1. Copyright 2014 by Diane S. Docking1 Risk Management: Hedging with Futures

2. Learning Objectives Know how risk can be hedged with forward and futures contracts Distinguish a microhedge from a macrohedge Be able to construct a micro- and macro- hedge Copyright 2014 by Diane S. Docking2

3. Hedging with Financial Futures contracts Copyright 2014 by Diane S. Docking3

4. 4 Purpose of Trading Financial Futures To Speculate_ –Take a position with the goal of profiting from expected changes in the contract’s 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

5. Copyright 2014 by Diane S. Docking5 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 __________ 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 __________ price

6. Copyright 2014 by Diane S. Docking6 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

7. Copyright 2014 by Diane S. Docking7 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 bank’s entire balance sheet position or portfolio of dissimilar assets.

8. Copyright 2014 by Diane S. Docking8 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

9. Copyright 2014 by Diane S. Docking 9 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

10. 10 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 114’215115’020109’225110’000 -0’165 Copyright 2014 by Diane S. Docking

11. 11 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 2014 by Diane S. Docking Always round DOWN

12. 12 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 102’27. (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 2014 by Diane S. Docking

13. 13 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 2014 by Diane S. Docking

14. 14 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 2014 by Diane S. Docking

15. 15 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

16. Example: Change in basis hedge – Eurodollar portfolio Union State Bank expects to receive a $100 million loan repayment in a few weeks. The Bank plans on investing the proceeds in 90-day Eurodollar deposits currently offering 1.42%. The bank is forecasting that ED rates will decrease in the next few weeks. How can the bank protect itself against a decrease in revenues using Eurodollar futures contracts? ED futures contracts expiring in 3 months are currently priced at 98.800. Assume br = 1. Copyright 2014 by Diane S. Docking16

17. 17 Solution to Example: Change in basis hedge – Eurodollar portfolio The bank needs to ____________ the futures contracts. How many futures contracts does the bank need to buy? Where:D c = (ED = 3 months = 3/12 = 0.25 yrs.) D f = duration of underlying security (3-mo. ED) =3/12 = 0.25 yrs. P f = Settle = 98.800 Discount = 100 – 98.80 = 1.20% = 120 bp x $25 tick = $3,000 1 mill. – 3,000 = $997,000 Copyright 2014 by Diane S. Docking go long

18. Example: Change in basis hedge – Eurodollar portfolio Union State Bank receives the $100 million loan repayment in a few weeks. At this time rates on 90-day Eurodollar deposits have dropped to 1.22%. The ED futures contracts expiring in 3 months are now priced at 98.95. How did this hedge perform? Copyright 2014 by Diane S. Docking18

19. Solution to Example: Change in basis hedge – ED portfolio (cont.) Cash Market Futures market Basis($/K) t0:t0: Opportunity lost on EDs at S 0 1.42% 98.58 Buy futures contracts at F 0 1.20% 98.80 98.58 – 98.80 = -0.22% -22 bp x $25 tick = -$550 / K t 1-month : Invest $100 million at ED spot of S 1 1.22% 98.78 Unwind hedge: Sell futures contracts at F 1 1.05% 98.95 98.78 – 98.95 = -0.17% -17 bp x $25 tick = -$425 / K +0.05% Opportunity Loss in cash market Gain in futures market 0.15% Change in basis+$125/K Copyright 2014 by Diane S. Docking19

20. Solution to Example: Change in basis hedge – ED portfolio (cont.) How did this hedge perform? (cont.) Total Loss in cash market (lost interest revenue on EDs): $100 mill. x 0.0020 x 90/360 = Total Gain in Futures market: 0.15% = 15 bp x $25 tick x 100 Ks = $37,500 Net loss on hedge * *Note: Change in basis = +$125/K x 100 Ks = $12,500. Were long a contract and basis narrowed; therefore, this results in a net loss on the hedge. Copyright 2014 by Diane S. Docking20

21. Solution to Example: Change in basis hedge – ED portfolio (cont.) What is the Bank’s effective interest revenue on this ED investment? Actual ED revenue = 100 mill. x.0122 x 0.25 = $305,000 Gain on futures = 15 bp x $25 tick x 100 Ks = 37,500 Net 3-month interest revenue on ED =$342,500 Annualized rate: (342,500/100 mill.) x (360/90) = 1.37% OR What is the Bank’s effective interest revenue? Original ED rate= 1.42% - change in basis= - 0.05% Spread= 1.37% Had Bank not hedged? Interest revenue= 1.22% Copyright 2014 by Diane S. Docking21

22. Copyright 2014 by Diane S. Docking22 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

23. Copyright 2014 by Diane S. Docking23 Example: Immunize Financial Institution Balance Sheet (Remember from DGAP Management) Given the average duration items from First National Bank’s 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)

24. Example: Immunize Financial Institution Balance Sheet (cont.) 24 Copyright 2014 by Diane S. Docking

25. 25 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!

26. Copyright 2014 by Diane S. Docking26 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 114’215115’020109’225110’000 -0’165

27. Copyright 2014 by Diane S. Docking 27 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?

28. 28 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 120’24. (There are three months left in the futures contract) How did this long hedge perform? Copyright 2014 by Diane S. Docking

29. 29 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 2014 by Diane S. Docking

30. 30 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 2014 by Diane S. Docking

31. 31 Complications in using financial futures Accounting and regulatory guidelines. Macrohedge of the bank’s 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.