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Chapter Eight

Chapter Eight. Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management. Key Topics in this Chapter. The Use of Derivatives Financial Futures Contracts: Purpose and Mechanics Short and Long Hedges Interest-Rate Options:Types of Contracts and Mechanics

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Chapter Eight

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  1. Chapter Eight Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management

  2. Key Topics in this Chapter • 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 • Caps, Floor, and Collars

  3. 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

  4. The Purpose of Financial Futures • To Shift the Risk of Interest Rate Fluctuations from Risk-Averse Investors to Speculators • To hedge Interest rate risk

  5. Chicago Board of Trade (CBT) Chicago Board Options Exchange Singapore Exchange LTD. (SGX) Chicago Mercantile Exchange (CME) Euronext.Liffe (Eurex) Sydney Futures Exchange Toronto Futures Exchange (TFE) South African Futures Exchange (SAFEX) The World’s Leading Futures and Option Exchanges

  6. 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

  7. What is a long hedge? • A long hedge is taken to protect against a fall in interest rates. A long hedge results when a futures contract is purchased • A long hedger offsets risk by buying financial futures around the time a net inflow of funds is expected in the form of maturing loans. If rates drop the inflow of funds can only be invested at a lower rate generating an opportunity loss. However if a long hedge is in place the loss on the reinvestment of the net cash inflow will be offset by a gain on the long futures position. Later as the net cash flow is invested a like amount of futures is sold

  8. What is a short hedge? • A short hedge is taken to protect against a rise in interest rates. • If more deposits than loans are maturing or are re - priced in a given future period the bank would need to replace or re-price those deposits. If rates move higher when the deposits are replaced or re –priced at higher rates the bank stands to lose money. The sale of a futures contract would generate profits that would offset such a loss

  9. Hedging with Futures Contracts

  10. 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) • If rates rise in the future, security prices will fall resulting in a lower price when the offsetting contract is purchased. The resulting profit offsets the loss on the negative gap position being hedged.

  11. 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) • If interest rate do fall the offsetting sale of the futures contract will occur at a higher price. The resulting profit will offset the loss due to lower interest rates on an asset sensitive position

  12. Interpret futures quotes from the wall street journal • The first column gives the opening price. The second and third the daily high and low prices. The fourth column shows the settlement price followed by the change in the settlement price from the previous day. The next two columns show the historic high and low prices. The last column shows the open interest in the contract

  13. Basis • Cash-Market Price (or Interest Rate) Less the Futures-Market Price (or Interest Rate)

  14. Basis • A futures currently selling at an interest yield of 4 % while yields in the cash market are 4.6%. What is the basis for this contract? • The basis for this contract is currently 4.6 – 4 = 60 basis points

  15. Hedging deposit costs with financial futures • Assume a rise in rates over the next three months from 10% to 10.5% • Loss on 100 million = 100,000,000 x .5%x 90/360 = $125,000 • To hedge against this loss sell 100 90 day Eurodollar futures trading at 91.5 at the start of the three month period . Price per $100 = 100 – (8.5 x 90/360) = 97.875 x 100,000,000/100 = 97,875,000 • Close to maturity Buy 100 90 day futures euro dollar futures at index of 91. Price per 100 = 100-(9x90/360 = 97.75 x100,000,000/100 = 97,750,000 • Profit on futures = 97,875,000 – 97,750,000 = 125,000

  16. Hedging with futuresproblem • March 10, 2005 Three month cash rate = 3%; Bank issues a $1million, 91 day euro dollar deposit to fund a 180 day loan at 3%. (six month cash rate = 3.25%). Fearing a rise in interest rates the bank sells one September 2005 Eurodollar futures contract at 3.85% • June 9,2005 Three month cash rate =3.88%; the bank issues a $1 million, 91day euro dollar time deposit at 3.88%. The bank also buys back one September 2005 futures at 4.33% What is the effective six month borrowing cost and how does it compare with the option of having issued a six month deposit to fund the six month loan. What would have been the result if no hedging action was taken.

  17. Solution

  18. Futures problem • A bank wishes to sell $150 million in new deposits next month. Interest rates today are 8% but are expected to rise to 8.25% next month. If management wishes to hedge what type of futures contract would you recommend? If the bank does not hedge what would be the amount of the loss?

