Using Derivatives to Manage Interest Rate Risk

Using Derivatives to Manage Interest Rate Risk
Chapter 9 Using Derivatives to Manage Interest Rate Risk

Any instrument or contract that derives its value from another underlying asset, instrument, or contract

Derivatives Used to Manage Interest Rate Risk Financial Futures Contracts Forward Rate Agreements Interest Rate Swaps Options on Interest Rates Interest Rate Caps Interest Rate Floors

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 The organized exchanges where futures contracts are traded Interest Rate Futures When the underlying asset is an interest-bearing security

Buyers 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 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

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

Forward versus Futures Contracts Futures Contracts Traded on formal exchanges Examples: Chicago Board of Trade and the Chicago Mercantile Exchange Involve standardized instruments Positions require a daily marking to market Positions require a deposit equivalent to a performance bond

Forward versus Futures Contracts Forward contracts Terms are negotiated between parties Do not necessarily involve standardized assets Require no cash exchange until expiration No marking to market

A Brief Example Assume you want to invest $1 million in 10-year T-bonds in six months and believe that rates will fall You would like to “lock in” the 4.5% 10-year yield prevailing today If such a contract existed, you would buy a futures contract on 10-year T-bonds with an expiration date just after the six-month period Assume that such a contract is priced at a 4.45% rate

A Brief Example If 10-year Treasury rates actually fall sharply during the six months, the futures rate will similarly fall such that the futures price rises An increase in the futures price generates a profit on the futures trade You will eventually sell the futures contract to exit the trade

A Brief Example You will eventually sell the futures contract to exit the trade Your effective yield will be determined by the prevailing 10-year Treasury rate and the gain (or loss) on the futures trade In this example, the decline in 10-year rates will be offset by profits on the long futures position

A Brief Example The 10-year Treasury rate falls by 0.80%, which represents an opportunity loss However, buying a futures contract generates a 0.77% profit The effective yield on the investment equals the prevailing 3.70% rate at the time of investment plus the 0.77% futures profit, or 4.47%

A Brief Example Loss from Treasury rate 4.5%-3.7% = 0.8% Gain from future rate 4.45%-3.68% = 0.77% Yield 3.7%+0.77% = 4.47%

Types of Future Traders Commission Brokers Execute trades for other parties Locals Trade for their own account Locals are speculators

Types of Future Traders Speculator Takes a position with the objective of making a profit Tries to guess the direction that prices will move and time trades to sell (buy) at higher (lower) prices than the purchase price

Types of Future Traders Scalper A speculator who tries to time price movements over very short time intervals and takes positions that remain outstanding for only minutes

Types of Future Traders Day Trader Similar to a scalper but tries to profit from short-term price movements during the trading day; normally offsets the initial position before the market closes such that no position remains outstanding overnight

Types of Future Traders Position Trader A speculator who holds a position for a longer period in anticipation of a more significant, longer-term market moves

Types of Future Traders Hedger Has an existing or anticipated position in the cash market and trades futures contracts to reduce the risk associated with uncertain changes in the value of the cash position Takes a position in the futures market whose value varies in the opposite direction as the value of the cash position when rates change Risk is reduced because gains or losses on the futures position at least partially offset gains or losses on the cash position

Types of Future Traders Hedger versus Speculator The essential difference between a speculator and hedger is the objective of the trader A speculator wants to profit on trades A hedger wants to reduce risk associated with a known or anticipated cash position

Types of Future Traders Spreader versus Arbitrageur Both are speculators that take relatively low-risk positions Futures Spreader May simultaneously buy a futures contract and sell a related futures contract trying to profit on anticipated movements in the price difference The position is generally low risk because the prices of both contracts typically move in the same direction

Types of Future Traders Arbitrageur Tries to profit by identifying the same asset that is being traded at two different prices in different markets at the same time Buys the asset at the lower price and simultaneously sells it at the higher price Arbitrage transactions are thus low risk and serve to bring prices back in line in the sense that the same asset should trade at the same price in all markets

The Mechanics of Futures Trading Initial Margin A cash deposit (or U.S. government securities) with the exchange simply for initiating a transaction Initial margins are relatively low, often involving less than 5% of the underlying asset’s value

The Mechanics of Futures Trading Maintenance Margin The minimum deposit required 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

