Irwin/McGraw-Hill 1 Futures and Forwards Chapter 24 Financial Institutions Management, 3/e By Anthony Saunders

Irwin/McGraw-Hill 2 Futures and Forwards n Second largest group of interest rate derivatives in terms of notional value and largest group of FX derivatives. Swaps are the largest. n Rapid growth of derivatives use has been controversial For example, Orange County, California.

Irwin/McGraw-Hill 3 Spot and Forward Contracts n Spot Contract Agreement at t=0 for immediate delivery and immediate payment. n Forward Contract Agreement to exchange an asset at a specified future date for a price which is set at t=0.

Irwin/McGraw-Hill 4 Futures Contracts n Futures Contract Similar to a forward contract except »Marked to market »Exchange traded (standardized contracts) »Lower default risk than forward contracts.

Irwin/McGraw-Hill 5 Hedging Interest Rate Risk Example: 20-year $1 million face value bond. Current price = $970,000. Interest rates expected to increase from 8% to 10% over next 3 months. From duration model, change in bond value:  P/P = -D   R/(1+R)  P/ $970,000 = -9  [.02/1.08]  P = -$161,666.67

Irwin/McGraw-Hill 6 Example continued:Naive hedge Hedged by selling 3 months forward at forward price of $970,000. Suppose interest rate rises from 8%to 10%. $970,000-$808,333=$161,667 (forward (spot price price) at t=3 months) Exactly offsets the on-balance-sheet loss. Immunized.

Irwin/McGraw-Hill 7 Hedging with futures n Futures used more commonly used than forwards. Microhedging »Individual assets. Macrohedging »Hedging entire duration gap. Basis risk »Exact matching is uncommon.

Irwin/McGraw-Hill 8 Routine versus Selective Hedging Routine hedging: reduces interest rate risk to lowest possible level. »Low risk - low return. Selective hedging: manager may selectively hedge based on expectations of future interest rates and risk preferences.

Irwin/McGraw-Hill 9 Macrohedging with Futures Number of futures contracts depends on interest rate exposure and risk-return tradeoff.  E = -[D A - kD L ] × A × [  R/(1+R)] Suppose: D A = 5 years, D L = 3 years and interest rate expected to rise from 10% to 11%. A = $100 million.  E = -(5 - (.9)(3)) $100 (.01/1.1) = -$2.09 million.

Irwin/McGraw-Hill 10 Risk-Minimizing Futures Position n Sensitivity of the futures contract:   F/F = -D F [  R/(1+R)] Or,   F = -D F × [  R/(1+R)] × F and F = N F × P F

Irwin/McGraw-Hill 11 Risk-Minimizing Futures Position Fully hedged requires  F =  E D F (N F × P F ) = (D A - kD L ) × A Number of futures to sell: N F = (D A - kD L )A/(D F × P F ) Perfect hedge may be impossible since number of contracts must be rounded down.

Irwin/McGraw-Hill 12 Basis Risk Spot and futures prices are not perfectly correlated. We assumed in our example that  R/(1+R) =  R F /(1+R F ) Basis risk remains when this condition does not hold. Adjusting for basis risk, N F = (D A - kD L )A/(D F × P F × b) where b = [  R F /(1+R F )]/ [  R/(1+R)]

Irwin/McGraw-Hill 13 Hedging FX Risk Hedging of FX exposure parallels hedging of interest rate risk. If spot and futures prices are not perfectly correlated, then basis risk remains. In order to adjust for basis risk, we require the hedge ratio, h =  S t /  f t N f = (Long asset position × h)/(size of one contract).

Irwin/McGraw-Hill 14 Estimating the Hedge Ratio n The hedge ratio may be estimated using ordinary least squares regression:  S t =  +  f t + U t The hedge ratio, h will be equal to the coefficient . The R 2 from the regression reveals the effectiveness of the hedge.

Irwin/McGraw-Hill 15 Hedging Credit Risk n More FIs fail due to credit-risk exposures than to either interest-rate or FX exposures. n In recent years, development of derivatives for hedging credit risk has accelerated. Credit forwards, credit options and credit swaps.

Irwin/McGraw-Hill 16 Credit Forwards n Credit forwards hedge against decline in credit quality of borrower. Common buyers are insurance companies. Common sellers are banks. Specifies a credit spread on a benchmark bond issued by a borrower. »Example: BBB bond at time of origination may have 2% spread over U.S. Treasury of same maturity.

Irwin/McGraw-Hill 17 Credit Forwards S F defines credit spread at time contract written S T = actual credit spread at maturity of forward Credit Spread Credit Spread Credit Spread at EndSellerBuyer S T > S F ReceivesPays (S T - S F )MD(A) (S T - S F )MD(A) S F >S T PaysReceives (S F - S T )MD(A) (S F - S T )MD(A)

Irwin/McGraw-Hill 18 Futures and Catastrophe Risk n CBOT introduced futures and options for catastrophe insurance. Contract volume is small but rising. Catastrophe futures to allow PC insurers to hedge against extreme losses such as hurricanes. Payoff linked to loss ratio

Irwin/McGraw-Hill 19 Regulatory Policy n Require a bank to Establish internal guidelines regarding hedging. Establish trading limits. Disclose large contract positions that materially affect bank risk to shareholders and outside investors. Beginning in 2000, derivative positions must be marked-to-market.