  19. Solution • In this case the bank would use a short hedge • The loss would amount to 150,000 x .025 x 30/360 = 31,250

  20. Question • What kind of hedge would be appropriate in the following circumstances: • Rising interest rates that could result in losses on fixed rate loans as they are not matched with fixed rate deposits • A financial firm is holding a large amount of floating rate loans not matched with floating rate deposits and rates are falling • A projected rise in rate threatens the value of a bond portfolio

  21. Answer • Use a short hedge in euro dollar futures to offset the impact of rising rates • Use a long hedge in treasury bond futures to offset the impact of falling rates • Use a short hedge in treasury bonds

  22. Change in the Market Value of the Futures Contract

  23. problem • By what amount will the market value of a treasury bond futures contract change if interest rates rise from 5% to 6%. The underlying Treasury bond has a duration of 10.48 years and the treasury bond futures contract is currently quoted at 113-06

  24. solution • Change in value = -10.48 x 113,187.50 x (.01/1+.05) = $11,297.19

  25. Number of Futures Contracts Needed

  26. Problem • A bank has assets with a duration of 8 years and liabilities have a duration of 3 years. To hedge this duration gap management plans to employ treasury bond futures which are currently quoted at 112-17 and have a duration of 10.36 years. The banks financial report shows total assets of $120 million and total liabilities of $97 million. How many futures contracts are needed to cover this exposure?

  27. solution • Number of futures contracts needed = 8 –[3 x (97/120) ] x 120,000,000/(10.36 x 112,531.25) = 574 contracts

  28. 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.

  29. 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

  30. Most Common Option Contracts Used By Banks • U.S. Treasury Bond Futures Options • Eurodollar Futures Option Note: Information contained in option quotes consist of information on strike prices and call and put premiums at each different strike price for given months

  31. Principal Uses of Option Contracts • Protection of a Security Portfolio • Hedging Against Positive or Negative Gap Positions Note: Put options are used to protect against a rise in interest rates (Fall in security prices). Call options are used to protect against a fall in interest rates (rise in liability security prices)

  32. 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

  33. Regulations For Options and Future Contracts • OCC – Risk Management of Financial Derivatives: Comptrollers Handbook • FASB – Statement 133 – Accounting for Derivatives Instruments and Hedging Activities

  34. Regulations • Each bank has to implement a proper risk management system comprised of 1)policies and procedures to control financial risk taking 2) risk measurement and reporting systems and 3) independent oversight and control processes • In addition FASB introduced FASB 133 which requires that all derivatives are recorded at their fair market value. Furthermore, the change in fair value of a derivative and a fair value of the item hedged must be reported on the income statement.

  35. Using euro dollar deposit options • You hedged your bank’s exposure to declining interest rates by buying one march call on euro dollar deposit futures at the march premium (6.25) quoted on Dec 13th 2005 ( exhibit 8-4) for the strike price of 9525 • How much did you pay for the call in dollars if you chose the strike price of 9525? • Value of call = 6.25 x 25 = 156.25 • In march the futures move to 96 what is the profit or loss • Payout from settlement = (9600-9525); 75x25=1875 • Net gain = 1875 – 156.25 = 1718.75

  36. Using US treasury Bond Futures Options • The premium quote for the march call is 3-24 for a strike price of 109. This means that you would pay 3 and 24/64ths percent of par value or 3,375 as a premium to have the right to a long position in the T- bond futures contract at 109,000. • If the futures price moves to 112 then this contract will be exercised resulting in a long position for one march contract. • If this contract is offset then a profit of $3000 will result. However this profit is not enough to cover the premium paid of $3,375

  37. Interest Rate Swap A Contract Between Two Parties to Exchange Interest Payments in an Effort to Save Money and Hedge Against Interest-Rate Risk

  38. 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

  39. Risks of Interest Rate Swaps • Substantial Brokerage Fees • Credit Risk • Basis Risk

  40. 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

  41. Example interest rate swap • Consider the following illustration in which Party A agrees to pay Party B periodic interest rate payments of LIBOR + 50bps (bps = basis points = 0.01%) in exchange for fixed interest rate payments of 3.00%. Note that there is no exchange of the principal amounts. Also note that the interest payments are settled in net (e.g. if LIBOR + 50bps is 1.25% then Party A receives 1.75% and pays B nothing). The fixed rate (3.00% in this example) is referred to as the swap rate. • Party A ---------pays Libor + 50bps (1.25) ----- Party B • Party B----- pays 3% fixed rate---------Party A • In the net party B pays 1.75%

  42. 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.

  43. 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

  44. Interest Rate Floor A Contract Setting the Lowest Interest Rate a Borrower is Allowed to Pay on a Flexible-Rate Loan

  45. 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.

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