1. Copyright 2013 by Diane S. Docking1 Risk Management: Hedging with Futures

2. Hedging with Financial Futures contracts Copyright 2013 by Diane S. Docking2

3. 3 Purpose of Trading Financial Futures To Speculate_ –Take a position with the goal of profiting from expected changes in the contracts price –No position in underlying asset (naked position) –Used by risk seekers To Hedge_ –Minimize or manage risks –Have position (or soon will have a position) in spot market with the goal to offset risk –Used by the risk averse

4. Copyright 2013 by Diane S. Docking4 Long vs. Short Hedges Long Hedge (Anticipatory Hedge) Involves purchasing futures contracts now as a temporary substitute for the purchase of the cash market commodity at a later date Purpose is to lock in a buying price Short Hedge Initiate with a sale of a futures contract as a temporary substitute for a later cash market sale of the underlying asset. Purpose is to lock in a selling price

5. Copyright 2013 by Diane S. Docking5 Long Hedge Lock in buying price Lock in inventory purchase prices Lay off (transfer) price risk Avoid lower than expected yields from loans and securities investments To protect against changing FX rates Why Hedge? Short Hedge: Lock in selling price Protect inventory value Avoid higher borrowing costs Avoid declining investment portfolio values To protect against changing FX rates

6. Copyright 2013 by Diane S. Docking6 Micro vs. Macro Hedge Micro Hedge A hedge strategy designed to reduce risk of a transaction associated with a specific asset, liability, or commitment or a portfolio of similar assets Macro Hedge A hedge strategy designed to reduce risk associated with a banks entire balance sheet position or portfolio of dissimilar assets.

7. Copyright 2013 by Diane S. Docking7 Steps in Executing a Hedge Step 1: Identify cash market risk/exposure Step 2: Determine long or short hedge Step 3: Decide on futures contract to use Step 4: Determine number of contracts Step 5: Execute hedge Step 6: Unwind hedge before expiration of futures and compute net gain or loss on hedge

8. Copyright 2013 by Diane S. Docking 8 Determining number of contracts for a Microhedge Where: D c = Duration in cash market P c = Price in cash market D f = Duration of futures contract P f = Price of futures contract br = change in futures prices/change in spot prices

9. 9 Example: Micro-Hedging Bonds with T-bond Futures Julie wants to protect the value of $100,000,000 of bonds over the near term. How best does she do this? She knows the following: –The duration of these bonds is 8 years. –The duration of the underlying T-bond futures is 6.5 years –br = 1.111 –The T-bond futures contract with 6-months to expiration is as follows: Treasury Notes (CBT) - $100,000; pts. 32nds of 100% OpenHighLowSettleChg. 6-months 114215115020109225110000 -0165 Copyright 2013 by Diane S. Docking

10. 10 Solution to Example: Micro-Hedging Bonds with T-bond Futures Julie needs to ____________ the futures contracts. How many futures contracts does she need to sell? Copyright 2013 by Diane S. Docking Always round DOWN

11. 11 Example: Micro-Hedging Bonds with T-bond Futures (cont.) Julie decides to sell 1,007 near-term futures contracts. Over the next month, interest rates increase 1%. The T-bond futures price falls to 10227. (There are five months left in the futures contract) How did this short hedge perform? That is, how much protection did selling futures contracts provide to her bonds? Copyright 2013 by Diane S. Docking

12. 12 Solution to Example: Micro-Hedging Bonds with T-bond Futures (cont.) PortfolioFutures market (Cash Mkt) Price Quote t0:t0: Current bonds value$100,000,000 Sell futures contracts at F 0 110.00 t 1-month : Current bonds value $100 mill. +[-8 x (+.01) x $100 mill.]$ 92,000,000 Unwind hedge: Buy futures contracts at F 1 (102 27/32) Loss in portfolio value Gain in futures market 7.15625 Copyright 2013 by Diane S. Docking

