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Managing Interest Rate & Exchange Rate Risk

Managing Interest Rate & Exchange Rate Risk. Hedging and Speculation. Part of operating a bank’s securities portfolio is to hedge the risks inherent in a bank’s balance sheets.

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Managing Interest Rate & Exchange Rate Risk

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  1. Managing Interest Rate & Exchange Rate Risk

  2. Hedging and Speculation • Part of operating a bank’s securities portfolio is to hedge the risks inherent in a bank’s balance sheets. • Hedge: Take a position in the securities markets to offset risk associated with portfolio or balance sheet position. • Many hedges are derivatives (a financial instrument whose value is determined by specific features of the underlying asset or investment). • Forwards • Futures • Options • Swaps Speculators trade to take on risk and make profits.

  3. Futures & Interest Rate Risk • Banks and other investors use these derivatives to insure against interest rate risk. CME CBOT

  4. Interest Rate Futures • Each contract specifies: • A delivery date. • A type of asset (including maturity and, if appropriate, a coupon rate) • Maturity date means # of periods from delivery date to maturity date. • A fixed quantity (referring to face value). • A sale price for the future • Additional Details

  5. For original interest rate derivatives, the future price is a contractual price for actual delivery of some security In efficient markets theory, the price of a future is the market’s forecast of the spot rate on the underlying security at the expiration date. If buyer expects spot price to be lower, wait and buy in spot market. If seller expects spot price to be higher, wait and sell in spot market. Futures Price

  6. Instruments Less than 1 Year • Deposit-like Money market instruments such as Negotiable CD’s, Eurodeposits, etc. are often quoted with a 360 day year with face value determined by initial deposit. • Assume that the maturity is D days with a yield of d360 . At the beginning, the investor will pay Face. At the end of D days, the issuer will pay initial Face plus interest • To calculate true annualized yield, convert to a 365 year

  7. Instruments Less than 1 Year • Yields for discount bonds sold at a price in money markets are usually reported on a discount basis: • Calculate Bond equivalent rate & annualized yield

  8. Example • You buy a 91 day Eurodeposit for $1 million. Broker quotes you a rate of 10%. Par value is

  9. You buy a 91 day Exchange fund bill with a face value of $1 million. Broker quotes you a rate on a discount basis of 10%. Price is

  10. Describing the Price • ST-Bond Derivatives: Seller must deliver bonds with designated face value and maturity. Buyer must deliver some money. That money is the futures price. The framework that the buyers use to describe this price is the implied bankers discount yield d*. • Posted Price: 100∙(1-d*) • Actual Price: Contractual Volume∙(1- ) • Negative relationship between actual yield in the spot market and the ultimate profitability of the future to the buyer.

  11. Example On February 6th, the listed price of a 90 day Tbill future was with delivery at end of Feb. was 95.56 • This implies d* = .044. Given Days = 90, the actual price was $1,000,000*(1-.011)= US$989,000. • Assume that by end of February, discount yield on spot 3month Treasuries is d* = .048. Then the spot price would be US$988,000. • Buyer of future having locked in a higher price, would then sell cheap Tbill in spot market losing $1000!

  12. Interest Rate Derivatives • Interest Rate • Some interest futures are not based on actual bond, but are based on interest rates in interbank or time deposit markets. Problem: No bond to deliver. • At settlement, no actual financial instrument changes hands. Instead, an artificial security is created using the interest rate as d. • If the actual interest rate is different from d*, then buyer/seller exchange cash with clearinghouse on the difference.

  13. Example • On February 6th, the price of a 3 month Euro deposit future with delivery at end of Feb. was 95.56 • This implies d* = .044. Given n = 90, the actual price was $1,000,000*(1-.011)= US$989,000. • Assume that by end of February, Euro deposit rate is d = .048. Then the spot price would be US$988,000. • Buyer of future must pay 1000 to clearinghouse.

  14. 1 Month HIBOR • HKEX Website • 3 Month HIBOR • HKEX Website • Two types of contracts on HK EX • 3 Year Exchange Fund Bonds • HKEX Website

  15. Positions: Short vs. Long • A long position: When the bank (or other investor) buys a future contract (i.e. promise to pay a certain price for the contracted volume of securities upon delivery). • A long position in treasury bill futures hedges against the risk of an interest rate fall. If interest rates fall, bond prices rise. The owner of a long position will be able to buy securities at less than their market price. • A short position: When the bank (or other investor) sells a future contract (i.e. promises to deliver the contracted volume of securities upon payment of a predetermined price). • A short position in treasury bill futures hedges against the risk of an interest rate rise. If interest rates rise, bond prices fall. The owner of a short position will be able to sell bonds above the market price making profits.

  16. Example: Short Hedge • Deposit rates/ExFundbill rates are 5%. A bank finances a 2-year 7% loan $1,000,000 with 1 year time deposits. NIM = 2%, NII = $20,000 • This creates interest rate risk: if interest rates rise, NIM will narrow. What if bank wants to insure against the possibility that interest rates will rise to 7% which would eliminate NII? • Clearing House offers 1year HIBOR future with volume of $1,000,000 at rate of 95 (i.e. d* = .05). • Take a short position on 1 contract with a delivery date of 1 year. {Promise to deliver 1year CD’s w/face value of $10000000 in 1 year}. What happens if interest rates rise to 7%? What happens if interest rate fall to 3%?

