Chapter 9: Using Derivatives to Manage Interest Rate Risk

Chapter 9: Using Derivatives to Manage Interest Rate Risk
© 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Using Derivatives to Manage Interest Rate Risk
Any instrument or contract that derives its value from another underlying asset, instrument, or contract. Most common interest rate derivatives: Interest rate swaps, caps, and floors. Financial futures contracts and credit default swaps. When used prudently, derivatives represent a cost- effective means to manage risk. Banks can replicate on-balance sheet transactions with off balance sheet contracts. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Characteristics of Financial Futures
Financial Futures Contracts: A commitment, between a buyer and a seller, on the quantity of a standardized financial asset or index. Futures Markets: Organized exchanges where futures contracts are traded. Interest Rate Futures: The underlying asset is an interest-bearing security. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Buyers: Buyers of long futures agree to pay the underlying futures price. Buyers gain when futures prices rise and lose when futures prices fall. Sellers Sellers of short futures agree to receive the underlying futures price or to deliver the underlying asset. Sellers gain when futures prices fall and lose when futures prices rise. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cash or Spot Market: Market for any asset where the buyer tenders payment and takes possession of the asset when the price is set. Forward Contract: Contract for any asset where the buyer and seller agree on the asset’s price but defer the actual exchange until a specified future date. Not necessarily standardized assets. Parties must just agree on asset quality and price. Little opportunity to walk away prior to delivery. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Characteristics of Financial Futures: A Brief Example
You want to invest $1 million in 10-year T-bonds in six months and believe that rates will fall. You want to “lock in” today’s 3%, 10-year yield. Buy a futures contract on 10-year T-bonds with an expiration date just after the six-month period, priced at a 3.25% rate. If 10-year Treasury rates fall during the six months, the futures rate will fall and the futures price rises. An increase in the futures price generates a profit on the futures trade. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Prior to investing the $1 million, you sell the futures contract to exit the trade. Effective yield determined by the prevailing 10-year Treasury rate and the gain (or loss) on the futures trade. The loss from a drop in the 10-year rates below 3% will be offset by profit on the long futures position. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The 10-year Treasury rate falls by 0.30%, which represents an opportunity loss. Buying a futures contract generates a 0.57% profit. Effective yield equals the prevailing 2.70% rate at the time of investment plus the 0.57% futures profit, or 3.27%. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Types of Future Traders
Future traders classified by strategies they pursue: Speculator: Takes a position with the objective of making a profit by trying to anticipate direction prices will move and timing trades accordingly. Scalper: Tries to time price movements over very short time intervals and takes positions for just minutes. Day trader: Tries to profit from short-term price movements during the trading day and keeps no outstanding positions overnight. Position trader: Spectator who holds position for a longer period in anticipation of significant, long-term moves. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Types of Future Traders
Future traders classified by strategies they pursue: Hedger: Has existing or anticipated position in the cash market and trades futures contracts to reduce risk associated with changes in value of the cash position. Essential difference between speculator and hedger is objective. Speculator wants to profit on trades. Hedger wants to reduce risk. Spreaders or arbitrageurs: Take low-risk positions. Future spreader both buys and sells a contract so that loss on one contract is at least partially offset by gain on the other. Arbitrageur buys an asset at a lower price and sells the same asset at a higher price, profiting on the difference. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Mechanics of Futures Trading
Initial Margin: A cash deposit (or U.S. government securities) posted with the exchange simply for initiating a transaction. Small amount, less than 5% of underlying asset’s value. Maintenance Margin: The minimum deposit allowable at the end of each day. Unlike margin accounts for stocks, futures margin deposits represent a guarantee that a trader will be able to make any mandatory payment obligations. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Mechanics of Futures Trading
Marking-to-Market is the daily settlement process at end of trading day, when trader’s account is credited with gains and debited with losses. Variation margin is the daily change in the account value due to marking-to-market. Every futures contract has a formal expiration date. Trading stops and participants settle their final positions. Less than 1% of financial futures contracts experience physical delivery at expiration because most traders offset their futures positions in advance. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

An Example: 90-Day Eurodollar Time Deposit Futures
Underlying asset is a Eurodollar time deposit with a 3-month maturity. Eurodollar rates are quoted on an interest-bearing basis, assuming a 360-day year. Each Eurodollar futures contract represents $1 million of initial face value of Eurodollar deposits maturing three months after contract expiration. More than 40 separate contracts are traded at any point in time as contracts expire in March, June, September and December each year. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Contracts trade according to an index: 100% – futures interest rate expressed in % terms. An index of indicates a futures rate of 4.5%. Each basis point change in the futures rate equals a $25 change in value of the contract (0.001 x $1 million x 90/360). If futures rates increase, value of contract decreases and vice versa. Buyers are “long” because they own a commitment regarding final price that can be realized at expiration. Sellers are “short” because they may be forced to come up with cash they do not currently have. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Buyers and sellers agree on price at expiration. Buyer owns commitment from seller to pay cash if the price of the underlying asset rises in the interim. Buyers make profit when rates fall and prices rise. Profits arise because buyers can offset initial positions by selling the same contract after prices have increased. Seller owns commitment from buyer to pay cash if the asset price falls. Seller makes profit when rates rise and prices fall. Sellers can profit if they can buy futures back at lower prices after rates rise. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Open: The index price at the open of trading. High: The high price during the day. Low: The low price during the day. Last: The last price quoted during the day. Change: The basis-point change between the last price quoted and the closing price the previous day. Settle: The previous day’s closing price. Volume: Previous day’s volume. Open Interest: Total number of contracts outstanding at end of day. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Expectations Embedded in Future Rates
Future rates provide information about consensus expectations of future cash rates. When rates rise as expiration dates extend into the future, signals expected increase in subsequent cash market rates. If the Eurodollar future rates on the prior slide are viewed as forecasts of three-month Eurodollar cash rates when each contract expires, the increase in futures rates suggesting rising Eurodollar rates. A flat yield curve suggests that rates will remain relatively constant. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Daily Marking-to-Market
Consider a trader who buys one December three-month Eurodollar futures contract at 99.2 or percent on June 21, 2013 posting $1,100 in cash as initial margin. Maintenance margin is set at $700 per contract. Futures contract expires approximately 18 months after the initial purchase, during which time the futures price and rate fluctuate daily. Contract increases in value when futures price rises or the futures rate declines. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Daily Marking-To-Market
Suppose on July 20 the futures rate falls to 0.70%. Trader could withdraw $250 (10 basis points × $25) from the margin account, representing the increase in value of the position but for this example does not. If futures rate increases to 0.88% the next day, the trader’s long position decreases in value. The 16 basis-point increase represents a $400 drop in margin and the ending account balance would be $950. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