The Mechanics of Futures Trading Marking-to-Market The daily settlement process where at the end of every trading day, a trader’s margin account is: Credited with any gains Debited with any losses Variation Margin The daily change in the value of margin account due to marking-to-market

The Mechanics of Futures Trading Expiration Date Every futures contract has a formal expiration date On the 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

An Example: 90-Day Eurodollar Time Deposit Futures The 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

An Example: 90-Day Eurodollar Time Deposit Futures Contracts trade according to an index: 100 – Futures Price = Futures Rate An index of indicates a futures rate of 5.5% 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)

An Example: 90-Day Eurodollar Time Deposit Futures Over forty separate contracts are traded at any point in time, as contracts expire in March, June, September and December each year Buyers make a profit when futures rates fall (prices rise) Sellers make a profit when futures rates rise (prices fall)

An Example: 90-Day Eurodollar Time Deposit Futures 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 PT CHGE The basis-point change between the last price quoted and the closing price the previous day

An Example: 90-Day Eurodollar Time Deposit Futures SETTLEMENT The previous day’s closing price VOLUME The previous day’s volume of contracts traded during the day OPEN INTEREST The total number of futures contracts outstanding at the end of the day.

Expectations Embedded in Future Rates According to the unbiased expectations theory, an upward sloping yield curve indicates a consensus forecast that short-term interest rates are expected to rise A flat yield curve suggests that rates will remain relatively constant

Expectations Embedded in Future Rates

Expectations Embedded in Future Rates The previous slide presents two yield curves at the close of business on June 5, 2008 There was a sharp decrease in rates from one year prior. The yield curve in June 2008 was relatively steep The difference between the one-month and 30-year Treasury rates was 289 basis points The yield curve in June 2007 was relatively flat

Expectations Embedded in Future Rates One interpretation of futures rates is that they provide information about consensus expectations of future cash rates When futures rates continually rise as the expiration dates of the futures contracts extend into the future, it signals an expected increase in subsequent cash market rates

Daily Marking-To-Market Consider a trader trading on June 6, 2008 who buys one December 2008 three-month Eurodollar futures contract at $96.98 posting $1,100 in cash as initial margin Maintenance margin is set at $700 per contract The futures contract expires approximately six months after the initial purchase, during which time the futures price and rate fluctuate daily

Daily Marking-To-Market Suppose that on June 13 the futures rate falls fro 3.02% to 2.92% The trader could withdraw $250 (10 basis points × $25) from the margin account, representing the increase in value of the position

Daily Marking-To-Market If the futures rate increases to 3.08% the next day, the trader’s long position decreases in value The 16 basis-point increase represents a $400 drop in margin such that the ending account balance would equal $950

Daily Marking-To-Market If the futures rate increases further to 3.23%, the 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 the trader does not meet the variation margin requirement

Daily Marking-To-Market The Basis Basis = Cash Price – Futures Price or Basis = Futures Rate – Cash 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

Speculation versus Hedging
Speculators Take On Risk To Earn Speculative Profits Speculation is extremely risky Example You believe interest rates will fall, so you buy Eurodollar futures If rates fall, the price of the underlying Eurodollar rises, and thus the futures contract value rises earning you a profit If rates rise, the price of the Eurodollar futures contract falls in value, resulting in a loss

Hedgers Take Positions to Avoid or Reduce Risk A hedger already has a position in the cash market and uses futures to adjust the risk of being in the cash market The focus is on reducing or avoiding risk

Hedgers Take Positions to Avoid or Reduce Risk Example A bank anticipates needing to borrow $1,000,000 in 60 days. The bank is concerned that rates will rise in the next 60 days A possible strategy would be to short Eurodollar futures. If interest rates rise (fall), the short futures position will increase (decrease) in value. This will (partially) offset the increase (decrease) in borrowing costs

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 needed Select the best futures contract Determine the appropriate number of futures contracts to trade

Steps in Hedging Buy or sell the appropriate futures contracts Determine when to get out of the hedge position, either by reversing the trades, letting contracts expire, or making or taking delivery Verify that futures trading meets regulatory requirements and the banks internal risk policies

A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates A long hedge (buy futures) is appropriate for a participant who wants to reduce spot market risk associated with a decline in interest rates If spot rates decline, futures rates will typically also decline so that 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

A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates On June 6, 2008, your bank expects to receive a $1 million payment on November 28, 2008, and anticipates investing the funds in three-month Eurodollar time deposits The cash market risk exposure is that the bank would like to invest the funds at today’s rates, but will not have access to the funds for over five months In June 2008, the market expected Eurodollar rates to increase as evidenced by rising futures rates.

