Saunders and Cornett, Financial Institutions Management, 4th Edition 1 “My interest is in the future because I am going to spend the rest of my life there.” Charles F. Kettering

Saunders and Cornett, Financial Institutions Management, 4th Edition 2 Hedging Risk for FIs Microhedge –Hedge the risk of a specific asset or liability. Macrohedge Naïve Hedge = Perfect Hedge for a Microhedge = Routing Hedge for Macrohedge –Eliminates all risk of a position. Immunized. –Most FIs hedge selectively. Basis Risk –Residual Risk that cannot be hedged because price fluctuations on cash and derivatives position differ. Step-by-Step Hedging Procedure

Saunders and Cornett, Financial Institutions Management, 4th Edition 3 Step-by-Step Hedging Procedure Step 1 –Risk analysis of underlying cash position. Step 2 –Quantification of impact on the cash position of interest rate/exchange rate changes. Step 3 –State the goal of the hedge Step 4 –Set up perfect hedge to use as a benchmark to implement hedge.

Saunders and Cornett, Financial Institutions Management, 4th Edition 4 Macrohedge Procedure

Saunders and Cornett, Financial Institutions Management, 4th Edition 5 Futures/Forwards: A Definition The obligation to buy (long) or sell (short) –An underlying financial security –At a predetermined price = futures/forwards price = P F –On a preset date – the delivery date. –If prices increase, long receives positive cash flows from short position holder. –If prices decrease, short receives positive cash flows from long position holder.

Saunders and Cornett, Financial Institutions Management, 4th Edition 6 Comparison of Futures vs. Forwards Organized exchange Standardized contract Clearing corp – 3 rd party guarantor Margin requirements Daily marked to market Over the counter Negotiated contract terms Counterparty credit risk exposure – no 3 rd party guarantor No cash flows until delivery date

Saunders and Cornett, Financial Institutions Management, 4th Edition 7 Interest Rate Futures Contracts Treasury bill/Euro Futures –$1m face value 91 day pure discount security –Delivery dates: Mar, June, Sept, Dec –IMM Index price = 100 – d where d = rate of discount –$ price = FV(1 – dt/360) Treasury bond Futures –$100,000 FV long T-bond with delivery option –Delivery dates: Mar, June, Sept, Dec –Priced per $100 FV in 32nds: 98-16=$98.50=$98,500

Saunders and Cornett, Financial Institutions Management, 4th Edition 8 Example of Interest Rate Microhedge FI intends to sell its T-bond portfolio in 60 days to underwrite an $11.168m investment project. The T-bonds are 15 yr 8% p.a. coupon with FV=$10m and yield of 6.75% p.a. T-bond MV = $11.168m. Step 1: Analyze the risk of cash position. Calculate duration = 9.33 yrs. Risk that price (interest rates) will decline (increase) over the next 60 days. Assume a 50 bp unanticipated increase in T-bond spot interest rates:  E  -D S P S  R S /(1+R S ) = -9.33($11.168m)(.0050) = - $504,000 Step 2: Loss of $504,000 on position when T-bond spot rates increase 50 bp.

Saunders and Cornett, Financial Institutions Management, 4th Edition 9 Microhedge Example (contd.) Step 3: Perfect hedge would generate cash flows of $504,000 whenever interest rates go up 50 bp. Short hedge: sell futures. Step 4: On the day that the hedge is implemented, the T- bond futures price is = /32 = $111, Implies a yield of 6.75% p.a. Calculate impact on short futures position of a 50 bp increase in T-bond futures rates.  F  -D F P F  R F /(1+R F ) = -9.33($111,687.50)(.0050) = $5,040 gain per futures contract sold The number of futures contracts sold is: N F  F =  E N F = -$504,000/5,040 = -100 contracts sold to implement microhedge to immunize against interest rate risk

Saunders and Cornett, Financial Institutions Management, 4th Edition 10 Example of Macrohedge Against Interest Rate Risk Step 1: D A = 7.5 yrs. D L =2.9 yrs. A=$750m L=$650m. DG = 5 yrs. Assume a 25 bp increase in interest rates such that  R S /(1+R S ) = + 25bp  E  -D G A  R S /(1+R S ) = -5($750m)(.0025) = - $9.375m Step 2: Loss of $9.375million in the market value of equity when interest rates unexpectedly increase by 25 bp.