If at market close on August 20, 2013, the futures rate further increases to 1.03%, trader must make a variation margin payment sufficient to bring the account up to $700. In this case, the account balance would have fallen to $575 and the margin contribution would equal $125. The exchange member may close the account if trader does not meet the variation margin requirement. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Basis refers to the cash price of an asset minus the corresponding futures price for the same asset at the same point in time. Basis = Cash Price – Futures Price or Basis = Futures Rate – Cash Rate May take any value with two price relationships between futures and cash instruments. Basis must equal zero at expiration. Basis normally narrows as expiration approaches by either increasing or declining to zero. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Speculation versus Hedging
Speculators take on risk to earn speculative profits. Extremely risky. For the most part futures rates and prices are determined by arbitrage activity. Any position can backfire in that a major market move can overwhelm initial mispricing. Holding a pure speculative position with a single contract for a lengthy period is relatively rare. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Speculation versus Hedging
Hedgers take positions to avoid or reduce risk. Enter futures transactions because normal business operations involve certain risks they are trying to reduce. Take opposite position in a futures contract relative to their cash market risk so that losses in one market are reduced by gains in the other. In a perfect hedge the net profit on both the futures and cash position equals zero at each price. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Steps in Hedging Identify the cash market risk exposure to reduce.
Given the cash market risk, determine whether a long or short futures position is appropriate to reduce risk. Select the best futures contract. Determine appropriate number of contracts to trade. Implement the hedge by buying or selling contracts. Determine when to get out of the hedge position. Verify the trading meets regulatory requirements and conforms to internal risk management policies. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Long Hedge: Reduce Risk Associated with a Decrease in Interest Rates
Long hedge (buy futures) appropriate for participant who wants to reduce spot market risk associated with a decline in interest rates. If spot rates decline, futures rates typically also decline so the value of the futures position will likely increase. Any loss in the cash market is at least partially offset by a gain in futures. Essentially fixes a rate or price. Risk is lower because the volatility of returns is lower. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

On June 21, 2013, your bank expects to receive a $1 million payment on November 28, 2013, and anticipates investing the funds in three-month Eurodollar time deposits at that time. Cash market risk exposure is bank would like to invest funds at today’s rates, but will not have access to the funds for over five months. If cash rates move lower between June and November, bank will realize an opportunity loss because it will have to invest at rates below those available today. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

In June 2013 market expected Eurodollar rates in increase as evidenced by rising future rates. To hedge, bank should buy futures contracts such that if cash rates fall, future rates will also fall and long future positions will increase in value as an offset to cash losses. The best futures contract will generally be the first contract that expires after the known cash transaction date. This contract is best because its futures price will generally show the highest correlation with the cash price. In this example, the December 2014 Eurodollar futures contract is the first to expire after November 2014. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The time line of the bank’s hedging activities: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A Short Hedge: Reduce Risk Associated with an Increase in Interest Rates
A short hedge (sell futures) applies to a participant who wants to reduce risk of increase in cash market interest rates or reduction in cash market prices. If cash rates increase, futures rates will generally increase so loss in the cash position is at least partially offset by a gain in the value of futures. If cash rates decrease, gain will be offset from a loss from futures and hedger gives up potential gains from an unhedged position. Essentially attempts to fix the interest rate realized. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

