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

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

J. K. Dietrich - FBE Fall, 2005 Hedging Balance Sheet Risk u Hedging on balance sheet –Matching duration of assets and liabilities: –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 Weighted average asset duration = Weighted average liability duration

J. K. Dietrich - FBE 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 counter- parties u Financial institution can take both sides

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

J. K. Dietrich - FBE Fall, 2005 Interest Rate Swap: Plain vanilla, Company A (receive floating) Company B (receive fixed) Notional Amount $100 mm $2.5mm $2.75mm 1/2 5% fixed 1/2 6-month LIBOR

J. K. Dietrich - FBE Fall, 2005 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 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 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, not notional value risk

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

J. K. Dietrich - FBE 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 Fall, 2005 Price Exposure in a Diagram P0P0 P0P0 Long Short Profit Loss 0 0 Profit Loss

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

J. K. Dietrich - FBE Fall, 2005 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 Fall, 2005 Interpreting Option Quotations in the Wall Street Journal u Listed option quotations versus “over-the- counter” 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 Fall, 2005 Call Options Profits at Maturity 0 Strike Price Profit Asset Value Payoff to Buyer

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

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

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

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

J. K. Dietrich - FBE Fall, 2005 Replication Futures with Options P0P0 P0P0 Long Profit Loss 0 0 Profit Loss Buy Call Write Put

J. K. Dietrich - FBE Fall, 2005 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 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