CHAPTER SEVEN Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management The purpose of this chapter is to examine how financial futures, option, and swap contracts, as well as selected other asset-liability management techniques can be employed to help reduce a bank’s potential exposure to loss as market conditions change. We will also discover how swap contracts and other hedging tools can generate additional revenues for banks by providing risk-hedging services to their customers.

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-3 Financial Futures Contract An Agreement Between a Buyer and a Seller Which Calls for the Delivery of a Particular Financial Asset at a Set Price at Some Future Date

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-4 The Purpose of Financial Futures To Shift the Risk of Interest Rate Fluctuations from Risk-Averse Investors to Speculators

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-5 The World’s Leading Futures and Option Exchanges Chicago Board of Trade (CBOT) Financial Exchange (FINEX) New York Futures Exchange (NYFE) Marche a Terme International De France (MATIF) Singapore Exchange LTD. (SGX) Chicago Mercantile Exchange (CME) London International Financial Futures Exchange (LIFFE) Sydney Futures Exchange Toronto Futures Exchange (TFE)

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-6 Most Common Financial Futures Contracts U.S. Treasury Bond Futures Contracts U.S. Treasury Bill Futures Contracts Three-Month Eurodollar Time Deposit Futures Contract 30-Day Federal Funds Futures Contracts One Month LIBOR Futures Contracts

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-7 Hedging with Futures Contracts Avoiding Higher Borrowing Costs and Declining Asset Values Use a Short Hedge: Sell Futures Contracts and then Purchase Similar Contracts Later Avoiding Lower Than Expected Yields from Loans and Securities Use a long Hedge: Buy Futures Contracts and then Sell Similar Contracts Later

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-8 Basis Risk Cash-Market Price (or Interest Rate) Less the Futures-Market Price (or Interest Rate)

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-9 Realized Return from Combining Cash and Futures Market Trading = Return Earned in the Cash Market +/- Profit or Loss from Futures Trading - Closing Basis Between Cash and Futures Market - Opening Basis Between Cash and Futures Market

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Number of Futures Contracts Needed

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Interest Rate Option It Grants the Holder of the option the Right but Not the Obligation to Buy or Sell Specific Financial Instruments at an Agreed Upon Price.

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Types of Options Put Option Gives the Holder of the Option the Right to Sell the Financial Instrument at a Set Price Call Option Gives the Holder of the Option the Right to Purchase the Financial Instrument at a Set Price

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Most Common Option Contracts Used By Banks U.S. Treasury Bill Futures Options Eurodollar Futures Option U.S. Treasury Bond Option LIBOR Futures Option

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Principal Uses of Option Contracts Protection of the Bond Portfolio Hedging Against Positive or Negative Gap Positions

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Interest Rate Swap A Contract Between Two Parties to Exchange Interest Payments in an Effort to Save Money and Hedge Against Interest- Rate Risk

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Quality Swap Borrower with Lower Credit Rating Pays Fixed Payments of Borrower with Higher Credit Rating Borrower with Higher Credit Rating Pays Short-Term Floating Rate Payments of Borrower with Lower Credit Rating

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Risks of Interest Rate Swaps Substantial Brokerage Fees Credit Risk Basis Risk Interest Rate Risk

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Netting The Swap Parties Only Swap the Net Difference Between the Interest Payments. This Reduces the Potential Damage if One Party Defaults on its Obligation

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Currency Swap An Agreement Between Two Parties, Each Owing Funds to Other Contractors Denominated in Different Currencies, to Exchange the Needed Currencies with Each Other and Honor Their Respective Contracts.

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Interest Rate Cap Protects the Holder from Rising Interest Rates. For an Up Front Fee Borrowers are Assured Their Loan Rate Will Not Rise Above the Cap Rate

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Interest Rate Floor A Contract Setting the Lowest Interest Rate a Borrower is Allowed to Pay on a Flexible-Rate Loan

McGraw-Hill/Irwin Bank Management and Financial Services, 6/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Interest Rate Collar A Contract Setting the Maximum and Minimum Interest Rates That May Be Assessed on a Flexible-Rate Loan. It Combines an Interest Rate Cap and Floor into One Contract.