2 Characteristics of financial futures Financial futures contracts …a commitment between two parties on the price and quantity of a standardized financial asset or index.They are traded on organized exchanges called future markets.Buyers of futures contracts, referred to as long futures, agree to pay the underlying futures price or receive the underlying asset.Sellers of futures contracts, referred to as short futures agree to receive the futures price or deliver the underlying asset.
3 Types of futures traders Futures traders have many different motivations and thus follow different strategies.Traders operating on the floor of an exchange are classified as either commission brokers, who execute trades for other parties, or locals, who trade for their own account.As the name suggests, commission brokers generate income by charging commissions for each trade and thus take no price risk.Locals are individuals who try to profit by buying contracts at prices less than what they sell the contracts for.As such, locals assume considerable price risk in their transactions but add liquidity to the markets.
4 Traders are further classified by the strategies they pursue At one extreme is the speculator who takes a position with the objective of making a profit …Speculators try to guess the direction that prices will move and time their trades to sell at higher prices than the purchase price.Locals are thus speculators.At the other extreme is the hedger …A hedger has an existing or anticipated position in the cash market and trades futures contracts (or some other contract) to reduce the risk associated with uncertain changes in value of the cash position.The cash position might involve owning or buying an asset, borrowing by issuing an interest-bearing liability, or a bank’s overall earnings and MVE sensitivity profile.
5 Speculators are often distinguished by the time they hold their positions. A scalper tries to time price movements over very short time intervals and takes positions that remain outstanding for just minutes.A day trader similarly tries to profit from short-term price movements during trading hours in any day, but offsets the initial position before market closing so that no position remains outstanding overnight.Finally, a position trader is a speculator who holds a position for a longer period in anticipation of a more significant, longer-term market move.
6 With hedging, the trader takes a position in the futures market whose value varies in the opposite direction as the value of the cash market position.Risk is reduced because gains or losses on the futures position at least partially offset gains or losses on the cash position.The essential difference between a speculator and hedger is the objective of the trader.A speculator wants to profit on trades while a hedger wants to reduce risk.
7 Traders may also be classified as spreaders or arbitrageurs. Both spreaders and arbitrageurs are speculators who take relatively low risk positions.A futures spreader may simultaneously buy a futures contract and sell a related futures contract trying to profit on anticipated movements in the price differenceThe position is generally low risk because the prices of both contracts typically move in the sameAn arbitrageur tries to profit by identifying the same asset that is being traded at two different prices in different markets at the same time.The arbitrageur buys the asset at the lower price and simultaneously sells it at the higher priceArbitrage 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.
8 Cash and forward markets. Cash or spot market transactions …the exchange of any asset between two parties who agree on the asset characteristics and price, where the buyer tenders payment and takes possession of the asset when the price is setA forward contract …involves two parties agreeing on asset characteristics, quantity, and price but deferring the actual exchange until a specified future date
9 Futures versus forward contracts Futures contracts differ from forward contracts because futures contracts:are traded on formal exchanges,the most prominent in the United States are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME)involve standardized instruments, andpositions require a daily marking to market.Forward contracts are:negotiated between parties,do not necessarily involve standardized assets, andrequire no cash exchange until expiration.
10 The mechanics of futures trading Each party to a futures transaction effectively trades with exchange members who, in turn, guarantee the performance of all participants.A buyer of a futures contract, with delivery in 60 days, can offset the position by selling the same contract one week later when 53 days remain to delivery.
11 Futures positions and margin requirements Exchange members require traders to meet margin requirements that specify the minimum deposit allowable at the end of each day.The change in value of each trader’s account at the end of every day:is credited to the margin accounts of those with gains anddebited the margin accounts of those with lossesmarking-to-market and the daily change in value variation margin.
12 Expiration and delivery Every futures contract has a formal expiration date.At expiration, trading stops and participants settle their final positions.
13 Example: 90-Day Eurodollar Time Deposit Futures Eurodollar futures contracts are traded on the International Monetary Market (IMM).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.Forty separate contracts are traded at any point in time, as contracts expire in March, June, September and December.