On June 21, 2014, bank expects to sell a six-month $1 million Eurodollar deposit on August 17, 2014. Cash market risk of loss is that Eurodollar time deposit rates will be higher in August. To hedge, the bank should sell Eurodollar futures. Example assumes bank immediately sells one September Eurodollar futures contract expecting to buy it back in August when it sells the Eurodollar investment. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The time line of the bank’s hedging activities: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Change in the Basis Long and short hedges work well if the futures rate moves in line with the cash rate. Risk assumed by trader in hedges is basis might change adversely between time hedge is initiated and closed. If basis (futures rate – cash rate) at time t is Bt, effective return can be expressed as: where the subscripts refer to the initiation (t=1) or termination (t = 2) of the hedge. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Basis Risk and Cross Hedging
Cross Hedge: Participant uses a futures contract based on security that differs from the security being hedged in the cash market. Example would be using Eurodollar futures to hedge price movement for commercial paper transactions. Risk is potentially greater because futures and cash rates may not move closely together on different securities. Basis risk can also be substantial because future and cash rates for the same underlying security may move in opposite directions prior to expiration. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Microhedging Applications
Microhedge: Hedging a transaction associated with a specific asset, liability or commitment Macrohedge: Taking futures positions to reduce aggregate portfolio interest rate risk. Banks generally restricted to using financial futures for hedging purposes under current regulations. Accounting must recognize futures on a micro basis by linking each transaction with specific instruments. Some analysts believe this forces microhedges that may increase risk. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Creating a Synthetic Liability with a Short Hedge
On June 21, 2013, a bank agreed to finance a $1 million six-month corporate loan. Management wanted to match fund the loan by issuing a $1 million, six-month Eurodollar time deposit: The six-month cash Eurodollar rate was 0.50%. The three-month Eurodollar rate was 0.27%. The three-month Eurodollar futures rate for September expiration equaled 0.33%. Rather than issue a direct six-month Eurodollar liability at 0.50%, bank created a synthetic six- month liability by shorting futures. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Creating a Synthetic Liability with a Short Hedge
Objective: Use the futures market to borrow at a lower rate than the six-month cash Eurodollar rate. Achieved by issuing a three-month Eurodollar and then another when the first matured. Short futures positions reduced risk of rising interest rates for the second cash Eurodollar borrowing. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Mechanics of Applying a Microhedge
Determine the bank’s interest rate position. Key decision is determining how much risk bank will accept. Forecast the dollar flows or value expected in cash market transactions. Choose the appropriate futures contract. Select vehicle that reduces interest rate risk. Appropriate contract usually one whose rates most highly correlate with those of asset or liabilities being hedged. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Mechanics of Applying a Microhedge
Determine the correct number of futures contracts. Determine the appropriate time frame for the hedge. Monitor hedge performance. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Macrohedging Applications
Focuses on reducing interest rate risk associated with a bank’s entire portfolio rather than with individual transactions. Assumes that interest rate risk is best evidenced by GAP or duration GAP and by sensitivity of banks earnings and EVE across different interest rates. Banks can use futures contracts to hedge this net portfolio rate sensitivity. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Hedging: GAP or Earnings Sensitivity
If bank loses when interest rates fall (positive GAP), it should use a long hedge to balance assets sensitivity. Declining interest rates should generate futures profits that offset net interest income decline. If bank loses when interest rates rise (negative GAP), it should use a short hedge to balance liability sensitivity. If rates increase and bank’s net interest income falls, sale of futures should profit a profit that offsets some of the lost net interest income. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Hedging: Duration GAP and EVE Sensitivity
To eliminate interest rate risk, bank could structure its portfolio so that duration gap equals zero: Futures can be used to adjust bank’s duration gap Appropriate size of a futures position can be determined using the following equation: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Accounting Requirements and Tax Implications
Regulators limit banks to using futures for hedging. If a bank has a dealer operation, it can use futures as part of its trading activities. All gains and losses on futures must be marked-to- market as they accrue which affects current income. To qualify as a hedge, use of futures must: Show cash transaction exposes bank to interest rate risk. A futures contract must lower the risk exposure, and the bank must designate the contract as a hedge. If criteria is not met, bank must stop deferring future gains and losses and account for proceeds as income. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Using Forward Rate Agreements (FRA) to Manage Rate Risk
FRA is a forward contract based on interest rates. Counterparties agree to a notional principal amount that serves as a reference figure in determining cash flows. “Notional” refers to the condition that the principal does not change hands, but is only used to calculate the value of interest payments. Buyer agrees to pay a fixed-rate coupon payment and receive a floating-rate payment in the future. Seller agrees to the opposite. Cash only changes hands if the actual interest rate at settlement differs from that initially expected. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Using Forward Rate Agreements (FRA) to Manage Rate Risk
Used to manage interest rate risk in the same way as financial futures: Buyer will receive (pay) cash when actual interest rate at contract settlement is greater (less) than the exercise rate at set at contract origination. Seller will receive (pay) cash when actual interest rate at contract settlement is less (greater) than the exercise rate at set at contract origination. FRAs are cash-settled at the settlement date and not marked-to-market. No interim cash flows or margin requirements. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Forward Rate Agreements (FRA): An Example
Metro Bank (as seller) enters into a receive fixed- rate/pay floating-rating FRA with County Bank (as buyer) with a six-month maturity based on a $1 million notional principal amount. The floating rate is three-month LIBOR and the fixed (exercise) rate is 5%. Metro Bank would refer to this as a “3 vs. 6” FRA at 5% on a $1 million notional amount from County Bank. The only cash flow will be determined in six months at contract maturity by comparing the prevailing 3-month LIBOR with 5%. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Assume that in 3 months three-month LIBOR equals 6%. Country would receive payment from Metro: The interest settlement amount is $2,500: Interest = ( )(90/360) $1,000,000 = $2,500 Represents interest that would be paid three months later at maturity of the instrument, so actual payment is discounted at the prevailing 3-month LIBOR. Actual interest = $2,500/[1+(90/360).06]=$2,463 © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Assume instead that in 3 months three-month LIBOR equals 3%. Country would make payment to Metro: The interest settlement amount is $5,000: Interest = ( )(90/360) $1,000,000 = $5,000 Actual payment is discounted at the prevailing 3-month LIBOR. Actual interest = $2,500/[1+(90/360).03]=$4,963 © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

