©2009, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Twenty-Three Managing Risk off the Balance Sheet with Derivative Securities

©2009, The McGraw-Hill Companies, All Rights Reserved 23-2 McGraw-Hill/Irwin Managing Risk off the Balance Sheet Managers are increasingly turning to off-balance- sheet (OBS) instruments such as forwards, futures, options, and swaps to hedge the risks their financial institutions (FIs) face –interest rate risk –foreign exchange risk –credit risk FIs also generate fee income from derivative securities transactions Managers are increasingly turning to off-balance- sheet (OBS) instruments such as forwards, futures, options, and swaps to hedge the risks their financial institutions (FIs) face –interest rate risk –foreign exchange risk –credit risk FIs also generate fee income from derivative securities transactions

©2009, The McGraw-Hill Companies, All Rights Reserved 23-3 McGraw-Hill/Irwin Managing Risk off the Balance Sheet A spot contract is an agreement to transact involving the immediate exchange of assets and funds A forward contract is an agreement to transact involving the future exchange of a set amount of assets at a set price A futures contract is an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily –futures contracts are marked to market daily—i.e., the prices on outstanding futures contracts are adjusted each day to reflect current futures market conditions A spot contract is an agreement to transact involving the immediate exchange of assets and funds A forward contract is an agreement to transact involving the future exchange of a set amount of assets at a set price A futures contract is an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily –futures contracts are marked to market daily—i.e., the prices on outstanding futures contracts are adjusted each day to reflect current futures market conditions

©2009, The McGraw-Hill Companies, All Rights Reserved 23-4 McGraw-Hill/Irwin Hedging with Forwards A naïve hedge is a hedge of a cash asset on a direct dollar-for-dollar basis with a forward (or futures) contract Managers can predict capital loss (ΔP) using the duration formula: where P = the initial value of an asset D = the duration of the asset R = the interest rate (and thus ΔR is the change in interest) FIs can immunize assets against risk by using hedging to fully protect against adverse movements in interest rates A naïve hedge is a hedge of a cash asset on a direct dollar-for-dollar basis with a forward (or futures) contract Managers can predict capital loss (ΔP) using the duration formula: where P = the initial value of an asset D = the duration of the asset R = the interest rate (and thus ΔR is the change in interest) FIs can immunize assets against risk by using hedging to fully protect against adverse movements in interest rates

©2009, The McGraw-Hill Companies, All Rights Reserved 23-5 McGraw-Hill/Irwin Hedging with Futures Microhedging is using futures (or forwards) contracts to hedge a specific asset or liability –basis risk is a residual risk that occurs because the movement in a spot asset’s price is not perfectly correlated with the movement in the price of the asset delivered under a futures (or forwards) contract –firms use short positions in futures contracts to hedge an asset that declines in value as interest rates rise Macrohedging is hedging the entire (leverage- adjusted) duration gap of an FI Microhedging is using futures (or forwards) contracts to hedge a specific asset or liability –basis risk is a residual risk that occurs because the movement in a spot asset’s price is not perfectly correlated with the movement in the price of the asset delivered under a futures (or forwards) contract –firms use short positions in futures contracts to hedge an asset that declines in value as interest rates rise Macrohedging is hedging the entire (leverage- adjusted) duration gap of an FI

©2009, The McGraw-Hill Companies, All Rights Reserved 23-6 McGraw-Hill/Irwin Hedging with Futures Microhedging and macrohedging –risk-return considerations FIs hedge based on expectations of future interest rate movements FIs may microhedge, macrohedge, or even overhedge –accounting rules can influence hedging strategies in 1997 FASB required that all gains and losses from derivatives used to hedge must be recognized immediately U.S. companies must report derivative related trading activity in annual reports futures contracts are not subject to risk-based capital requirements impose by bank regulators (forward can be) Microhedging and macrohedging –risk-return considerations FIs hedge based on expectations of future interest rate movements FIs may microhedge, macrohedge, or even overhedge –accounting rules can influence hedging strategies in 1997 FASB required that all gains and losses from derivatives used to hedge must be recognized immediately U.S. companies must report derivative related trading activity in annual reports futures contracts are not subject to risk-based capital requirements impose by bank regulators (forward can be)

©2009, The McGraw-Hill Companies, All Rights Reserved 23-7 McGraw-Hill/Irwin Options Many types of options are used by FIs to hedge –exchange-traded options –over-the-counter (OTC) options –options embedded in securities –caps, collars, and floors Buying a put option on a bond can hedge interest rate risk exposure related to bonds that are held as assets –the put option truncates the downside losses –the put option scales down the upside profits, but still leaves upside profit potential Similarly, buying a call option on a bond can hedge interest rate risk exposure related to bonds held on the liability side of the balance sheet Many types of options are used by FIs to hedge –exchange-traded options –over-the-counter (OTC) options –options embedded in securities –caps, collars, and floors Buying a put option on a bond can hedge interest rate risk exposure related to bonds that are held as assets –the put option truncates the downside losses –the put option scales down the upside profits, but still leaves upside profit potential Similarly, buying a call option on a bond can hedge interest rate risk exposure related to bonds held on the liability side of the balance sheet