14 Example (continued): 90-Day Eurodollar Time Deposit Futures Eurodollar futures contracts trade according to an index that equals: 100% - the futures interest rate expressed in percentage terms.An index of indicates a futures rate of 8.5 percent.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).
15 Eurodollar Futures 100 - settlement price = futures rate PercentTreasury Bills (CME)-$1 mil.; pts of 100%June97.8197.84Est vol 20; vol Mon 3; open int 283,13.+.032.162283LIBOR-1 Mo. (CME)-$3,000,000; pts of 100%AprMayJulyNovDec98.0997.9697.7397.5296.5796.2697.9997.7897.5996.6796.2898.0897.9597.7297.9896.29Est vol 2,678; vol Mon 2,033; open int 40,267,582.Est vol 607,572; vol Mon 457,488; open int 4,417,394,31,950.......01.05.08.131.912.022.222.413.333.7115,41311.4006,4425,40710035Eurodollar (CME)-$1 Million; pts of 100%AugSeptMr03Mr04Mr05Mr06Mr07Dc08Dc0997.8997.6897.4696.9796.7396.0895.4895.0194.6694.4094.2494.0793.9393.7693.7093.5993.4993.3593.3393.2793.2393.0893.1192.8792.7392.6997.9297.5397.0496.8496.2295.6495.1494.7994.5594.3994.2394.0893.8993.8293.7193.6293.4793.4093.2193.0192.8692.7497.8897.4596.7296.0795.4794.9894.6394.0693.9193.7493.6893.5793.4893.2593.1993.0792.7292.6296.8396.2195.6394.5494.3894.2193.8393.7393.6393.5093.3493.2293.0292.75.04.06.10.14.12.11.092.082.272.482.963.173.794.374.865.215.465.625.795.9188.8.131.526.376.506.526.606.666.786.987.147.2561,75028,573761,291751658,902771,418415,167316,425230,760184,073130,198119,015112,29889,48083,50156,61674,95644,05448,56237,80145,22330,97319,26710,9864,1442,219OPENHIGHLOWSETTLECHANGEYIELDINT.Eurodollar FuturesThe first column indicates the settlement month and year.Each row lists price and yield data for a distinct futures contract that expires sequentially every three months.The next four columns report the opening price, high and low price, and closing settlement price.The next column, headed Chg, the change in settlement price from the previous day.The two columns under Yield convert the settlement price to a Eurodollar futures rate as:100 - settlement price = futures rate
17 The basisThe term basis refers to the cash price of an asset minus the corresponding futures price for the same asset at a point in time.For Eurodollar futures, the basis can be calculated as the futures rate minus the cash rate.It may be positive or negative, depending on whether futures rates are above or below cash rates.
18 The relationship between futures rates and cash rates -- one possible pattern December2002FuturesRate)tnecrePCashRate(etaRBasisFuturesRate-CashRateApril 2, August 23, Expiration December 17, 2002
19 Speculation versus hedging Futures traders who take speculative positions purposefully increase their overall risk position with the hope of earning extraordinary profits.Futures traders who hedge take a position to reduce overall risk by:positioning the futures contract to increase in value when the cash position decreases in value, and vice versaWith financial futures, risk cannot be eliminated, only reduced.Traders normally assume basis risk in that the basis (futures rate minus the cash rate) might change adversely between the time the hedge is initiated and closed.
20 Profit Diagrams for the September 1998 Eurodollar Futures Contract
21 Seven basic steps in implementing hedges for commercial banks: Identify the cash market risk exposure to reduceBased on the cash market risk, determine whether a long or short futures position is neededSelect the best futures contractDetermine the appropriate number of futures contracts to trade. (Hedge Ratio)Buying or selling the appropriate futures contractsDetermine when to get out of the hedge position, either by reversing the trades in Step 5, letting contracts expire, or making or taking deliveryVerify that futures trading meets regulatory requirements and the banks internal risk policies
22 A long hedgeA long hedge is appropriate for a participant who wants to reduce cash market risk associated with a decline in interest rates.If cash 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.