  17. Futures Prices • Closing Accounts: If investor wants to get rid of futures contract, they can settle it at the current price of the future rather than wait to settle at the spot price on delivery day. • Margin: Most exchanges require futures markets participants to keep a small account at clearinghouse • Marking to Market: When price changes at the end of one trading day to the next, changes in the value of open future positions are added to or subtracted from the account.

  18. Options • Option - is an agreement giving its holder the right (but not the obligation) to buy or sell a specified asset, over a limited time period, at a specified price (exercise price or strike price) in exchange for a premium payment. • Call Options • Put Options

  19. Call Option- an agreement in which the option writer sells the holder the right to buy a specified asset on or before a future date. The buyer of the call expects the price of the asset to increase over the life of the option, eventually exceeding the exercise price. (i.e. the buyer expects interest rates to fall) The value of the option rises as the price of the asset rises. Put Option- an agreement in which the option writer sells the holder the right to sell a specified asset on or before a future date at the strike price. The buyer of the put expects the price of the asset to fall below the strike price. (i.e. the buyer expects interest rates to rise). The value of the option rises as the price of the asset declines.

  20. Floating Rate Loans • Interest rate on mortgage loans in HK vary over time with some base short-term interest rate. • In terms of interest rate risk, (though not liquidity or credit risk) mortgage loans are short-term instruments. • Banks typically use short-term government bill rate, interbank rate, or government discount rate as base rate. In HK, banks set their own base rate.

  21. Hedging Practices of HK Banks

  22. Interest Rate Swaps • One bank may have a comparative advantage in raising funds in short-term markets and lending in long-term markets. Another financial institution may have an advantage in raising funds in long-term markets and have short-term investment opportunities. • Solution 1: To reduce on-balance sheet interest rate risk, each institution may raise funds in ways not to their best advantage. • Solution 2: To trade revenue streams on assets and/or cost stream on liabilities.

  23. Interest Rate Swaps • “Plain Vanilla” Interest Swap • Two parties agree on a notional amount of principal (which does not change hands). • One party will pay the counterparty a fixed interest in every period. • The counterparty will pay the first a floating interest rate as a markup over LIBOR. • Only the net difference in interest is actually paid. Exotic Swaps: New types of swaps invented all the time

  24. Swaps Importance Growing Quickly

  25. Pricing Swaps • Swaps are subject to counter-party risk. • Plain vanilla swaps are usually intermediated by swaps dealers with good credit. • Floating rates are typically 3 month LIBOR. • Fixed interest rate payments are the rate of Treasury bonds (in HK, exchange fund bills) plus some spread. • Typically, 3 month Tbills & LIBOR are very close. • Dealers quote bid & offer

  26. Example from Bank Management by Koch & McDonald • If you will agree to pay dealer 3 month LIBOR for 5 years, he will agree to pay you a fixed rate of 5.23. • If you will agree to pay dealer a fixed interest rate of 5.23, he will agree to pay you 3 month LIBOR.

  27. Bid/Offer Rates on US • If you will agree to pay dealer 3 month LIBOR for 5 years, he will agree to pay you a fixed rate of 4.95. • If you will agree to pay dealer a fixed interest rate of 4.98, he will agree to pay you 3 month LIBOR.

  28. Swap Applications • Microhedge: Hedge a specific Asset or Liability • Macrohedge: Hedge aggregate rate sensitivity. If bank has a positive aggregate duration gap, bank can synthetically immunize by engaging in Pay Fixed/Received Floating Swaps.

  29. Final Exam • Thursday, March 27th 9-12pm. Room 2303 • Style: Approximately 25% multiple choice problems, 25% short answer problems, 50% longer problems similar to the homework problems.

  30. Group Project • Wednesday, March 19thth 9-12am • 7 projects: 10-20 minutes each • Powerpoints/slides?

  31. Order • Fan li, Qian Zhiyi, Liu Jielan, Wei Zhenhui, Wei Qian, Cui Lu • Wang hongxia, Chan Wanyu, Yang Linfang, Zhang Hui, Lam Kit Yung, Chen Qian • Wang Siye, Pao Wing Kin, Xie Xuhong, Deng Qiyan, Zhang Jing, Xie Jun • Hu Lin, Hu Xiaoyan, Jin ye, Zhang yan, Chen Shuo • Ye He, Chen Rui, Chan Chi Yeung, Wang Xuan, Lin Xiaotao, • Li Ka Man, Zhu Xiaolei, Deng Haibo, Jiang Kun, Pang Ming, Leung Wai Yan

  32. Xue, Yuhan; Zhou, Yi; He Miao; Yang Liuqing; Zhou Sinan • Debin Xu; Jing Zhang; Xiaoxing Wang; Mao Ye; Jingying Yu. • Yang Linyan; Liu Yu; Peng Jia; Xia Yingying; Li Juan; Liang Feng • Mu Chen; Fu Binbin; Jing Jing; Penghang Ren; Yichao Wu • Zhao Xin Ho; Danwei Liu; Jing Zhao; Xiao Yin Liu • Yang Zhiming; Zheng Canhao, Lin YuanYuan; Li Yan; Yang Guanlin; Liu Shasha • Hao Jie, Li Yu; Jing Sun; Yan Li, Xiang Hong Tang; Song Huo Dong

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