13. 13 Solution to Example: Micro-Hedging Bonds with T-bond Futures (cont.) Total Loss in bonds: = Total Gain in Futures market: 7.15625 x $1,000 x 1,007Ks = $7,206,343.75 Net gain/ on hedge Value of bonds at t 1-month, including hedge effects: $92,000,000 + $7,206,344= $99,206,344 Or $100,000,000 - $793,656 = $99,206,344 Copyright 2013 by Diane S. Docking

14. 14 Determining number of contracts for a Macrohedge where N f = number of futures contracts DGAP K = Duration Gap of bank capital or portfolio duration*. TA= total assets of bank or portfolio D f = duration of futures contract P f = current price of futures contract br = change in futures prices/change in spot prices

15. Copyright 2013 by Diane S. Docking15 Example: Immunize Financial Institution Balance Sheet (Remember from DGAP Management) Given the average duration items from First National Banks Balance Sheet (see next slide), we calculated the Duration Gap of capital and saw what happens if interest rates decrease from 6% to 4.5%. (See next slides)

16. Example: Immunize Financial Institution Balance Sheet (cont.) 16 Copyright 2013 by Diane S. Docking

17. 17 Example: Immunize Financial Institution Balance Sheet (cont.) $ in K if rates decrease: TE_ current $5,000,000 K TE_ new $3,529,717 Regulatory capital requirements could be in trouble and bank in danger of being declared insolvent!

18. Copyright 2013 by Diane S. Docking18 Example: Immunize Financial Institution Balance Sheet (cont.) You want to protect the capital of the bank over the next 3 months. How best can you do this using T-bond futures contracts expiring in 6 months, with a duration on 6.5 years? Treasury Notes (CBT) - $100,000; pts. 32nds of 100% OpenHighLowSettleChg. 6-months 114215115020109225110000 -0165

19. Copyright 2013 by Diane S. Docking 19 Solution to Example: Immunize Financial Institution Balance Sheet 1.How can the Bank hedge this risk? –If interest rates decrease, prices increase; therefore a futures contract. 2.How many futures contracts does the bank need to buy?

20. 20 Example: Immunize Financial Institution Balance Sheet (cont.) Assume that over the next three months, interest rates decrease 1.60% to 4.4%. The T-bond futures price rises to 12024. (There are three months left in the futures contract) How did this long hedge perform? Copyright 2013 by Diane S. Docking

21. 21 Solution to Example: Immunize Financial Institution Balance Sheet (cont.) 3.How did this long hedge perform? Capital Futures market (Cash Mkt) Price Quote t0:t0: Current capital balance $5,000,000 Buy futures contracts at F 0 t 3-month : Current capital balance $5 mill. – 1,568,302** = $3,431,698 Unwind hedge: Sell futures contracts at F 1 120.75 **Change in Capital if rates decrease 1.6%: - (-1.039) x (-.016/1.06) x $100 mill. = Gain in futures market 10.75 Copyright 2013 by Diane S. Docking

22. 22 Solution to Example: Immunize Financial Institution Balance Sheet (cont.) 3.How did this long hedge perform? (cont.) Total Loss in capital = Total Gain in Futures market: 10.75 x $1,000 = $10,750/K $10,750/K x 145Ks = $1,558,750 Net gain/ on hedge 4.Capital value with macro hedge = $5 mill – 9,552 = $4,990,448 Copyright 2013 by Diane S. Docking

23. 23 Complications in using financial futures Accounting and regulatory guidelines. Macrohedge of the banks entire portfolio -- cannot defer gains and losses on futures, so earnings are less stable with this hedge strategy. Microhedge linked to a specific asset -- can defer gains and losses on futures until contracts mature. Basis risk is the difference between the cash and futures prices. These two prices are not normally perfectly correlated (e.g., corporate bond rates in a cash position versus T-bill futures rates). Bank gaps are dynamic and change over time. Futures options allow the execution of the futures position only to hedge losses in the cash position. Gains in the cash position are not offset by losses in the futures position.

24. Copyright 2013 by Diane S. Docking24 Basis Risk Basis in a futures contract is (in prices): Basis t = Spot t - Futures t Basis in a futures contract is (in interest rates): Basis t = Futures t - Spot t