©2009, The McGraw-Hill Companies, All Rights Reserved Hedging with Put Options Payoff Payoff for a bond Gain held as an asset Net payoff function 0 Bond price X -P Payoff from buying a put Payoff on a bond Loss Payoff Payoff for a bond Gain held as an asset Net payoff function 0 Bond price X -P Payoff from buying a put Payoff on a bond Loss McGraw-Hill/Irwin 23-8

©2009, The McGraw-Hill Companies, All Rights Reserved 23-9 McGraw-Hill/Irwin Options Buying a call option on a bond –as interest rates fall, bond prices rise, and the call option buyer has a large profit potential –as interest rates rise, bond prices fall, but the call option losses are bounded by the call option premium Writing a call option on a bond –as interest rates fall, bond prices rise, and the call option writer has a large potential losses –as interest rates rise, bond prices fall, but the call option gains are bounded by the call option premium Buying a call option on a bond –as interest rates fall, bond prices rise, and the call option buyer has a large profit potential –as interest rates rise, bond prices fall, but the call option losses are bounded by the call option premium Writing a call option on a bond –as interest rates fall, bond prices rise, and the call option writer has a large potential losses –as interest rates rise, bond prices fall, but the call option gains are bounded by the call option premium

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Options Buying a put option on a bond –as interest rates rise, bond prices fall, and the put option buyer has a large profit potential –as interest rates fall, bond prices rise, but the put option losses are bounded by the put option premium Writing a put option on a bond –as interest rates rise, bond prices fall, and the put option writer has large potential losses –as interest rates fall, bond prices rise, but the put option gains are bounded by the put option premium Buying a put option on a bond –as interest rates rise, bond prices fall, and the put option buyer has a large profit potential –as interest rates fall, bond prices rise, but the put option losses are bounded by the put option premium Writing a put option on a bond –as interest rates rise, bond prices fall, and the put option writer has large potential losses –as interest rates fall, bond prices rise, but the put option gains are bounded by the put option premium

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Caps, Floors, and Collars Buying a cap means buying a call option, or a succession of call options, on interest rates –like buying insurance against an (excessive) increase in interest rates Buying a floor is akin to buying a put option on interest rates –seller compensates the buyer should interest rates fall below the floor rate –like caps, floors can have one or a succession of exercise dates A collar amounts to a simultaneous position in a cap and a floor –usually involves buying a cap and selling a floor Buying a cap means buying a call option, or a succession of call options, on interest rates –like buying insurance against an (excessive) increase in interest rates Buying a floor is akin to buying a put option on interest rates –seller compensates the buyer should interest rates fall below the floor rate –like caps, floors can have one or a succession of exercise dates A collar amounts to a simultaneous position in a cap and a floor –usually involves buying a cap and selling a floor

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Contingent Credit Risk Contingent credit risk is the risk that the counterparty defaults on payment obligations –forward contracts are exposed to counterparty default risk as they are nonstandard contracts entered into bilaterally –options traded OTC are exposed to counterparty risk –futures and options traded on organized exchanges are exposed to relatively less contingent credit risk the exchanges act as guarantors in the transactions the contracts are marked-to-market daily so losses (and gains) are realized daily Contingent credit risk is the risk that the counterparty defaults on payment obligations –forward contracts are exposed to counterparty default risk as they are nonstandard contracts entered into bilaterally –options traded OTC are exposed to counterparty risk –futures and options traded on organized exchanges are exposed to relatively less contingent credit risk the exchanges act as guarantors in the transactions the contracts are marked-to-market daily so losses (and gains) are realized daily

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Swaps Swap agreements involve restructuring asset or liability cash flows in a preferred direction The market for swaps has grown enormously in recent years –the notional value of swap contracts outstanding at U.S. commercial banks was more than $111 trillion in 2008 There are several types of swaps –interest rate swaps –currency swaps –credit risk swaps –commodity swaps –equity swaps Swap agreements involve restructuring asset or liability cash flows in a preferred direction The market for swaps has grown enormously in recent years –the notional value of swap contracts outstanding at U.S. commercial banks was more than $111 trillion in 2008 There are several types of swaps –interest rate swaps –currency swaps –credit risk swaps –commodity swaps –equity swaps

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Swaps Hedging with interest rate swaps: an example –a money center bank (MCB) may have floating-rate loans and fixed-rate liabilities the MCB has a negative duration gap –a savings bank (SB) may have fixed-rate mortgages funded by short-term liabilities such as retail deposits the SB has a positive duration gap –accordingly, an interest swap can be entered into between the MCB and the SB either: directly between the two FIs indirectly through a broker or agent who charges a fee to accept the credit risk exposure and guarantee the cash flows Hedging with interest rate swaps: an example –a money center bank (MCB) may have floating-rate loans and fixed-rate liabilities the MCB has a negative duration gap –a savings bank (SB) may have fixed-rate mortgages funded by short-term liabilities such as retail deposits the SB has a positive duration gap –accordingly, an interest swap can be entered into between the MCB and the SB either: directly between the two FIs indirectly through a broker or agent who charges a fee to accept the credit risk exposure and guarantee the cash flows

