Futures and Forwards Chapter 23 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

Overview  Derivative securities have become increasingly important as FIs seek methods to hedge risk exposures. The growth of derivative usage is not without controversy since misuse can increase risk. This chapter explores the role of futures and forwards in risk management.

Futures and Forwards  Second largest group of interest rate derivatives in terms of notional value and largest group of FX derivatives. Swaps are the largest.

Derivatives  Rapid growth of derivatives use has been controversial Orange County, California Bankers Trust Allfirst Bank (Allied Irish)  As of 2000, FASB requires that derivatives be marked to market Transparency of losses and gains on financial statements

Web Resources  For further information on the web, visit FASB

Spot and Forward Contracts  Spot Contract Agreement at t=0 for immediate delivery and immediate payment.  Forward Contract Agreement to exchange an asset at a specified future date for a price which is set at t=0.  Counterparty risk

Futures Contracts  Futures Contract similar to a forward contract except: Marked to market Exchange traded  Rapid growth of off market trading systems Standardized contracts  Smaller denomination than forward Lower default risk than forward contracts.

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

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.

Hedging with futures  Futures more commonly used than forwards. Microhedging  Individual assets. Macrohedging  Hedging entire duration gap  Found more effective and generally lower cost. Basis risk  Exact matching is uncommon  Standardized delivery dates of futures reduces likelihood of exact matching.

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.  Partially hedge duration gap or individual assets or liabilities

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) = -$2.091 million.

Risk-Minimizing Futures Position  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

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.

Payoff profiles Short Position Long Position Futures Price

Futures Price Quotes  T-bond futures contract: $100,000 face value  T-bill futures contract: $1,000,000 face value quote is price per $100 of face value Example: /32 for T-bond indicates purchase price of $112, per contract  Delivery options Conversion factors used to compute invoice price if bond other than the benchmark bond delivered

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 × br) where br = [  R F /(1+R F )]/ [  R/(1+R)]

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.  Tailing the hedge Interest income effects of marking to market allows hedger to reduce number of futures contracts that must be sold to hedge

Basis Risk  In order to adjust for basis risk, we require the hedge ratio, h =  S t /  f t N f = (Long asset position × estimate of h)/(size of one contract).

Estimating the Hedge Ratio  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.

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

Credit Forwards  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.

Credit Forwards CS F defines agreed forward credit spread at time contract written CS T = actual credit spread at maturity of forward Credit Spread Credit Spread Credit Spread at EndSellerBuyer CS T > CS F ReceivesPays (CS T - CS F )MD(A) (CS T -C S F )MD(A) CS F >CS T PaysReceives (CS F - CS T )MD(A) (CS F - CS T )MD(A)

Futures and Catastrophe Risk  CBOT introduced futures and options for catastrophe insurance. Contract volume is rising. Catastrophe futures to allow PC insurers to hedge against extreme losses such as hurricanes. Payoff linked to loss ratio (insured losses to premiums) Example: Payoff = contract size × realized loss ratio – contract size × contracted futures loss ratio. $25,000 × $25,000 – 0.8 = $17,500 per contract.

Regulatory Policy  Three levels of regulation: Permissible activities Supervisory oversight of permissible activities Overall integrity and compliance  Functional regulators SEC and CFTC  As of 2000, derivative positions must be marked-to-market.  Exchange traded futures not subject to capital requirements: OTC forwards potentially subject to capital requirements

Regulatory Policy for Banks  Federal Reserve, FDIC and OCC require banks Establish internal guidelines regarding hedging. Establish trading limits. Disclose large contract positions that materially affect bank risk to shareholders and outside investors. Discourage speculation and encourage hedging  Allfirst/Allied Irish: Existing (and apparently inadequate) policies were circumvented via fraud and deceit.

Federal Reserve Chicago Board of Trade Chicago Mercantile Exchange CFTC FDIC FASB OCC SEC Pertinent websites