County Bank would pay fixed-rate/receive floating- rate as a hedge if it was exposed to loss in a rising rate environment. This is analogous to a short futures position. Metro Bank would take its position as a hedge if it were exposed to loss in a falling rate environment. This is analogous to a long futures position. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Potential Problems with FRAs
Essentially credit instruments. Might not be paid when the counterparty owes you cash. There is no clearinghouse to guarantee performance and no daily marking-to market or collateral that is posted. May be difficult to find a counterparty that wants to take exactly the opposite position. Parties might want different notional principal amounts or have different settlement amounts so transaction costs can be large. FRAs are not as liquid as many alternatives. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Basic Interest Rate Swaps as a Risk Management Tool: Characteristics
Basic (Plain Vanilla) Interest Rate Swap: Agreement between two parties to exchange a series of cash flows based on specified notional principal amount. One party makes payments based on a fixed interest rate and receives floating-rate payments. Other party does the reverse. A swap dealer generally serves as an intermediary so a party can take any position and the dealer takes the other. Intermediary may serve as an agent with no risk exposure or a dealer who accepts the risk of adverse rate changes. If risk not assumed, intermediary hopes to earn the bid-offer spread. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Basic (Plain Vanilla) Interest Rate Swap: Conceptually, a package of FRAs. Swap payments are netted and the notional principal never changes hands. Consider the following two-year swap: Involves eight quarterly payments and based on the three-month LIBOR floating rate: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Swaps represent another way for firms: with mismatched assets and liabilities to microhedge or macrohedge. or that want to increase risk to adjust their earnings sensitivity in the desired way. Today the most common use of basic swaps is to adjust the rate sensitivity of a specific asset or liability. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Convert a Floating-Rate Liability to a Fixed Rate Liability: Consider a bank that makes a $1 million, three-year fixed- rate loan with quarterly interest at 8%. It finances the loan by issuing a three-month Eurodollar deposit priced at three-month LIBOR. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Transaction exhibits considerable interest rate risk. Bank is liability sensitive and loses if LIBOR rises. Can use basic swap to microhedge this transaction. Using Exhibit 9.8 data, bank could agree to pay 0.88% and receive 3-month LIBOR against $1 million for three years, reducing risk and effectively fixing the interest rate. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Convert a Fixed-Rate Asset to a Floating-Rate Asset: Consider a bank customer who demands a fixed-rate loan. Bank policy is to make only floating-rate loans because it is liability sensitive and will lose if interest rates rise. Assume bank makes the same $1 million, three-year fixed-rate loan as in the previous example. Can enter into a three-year basic swap with a $1 million notional principal amount. Swap effectively converts a fixed-rate loan into a loan with a rate that floats with the prime rate. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Convert a Fixed-Rate Asset to a Floating-Rate Asset: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Create a Synthetic Security: Some view interest rate swaps as synthetic securities. They enter into a swap contract that essentially replicates the net cash flows from a balance sheet transaction. On June 21, 2013 a bank buys a three-year Treasury yielding 0.71%, which it finances by issuing a three-month deposit. Bank is liability sensitive as it will see net interest income from this combined transaction fall if the cost of reissuing the three month deposit falls over time. Alternatively, could enter into a 3-month swap agreeing to pay three-month LIBOR and receive a fixed rate. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Macrohedge: Banks can use interest rate swaps to hedge aggregate risk exposure measured by earnings and EVE sensitivity. Bank that is liability sensitive or has a positive duration gap will take a basic swap position that potentially produces profits when rates increase. This means paying a fixed rate and receiving a floating rate. Profits offset losses from lost net interest income or declining EVE. In terms of GAP analysis, a liability-sensitive bank has more rate-sensitive liabilities than rate-sensitive assets. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Macrohedge: To hedge, liability sensitive bank needs equivalent of more RSAs. Swap that pays fixed and receives floating is comparable to increasing RSAs relative to RSLs because the receipt reprices with rate changes. Any bank that is asset sensitive or has a negative duration gap will take a swap position that potentially produces profits when rates fall. Swap that pays floating and receives fixed is comparable to increasing RSLs relative to RSAs. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Pricing Basic Swaps Floating rate is based on some predetermined money market rate or index. Payment frequency is set at every six, three, or one month, and matched with the money market rate. Fixed rate is set at a spread above the comparable maturity fixed rate security. Basic swaps are priced at a zero net present value. After substituting an expected value for the floating rate at each valuation date, present value of net cash flows must equal zero. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Comparing Financial Futures, FRAs and Basic Swaps: Similarities
Each enables a party to enter an agreement, which provides for cash receipts or cash payments depending on how interest rates move. Each allows bank to alter interest rate risk exposure. None requires much initial cash commitment to take a position. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Comparing Financial Futures, FRAs and Basic Swaps: Differences
Financial futures are based on fixed principal amounts. FRAs and interest rates swap notional principal amounts are negotiated. Financial futures require daily marking-to-market, which is not required with FRAs and swaps. Exposes futures participants to some risks and liquidity requirements that FRAs and swaps avoid. Many futures contracts cannot be traded out more than 3-4 years. Interest rate swaps extend years. FRA market is not very liquid and most contracts are short term. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Risk with Swaps Risk of dramatic changes in interest rates when locked into fixed-rate swaps. Secondary market exists for swaps to reduce firm’s exposure to positions it might want to exit. The more complicated the swap, the more difficult it is to trade. Credit risk exists because the counterparty to a swap contract may default. This is not as great for a single contract since the swap parties exchange only net interest payments. Counterparty risk extremely important to swap participants. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Interest Rate Caps and Floors
Interest rate cap is an agreement between two counter-parties that limits buyer’s interest rate exposure to a maximum rate. Buying a cap is the purchase of a call option on an interest rate. Interest rate floor is an agreement between two counter-parties that limits buyer’s interest rate exposure to a minimum rate. Buying a floor is the purchase of a put option on an interest rate. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Interest Rate Collar and Reverse Collar
The simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same index for the same maturity and notional principal amount. Cap rate is set above the floor rate. Buyer objective is protection against rising interest rates. A collar creates a band within which the buyer’s effective interest rate fluctuates. A zero cost collar is designed to establish a collar where the buyer has no net premium payment. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Interest Rate Collar and Reverse Collar
Buying an interest rate floor and simultaneously selling an interest rate cap. Objective is to protect bank from falling interest rates. Size of premiums for caps and floors determined by: Relationship between strike rate and three month LIBOR. Indicates how much LIBOR must move before the cap or floor is in-the-money. Prevailing economic conditions influence premiums via the shape of yield curve and volatility of interest rates. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Protecting against Falling Interest Rates
Assume that bank is asset sensitive such that net interest income will decrease if interest rates fall. Banks holds loans priced at prime plus 1% and funds loans with a three-year fixed-rate deposit at 3.75% percent. Current prime rate is 5% and initial three-month LIBOR equals 2.68%. Movements in prime rate and LIBOR are perfectly correlated. Management believes interest rates will fall over the next three years. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Protecting against Falling Interest Rates
Considering three approaches to reduce risk associated with falling rates: Entering into a basic interest rate swap to pay three- month LIBOR and receive a fixed rate. Hedge Outcome: Fix the spread at current levels. Buying an interest rate floor. Hedge Outcome: Protect against loss from falling rates while retaining the benefits from rising rates. Buying a reverse collar. Hedge Outcome: Spread will vary within a band. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Protecting against Rising Interest Rates
Assume bank is liability sensitive. Has 3-year fixed rate loans at 7% funded via three-month Eurodollar deposits at the prevailing LIBOR minus 0.25%. Three strategies to hedge the risk: Basic swap: Pay 3.72% fixed and receive 3-month LIBOR. Hedge Outcome: Swap fixes the margin at current levels. Buy a cap on 3-month LIBOR with 3% strike rate. Hedge Outcome: Protect against loss from rising rates while retaining the benefits from falling rates. Buy a collar on 3-month LIBOR. Hedge Outcome: Spread will vary within a band. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Credit Default Swaps (CDSs)
Popularity and use grew dramatically during the financial crisis. Appeal was ability to use derivatives to hedge credit risk or speculate that certain types of instruments were mispriced by market participants. Contract between two counterparties designed to transfer credit risk in a fixed income instrument from one to another. Because value is based on underlying instrument, CDS is a credit derivative. Buyer of swap makes periodic payments to seller. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

