McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Twenty-four Managing Risk with Derivative Securities

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Forward and Futures Contracts Spot Contract –An agreement to transact involving the immediate exchange of assets and cash Forward Contract –An agreement to transact involving the future exchange of a prespecified amount of assets at a prespecified price Futures Contract –An agreement to transact involving the future exchange of a set amount of assets for a price that is resettled and marked- to-market daily Marked to market –prices on outstanding futures contracts are adjusted each day to reflect current futures market conditions Spot Contract –An agreement to transact involving the immediate exchange of assets and cash Forward Contract –An agreement to transact involving the future exchange of a prespecified amount of assets at a prespecified price Futures Contract –An agreement to transact involving the future exchange of a set amount of assets for a price that is resettled and marked- to-market daily Marked to market –prices on outstanding futures contracts are adjusted each day to reflect current futures market conditions

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Hedging with Forward and Futures Contracts Hedging with Forward Contracts –naïve hedge - a hedge of a cash asset on a direct dollar-for- dollar basis with a forward or futures contract –immunized - describes an FI that is fully hedged or protected against adverse movements in interest rates (or asset prices) Hedging with Futures Contracts –microhedging - using a futures (forward) contract to hedge a specific asset or liability –basis risk - a residual risk that occurs because the movement in a spot asset’s price is not perfectly correlated with the movement in the price of the asset delivered under a futures or forward contract –macrohedging - hedging the entire duration gap of an FI Hedging with Forward Contracts –naïve hedge - a hedge of a cash asset on a direct dollar-for- dollar basis with a forward or futures contract –immunized - describes an FI that is fully hedged or protected against adverse movements in interest rates (or asset prices) Hedging with Futures Contracts –microhedging - using a futures (forward) contract to hedge a specific asset or liability –basis risk - a residual risk that occurs because the movement in a spot asset’s price is not perfectly correlated with the movement in the price of the asset delivered under a futures or forward contract –macrohedging - hedging the entire duration gap of an FI

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Macrohedging versus Microhedging Factors that affect an FI’s choice: –Risk-return considerations –Accounting rules and hedging strategies –Policies of bank regulators Microhedging with futures –depends on the interest rate risk exposure created by a particular asset or liability on the balance sheet Factors that affect an FI’s choice: –Risk-return considerations –Accounting rules and hedging strategies –Policies of bank regulators Microhedging with futures –depends on the interest rate risk exposure created by a particular asset or liability on the balance sheet

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Profit or Loss on a Futures Position in Eurodollar Futures Taken on Jan 18, 2000 Payoff Short Position Payoff Long Position Gain prices fall prices rise prices fall prices rise rates rise rates fall rates rise rates fall Futures Futures 0 Price 0 Price Payoff Loss Payoff Short Position Payoff Long Position Gain prices fall prices rise prices fall prices rise rates rise rates fall rates rise rates fall Futures Futures 0 Price 0 Price Payoff Loss

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved FI Value Change On and Off the Balance Sheet from a Perfect Short-Hedge Value Change Change in Capital Value Gain Due to Change in Asset Value Asset Price at End of Hedge Change in Capital Value Value Change Due to Hedge Position Loss Asset Price at Beginning of Hedge Value Change Change in Capital Value Gain Due to Change in Asset Value Asset Price at End of Hedge Change in Capital Value Value Change Due to Hedge Position Loss Asset Price at Beginning of Hedge

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Options Strategies that FIs employ to hedge interest rate risk –Buying a call option on a bond a strategy to take when interest rates are expected to fall –Writing a call option on a bond a strategy to take when interest rates are expected to rise –Buying a put option on a bond a strategy to take when interest rates are expected to rise –Writing a put option on a bond a strategy to take when interest rates are expected to fall Strategies that FIs employ to hedge interest rate risk –Buying a call option on a bond a strategy to take when interest rates are expected to fall –Writing a call option on a bond a strategy to take when interest rates are expected to rise –Buying a put option on a bond a strategy to take when interest rates are expected to rise –Writing a put option on a bond a strategy to take when interest rates are expected to fall

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Hedging with Options Payoff Payoff Function of Gain a bond in an FI’s portfolio Net payoff function 0 Bond price X -P Payoff Function from buying a put Payoff on a bond Loss Payoff Payoff Function of Gain a bond in an FI’s portfolio Net payoff function 0 Bond price X -P Payoff Function from buying a put Payoff on a bond Loss

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Swaps The largest segment of the U.S. commercial bank swap market comprises interest rate swaps which allow FIs to put in place a long-term hedge Currency swap - used to hedge against exchange rate risk from mismatched currencies Credit risk concerns with swaps –Netting and swaps –Payment flows are interest, not principal –Standby letters of credit The largest segment of the U.S. commercial bank swap market comprises interest rate swaps which allow FIs to put in place a long-term hedge Currency swap - used to hedge against exchange rate risk from mismatched currencies Credit risk concerns with swaps –Netting and swaps –Payment flows are interest, not principal –Standby letters of credit

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Comparison of Hedging Methods Writing versus buying options –FIs prefer to buy rather than write options –In writing an option, the upside profit potential is truncated but the downside losses are not –Naked options - option positions that do not identifiably hedge an underlying asset or liability - considered risky Futures versus options hedging –many FIs prefer option-type contracts to future/forwards Swaps versus forwards, futures, and options –futures and options are standardized with fixed principal and lower default risk –swaps provide better long-term protection against risk but have higher default risk Writing versus buying options –FIs prefer to buy rather than write options –In writing an option, the upside profit potential is truncated but the downside losses are not –Naked options - option positions that do not identifiably hedge an underlying asset or liability - considered risky Futures versus options hedging –many FIs prefer option-type contracts to future/forwards Swaps versus forwards, futures, and options –futures and options are standardized with fixed principal and lower default risk –swaps provide better long-term protection against risk but have higher default risk