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Interest Risk Management Index Futures, Options, and Other Derivatives Chapter 12
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Stock Index Futures
Instruments for hedging exposure to changes in market values, specifically exposure to the change of values in equity portfolios
Stock index futures contracts
are traded regularly on many different groups of domestic stocks
Provide diversification automatically
Are assumed to have a beta of one for that group of stocks
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3. Theoretical Basis of Stock Index Futures
Capital Asset Pricing Model (CAPM)
Efficient Markets Hypothesis (EMH)
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4. Characteristics of Stock Index Futures
Cannot make or take delivery of index
Value of a contract = index X $ amount
Limitations on price movement
Greater price volatility
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5. Financial Institutions and Stock Index Futures
Hedging against a Decline in the Market
Can sell all or part of portfolio
Can sell stock index futures (a short hedge)
Number of Contracts
Value of Portfolio
NF =
X Bp
Futures Index X Multiplier
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6. Stock Index Futures Example
Suppose that a pension fund manager holds a stock portfolio of $600 million on December 4, and the DJIA index is at The equity market had been on an upswing, but a downturn is predicted in December. The manager chooses to sell DJIA stock index futures. The previous day’s index settlement level on the December futures contract was 9870 and the index multiplier is $10, Bp =1.
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7. THE SHORT HEDGE: PORTFOLIO BETA OF 1.0 (FORECAST: BEAR MARKET)
A short hedge with index futures is used when falling securities prices are forecasted. The profit on the futures position can be used to offset losses in a portfolio of stocks.
Cash Market
Futures Market
December 4, 2003 December 4, 2003
DJIA Index: DJIA Index settlement level 9870 (Dec. )
Stock portfolio value: Sell 5,066 contracts
$500,000, × $10 × 5,066 = $500,014,200
December 15, 2003 December 15, 2003
Forecast Was incorrect; Stock Prices Rose Instead (Bull Market)
DJIA Index: DJIA Index settlement level: 10,025
DJIA percent rise Close out position: Buy 5,066 contracts
= ( )/ Futures Price DJIA has risen 1.57%
= 1.51% Loss on Futures Contract =
Gain on Portfolio = $500,000,000 X ( ,025) X $10 X 5,066 = ($7,852,300)
= $7,550,000
Cash Market Gain Futures Market Loss
December 4, 2003 value $500,000,000 December 4, 2003 Short $500,014,200
December 15, 2003 value ,550,000 December 15, 2003 Buy ,866,500
Gain in Portfolio $ 7,550,000 Loss on Futures Contracts ($ 7,852,300)
Net Hedging Loss = ($302,000)
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8. Program Trading: Index Arbitrage
Program trading is the simultaneous placement of buy and sell orders for groups of stocks totaling $1 million or more
Index arbitrage is simultaneously trading stock and stock index futures to profit from changes in the spread between the two
Index arbitragers
Are seeking to make a profit
Are not hedging to avoid or mitigate risk
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Index Arbitrage
Cash Market
Futures Market
February 26
MMI: MMI settlement level
Buy 2,000 shares of each MMI stock Sell 18 contracts
Value = $2,749, × $500 × 18 = $2,821,950
If Prices Increase by March 21
MMI increase = 5.238% MMI settlement level:
MMI: , an increase of 4.631%
Close out position buying 18 contracts
Stock portfolio value: $2,893, × $500 × 18 = $2,952,630
Cash market gain = $144,000 Futures Market Loss = ($130,680)
Net Gain = $13,320
If Prices Decrease by March 21
MMI decrease= 5.23% MMI settlement level:
MMI: , a decrease of 5.785%
Stock portfolio value: Close out position buying 18 contracts:
$2,605, × $500 × 18 = $2,658,690
Cash market loss = ($144,000) Futures Market Gain = $163,260
Net Gain = $19,260
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10. Options on Financial Assets
Option - is an agreement giving its holder the right to buy or sell a specified asset, over a limited time period, at a specified price (exercise price or strike price).
American Options
European Options
Call Options
Put Options
Premiums
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11. Differences Between Options and Futures
An option does not obligate the holder to undertake the purchase or sale.
The holder may choose not to exercise the option to buy or sell.
American options can be exercised at any point during their lives.
With futures, an exchange of securities takes place only on the specified delivery date.
Futures are similar to European options which can be exercised only at expiration.
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Call Options
A call option is an agreement in which the option writer sells the holder the right to buy a specified asset on or before a future date.
The buyer of the call expects the price of the asset to increase over the life of the option, eventually exceeding the exercise price.
The value of the option rises as the price of the asset rises.
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Put Options
A put option is an agreement in which the option writer sells the holder the right to sell a specified asset on or before a future date at the strike price.
The buyer of the put expects the price of the asset to fall below the strike price.
The value of the option rises as the price of the asset declines.
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Option Values
Call (right to buy) option values are higher if
Strike price is lower
Expiration date is more distant
Put (right to sell) option values are higher if
Strike price is higher
Expiration date is more current
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15. Options and Financial Institutions
Regulation of Options Trading
Banks
May use options to hedge (reduce) risk
May not use options to increase risk
Buying options is ok, writing options is ???
Thrifts
May both buy and write options
Must report positions to regulators
Other financial institutions
Securities firms, insurance firms, etc have much greater latitude in the use of options
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LEAPS
Long-term equity anticipation securities
Options with expiration dates up to three years
Written on about 100 stocks, several indexes
Lower volume than traditional options
Less volatility than traditional options
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Option Premiums
It is the price paid to purchase the option.
It reflects the cost of the option.
If the option is not exercised, the cost of the option is the option premium.
