1. Chapter Six Risk Management: Financial Futures,
Options, Swaps, and Other Hedging Tools

2. VOCABULARY REVIEW
From Chapter 5 – Risk Management Asset Management Liability Management Funds Management Risks: Default or credit risk Price risk Liquidity risk Call risk Inflation risk Maturity risk Interest rate risk Reputation risk

3. VOCABULARY REVIEW
From Chapter 5 – Risk Management Yield to Maturity Net Interest margin Spread or gap From Chapter 10 – Pricing Services Transaction deposit accounts Non-transaction deposit accounts Core deposits

4. VOCABULARY REVIEW
From Chapter 10 – Pricing Services Cost plus pricing Conditional pricing Relationship pricing Truth in Savings Act Lifeline Banking

5. Financial Futures Contracts Options
Key Topics
The Use of Derivatives
Financial Futures Contracts
Options
Puts
Calls
Interest-Rate Swaps
Regulations and Accounting Rules
Gail and Healthy Hen Farms Example

6. Key Vocabulary in Today’s Lesson
Premium or Fee
Off-balance sheet items
Hedging
Derivatives
Futures
Swaps
Options
Puts
Calls

7. Introduction p
The asset-liability management tools in this chapter are used by banks sensitive to the risk of changes in market interest rates
Many of the risk management tools in this chapter are used by banks to cover interest rate risk, but are also sold to customers who need risk protection and generate fee income for the banks

8. Introduction p
Most of the financial instruments in this chapter are derivatives
WHAT IS A DERIVATIVE?
A security that derives (gets) its value from an underlying asset such as stocks, bonds, commodities like wheat, gold, oil or even a house.
It is a contract between 2 parties
Derivatives can be:
Futures
Options
Swaps

9. Uses of Derivative Contracts Among FDIC-Insured Banks p. 168
Derivatives help banks manage risk.
Derivatives are risk-hedging assets that help a bank protect its balance sheet in case interest rates change.
Hedging: A means of protection or defense, especially against financial loss. For example, protection against inflation (rising prices)

10. Uses of Derivative Contracts Among FDIC-Insured Banks p. 168
The very largest banks do the most trading in derivatives.
Interest-rate risk is by far the most common reason for using derivatives.
The leading type of risk-hedging contracts are swaps, followed by financial futures and options

11. EXHIBIT 8-1 Types of Derivative Contracts p. 169

12. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price p. 169
In Chapter 5, we explored the nature of gaps between assets and liabilities that are exposed to interest rate risk

13. Derivatives are considered off-balance sheet items
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) p. 169
A futures contract is an agreement reached today between a buyer and a seller that calls for delivery of a security in exchange for cash at some future date
Derivatives are considered off-balance sheet items
Sellers of financial assets remove the assets from their balance sheet and account for the losses or gains on their income statements

14. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) p. 170
When the contract is made, 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 set price, it must deposit an initial amount (margin) of money
The initial margin is the investor’s equity in the position when he or she buys (or sells) the contract

15. Buyers of futures contracts
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) p
Buyers of futures contracts
A buyer of a futures contract is said to be long futures. Buyer = Long
Agrees to pay the asset’s futures price or take delivery of the asset
Buyers gain when futures prices rise and lose when futures prices fall

16. Sellers of futures contracts
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (cont) p
Sellers of futures contracts
A seller of a futures contract is said to be short futures seller = short
Agrees to receive the asset’s futures price or to deliver the asset
Sellers gain when futures prices fall and lose when futures prices rise

17. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (cont) p. 170
The financial futures markets shift the risk of interest-rate changes from investors who want to minimize risk, such as banks and insurance companies, to speculators/investors who are willing to accept and maybe profit from such risks.

18. OPTIONS grant the holder of securities the right to:
OPTIONS P
OPTIONS grant the holder of securities the right to:
Place (put) or sell those securities with another investor (buyer) at an agreed upon price before the option expires or
Take delivery of securities (call) or buy from another investor at a an agreed upon price before the option’s expiration date

19. OPTIONS P
Put option - An option contract giving the owner the right, but not the obligation, to sell a certain amount of an underlying security at a certain price within a certain time. Jim & Dan both want to buy put options. Jim owns 1000 shares of Alibaba. The current price is $25/share. Jim will retire in 1 year and want to make sure he can get that price.

20. OPTIONS P
Jim finds an investor who will sign a contract to pay Jim $25 per share in 1 year. Jim pays him a fee. $ If the shares in 1 year’s time go below $25 Jim is protected. He gets his $25 per share. If the price goes above $25 Jim does not have to use or exercise his option. He only loses the fee.