If specific default event occurs during time horizon of the swap, seller makes a payoff to buyer. Buyer gets protection against value decline of the underlying instrument. Seller guarantees performance of the instrument. Counterparties do not have to own the underlying instrument to trade the CDS. Often labeled a form of insurance although no insurable interest is required. AIG’s 2008 CDS activities cost U.S. Treasury $150 billion. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Steps to prevent future abuses: Must be constraints on how much protection a CDS seller can sell. Regulators must collect and evaluate information about CDSs in a timely fashion and provide guidelines to manage risk. Collateral requirements should be strictly enforced. There must be transparency in pricing of CDSs. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 11: Managing Liquidity

Meeting Liquidity Needs
Bank liquidity refers to a bank’s capacity to acquire immediately available funds at a reasonable price. Firms can acquire liquidity in three distinct ways: Selling assets, new borrowings and new stock issues. Effectiveness of each liquidity source at meeting liquidity needs depends on: Market conditions, evidenced by the market’s perception of risk at the institution as well as in the marketplace Market’s perception of bank management and strategy. The current economic environment. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Holding Liquid Assets Liquid assets can be easily and quickly converted into cash with minimal loss. Four basic types of cash assets: Vault cash, demand deposit balances held at Federal Reserve Banks, demand deposits held at private financial institutions and cash items in process of collection (CIPC). Cash assets represent a significant opportunity cost for institutions because they earn little interest. Objective is to minimize cash and only hold what is required by law or for operational needs. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Holding Liquid Assets Cash assets do not satisfy bank’s liquidity needs. Do not cover unanticipated cash requirements. Banks hold cash to satisfy four objectives: Meet customers’ regular transaction needs. Meet legal reserve requirements. Assist in the check-payment system. Purchase correspondent banking services. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Holding Liquid Assets Banks own five types of liquid assets:
Cash and due from banks in excess of requirements. Federal funds sold and reverse repurchase agreements. Short-term Treasury and agency obligations. High-quality short-term corporate and municipal securities. Government-guaranteed loans that can be readily sold. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

New Borrowing Banks can access liquid funds by borrowing.
Attractive because quick and prices are predictable. Historically banks had an advantage over non-depository institutions through funding with low-cost deposit accounts. Use of non-core funding sources adds liquidity risk. When an institution gets in trouble, lenders and the FHLB withdraw from the market or increase collateral requirements. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Objectives of Cash Management
Banks want to hold as few cash assets as possible without creating problems from deposit outflows. Significant risks in holding too little cash: Potential liquidity problems and increased borrowing costs. Difficult to predict timing and magnitude of deposit transactions that influence deposits held. Deposit inflows raise legal reserve requirements and increase actual reserve assets and correspondent deposits. Deposit outflows do the opposite. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Reserve Balances at the Federal Reserve Bank
Banks hold deposits at the Federal Reserve: because the Federal Reserve imposes legal reserve requirements and deposit balances qualify as legal reserves. to help process deposit inflows and outflows caused by check clearings, maturing time deposits and securities, wire transfers, and other transactions. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Required Reserves and Monetary Policy
Purpose of required reserves is to enable Federal Reserve to control the nation’s money supply. The Fed has three distinct monetary policy tools: Open market operations. Sale or purchase of U.S. government securities in the open market is Fed’s most flexible means of carrying out policy objectives. Discount window borrowing occurs when banks borrow directly from the Feds. Changes in the discount rate directly affect the cost of borrowing. Changes in the reserve requirement impact the amount that banks can lend. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Required Reserves and Monetary Policy
Required Reserves Example: Required reserve ratio of 10% means a bank with $100 in demand deposits must hold $10 in required reserves. Thus the bank can lend out only 90% of its deposits. If the required reserve increases (decreases), the amount that banks can lend decreases (increases). The amount of deposit balances a bank holds at the Federal Reserve will vary directly with magnitude of reservable bank liabilities. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Impact of Sweep Accounts on Required Reserve Balances
Sweep account enables a bank to shift funds from transactions accounts to MMDAs or other accounts. Computer dynamically reclassifies balances from a reservable to a nonreservable account. Two types of retail sweep programs in use today: Weekend program reclassifies transaction deposits to savings deposits on Friday and back on Monday, cutting reserve requirements almost in half. Minimum threshold account moves funds between transaction and MMDA account, limited to six per month. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Impact of Sweep Accounts on Required Reserve Balances
Retail sweep accounts not to be confused with business sweep accounts. Regulation Q prohibits banks from paying interest on business demand deposit accounts. Commercial sweep account sweeps excess funds from business demand deposits overnight (typically) into nondeposit, interest-earning assets. These liabilities are not bank deposit accounts or FDIC insured, so they are not subject to reserve requirements. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Meeting Legal Reserve Requirements
Required reserves are calculated over a two-week period. Bank does not have to hold a specific amount of cash each day but a minimum amount over a longer period. Fed follows a lagged reserve accounting system (LRA) which requires banks to hold reserves against deposit balances from 3-5 weeks earlier. Facilitates planning but reduces Fed’s ability to control the money supply and may increase interest rate volatility. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Three elements of required reserves: Dollar magnitude of base liabilities. Required reserve fraction. Dollar magnitude of qualifying cash assets. Base liabilities are composed of net transaction accounts. Bank’s qualifying reserve assets include vault cash, deposits held at the Federal Reserve Banks and deposits held in pass-through accounts at other institutions. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Lagged Reserve Accounting
Computation Period (CP): Consists of two one-week reporting periods beginning on a Tuesday and ending on the second Monday thereafter. Maintenance Period (MP): Consists of 14 consecutive days beginning on a Thursday and ending on the second Wednesday thereafter. Reserve balance requirement to be maintained in any given 14-day MP equals: Reserve requirement calculated as of the CP ending 17 days prior to the start of the MP minus vault cash as of the same CP used to calculate the reserve requirement. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