A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates In order to hedge, the bank should buy futures contracts 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 2008 Eurodollar futures contract is the first to expire after November 2008

A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates The time line of the bank’s hedging activities:

A Short Hedge: Reduce Risk Associated With A Increase In Interest Rates A short hedge (sell futures) is appropriate for a participant who wants to reduce spot market risk associated with an increase in interest rates If spot rates increase, futures rates will typically also increase so that the value of the futures position will likely decrease. Any loss in the cash market is at least partially offset by a gain in the futures market

A Short Hedge: Reduce Risk Associated With A Increase In Interest Rates On June 6, 2008, your bank expects to sell a six-month $1 million Eurodollar deposit on August 17, 2008 The cash market risk exposure is that interest rates may rise and the value of the Eurodollar deposit will fall by August 2008 In order to hedge, the bank should sell futures contracts

A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates In order to hedge, the bank should sell futures contracts In this example, the September 2008 Eurodollar futures contract is the first to expire after September 17, 2008

A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates The time line of the bank’s hedging activities:

Change in the Basis Long and short hedges work well if the futures rate moves in line with the spot rate The actual risk assumed by a trader in both hedges is that the basis might change between the time the hedge is initiated and closed

Change in the Basis Effective Return = Initial Cash Rate – Change in Basis = Initial Cash Rate – (B2 – B1) where : B1 is the basis when the hedge is opened B2 is the basis when the hedge is closed

Change in the Basis Effective Return: Long Hedge = Initial Cash Rate – (B2 – B1) = 2.68% - (0.10% %) = 2.92% Effective Return: Short Hedge = 3.00% - (0.14% %) = 2.69%

Basis Risk and Cross Hedging Cross Hedge Where a trader uses a futures contract based on one security that differs from the security being hedged in the cash market

Basis Risk and Cross Hedging Cross Hedge Example Using Eurodollar futures to hedge changes in the commercial paper rate Basis risk increases with a cross hedge because the futures and spot interest rates may not move closely together

Microhedging Applications
Microhedge The hedging of a transaction associated with a specific asset, liability or commitment Macrohedge Taking futures positions to reduce aggregate portfolio interest rate risk

Banks are generally restricted in their use of financial futures for hedging purposes Banks must recognize futures on a micro basis by linking each futures transaction with a specific cash instrument or commitment Some feel that such micro linkages force microhedges that may potentially increase a firm’s total risk because these hedges ignore all other portfolio components

Creating a Synthetic Liability with a Short Hedge Example Assume that on June 6, 2008, a bank agreed to finance a $1 million six-month 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 3% The three-month Eurodollar rate was 2.68% The three-month Eurodollar futures rate for September 2008 expiration equaled 2.83%

Creating a Synthetic Liability with a Short Hedge Rather than issue a direct six-month Eurodollar liability at 3%, the bank created a synthetic six-month liability by shorting futures The objective was to use the futures market to borrow at a lower rate than the six-month cash Eurodollar rate A short futures position would reduce the risk of rising interest rates for the second cash Eurodollar borrowing

Creating a Synthetic Liability with a Short Hedge

The Mechanics of Applying a Microhedge Determine the bank’s interest rate position Forecast the dollar flows or value expected in cash market transactions Choose the appropriate futures contract

The Mechanics of Applying a Microhedge Determine the correct number of futures contracts Where NF = number of futures contracts A = Dollar value of cash flow to be hedged F = Face value of futures contract Mc = Maturity or duration of anticipated cash asset or liability Mf = Maturity or duration of futures contract

The Mechanics of Applying a Microhedge Determine the Appropriate Time Frame for the Hedge Monitor Hedge Performance

Macrohedging Applications
Focuses on reducing interest rate risk associated with a bank’s entire portfolio rather than with individual transactions

Hedging: GAP or Earnings Sensitivity If a bank loses when interest rates fall (the bank has a positive GAP), it should use a long hedge If rates rise, the bank’s higher net interest income will be offset by losses on the futures position If rates fall, the bank’s lower net interest income will be offset by gains on the futures position

