©2007, The McGraw-Hill Companies, All Rights Reserved 23-1 McGraw-Hill/Irwin Chapter Twenty-three Managing Risk with Derivative Securities

©2007, The McGraw-Hill Companies, All Rights Reserved 23-2 McGraw-Hill/Irwin Forward and Futures Contracts Spot Contract Forward Contract Futures Contract Marked to market Spot Contract Forward Contract Futures Contract Marked to market

©2007, The McGraw-Hill Companies, All Rights Reserved 23-3 McGraw-Hill/Irwin Hedging with Forward and Futures Contracts Hedging with Forward Contracts –naïve hedge –immunized Hedging with Futures Contracts –microhedging –basis risk –macrohedging Hedging with Forward Contracts –naïve hedge –immunized Hedging with Futures Contracts –microhedging –basis risk –macrohedging

©2007, The McGraw-Hill Companies, All Rights Reserved 23-4 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 23-5 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 23-6 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 23-7 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 23-8 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 23-9 McGraw-Hill/Irwin Swaps The largest segment of the U.S. commercial bank swap market comprises interest rate swaps 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Caps, Floors, and Collars Buying a cap –Call option or succession of call options on interest rates Buying a floor –A put option on interest rates Buying a collar –Taking a simultaneous position in a cap and a floor Buying a cap –Call option or succession of call options on interest rates Buying a floor –A put option on interest rates Buying a collar –Taking a simultaneous position in a cap and a floor

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Risks Associated with Futures, Forwards, and Options FI’s can be either users or dealers of derivative contracts for hedging Contingent credit risk when FI’s expand positions in forward, futures, and option contracts FI’s can be either users or dealers of derivative contracts for hedging Contingent credit risk when FI’s expand positions in forward, futures, and option contracts

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Currency Swaps Currency swaps –Used as a hedge against foreign exchange rate risk Fixed-Fixed currency swaps Currency swaps –Used as a hedge against foreign exchange rate risk Fixed-Fixed currency swaps

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Credit Risk Concerns with Swaps Netting and Swaps Payment flows are interest, not principal Standby letters of credit Netting and Swaps Payment flows are interest, not principal Standby letters of credit

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Comparison of Hedging Methods Writing versus buying options Futures versus options hedging –many FIs prefer option-type contracts to future/forwards Swaps versus forwards, futures, and options –swaps provide better long-term protection against risk but have higher default risk Writing versus buying options Futures versus options hedging –many FIs prefer option-type contracts to future/forwards Swaps versus forwards, futures, and options –swaps provide better long-term protection against risk but have higher default risk