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Swaps (example cont.) –a plain vanilla swap is used—i.e., a standard agreement without any special features –the SB sends fixed-rate interest payments to the MCB thus, the MCB’s fixed-rate inflows are now matched to its fixed-rate payments –the MCB sends variable-rate interest payments to the SB thus, the SB’s variable-rate inflows are now matched to its variable-rate payments (example cont.) –a plain vanilla swap is used—i.e., a standard agreement without any special features –the SB sends fixed-rate interest payments to the MCB thus, the MCB’s fixed-rate inflows are now matched to its fixed-rate payments –the MCB sends variable-rate interest payments to the SB thus, the SB’s variable-rate inflows are now matched to its variable-rate payments

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Swaps

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Swaps Hedging with currency swaps: an example –consider a U.S. FI with fixed-rate $ denominated assets and fixed-rate £ denominated liabilities –also consider a U.K. FI with fixed-rate £ denominated assets and fixed-rate $ denominated liabilities –the FIs can engage in a currency swap to hedge their foreign exchange exposure that is, the FIs agree on a fixed exchange rate at the inception of the swap agreement for the exchange of cash flows at some point in the future both FIs have effectively hedged their foreign exchange exposure by matching the denominations of their cash flows Hedging with currency swaps: an example –consider a U.S. FI with fixed-rate $ denominated assets and fixed-rate £ denominated liabilities –also consider a U.K. FI with fixed-rate £ denominated assets and fixed-rate $ denominated liabilities –the FIs can engage in a currency swap to hedge their foreign exchange exposure that is, the FIs agree on a fixed exchange rate at the inception of the swap agreement for the exchange of cash flows at some point in the future both FIs have effectively hedged their foreign exchange exposure by matching the denominations of their cash flows

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Credit Risk and Swaps The growth of the over-the-counter swap market was a major factor underlying the imposition of the BIS risk- based capital requirements –the fear was that out-of-the-money counterparties would have incentives to default –BIS now requires capital to be held against interest rate, currency, and other swaps Credit risk on swaps differs from that on loans –netting: only the difference between the fixed and the floating payment is exchanged between swap parties –payment flows are interest and not principal –standby letters of credit are required of poor-quality swap participants The growth of the over-the-counter swap market was a major factor underlying the imposition of the BIS risk- based capital requirements –the fear was that out-of-the-money counterparties would have incentives to default –BIS now requires capital to be held against interest rate, currency, and other swaps Credit risk on swaps differs from that on loans –netting: only the difference between the fixed and the floating payment is exchanged between swap parties –payment flows are interest and not principal –standby letters of credit are required of poor-quality swap participants

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Comparing Hedging Methods Writing vs. buying options –writing options limits upside profits but not downside losses –buying options limits downside losses but not upside profits –CBs are prohibited from writing options in some areas Futures vs. options hedging –futures produces symmetric gains and losses –options protect against losses but do not fully reduce gains Swaps vs. forwards, futures, and options –swaps and forwards are OTC contracts, unlike options and futures –futures are marked to market daily –swaps can be written for longer time horizons Writing vs. buying options –writing options limits upside profits but not downside losses –buying options limits downside losses but not upside profits –CBs are prohibited from writing options in some areas Futures vs. options hedging –futures produces symmetric gains and losses –options protect against losses but do not fully reduce gains Swaps vs. forwards, futures, and options –swaps and forwards are OTC contracts, unlike options and futures –futures are marked to market daily –swaps can be written for longer time horizons

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Regulation Regulators specify “permissible activities” that FIs may engage in Institutions engaging in permissible activities are subject to regulatory oversight Regulators judge the overall integrity of FIs engaging in derivatives activity based on capital adequacy regulation The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are the functional regulators of derivatives securities markets Regulators specify “permissible activities” that FIs may engage in Institutions engaging in permissible activities are subject to regulatory oversight Regulators judge the overall integrity of FIs engaging in derivatives activity based on capital adequacy regulation The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are the functional regulators of derivatives securities markets

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Regulation The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have implemented uniform guidelines that require banks to: –establish internal guidelines regarding hedging activity –establish trading limits –disclose large contract positions that materially affect the risk to shareholders and outside investors As of 2000 the FASB requires all firms to reflect the marked-to- market value of their derivatives positions in their financial statements Swap markets are governed by relatively little regulation—except indirectly at FIs through bank regulatory agencies The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have implemented uniform guidelines that require banks to: –establish internal guidelines regarding hedging activity –establish trading limits –disclose large contract positions that materially affect the risk to shareholders and outside investors As of 2000 the FASB requires all firms to reflect the marked-to- market value of their derivatives positions in their financial statements Swap markets are governed by relatively little regulation—except indirectly at FIs through bank regulatory agencies