1. EXHIBIT 8–3 Trade-Off Diagrams for Financial Futures Contracts
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EXHIBIT 8–3 Trade-Off Diagrams for Financial Futures Contracts
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2. 8-2
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
How many futures contracts does a financial firm need to cover a given size risk exposure?
The objective is to offset the loss in net worth due to changes in market interest rates with gains from trades in the futures market
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3. 8-3
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
If we set the change in net worth equal to the change in the futures position value, we can solve for the number of futures contracts needed to fully hedge a financial firm’s overall interest-rate risk exposure and protect its net worth
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4. Interest-Rate Options
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Interest-Rate Options
The interest-rate option grants a holder of securities the right to either
Place (put) those instruments with another investor at a prespecified exercise price before the option expires or
Take delivery of securities (call) from another investor at a prespecified price before the option’s expiration date
In the put option, the option writer must stand ready to accept delivery of securities from the option buyer if the latter requests
In the call option, the option writer must stand ready to deliver securities to the option buyer upon request
The fee that the buyer must pay for the privilege of being able to put securities to or call securities away from the option writer is known as the option premium
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5. Interest-Rate Options (continued)
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Interest-Rate Options (continued)
For standardized exchange-traded interest-rate options, the most activity occurs using options on futures, referred to as the futures options market
Most common option contracts used by banks
U.S. Treasury Bond Futures Options
Grant the options buyer the right to a short position (put) or a long position (call) involving one T-bond futures contract for each option
Eurodollar Futures Option
Give the buyer the right to deliver (put) or accept delivery (call) of one Eurodollar deposit futures contract for every option exercised
Exchange-traded futures options are generally set to expire in March, June, September, or December to conform to most futures contracts
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6. EXHIBIT 8–4 Futures Options Sample Prices
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EXHIBIT 8–4 Futures Options Sample Prices
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7. Interest-Rate Options (continued)
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Interest-Rate Options (continued)
Most options today are used by money center banks
They appear to be directed at two principal uses
Protecting a security portfolio through the use of put options to insulate against falling security prices (rising interest rates)
There is no delivery obligation under an option contract so the user can benefit from keeping his or her securities if interest rates fall and security prices rise
Hedging against positive or negative gaps between interest- sensitive assets and interest-sensitive liabilities
For example, put options can be used to offset losses from a negative gap when interest rates rise, while call options can be used to offset a positive gap when interest rates fall
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EXHIBIT 8–5 Payoff Diagrams for Put and Call Options Purchased by a Financial Institution
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EXHIBIT 8–6 Payoff Diagrams for Put and Call Options Written by a Financial Firm
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10. Regulations and Accounting Rules for Bank Futures and Options Trading
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Regulations and Accounting Rules for Bank Futures and Options Trading
Regulators expect a financial firm’s board of directors to provide oversight while senior management is responsible for the development of an appropriate risk-management system
The risk-management system is to be comprised of
Policies and procedures to control financial risk taking
Risk measurement and reporting systems
Independent oversight and control processes
The OCC requires the banks it supervises to measure and set limits with regards to nine different aspects of risk associated with derivatives
These risks are strategic risk, reputation risk, price risk, interest rate risk, liquidity risk, foreign exchange risk, credit risk, transaction risk, and compliance risk
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11. 8-11
Regulations and Accounting Rules for Bank Futures and Options Trading (continued)
In 1998, the Financial Accounting Standards Board (FASB) introduced Statement 133 (FAS 133)
“Accounting for Derivative Instruments and Hedging Activities”
FAS 133 requires that all derivatives be recorded on the balance sheet as assets or liabilities at their fair value
With regard to interest rate risk, FAS 133 recognized two types of hedges: a fair value hedge and a cash flow hedge
The objective of a fair value hedge is to offset losses due to changes in the value of an asset or liability
Cash flow hedges try to reduce risk associated with future cash flows (interest on loans or interest payments on debt)
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12. 8-12
Interest-Rate Swaps
An interest-rate swap is a way to change a borrowing institution’s exposure to interest-rate fluctuations and achieve lower borrowing costs