Saunders and Cornett, Financial Institutions Management, 4th Edition 11 Macrohedge Example (cont.) Step 3: Perfect hedge would generate positive cash flows of $9.375 million whenever spot rates increase 25 bp. Short hedge: sell T-bill futures. Step 4: T-bill future IMM Index price = Implies T-bill futures rate = 2.75% p.a. T-bill futures are 91day pure discount instruments. T-bill futures price P F =$1m( (91)/360)=$993,  F  -D F P F  R F /(1+R F ) = -0.25($993,048.61)(.0025) = $ gain per futures contract sold The number of futures contracts sold is: N F  F =  P N F = -$9.375m/ = -15,104 contracts sold to implement macrohedge to immunize against ALL interest rate risk

Saunders and Cornett, Financial Institutions Management, 4th Edition 12 Example of Currency Microhedge Step 1: Global Goodies is a US company that is expecting delivery of 125 million yen of consumer electronics in 45 days. Todays yen-US$ FX rate is US$ –$cash flow = net currency exposure(  FX) = -JY125m( ) = -$18,750 Step 2: Whenever the yen-$ increases, the cost of purchasing the imported goods increases. For a $ per yen shock, the company loses $18,750.

Saunders and Cornett, Financial Institutions Management, 4th Edition 13 Currency Microhedge contd. Step 3: Earn $18,750 whenever yen-US$ increases by $ per JY. Long hedge Step 4: Use yen forwards: F(P S -P F ) = +JY125m( )=$18,750 –Buy 125m yen forward for delivery in 45 days.

Saunders and Cornett, Financial Institutions Management, 4th Edition 14 Interest Rate Shocks are Arbitrary Interest rate shock drops out of final formula (as long as interest rates change by the same amount in spot and futures markets): For microhedge: N F = (D S P S )/(D F P F ) For macrohedge: N F = (DG)A/(D F P F ) What happens when rates do not change by the same amount in the spot and futures market? Basis risk.

Saunders and Cornett, Financial Institutions Management, 4th Edition 15 Macrohedge Example With Basis Risk Basis Risk = br = (futures rate sensitivity) (spot rate sensitivity) =  R F (1+R S )/  R S (1+R F ) Assume that T-bill futures rates fluctuate 25% more than T- bill spot rates so: br=1.25.  F  -D F P F  R F /(1+R F ) = -0.25($993,048.61)(.0025)(1.25) = $ gain per futures contract sold The number of futures contracts sold is: N F  F =  P N F = -$9.375m/ = -12,083 contracts sold to implement macrohedge to immunize against ALL interest rate risk Futures Hedge Formula with Basis Risk: For microhedge: N F = (D S P S )/(D F P F br) For macrohedge: N F = (DG)A/(D F P F br)

Saunders and Cornett, Financial Institutions Management, 4th Edition 16 The Hedge Ratio = 1/br Hedge Ratio = h =  S/  F If h=1, then br=1 and no basis risk. If h>1 (h 1) and need more (fewer) futures contracts to construct hedge. Estimate h using OLS regression over time:  S t =  +  F t + u t such that:  is the hedge ratio So: Futures Hedge Formula with Basis Risk: For microhedge: N F = (  D S P S )/(D F P F ) For macrohedge: N F = (  DG)A/(D F P F )

Saunders and Cornett, Financial Institutions Management, 4th Edition 17 Hedging Credit Risk with Credit Risk Forwards Credit forward hedges against an increase in default risk on a loan. Benchmark bond CS F. MD=modified duration. Actual CS T on forward maturity date. Figure 15.8: Hedging loan default risk by selling a credit forward contract. Even if CS F > CS T, then there is a maximum cash outflow since CS T > 0

Saunders and Cornett, Financial Institutions Management, 4th Edition 18