An Application: Reserve Calculation Under LRA
Four steps: Calculate daily average balances outstanding during the lagged computation period. Apply the reserve percentages. Subtract vault cash. Add or subtract the allowable reserve carried forward from the prior period. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Correspondent Banking Services
System of relationships in which the correspondent bank (upstream correspondent) sells services to the respondent bank (downstream correspondent). Some services are too expensive to provide independently or cannot be provided by respondent banks due to regulatory constraints. Predominant services purchased fall into three categories: Check clearing and related services are attractive because respondent bank can reduce float. Investment services. Credit related transactions. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Check collection, wire transfer, coin and currency supply Loan participation assistance Data processing services Portfolio analysis and investment advice Federal funds trading Securities safekeeping Arrangement of purchase or sale of securities Investment banking services Loans to directors and officers International financial transactions © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Community respondent banks have found themselves circumvented by correspondent banks marketing directly to respondent’s customers resulting in: Unbundling correspondent bank services by purchasing services from more than one correspondent bank. Forming and buying services from cooperative institutions known as bankers’ banks that provide correspondent banking services only to financial institutions. Bankers’ banks do not market to retail customers and only compete with other correspondent banks. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Short-Term Liquidity Planning

Managing Float During any day, more than $100 million in checks drawn on U.S. banks waiting to be processed. Customers deposit checks but cannot use the proceeds until banks gives approval, typically in several days. Checks in process of collection, called float, are a source of both income and expense to banks. Deposit institutions float with EFTs by authorizing payments is excess of their balances. Negative balances called daylight overdrafts are generally covered by the end of each day. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Managing Float Overdrafts could potentially close down the electronic payment system. Primary risk is that some bank might fail because it cannot meet a payment obligation. Failure might produce liquidity problems at other banks resulting in a ripple effect. EFT participants required to maintain positive balances at the Fed and correspondent banks at the end of each day. Daylight overdrafts are costless to deficient banks because no interest or fees are paid. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Liquidity versus Profitability
Trade-off between liquidity and profitability. The more liquid a bank is, the lower its return on equity and return on assets, all other things being equal. Large holdings of cash assets decrease profits because of the opportunity loss of interest income. Short-term securities normally carry lower yields than comparable longer-term securities. Loans carrying the highest yields generally the least liquid. Liquidity planning focuses on guaranteeing that immediately available funds are available at the lowest cost. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Relationship Between Liquidity, Credit Risk, and Interest Rate Risk
Liquidity risk for a poorly managed bank closely follows credit and interest rate risk. Banks that experience large deposit outflows can often trace the source to either credit problems or earnings declines from interest rate gambles that backfired. Liquidity planning forces management to monitor overall risk position such that credit risk partially offsets interest rate risk assumed. Potential liquidity needs must reflect estimates of new loan demand and potential deposit losses. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Relationship Between Liquidity, Credit Risk, and Interest Rate Risk

Asset Liquidity Measures
Asset liquidity refers to the ease of converting an asset to cash with a minimum of loss. Most liquid assets are near term and highly marketable. Includes cash and due from banks in excess of required holdings, federal funds sold, reverse repurchase agreements, short-term U.S. Treasury and agency securities, highly rated corporate and municipal securities and loans that can be readily sold or securitized. Liquidity measures are normally expressed in percentage terms as a fraction of total assets. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Pledging Requirements: Not all of a bank’s securities can be easily sold. Banks are required to pledge collateral against certain types of borrowings. U.S. Treasuries or municipals normally constitute the least-cost collateral and, if pledged against debt, cannot be sold until the bank removes the claim or substitutes other collateral. Collateral is required against four different liabilities: Repurchase agreements, discount window borrowings, public deposits owned by the U.S. Treasury or any state or municipal government unit, FLHB advances © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Loans: Many banks and bank analysts monitor loan-to-deposit ratios as a general measure of liquidity. Loans are presumably the least liquid of assets, while deposits are the primary source of funds. A high ratio indicates illiquidity because a bank is fully loaned up relative to its stable funding. A low ratio suggests that a bank has additional liquidity because it can grant new loans financed with stable deposits. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Liability Liquidity Measures
Liability liquidity is ease which bank can issue debt to acquire clearing balances at reasonable costs. Measures reflect a bank’s asset quality, capital base, and composition of outstanding deposits and other liabilities. Commonly cited ratios: Total equity to total assets; Loan to deposits Loan losses to net loans; Reserve for loan losses to loans Percentage composition of deposits; Total deposits to total assets; Core deposits to total assets Federal funds purchased and RPs to total assets. Commercial and other short-term borrowings to total assets. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Liability Liquidity Measures
Core Deposits: Base level of deposits bank expects regardless of the economic environment. Volatile Deposits: Difference between actual deposits and base estimate of core deposits. Bank’s Net Noncore Funding Dependency Ratio: Positive value indicates the bank is highly liquid while a negative value indicates relative illiquidity because volatile, purchased funding exceeds short-term assets. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Basel III and the Liquidity Coverage Ratio
Effective in 2015, Federal Reserve Board of Governors, FDIC, and OCC proposed internationally active banks meet minimum liquidity requirement linked to holding of liquid assets: Impacts banks with $250 billion + in assets or $10 billion + in foreign exposure on balance sheet. Establishes liquidity coverage ratio (LCR) measured as ratio of high-quality liquid assets to projected net cash outflows. Objective is to improve large organizations’ liquidity risk management. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Longer-Term Liquidity Planning
Involves projecting cash inflows and outflows over 90 days, 180 days, one year and beyond if needed. Objective is to ensure bank does not face an unanticipated liquidity crisis. Forecasts in deposit growth and loan demand required. Projections are separated into three categories: base trend, short-term seasonal, and cyclical values. Analysis assesses a bank’s liquidity gap, measured as the difference between potential uses of funds and anticipated sources of funds, over monthly intervals. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Longer-Term Liquidity Planning
Bank’s monthly liquidity needs estimated as forecasted change in loans plus required reserves minus forecast change in deposits: Liquidity needs = Forecasted Δloans + ΔRequired reserves - Forecasted Δdeposits Positive figure means bank needs additional liquid funds. Negative figure suggests bank will have surplus funds to invest. Analysis can be used to identify longer-term trends in fund flow. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Considerations in the Selection of Liquidity Sources
Costs should be evaluated in present value terms as interest income and expense may arise over time. Choice of one source over another often involves an implicit interest rate forecast. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Contingency Funding Plans
Financial institutions must have carefully designed contingency plans that: Address strategies for handling unexpected liquidity crises. Outline appropriate procedures for dealing with liquidity shortfalls occurring under abnormal conditions. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Contingency Planning A contingency plan should include:
Narrative section addressing senior officers responsible for dealing with external constituencies, internal and external reporting requirements, and events that trigger specific funding needs. Quantitative section assessing the impact of potential adverse events on bank’s balance sheet: Should incorporate timing of events by assigning run-off rates, identify potential sources of new funds and forecast associated cash flows across numerous short and long term scenarios and time intervals, including a wide range of potential internal crises. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Contingency Planning A contingency plan should include:
Section summarizing key risks and potential sources of funding, identifying how the modeling will monitored and tested, and establishing relevant policy limits. Liquidity contingency strategy should clearly outline actions needed to provide the necessary liquidity. Plan must consider cost of changing asset or liability structure versus the cost of facing a liquidity deficit. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Contingency Planning Should prioritize which assets would have to be sold in the event a crisis intensifies. Relationship with liability holders should be factored into contingency strategy. Should provide for back-up liquidity. Must have specific action steps and establish lines of decision-making authority. Should be approved by board of directors. Difficult because when plan is being made because probability of needing it seems remote. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 12: The Effective Use of Capital