Hedging: GAP or Earnings Sensitivity If a bank loses when interest rates rise (the bank has a negative GAP), it should use a short hedge If rates rise, the bank’s lower net interest income will be offset by gains on the futures position If rates fall, the bank’s higher net interest income will be offset by losses on the futures position

Hedging: Duration GAP and EVE Sensitivity To eliminate interest rate risk, a bank could structure its portfolio so that its duration gap equals zero

Hedging: Duration GAP and EVE Sensitivity Futures can be used to adjust the bank’s duration gap The appropriate size of a futures position can be determined by solving the following equation for the market value of futures contracts (MVF), where DF is the duration of the futures contract

Hedging: Duration GAP and EVE Sensitivity Example: With a positive duration gap, the EVE will decline if interest rates rise

Hedging: Duration GAP and EVE Sensitivity Example: The bank needs to sell interest rate futures contracts in order to hedge its risk position The short position indicates that the bank will make a profit if futures rates increase

Hedging: Duration GAP and EVE Sensitivity Example: If the bank uses a Eurodollar futures contract currently trading at 4.9% with a duration of 0.25 years, the target market value of futures contracts (MVF) is: MVF = $4,096.82, so the bank should sell four Eurodollar futures contracts

Accounting Requirements and Tax Implications Regulators generally limit a bank’s use of futures for hedging purposes If a bank has a dealer operation, it can use futures as part of its trading activities In such accounts, gains and losses on these futures must be marked-to-market, thereby affecting current income Microhedging To qualify as a hedge, a bank must show that a cash transaction exposes it to interest rate risk, a futures contract must lower the bank’s risk exposure, and the bank must designate the contract as a hedge

Using Forward Rate Agreements to Manage Rate Risk
A forward contract based on interest rates based on a notional principal amount at a specified future date Similar to futures but differ in that they: Are negotiated between parties Do not necessarily involve standardized assets Require no cash exchange until expiration (i.e. there is no marking-to-market) No exchange guarantees performance

Notional Principal Serves as a reference figure in determining cash flows for the two counterparties to a forward rate agreement agree “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 against the notional principal at some specified future date

Seller Agrees to pay a floating-rate payment and receive the fixed-rate payment against the same notional principal The buyer and seller will receive or pay cash when the actual interest rate at settlement is different than the exercise rate

Forward Rate Agreements: An Example Suppose that Metro Bank (as the seller) enters into a receive fixed-rate/pay floating-rating forward rate agreement with County Bank (as the buyer) with a six-month maturity based on a $1 million notional principal amount The floating rate is the 3-month LIBOR and the fixed (exercise) rate is 5%

Forward Rate Agreements: An Example 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%

Forward Rate Agreements: An Example Assume that in three months 3-month LIBOR equals 6% In this case, Metro Bank would receive from County Bank $2,463 The interest settlement amount is $2,500: Interest = ( )(90/360) $1,000,000 = $2,500 Because this represents interest that would be paid three months later at maturity of the instrument, the actual payment is discounted at the prevailing 3-month LIBOR Actual interest = $2,500/[1+(90/360).06]=$2,463

Forward Rate Agreements: An Example If instead, LIBOR equals 3% in three months, Metro Bank would pay County Bank: The interest settlement amount is $5,000 Interest = ( )(90/360) $1,000,000 = $5,000 Actual interest = $5,000 /[1 + (90/360).03] = $4,963

Forward Rate Agreements: An Example 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 sell fixed-rate/receive floating-rate as a hedge if it was exposed to loss in a falling rate environment. This is analogous to a long futures position

Potential Problems with FRAs There is no clearinghouse to guarantee, so you might not be paid when the counterparty owes you cash It is sometimes difficult to find a specific counterparty that wants to take exactly the opposite position FRAs are not as liquid as many alternatives

Basic Interest Rate Swaps as a Risk Management Tool
Characteristics Basic (Plain Vanilla) Interest Rate Swap An agreement between two parties to exchange a series of cash flows based on a specified notional principal amount Two parties facing different types of interest rate risk can exchange interest payments

Characteristics Basic (Plain Vanilla) Interest Rate Swap One party makes payments based on a fixed interest rate and receives floating rate payments The other party exchanges floating rate payments for fixed-rate payments When interest rates change, the party that benefits from a swap receives a net cash payment while the party that loses makes a net cash payment