23 Key steps in hedging to a bank that implements a Eurodollar futures hedge. Consider the following time line.On April 2, 2002, your bank expects to receive a $1 million payment on November 8, 2002, and anticipates investing the funds in 3-month Eurodollar time deposits.If the bank had the funds in hand in April, it would immediately buy Eurodollar deposits.The cash market risk exposure is that the bank will not have access to the funds for seven months.In April 2002, the market expected Eurodollar rates to increase sharply as evidenced by rising futures rates.In order to hedge, the bank should buy futures contracts, a long futures positionThe best futures contract will generally be the December 2002, 3-month Eurodollar futures contract, which is the first to expire after November 2002.The contract that expires immediately after the known cash transactions date is generally best because its futures price will show the highest correlation with the cash price.
25 A short hedgeA short hedge applies to any participant who wants to reduce the risk of an increase in cash market interest rates (or a reduction in cash market prices).The appropriate strategy is to sell futures contracts on securities similar to those evidencing the cash market risk.If cash rates increase, futures rates will generally increase, so the loss in the cash position will be at least partially offset by a gain in futures value.
27 Change in the basisLong and short hedges work well if the futures rate moves coincidentally with the cash rate.The actual risk assumed by a trader in both hedges is not that the level of interest rates moves against the cash position, but that the basis might change adversely between the time the hedge is initiated and closed.The effective return from a hedge equals total income from the combined cash and futures positions relative to the investment amount:Effective return = Initial cash rate - Change in basis
28 Basis risk and cross hedging In a perfect hedge, the profit or loss in the cash position is exactly offset by the profit or loss from the futures position.This would occur if the basis change always equaled zero.A cross hedge is one in which a participant uses a futures contract based on one security that differs from the security being hedged in the cash market.
29 Microhedging applications Microhedges refers to the hedging of a transaction associated with a specific asset, liability, or commitment.Macrohedges involve taking futures positions to reduce aggregate portfolio interest rate risk, typically measured by GAP or duration gap.Banks are generally restricted to using financial futures for hedging purposes.They must recognize futures on a micro basis by linking each futures transaction with a specific cash instrument or commitment in a contemporaneous log of hedge transactions.
30 Microhedging versus macrohedging. Many analysts feel that such micro linkages force microhedges that may potentially increase a firms total risk because these hedges ignore all other portfolio components.Accounting requirements may focus attention on inappropriate risk measures.
31 Creating a synthetic liability with a short hedge 4/2/027/3/029/30/026 month deposit = 2.60%synthetic 6 month deposit5.70%2.88%-0.06%All in cost =2.43%2.82%Profit =3-month synthetic Eurodollar3-month cash Eurodollar
32 Creating a synthetic 6-month eurodollar liability
33 The mechanics of applying a microhedge Determine the banks interest rate risk positionForecast the dollar flows expected in cash market transactionsChoose the appropriate futures contractDetermine the correct number of futures contractsNF = number of futures contractsA = dollar value of cash flow to be hedgedF = face value of futures contractMc = maturity or duration of anticipated cash asset or liab.Mf = maturity or duration of futures contractDetermine the appropriate time frame for the hedgeMonitor hedge performance
34 Macrohedging applications When establishing a macrohedge, examine aggregate interest rate risk position.The dollar magnitude of rate-sensitive assets minus the dollar magnitude of rate-sensitive liabilities equals the funding GAP.If the funding GAP is positive, net interest income rises when interest rates rise and falls when interest rates fall.With a positive GAP, a bank will institute a long hedge.Banks alternatively offset a negative GAP via a short hedge, which should produce futures profits when rates increase.