Why Worry about Bank Capital?
Capital reduces risk by cushioning earnings volatility and restricting growth opportunities. Reduces expected returns to shareholders as equity is more expensive than debt. Decreasing capital increases risk by increasing financial leverage and the risk of failure. Firms with greater capital can borrow at lower rates, make larger loans and expand faster through acquisition or internal growth. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Why Worry about Bank Capital?
Regulators primary objective is to ensure safety and soundness of U.S. financial system. Regulators specify minimum amounts of equity and other qualifying capital banks must maintain. Historically, minimum capital-to-total-assets were stipulated without regard to asset quality. Equity-to-asset ratios are much higher in 2013 than for all but the smallest banks, demonstrating the problem that small bank face in exiting the recession. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Risk-Based Capital Standards and The 1986 Basel Agreement
Historically, bank capital requirements were independent of risk. In 1986, Basel Agreement proposed banks maintain minimum capital reflecting the riskiness of assets. Minimum capital requirements linked to credit risk as determined by composition of assets. Stockholders’ equity deemed most critical type of capital. Minimum requirement 8% of risk-adjusted assets. Capital requirements standardized between countries to level the playing field. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Risk-Based Elements of Basel I
Classify assets into one of four risk categories. Classify off-balance sheet commitments into the appropriate risk categories. Multiply the dollar amount of assets in each risk category by the appropriate risk weight to calculate risk-weighted assets. Multiply risk-weighted assets by the minimum capital percentages, currently 4% for Tier 1 capital and 8% for total capital. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What Constitutes Bank Capital?
Capital (Net Worth): The cumulative value of assets minus the cumulative value of liabilities or ownership in the firm. Total Equity Capital: Sum of common stock, surplus, retained earnings, capital reserves, net unrealized holding gains (losses) and perpetual preferred stock. Regulatory capital ratios focus on the book value of equity. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What Constitutes Bank Capital?
Tier 1 (Core) Capital: Common stockholders’ equity, noncumulative perpetual preferred stock and any related surplus. Minority interest in consolidated subsidiaries, less intangible assets such as goodwill. Tier 2 (Supplementary) Capital: Preferred stocks and any surplus. Limited amounts of term-subordinated debt and a limited amount of the allowance for loan and lease losses (up to percent of gross. risk-weighted assets) © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Tier 3 Capital Requirements for Market Risk Under Basel I
Leverage Capital Ratio: Tier 1 capital divided by total assets net of goodwill and disallowed intangible assets and deferred tax assets. Minimum of 3% required by regulation. Market Risk: Risk of loss from interest rate fluctuations, equity prices, foreign exchange rates, commodity prices, and exposure to specific risk associated with debt and equity positions in the bank’s trading portfolio. Banks with significant market risk must measure their exposure and hold sufficient capital to mitigate the risk. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Tangible Common Equity
Equals a bank’s tangible assets minus its liabilities and any preferred stock outstanding. Reflects what would be left over if a bank liquidated and used its proceeds to pay off debt and preferred stockholders. Assigns no value to intangible assets. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Basel III Capital Standards
Approved in July 2013 with intent to increase bank capital requirements and upgrade capital quality. Imposes higher minimum capital ratios and places a greater emphasis on common equity as a preferred form of capital. Rules apply differently to larger organizations vs. smaller. Smaller organizations can count more items as capital and have more time to comply with the new requirements. Stricter rules on what qualifies as capital and a new minimum capital ratio. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Basel III Capital Standards
When implemented, banks must hold a capital conservation buffer plus old RBC minimums. Minimum capital requirements when implemented in 2019: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Weaknesses of the Risk-Based Capital Standards
Standards only consider credit risk except for market risk at large banks with extensive trading. Banks capital requirements is determined by asset composition. Banks subject to the advanced approaches of Basel II use internal models to assess credit risk and report results of their model to regulators. Many large institutions’ dramatically understate risk. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What is the Function of Bank Capital?
For regulators, bank capital serves to protect the deposit insurance fund in case of bank failures. Bank capital reduces bank risk by: providing a cushion for firms to absorb losses and remain solvent. providing ready access to financial markets, which guards against liquidity problems from deposit outflows. constraining growth and limits risk taking. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