Swap participants can convert from fixed to floating interest rates or from floating to fixed interest rates and more closely match the maturities of their liabilities to the maturities of their assets
The most popular short-term, floating rates used in interest rate swaps today include the London Interbank Offered Rate (LIBOR) on Eurodollar deposits, Treasury bill and bond rates, the prime bank rate, the Federal funds rate, and interest rates on CDs issued by depository institutions
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13. Interest-Rate Swaps (continued)
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Interest-Rate Swaps (continued)
Quality Swap
Borrower with lower credit rating pays fixed payments of borrower with higher credit rating
Borrower with higher credit rating pays short-term floating rate payments of borrower with lower credit rating
Reverse Swap
A new swap agreement offsets the effects of an existing swap contract
“Swaptions”
Options for one or both parties to make certain changes in the agreement, take out a new option, or cancel an existing swap agreement
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14. EXHIBIT 8–7 The Interest-Rate Swap
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EXHIBIT 8–7 The Interest-Rate Swap
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15. Interest-Rate Swaps (continued)
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Interest-Rate Swaps (continued)
The principal amount of the loans, usually called the notional amount, is not exchanged
Only the net amount of interest due usually flows to one or the other party to the swap
The swap itself normally will not show up on a swap participant’s balance sheet
Actual defaults are limited
If a swap partner is rated BBB or lower, it may be impossible to find a counterparty to agree to the swap
Low-rated partner may be required to agree to a credit trigger clause
Basis risk and interest rate risk can be significant
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16. Caps, Floors, and Collars
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Caps, Floors, and Collars
An interest-rate cap protects its holder against rising market interest rates
In return for paying an up-front premium, borrowers are assured that institutions lending them money cannot increase their loan rate above the level of the cap
Alternatively, the borrower may purchase an interest-rate cap from a third party, with that party promising to reimburse borrowers for any additional interest they owe their creditors beyond the cap
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17. Caps, Floors, and Collars (continued)
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Caps, Floors, and Collars (continued)
Interest-Rate Cap Example
A bank purchases a cap of 11 percent on its borrowings of $100 million in the Eurodollar market for one year
Suppose interest rates in this market rise to 12 percent for the year
The financial institution selling the cap will reimburse the bank purchasing the cap the additional 1 percent in interest
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18. Caps, Floors, and Collars (continued)
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Caps, Floors, and Collars (continued)
Financial-service providers can also lose earnings in periods of falling interest rates, especially when rates on floating-rate loans decline
A lending institution can establish an interest-rate floor under its loans so that, no matter how far loan rates tumble, it is guaranteed some minimum rate of return
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19. Caps, Floors, and Collars (continued)
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Caps, Floors, and Collars (continued)
Interest-Rate Floor Example
Suppose a lender extends a $10 million floating-rate loan to one of its corporate customers for a year at prime insists on a minimum (floor) interest rate on this loan of 7 percent
If the prime rate drops below the floor to 6 percent for one year, the customer will pay not only the 6 percent prime rate but also pay out an interest rebate to the lender of
Assuming the borrower does not default, lender assured a minimum return of 7 percent on its loan
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20. Caps, Floors, and Collars (continued)
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Caps, Floors, and Collars (continued)
Lending institutions and their borrowing customers also make heavy use of the interest-rate collar
Combines in one agreement a rate floor and a rate cap
Interest-Rate Collar Example
A customer who has just received a $100 million loan and asks for a collar on the loan’s prime rate between 11 percent and 7 percent
The lender will pay its customer’s added interest cost if prime rises above 11 percent, while the customer reimburses the lender if prime drops below 7 percent
The collar’s purchaser pays a premium for a rate cap while receiving a premium for accepting a rate floor
The net premium paid for the collar can be positive or negative, depending upon the outlook for interest rates and the risk aversion of borrower and lender at the time of the agreement
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21. 8-21
Quick Quiz
What are financial futures contracts? Which financial institutions use futures and other derivatives for risk management? How can financial futures help financial service firms deal with interest rate risk?
What futures transactions would most likely be used in a period of rising interest rates? Falling interest rates?
Explain what is involved in a put option. What is a call option? What is an option on a futures contract?
What is the purpose of an interest-rate swap?
How can financial-service providers make use of interest-rate caps, floors, and collars to generate revenue and help manage interest rate risk?
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