35 Hedging and duration gap To eliminate i-rate risk, a bank could structure its portfolio so that the duration gap equals zero:This can be done by using futures to create a synthetic gap that approximately equals zero.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:
36 Example: our bank has a positive duration gap of 1 Example: our bank has a positive duration gap of 1.4 years, hence, market value of equity decline if interest rates rise. It thus 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.Assuming the bank uses a Eurodollar futures contract currently trading at 4.9 percent with a duration of 0.25 years, the target market value of futures contracts (MVF) is:or MVF $4,024.36, sell four Eurodollar futures contracts.If all interest rates increased by 1 percent, the profit on the four futures contracts would total $10,000 (4 x 100 x $25), or $2,000 less than the decrease in market value of equity associated with the increase in cash rates (see Exhibit 9.2).
37 Accounting requirements and tax implications Regulators generally limit banks to using 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 as they accrue, thereby affecting current income.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 banks risk exposure, and the bank must designate the contract as a hedge.
38 A forward rate agreement (FRA) …a forward contract based on interest rates The buyer of a FRA agrees to pay a fixed-rate coupon payment (at the exercise rate) and receive a floating-rate payment against a notional principal amount at a specified future date.The buyer of a FRA will receive (pay) cash when the actual interest rate at settlement is greater than the exercise rate (specified fixed-rate).The seller of a FRA agrees to make a floating-rate payment and receive a fixed-rate payment against a notional principal amount at a specified future date.The seller of a FRA will receive (pay) cash when the actual interest rate at settlement is less than the exercise rate.
39 Forward rate agreements (FRA) While futures and forward contracts are similar, forward contracts differ becausethey are negotiated between counterpartiesthere is no daily settlement or marking-to-marketno exchange guarantees performance
40 Notional principal amounts The two counterparties to a FRA agree to a notional principal amount that serves as a reference figure in determining cash flows.Notional refers to the condition that the principal does not change hands, but is only used to calculate the value of interest payments.The buyer of the FRA agrees to pay a fixed-rate coupon payment and receive a floating-rate payment against the notional principal at some specified future date.The seller of the FRA agrees to pay a floating-rate payment and receive the fixed-rate payment against the same notional principal.
41 Example: Forward rate agreements Metro Bank would refer to this as a “3 vs. 6” FRA at 7 percent on a $1 million notional amount from County Bank.a 6-month maturitybased on a $1 million notional principal amountfloating rate is 3-month LIBOR and the fixed (exercise) rate is 7 percentThe phrase “3 vs. 6” refers to a 3-month interest rate observed three months from the present, for a security with a maturity date six months from the present.The only cash flow will be determined in six months at contract maturity by comparing the prevailing 3-month LIBOR with 7 percent.
42 Metro Bank “3 vs. 6” FRA at 7 percent on a $1 million notional amount from County Bank Assume that in three months 3-month LIBOR equals 8 percent.In this case, Metro Bank would receive from County Bank $2,451.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).08]=$2,541If instead, LIBOR equals 5 percent in three months. Metro Bank would pay County Bank:interest = ( )(90/360) $1,000,000 = $5,000or $5,000 /[1 + (90/360).05] = $4,938
43 Metro Bank’s position is similar to a futures position In the previous 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 positionMetro Bank would take its position as a hedge if it was exposed to loss in a falling (relative to forward rate) rate environment.This is analogous to a long futures position
44 Interest rate swaps as a risk management tool Interest rate swap …an agreement between two parties to exchange interest payments for a specific maturity on a specified principal amount.
45 Plain vanilla swaps … two parties facing different types of interest rate risk can exchange interest paymentsOne exchanges a fixed-rate payment for a floating rate payment.The other party exchanges a floating rate payment for a fixed-rate payment.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.
46 Swap transactionsMost swap transactions are handled by swap dealers who make a market in swap contracts.They offer terms for both fixed-rate and floating rate payers and earn a spread for their services.With an interest rate swap transaction, the two firms essentially trade interest rate payments on a portion of their portfolios.Risk can be reduced if the firm with a negative GAP makes a fixed-rate interest payment in exchange for a floating-rate interest receipt.The firm with a positive GAP takes the opposite position, by making floating-interest payments in exchange for a fixed-rate receipt.