How Much Capital Is Adequate?
Regulators prefer more capital which reduces the likelihood of failure and increases bank liquidity. Bankers prefer less capital as the smaller a bank’s equity base the greater its financial leverage and equity multiplier. High leverage coverts a normal ROA into high ROE. Riskier banks should hold more capital while lower- risk banks should be allowed to increase financial leverage. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Effect of Capital Requirements on Bank Operating Policies
Limiting Asset Growth: Minimum capital requirements restrict bank‘s ability to grow. Additions to assets mandate additions to capital to meet minimum capital-to-asset ratios. Each bank must limit asset growth to some percentage of retained earnings plus new external capital. Must determine growth strategy while meeting minimum capital requirements. Higher ROA is one option: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Limiting Asset Growth: Relationship for internally generated capital: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changing the Capital Mix: Internal versus external capital. Changing Asset Composition: Shift from high-risk to lower-risk categories. Pricing Policies: Raise rates on higher-risk loans. Shrinking the Bank: Fewer assets requires less capital. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Characteristics of External Capital Sources
Subordinated debt advantages: Interest payments are tax-deductible. Shareholders do not reduce proportionate ownership. Generates additional profits as long as earnings before interest and taxes exceed interest payments. Subordinated debt disadvantages: Does not qualify as Tier 1 or core capital. Interest and principal payments are mandatory. Many issues require sinking funds. Fixed maturity and banks cannot charge losses against it. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Contingent Convertible Capital
Common stock advantages: No fixed maturity and thus a permanent source of funds. Dividend payments are discretionary. Losses can be charged against equity. Common stock disadvantages: Dividends are not tax-deductible. Transactions costs on new issues exceed new debt costs. Shareholders sensitive to earnings dilution and possible loss of control in ownership. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Preferred Stock: Form of equity in which investors' claims are senior to those of common stockholders. Dividends are not tax-deductible. Corporate investors in preferred stock pay taxes on only 20 percent of dividends. Most issues take the form of adjustable-rate perpetual stock. Has the same disadvantages of common stock but the earnings dilution is less than with common stock. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Trust Preferred Stock: Hybrid form of equity capital at banks. Effectively pays dividends that are tax deductible To issue the security, bank establishes a trust company. Trust company sells preferred stock to investors and loans the proceeds of the issue to the bank. Interest on the loan equals dividends paid on preferred stock. Interest on loan is tax deductible such that the bank deducts dividend payments. Counts as Tier 1 capital. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

TARP Capital Purchase Program: The Troubled Asset Relief Program’s Capital Purchase Program (TARP-CPP), allowed institutions to sell preferred stock that qualified as Tier 1 capital to the Treasury. Could issue senior preferred stock equal to not less than 1% of risk-weighted assets and not more than the lesser of $25 billion, or 3%, of risk-weight assets. Paid 5% per annum for five years and 9% afterwards. In 2014, many banks with outstanding TARP stock saw the required dividend payment rise to the higher price. Many institutions repaid their TARP stock by 2014. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Leasing Arrangements: Many banks enter into sale and leaseback arrangements as a source of immediate capital. Most transactions involve selling bank-owned headquarters or other real estate and simultaneously leasing it back from the buyer. Terms can be structured to allow the bank to maintain complete control while receiving large amounts of cash at low cost. Effectively converts the appreciated value of real listed on the bank’s book at cost to cash. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Planning Process can be summarized in three steps:
Generate pro formal balance sheet and income statements for the bank. Select a dividend payout. Analyze the costs and benefits of alternative sources of external capital. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Capital Planning: Applications
Bank exhibiting a deteriorating profit trend. Classified assets and loan loss provisions are rising and earnings prospects are bleak, given the economy. Federal regulators who examined bank indicated the primary capital-to-asset ratio should be increased from its current 7% to 8.5% within four years. Following exhibit identifies different strategies for meeting the required increase. In practice, bank will consider numerous other alternatives by varying assumptions until best plan is determined. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Depository Institutions Capital Standards
The Federal Deposit Insurance Improvement Act (FDICIA) was passed with the intent of revising bank capital requirements to: emphasize the importance of capital. authorize early intervention in problem institutions. authorize regulators to measure interest rate risk at banks and require additional capital when deemed excessive. Focal point is the system of prompt regulatory action which divides banks into zones and mandates action when capital minimums not met. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Depository Institutions Capital Standards
Five capital categories with first two representing: Well-capitalized banks not subject to any directives. Adequately capitalized banks but cannot obtain brokered deposits without FDIC approval. Banks in the bottom categories prompt action: Undercapitalized banks do not meet at least one of the three minimum capital requirements. Significantly undercapitalized banks have capital that falls below at least one of three standards. Critically undercapitalized banks do not meet minimum threshold levels for the three capital ratios. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes to Capital Standards Under Basel III
Basel Committee agreed on principles to “strengthen global capital and liquidity rules” known as Basel III. Standards will be implemented over time by G20 countries and have the general impact of increasing capital requirements (decreasing financial leverage). Formal standards that set minimum liquidity requirements, increase minimum capital requirements and redefine what constitutes regulatory capital. Focuses on common equity as the “best” form of capital. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes to Capital Standards Under Basel III
Regulatory capital standards that put more emphasis on common equity required generally lower financial leverage. Requirements will put pressure on bank returns on equity. Lower returns will increase cost of capital making it more expensive and difficult to issue new stock to investors. Banks will be forced to raise loan rates, cut expenses, or find new income to cover higher cost of capital. Impact is much broader than provisions suggest. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 9: Using Derivatives to Manage Interest Rate Risk

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Chapter 9: Using Derivatives to Manage Interest Rate Risk

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