Characteristics Basic (Plain Vanilla) Interest Rate Swap Conceptually, a basic interest rate swap is a package of FRAs As with FRAs, swap payments are netted and the notional principal never changes hands

Characteristics Plain Vanilla Example Using data for a 2-year swap based on 3-month LIBOR as the floating rate This swap involves eight quarterly payments. Party FIX agrees to pay a fixed rate Party FLT agrees to receive a fixed rate with cash flows calculated against a $10 million notional principal amount

Characteristics Plan Vanilla Example

Characteristics Plain Vanilla Example If the three-month LIBOR for the first pricing interval equals 3% The fixed payment for Party FIX is $83,770 and the floating rate receipt is $67,744 Party FIX will have to pay the difference of $16,026 The floating-rate payment for Party FLT is $67,744 and the fixed-rate receipt is$83,520 Party FLT will receive the difference of $15,776 The dealer will net $250 from the spread ($16,026 -$15,776)

Characteristics Plain Vanilla Example At the second and subsequent pricing intervals, only the applicable LIBOR is unknown As LIBOR changes, the amount that both Party FIX and Party FLT either pay or receive will change Party FIX will only receive cash at any pricing interval if three-month LIBOR exceeds 3.36% Party FLT will similarly receive cash as long as three-month LIBOR is less than 3.35%

Characteristics 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

Characteristics Convert a Floating-Rate Liability to a Fixed Rate Liability By itself, this transaction exhibits considerable interest rate The bank is liability sensitive and loses (gains) if LIBOR rises (falls) The bank can use a basic swap to microhedge this transaction Using the data from Exhibit 9.8, the bank could agree to pay 3.72% and receive three-month LIBOR against $1 million for the three years By doing this, the bank locks in a borrowing cost of 3.72% because it will both receive and pay LIBOR every quarter

Characteristics Convert a Floating-Rate Liability to a Fixed Rate Liability The use of the swap enables the bank to reduce risk and lock in a spread of 4.28 percent (8.00 percent − 3.72 percent) on this transaction while effectively fixing the borrowing cost at 3.72 percent for three years

Characteristics Convert a Fixed-Rate Asset to a Floating-Rate Asset Consider a bank that has a customer who demands a fixed-rate loan The bank has a policy of making only floating-rate loans because it is liability sensitive and will lose if interest rates rise Ideally, the bank wants to price the loan based on prime Now assume that the bank makes the same $1 million, three-year fixed-rate loan as in the “Convert a Floating-Rate Liability to a Fixed Rate Liability” example

Characteristics Convert a Fixed-Rate Asset to a Floating-Rate Asset The bank could enter into a swap, agreeing to pay a 3.7% fixed rate and receive prime minus 2.40% with quarterly payments This effectively converts the fixed-rate loan into a variable rate loan that floats with the prime rate

Characteristics Create a Synthetic Hedge Some view basic interest rate swaps as synthetic securities As such, they enter into a swap contract that essentially replicates the net cash flows from a balance sheet transaction Suppose a bank buys a three-year Treasury yielding 2.73%, which it finances by issuing a three-month deposit As an alternative, the bank could enter into a three-month swap agreeing to pay three-month LIBOR and receive a fixed rate

Characteristics Macrohedge Banks can also use interest rate swaps to hedge their aggregate risk exposure measured by earnings and EVE sensitivity A bank that is liability sensitive or has a positive duration gap will take a basic swap position that potentially produces profits when rates increase With a basic swap, this means paying a fixed rate and receiving a floating rate Any profits can be used to offset losses from lost net interest income or declining

Characteristics Macrohedge In terms of GAP analysis, a liability-sensitive bank has more rate-sensitive liabilities than rate-sensitive assets To hedge, the bank needs the equivalent of more RSAs A swap that pays fixed and receives floating is comparable to increasing RSAs relative to RSLs because the receipt reprices with rate changes

Pricing Basic Swaps The floating rate is based on some predetermined money market rate or index The payment frequency is coincidentally set at every six months, three months, or one month, and is generally matched with the money market rate The fixed rate is set at a spread above the comparable maturity fixed rate security

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 managers to alter a bank’s interest rate risk exposure None requires much of an initial cash commitment to take a position

