McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Chapter Eight Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management

8-2 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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

8-3 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e The Purpose of Financial Futures To Shift the Risk of Interest Rate Fluctuations from Risk-Averse Investors to Speculators

8-4 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e The World’s Leading Futures and Option Exchanges 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)

8-5 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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

8-6 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Hedging with Futures Contracts Avoiding Higher Borrowing Costs and Declining Asset Values Use a Short Hedge: Sell Futures Contracts and then Purchase Similar Contracts Later Avoiding Lower Than Expected Yields from Loans and Securities Use a long Hedge: Buy Futures Contracts and then Sell Similar Contracts Later

8-7 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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)

8-8 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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)

8-9 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Basis Cash-Market Price (or Interest Rate) Less the Futures-Market Price (or Interest Rate)

8-10 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Realized Return from Combining Cash and Futures Market Trading = Return Earned in the Cash Market +/- Profit or Loss from Futures Trading -Closing Basis Between Cash and Futures Market -Opening Basis Between Cash and Futures Market

8-11 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Change in the Market Value of the Futures Contract

8-12 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Number of Futures Contracts Needed

8-13 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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.

8-14 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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

8-15 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Most Common Option Contracts Used By Banks U.S. Treasury Bond Futures Options Eurodollar Futures Option

8-16 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Principal Uses of Option Contracts Protection of a Security Portfolio Hedging Against Positive or Negative Gap Positions

8-17 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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

8-18 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Regulations For Options and Future Contracts OCC – Risk Management of Financial Derivatives: Comptrollers Handbook FASB – Statement 133 – Accounting for Derivatives Instruments and Hedging Activities

8-19 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Interest Rate Swap A Contract Between Two Parties to Exchange Interest Payments in an Effort to Save Money and Hedge Against Interest-Rate Risk

8-20 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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

8-21 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Risks of Interest Rate Swaps Substantial Brokerage Fees Credit Risk Basis Risk Interest Rate Risk

8-22 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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

8-23 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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.

8-24 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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

8-25 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Interest Rate Floor A Contract Setting the Lowest Interest Rate a Borrower is Allowed to Pay on a Flexible-Rate Loan

8-26 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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.