1. Chapter Eight Risk Management: Financial Futures,
Options, Swaps, and Other Hedging Tools
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2. Key Topics The Use of Derivatives
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Key Topics
The Use of Derivatives
Financial Futures Contracts: Purpose and Mechanics
Short and Long Hedges
Interest-Rate Options: Types of Contracts and Mechanics
Interest-Rate Swaps
Regulations and Accounting Rules
Caps, Floors, and Collars
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3. 8-3
Introduction
The asset-liability management tools we explore here are useful across a broad range of financial-service providers sensitive to the risk of changes in market interest rates
Many of the risk management tools in this chapter are not only used by financial firms to cover their own interest rate risk, but are also sold to customers who need risk protection and generate fee income for the providers
Most of the financial instruments in this chapter are derivatives
They derive their value from the value and terms of underlying instruments
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4. Uses of Derivative Contracts Among FDIC-Insured Banks
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Uses of Derivative Contracts Among FDIC-Insured Banks
Due to their high exposure to various forms of risk, banks and their principal competitors are among the heaviest users of derivative contracts
These risk-hedging instruments allow a financial firm to protect its balance sheet and/or income and expense statement in case interest rates, currency prices, or other financial variables move against the hedger
Approximately 15 percent of all banks operating in the United States reportedly employ the use of derivatives to subdue risk in its various forms
Today the bulk of trading in derivatives is centered in the very largest banks worldwide
Interest-rate risk is by far the most common target for derivatives, with foreign exchange (currency) risk running a distant second
The leading type of risk-hedging contracts are swaps, followed by financial futures and options
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5. 8-5
EXHIBIT 8-1 Types of Derivative Contracts Used by Depository Institutions to Manage Different Types of Risk Exposure, 2010
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Financial Futures Contracts: Promises of Future Security Trades at a Preset Price
In Chapter 7, we explored the nature of gaps between assets and liabilities that are exposed to interest rate risk
The preceding chapter developed one other measure of the difference between risk-exposed assets and liabilities – the leverage-adjusted duration gap
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Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
A financial futures contract is an agreement reached today between a buyer and a seller that calls for delivery of a particular security in exchange for cash at some future date
Financial futures trade in futures markets and are usually accounted for as off-balance-sheet items on the financial statements of financial-service firms
Sellers of financial assets remove the assets from their balance sheet and account for the losses or gains on their income statements
Buyers of financial assets add the item purchased to their balance sheet
In cash markets, buyers and sellers exchange the financial asset for cash at the time the price is set
In futures markets buyers and sellers exchange a contract calling for delivery of the underlying financial asset at a specified date in the future
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8. 8-8
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
When the contract is created, neither buyer nor seller is making a purchase or sale at that point in time, only an agreement for the future
When an investor buys or sells futures contracts at a designated price, it must deposit an initial margin
The initial margin is the investor’s equity in the position when he or she buys (or sells) the contract
Each trader’s account is marked-to-market
When a trader’s equity position falls below the maintenance margin (the minimum specified by the exchange) the trader must deposit additional funds to the equity account to maintain his or her position, or the futures position is closed out within 24 hours
The mark-to-market process takes place at the end of each trading day
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9. 8-9
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Buyers of futures contracts
A buyer of a futures contract is said to be long futures
Agrees to pay the underlying futures price or take delivery of the underlying asset
Buyers gain when futures prices rise and lose when futures prices fall
Sellers of futures contracts
A seller of a futures contract is said to be short futures
Agrees to receive the underlying futures price or to deliver the underlying asset
Sellers gain when futures prices fall and lose when futures prices rise
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10. 8-10
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
The financial futures markets are designed to shift the risk of interest-rate fluctuations from risk-averse investors, such as banks and insurance companies, to speculators willing to accept and possibly profit from such risks
Futures contracts are traded on organized exchanges
For example, the Chicago Mercantile Exchange or the London Financial Futures Exchange
On the exchange floor, floor brokers execute orders received from the public to buy or sell these contacts at the best prices available
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11. 8-11
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Futures contracts are also traded over the counter (OTC)
Often less costly for traders
These are most often called forward contracts
Forward contracts
Generally more risky – counterparty risk and liquidity risk
Terms are negotiated between parties
Do not necessarily involve standardized assets
Require no cash exchange until expiration
No marking to market
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12. 8-12
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Most common financial futures contracts
U.S. Treasury Bond Futures Contracts
Three-Month Eurodollar Time Deposit Futures Contract
30-Day Federal Funds Futures Contracts
One Month LIBOR Futures Contracts
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13. 8-13
EXHIBIT 8–2 Sample Market Prices for Interest-Rate Futures in Recent Years
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Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Short Futures Hedge Process
Today – contract is sold through an exchange
Sometime in the future – contract is purchased through the same exchange
Results – the two contracts are cancelled out by the futures clearinghouse
Gain or loss is the difference in the price purchased for (at the end) and the price sold for (at the beginning)
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Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Long Futures Hedge Process
Today – contract is purchased through an exchange
Sometime in the future – contract is sold through the same exchange
Results – the two contracts are cancelled by the clearinghouse
Gain or loss is the difference in the purchase price (at the beginning) and the price sold for (at the end)
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Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
The three most typical interest-rate hedging problems financial firms face are
Protecting the value of securities and fixed-rate loans from losses due to rising interest rates
Avoiding a rise in borrowing costs
Avoiding a fall in the interest returns expected from loans and security holdings
Where the financial institution faces a positive interest-sensitive gap, it can protect against loss due to falling interest rates by covering the gap with a long hedge
If the institution is confronted with a negative interest-sensitive gap, it can avoid unacceptable losses from rising market interest rates by covering with a short hedge
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Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Basis Risk
The basis is the cash price of an asset minus the corresponding futures price for the same asset at a point in time
For financial futures, the basis can be calculated as the futures rate minus the spot rate
It may be positive or negative, depending on whether futures rates are above or below spot rates
May swing widely in value far in advance of contract expiration
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18. 8-18
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Basis Risk with a Short Hedge
You are concerned about the interest-rate risk exposure for bonds in a financial institution’s securities portfolio
You fear increasing interest rates that would decrease the value of those bonds
You have a long position in the cash market
To hedge this possible increase in market interest rates, you could take a short position in the futures market
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Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Basis Risk with a Short Hedge
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Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Basis Risk with a Long Hedge
If you have concerns about declining interest rates, you could create a long hedge
To hedge the decrease in interest rates, you could take a long position in the futures market
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