21. OPTIONS P
Now, let’s look at a Put option for Dan: Dan doesn’t own Alibaba stock but he pays a fee to an Investor to buy 1000 shares at $25 per share in 1 month from now $ If the price goes below 25 to say $15 He can buy the 1000 shares at $15,000 and sell them at $25,000, a profit of $10,000 minus the option fee or premium. If the price goes above $25 per share he doesn’t have to use his option, and just loses the fee.

22. OPTIONS P
Call option, An agreement that gives an investor the right (but you don’t have to) to buy a stock, bond, commodity, or other asset at a certain price within a certain time period. It may help you to think that a call option gives you the right to “call in” or exercise (buy) an asset. This allows an investor to take a risk and buy a stock he doesn’t own

23. OPTIONS P
Let’s look at an example: Ken thinks Alibaba stock will rise in price. He doesn’t own any shares but wants to buy some. Ken talks to Bob who has 100 shares of Alibaba at $20 per share but Bob thinks it could fall to $15 per share. Bob agrees to sell (sign a contract) his 100 shares at $22 in 1 month. Ken pays Bob a fee, called a premium - $22-20 =2 x 100 = $200

24. $22-------------------------------------
OPTIONS P $
If the price goes up to $30 Ken buys 10 shares $22 from Bob and sells them at $30
$ $2200 = $800 gross profit
$800 - $200 premium = $600 net profit.
If the price is below, Ken does not have to buy (exercise the option) the shares but loses his $200 premium. But now he can buy shares at a lower cost.

25. Interest-Rate Options (continued)
Banks use options today to minimize risks. Options are used mostly by money center (large) banks
They appear to be directed at two principal uses
Protecting a security portfolio through the use of put options to protect against falling security prices (rising interest rates)

26. Interest-Rate Options (continued)
Hedging (protection) 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

27. Regulations for Bank Futures and Options Trading p. 186-187
Regulators expect banks to have a good risk-management system. They set limits based on the following risks:
Some of these risks are:
Reputation risk
Price risk
Interest rate risk
Liquidity risk
Credit risk

28. Interest-Rate Swaps p. 188-192
An interest-rate swap is an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a certain amount.
Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR) – London Interbank offered rate.
This allows a bank to minimize interest- rate risk and have lower borrowing costs.

29. Interest-Rate Swaps (continued) p. 188-189
The principal amount of the loans is not exchanged
Only the net amount of interest due 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 – an off balance sheet activity.
Actual defaults are limited
Interest rate risk can be a problem if one of the parties does not make the payments.

30. CHAPTER 6 SUMMARY
This chapter focused on derivatives - financial futures contracts such as, options and swaps that help banks deal with losses due to changing market interest rates.
Financial futures contracts are agreements to deliver bonds, treasury bills at a certain prices on a future date. These derivatives are more common because of their low cost.

31. CHAPTER 6 SUMMARY
Option contracts give owners the right to deliver (put) or take delivery of (call) of a stock at a certain price on or before a future date. Options provide risk protection should interest rates change.
Interest-rate swaps are agreements between 2 people or parties to exchange interest payments so that each party or person or bank can better match cash inflows & outflows.
Derivatives are used more by large banks and insurance companies.

32. Derivatives – Definition and Example
The Definition in Review: Derivatives are financial products with value that come from an asset or set of assets. These can be stocks, bonds or almost anything. A derivative's value is based on an asset, but ownership of a derivative doesn't mean ownership of the asset. We will look at some examples.

33. Derivatives – Definition and Example
The Barnyard Basics Of Derivatives – The Future of Healthy Hen Farms and it’s owner Gail. A Futures Contract P. 170
Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market, with all the reports of bird flu coming. Gail wants a way to protect her business from bad news. Gail meets with an investor who enters into a futures contract with her.

34. Derivatives Example – Gail & Happy Hen Farms
Investor Joe agrees to pay $30 per bird in six months' time, no matter what the price. They sign a contract.
Gail pays Joe a fee for this service.
If, at that time, the price is above $30, Joe will benefit as he will be able to buy the birds for less than market cost and sell them on the market at a higher price for a gain.
If the price goes below $30, then Gail will benefit because she will be able to sell her birds for more than the current market price, or more than what she would get for the birds in the open market.
Healthy Hen Farms
Owner Gail
Investor Joe

35. Example – Healthy Hen Farms
By entering into a futures contract, Gail is protected from price changes in the market, as she has locked in a price of $30 per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but she will be protected if the price falls to $10 on news of a bird flu outbreak. By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations.

36. Example – Healthy Hen Farms
Now we will learn about an INTEREST RATE SWAP
Gail has decided that it's time to take Healthy Hen Farms to the next level. She has already acquired all the smaller farms near her and is looking at opening her own processing plant. She tries to get more financing, but the lender, Lenny, rejects her.