Comparing Financial Futures, FRAs and Basic Swaps Differences Financial futures are standardized contracts based on fixed principal amounts while with FRAs and interest rate swaps, parties negotiate the notional principal amount Financial futures require daily marking-to-market, which is not required with FRAs and swaps Many futures contracts cannot be traded out more than three to four years, while interest rate swaps often extend 10 to 30 years The market for FRAs is not that liquid and most contracts are short term

The Risk with Swaps Counterparty risk is extremely important to swap participants 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 The notional principal amount never changes hands, such that a party will not lose that amount

Interest Rate Caps and Floors
Buying an Interest Rate Cap Interest Rate Cap An agreement between two counterparties that limits the buyer’s interest rate exposure to a maximum rate Buying a cap is the same as purchasing a call option on an interest rate

Buying an Interest Rate Floor Interest Rate Floor An agreement between two counterparties that limits the buyer’s interest rate exposure to a minimum rate Buying a floor is the same as purchasing a put option on an interest rate

Interest Rate Collar and Reverse Collar Interest Rate 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 A collar creates a band within which the buyer’s effective interest rate fluctuates

Interest Rate Collar and Reverse Collar Zero Cost Collar A collar where the buyer pays no net premium The premium paid for the cap equals the premium received for the floor Reverse Collar Buying an interest rate floor and simultaneously selling an interest rate cap Used to protect a bank against falling interest rates

Interest Rate Collar and Reverse Collar The size of the premiums for caps and floors is determined by: The relationship between the strike rate an the current index This indicates how much the index must move before the cap or floor is in-the-money The shape of yield curve and the volatility of interest rates With an upward sloping yield curve, caps will be more expensive than floors

Protecting Against Falling Interest Rates Assume that a bank is asset sensitive The bank holds loans priced at prime plus 1% and funds the loans with a three-year fixed-rate deposit at 3.75% percent Management believes that interest rates will fall over the next three years

Protecting Against Falling Interest Rates It is considering three alternative 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 Buying an interest rate floor Buying a reverse collar Note that, initially, the bank holds assets priced based on prime and deposits priced based on a fixed rate of 3.75%

Protecting Against Falling Interest Rates Strategy: Use a Basic Interest Rate Swap: Pay Floating and Receive Fixed As shown on the next slide, the use of the swap effectively fixes the spread near the current level, except for basis risk

Protecting Against Falling Interest Rates Strategy: Buy a Floor on the Floating Rate As shown on the next slide, the use of the floor protects against loss from falling rates while retaining the benefits from rising rates

Protecting Against Falling Interest Rates Strategy: Buy a Reverse Collar: Sell a Cap and Buy a Floor on the Floating Rate As shown on the next slide, the use of the reverse collar differs from a pure floor by eliminating some of the potential benefits in a rising-rate environment The bank actually receives a net premium up front and while this is attractive up front, if rates increase sufficiently, the bank does not benefit The net result is that the bank’s spread will vary within a band

Protecting Against Rising Interest Rates Assume that a bank is liability sensitive That bank has made three-year fixed-rate term loans at 7% funded with three-month Eurodollar deposits for which it pays the prevailing LIBOR minus 0.25% Management believes is concerned that interest rates will rise over the next three years

Protecting Against Rising Interest Rates It is considering three alternative approaches to reduce risk associated with rising rates: Entering into a basic interest rate swap to pay a fixed rate and receive the three-month LIBOR Buying an interest rate cap Buying a collar

Protecting Against Rising Interest Rates Strategy: Use a Basic Interest Rate Swap: Pay Fixed and Receive Floating As shown on the next slide, the use of the swap effectively fixes the spread near the current level, except for basis risk

Protecting Against Rising Interest Rates Strategy: Buy a Cap on the Floating Rate As shown on the next slide, the use of the cap protects against loss from rising rates while retaining the benefits from falling rates

Protecting Against Rising Interest Rates Strategy: Buy a Collar: Buy a Cap and Sell a Floor on the Floating Rate As shown on the next slide, the use of the collar differs from a pure cap by eliminating some of the potential benefits in a falling-rate environment The net result is that the collar effectively creates a band within which the bank’s margin will fluctuate

Chapter 9 Using Derivatives to Manage Interest Rate Risk

Using Derivatives to Manage Interest Rate Risk

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