47 Interest rate swap dealer quotes for basic swaps: fixed-rate versus 3-month LIBOR, April 2, 2002 The first column indicates the term or maturity of the basic swap contract.The second column lists the prevailing U.S. Treasury spot rate with the same maturity as that for the swap.The third block of data represents the dealer’s bid-offer spread relative to the prevailing Treasury rate.The final block of data provides the fixed rates for the different maturity swaps.Bid rates indicate the fixed rate that a swap party will receive if it pays 3-month LIBOR.Offer rates indicate the fixed rate that a swap party will pay if it receives 3-month LIBOR.The difference represents the dealer’s spread or profit potential.
48 Conceptually, a basic interest rate swap is a package of FRAs As with FRAs, swap payments are netted and the notional principal never changes handsUsing data for a 2-year swap based on 3-month LIBOR as the floating rateThis swap involves eight quarterly payments.Party FIX agrees to pay a fixed rateParty FLT agrees to receive a fixed rate with cash flows calculated against a $10 million notional principal amountThe following rates apply:Party FIX: Pay: 3.96% Receive: 3-month LIBORParty FLT: Pay: 3-month LIBOR Receive: 3.95%
49 Cash flows associated with basic interest rate swap position
50 Adjust the rate sensitivity of an asset or liability The most common use of basic swaps is to adjust the rate sensitivity of a specific asset or liability:making a fixed-rate loan a floating rate loan, converting a floating rate liability to a fixed-rate liabilityConsider a bank that makes a $1 million, 3-year fixed-rate loan at 9 percentif it finances the loan by issuing a 3-month Eurodollar deposit priced at 3-month LIBOR.The following T-account demonstrates the transactionAsset LiabilityLoan: $1 million month Eurodollar deposit:3-year maturity $1 millionRate: 9% fixed Rate: 3-month LIBOR floating
51 This transaction exhibits considerable interest rate risk Net interest income will shrink if it rolls-over the 3-month deposit at each maturity date and LIBOR increases.The bank is liability sensitive and loses (gains) if LIBOR rises (falls).The bank could agree to pay 4.56% and receive 3-month LIBOR against $1 million for the 3 years, matching this with its continuous issuance of 3-month EurodollarNet Effect of Balance Sheet Transaction + SwapReceive: 9% from loan + 3-month LIBOR from swapPay: 3-month LIBOR from Eurodollar deposit % from swapNet spread = 4.44%The use of the swap enables the bank to reduce risk and lock-in a spread of 4.44% (9%- 4.56%)
52 Commercial customer who demands a fixed-rate loan. The bank wants to price the loan off of prime.Suppose that the bank makes the $1 million, 3-year fixed-rate loan.Enter a 3-year basic swap involving prime as the floating-rate and a fixed-rate based off of prevailing Treasuries.$1 million notional principal amount, agreeing to pay a 4.56 percent fixed rate and receive prime minus 2.82 percent with quarterly payments.The effective interest rate received is now a floating rate equal to prime plus 162 basis points:Loan Basic SwapReceive: 9.00% Prime %Pay: %Net receipt: Prime + (9.00% % %) or Prime +1.62%This swap effectively converts a fixed-rate loan into a loan with a rate that floats with the prime rate.
53 Comparing financial futures, FRAs, and basic swaps Financial futures are standardized contracts based on fixed principal amounts.Parties negotiate the notional principal amount with FRAs and interest rate swaps.Financial futures require daily marking-to-market, which is not required with FRAs and swaps.The market for FRAs is not that liquid and most contracts are short-term.Swap activity has recently grown to where participants can readily buy and sell swaps in a secondary market and thus exit a position when needed.Swap documentation is quite standardized and participating firms can negotiate master agreements with partners that enhance the development of long-term business relationships.
54 The risk with swapsThey lock in much higher fixed interest expense for the benefit of risk reductionThere is some credit risk with swaps as well, but this is not as great as it originally seemsSwap parties exchange only net interest payments, so no principal is at risk