37. Interest Rate Swap – Introducing Lenny p. 188
The reason Lenny rejects Gail is that to
take over other farms she financed her
takeovers with a large variable-rate loan,
and Larry the lender is worried that, if interest
rates rise, Gail won't be able to pay her debts. Lenny tells Gail that he will only
lend to her if she can convert the loan to a fixed-rate. Unfortunately, her other
lenders refuse to change her current loan terms because they are hoping
interest rates will increase too. ENTER SAM
Sam has a fixed-rate loan about
the same size as Gail’s and he wants
to change it to a variable-rate loan
because he hopes interest rates will go down in the future.
Gail and a larger Healthy Hen Farm Business
Lenny the Lender
SAM THE RESTAURANT OWNER
GAIL & HEALTHY H EN FARMS

38. GAIL AND SAM SWAP LOANS
Gail and Sam decide to swap loans. They work out a deal in which Gail's payments go toward Sam's loan and his payments go toward Gail's loan. Although the names on the loans haven't changed, their contract allows them both to get the type of loan they want.
Each person still pays their same loan amount and must still pay off their debt. And they pay a fee to a bank or financial provider to do the swap. What they are swapping is the interest rate only.

39. GAIL AND SAM SWAP LOANS
On each payment due date Gail and Sam exchange only the Net difference between the interest payments each owes the other person.
This is a bit risky for both of them because if one of them defaults or goes bankrupt, it may require a payment for which either Gail or Sam may be unprepared. However, it allows them to change their loans to meet their individual needs.

40. BUYING DEBT – DERIVATIVES AND HOW IT WORKS
With Gail now having a fixed rate loan, Lenny the Lender is now willing to make a larger loan to Gail so she can expand or grow her Healthy Hen Farms business. Lenny
is also happy to be getting a return on his money.
ENTER Dale is Lenny’s friend and he asks Dale for a loan
because he wants to start a film company.
LENNY THE LENDER
DALE THE MOVIE MAKER

41. BUYING DEBT – DERIVATIVES AND HOW IT WORKS
Lenny knows Dale has a lot of collateral and that the loan would be at a higher interest rate because of the more volatile nature of the movie industry, so he's kicking himself for loaning all of his money to Gail. Lenny turns Gail's loan into a credit derivative and sells it to a speculator at a discount to the true value. Although Lenny doesn't see the full return on the loan, he gets his money back and can now loan it out again to his friend Dale.
LENNY THE LENDER
DALE THE MOVIE MAKER

42. Derivatives and the Fee Benefit
Lenny, likes this system so much that he continues to spin out (make) his loans as credit derivatives, taking modest returns in exchange for less risk of default and more liquidity.

43. Derivatives and the Fee Benefit
How this works: Lenny sells his fixed rate loan he made to Gail at a much lower interest rate than he could make to his friend Dale. Because, Dale’s loan is more risky the interest rate is much higher and since Dale has good collateral Lenny knows he can collect if Dale defaults (cannot make his payment) on his loan. Lenny also makes a fee for selling Gail’s fixed rate loan.

44. OPTIONS
Years later, Healthy Hen Farms Corporation and CEO Gail, is a publicly traded corporation (HEN) and is
America’s largest poultry
(chicken) producer.
Gail and Sam, remember him? They both are looking forward to a good retirement.
Sam bought quite a few shares of HEN. In fact, he has more than $100,000 invested in the company.
HEN

45. OPTIONS
Sam is getting nervous because he is worried that another shock, perhaps another case of bird flu, might decrease his retirement money. Sam starts looking for someone to take on his risk. Lenny, who now makes lots of money on these deals agrees to help him out.
HEN

46. OPTIONS – CALLS AND PUTS P. 180 - 186
Lenny makes a deal in which Sam pays Lenny a fee to for the right (but not the obligation) to sell Lenny the HEN shares in a year's time at their current price of $25 per share. If the share prices go down in price, Lenny protects Sam from the loss of his retirement savings. Lenny is OK because he has been collecting the fees and can handle the risk. This is called a put option, but it can be done in reverse by someone agreeing to buy a stock in the future at a fixed price (called a call option).

47. OPTIONS – CALLS AND PUTS P. 180 - 186
The Bottom Line Healthy Hen Farms remains stable until Sam and Gail have both pulled their money out for retirement. Lenny profits from the fees and his booming trade as a financier.
Thus ends the story of Gail, Sam and Lenny and I hope you have learned how derivatives, swaps, futures and options work.

48. CONCLUSION OF THE TALE OF GAIL AND HEALTHY HEN FARMS
In this tale, you can see how derivatives can move risk (and the accompanying rewards) from the risk averse (avoiders) to the risk seekers. Although Warren Buffett once called derivatives, "financial weapons of mass destruction," derivatives can be very useful tools, provided they are used properly.
Like all other financial instruments, derivatives can be risky, but they also hold potential to help the function of the financial system.