is the right (not the obligation) to buy or sell an asset at a fixed price before a given date – call is right to buy, put is right to sell – strike or exercise price is a fixed price which determines conversion value – expiration date u Options on stocks, commodities, real estate, and future contracts J. K. Dietrich - FBE 524 - Fall, 2005

Interpreting Option Quotations in the Wall Street Journal u Listed option quotations versus “over-thecounter” options u Stock versus commodity u Futures options versus asset options u Strike/Expiration of Call/Put u Volume, last, and open interest u LEAPs and index options J. K. Dietrich - FBE 524 - Fall, 2005

Call Options Profits at Maturity Profit Payoff to Buyer 0 J. K. Dietrich - FBE 524 - Fall, 2005 Strike Price Asset Value

Call Writer’s (Seller’s) Profits Profit Strike Price 0 Possible Cost to Writer Loss J. K. Dietrich - FBE 524 - Fall, 2005 Asset Value

Option Value Sensitivity to Price Changes in Assets Buy Put S Write Put J. K. Dietrich - FBE 524 - Fall, 2005 Buy Call S Write Call

Option Values u Conversion value = asset value - strike price u Option premium = Option value conversion value u Factors determining option premiums » Time to maturity » Asset value » Strike price » Volatility » Interest rate J. K. Dietrich - FBE 524 - Fall, 2005

Value of Call Options Profit Option Premium 0 Strike Price Asset Value “In the Money” “Out of the Money” “At the Money” J. K. Dietrich - FBE 524 - Fall, 2005

Caps, floors, and collars u If a borrower has a loan commitment with a cap (maximum rate), this is the same as a put option on a note u If at the same time, a borrower commits to pay a floor or minimum rate, this is the same as writing a call u A collar is a cap and a floor J. K. Dietrich - FBE 524 - Fall, 2005

Collars: Cap 6%, floor 4% Profit 0 Loss J. K. Dietrich - FBE 524 - Fall, 2005 9400 9500 9600

Replication Futures with Options Profit 0 Loss J. K. Dietrich - FBE 524 - Fall, 2005 Profit Long P 0 0 Loss Buy Call P 0 Write Put

Other option developments u Credit risk options u Casualty risk options u Requirements for developing an option – Interest – Calculable payoffs – Enforceable J. K. Dietrich - FBE 524 - Fall, 2005

Next week: Oct. 26, 2005 u Provide me with one-page description of group project, including (1) problem to be addressed, (2) analytical framework to be used, and (3) data analysis and sources to be employed to address problem in (1) u Read Chapters 10 and 11 and review contents of Instruments of the Money Market J. K. Dietrich - FBE 524 - Fall, 2005