Since a large asset price change is necessary to cover the cost of the premium, it is better to hedge instruments with large expected price changes with options.
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18. Market Forecasts and Option Hedges
Falling stock prices or rising interest rates suggest the use of puts.
Rising stock prices or falling interest rates suggest the use of calls.
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19. Hedging With Options: An Illustration
Suppose that in June, 2006, the bond portfolio manager for a large insurance firm forecasts a sharp decline in interest rates over the next 3 months. The insurance company is expecting a large inflow from sales of insurance policies in August. The manager wants to hedge the opportunity loss on the investment of those premiums. However, the manager of a money market fund holds the opposite expectations for interest rate movements. She is willing to write a call option on T-bond futures contracts. Suppose T-bond futures for September delivery are currently trading at 75.5% of par. The call option has a strike price of 76, a premium of $1, and an expiration of August 2006.
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20. HEDGING WITH OPTIONS ON T-BOND FUTURES CONTRACTS (LONG HEDGE)
Treasury Bond Call Option
Premium: $1, Strike price: Expiration date: August 2006
Security: Treasury bond futures contract for September delivery
$100,000 face value
Current market value: 75.5
Scenario 1: Interest Rate Increase
T-bond futures contract value: < Call option not exercised.
Results of the hedge: ($1,187.50) (premium is lost)
Scenario 2: Interest Rates Fall Slightly
T-bond futures contract market value: Call option exercised.
Contract purchased at 76 and sold at 77.
Result of hedge ($187.50) Loss
Scenario 3: Interest Rates Fall Significantly
T-bond futures contract market value: Call option exercised.
Contract purchased at 76 and sold at 81.
Result of hedge $3, Gain
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21. HEDGING WITH T-BOND FUTURES CONTRACTS (LONG HEDGE)
Futures hedges also provide opportunities to gain if forecasts are correct. If forecasts are incorrect, however, losses on a futures position can be larger than losses on comparable hedging strategies.
The Long Hedge
Treasury bond futures contract for September delivery
$100,000 face value
Current market value: 75.5
Scenario 1: Interest Rates Increase Scenario 2: Interest Rates Fall Slightly
T-bond futures contracts market value: 70 T-bond futures contract market value: 77
Position closed at loss of 5.5 of contract. Pos. closed at profit of 1.5 of contract.
Results of hedge: -$5,500 loss Results of the hedge: $1500 profit
Scenario 3: Interest Rates Fall Significantly
T-bond futures contract market value: 81
Position closed at profit of 5.5 of contract.
Results of the hedge: $5,500 profit
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Interest Rate Swaps
A swap agreement is an exchange of cash flows between two parties.
Parties in a swap agreement are referred to as counterparties.
In the simplest interest rate swap one counterparty exchanges a fixed-rate payment obligation for a floating-rate one, while the other counterparty exchanges floating for fixed.
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23. Details on Interest Rate Swaps
Initially, the floating rate will probably be lower than the fixed rate.
The relationship could change over the life of the swap as interest rate levels fluctuate.
The differential between the floating-rate and fixed-rate can be viewed as the insurance premium paid to transfer interest rate risk exposure to the counterparty accepting the floating-rate obligation.
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24. Exchange of Obligations in an Interest Rate Swap
This swap involves an S&L that exchanges its variable-rate interest obligations for the fixed rate interest obligations of a counterparty commercial bank. The cost of the swap is the initially higher interest payments the S&L must make.
Savings
Association
Commercial Bank
Counterparty
S&L Pays Interest on $50 Million at 8.5%
Bank Pays Interest on $50 Million at LIBOR %
8.5% Fixed-Rate Obligation in Eurodollar Markets
Variable Rate Obligation on Deposits
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Swaps as a Hedging Tool
Plain Vanilla Swap
Exchanging Interest Obligations
Cost and Benefits of a Swap Agreement
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26. Important Factors in a Swap
Maturity
Interest Rate Index
The Role of Brokers and Dealers
Credit Risk
Asset Swaps and Liability Swaps
Liability Swaps Used to Reduce Interest Costs
Currency Swaps Used to Reduce Foreign Exchange Risk
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More Exotic Swaps
Commodity Swaps
Equity Swaps
Swaps versus Futures Hedging
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28. Swap Options and Futures
A call swaption gives the buyer an opportunity to enter into a swap agreement in the future to receive a fixed rate and pay a floating rate.
A put swaption gives the buyer the right to make a future swap agreement to receive a floating rate and pay a fixed rate.
Swap Futures
A swap future is a futures contract in which the “cash instrument” is a generic, plain vanilla swap with a 3 to 5 year life.
Variable rate is indexed to LIBOR
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29. COMPARING INTEREST RATE FUTURES AND INTEREST RATE SWAPS
These comparisons show that swaps are more flexible hedging tools than futures, but futures markets are large, more well-developed, and more standardized.
Feature Futures Swaps
Maturities available 1½ to 2 years 1 month to 20 years
Costs Margins and commissions Brokers’/dealers’ fees
Size of hedges available Standardized contract values Any amount over $1m
Contract expiration dates Fixed quarterly cycle Any dates
Difficulty of management Complex Simple
Termination positions Closed out with opposite Unwound or reversed
contract
Transactions completed through Organized exchanges Commercial or
investment banks
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30. Interest Rate Caps, Floors, and Collars
The purchaser pays a premium for the right to limit the cost of its liabilities to a specified rate
Interest Rate Floors
Purchased to protect against the possibility that returns on variable-rate instruments will fall so low that they no longer exceed the cost of funding sources
Interest Rate Collars
Purchase both caps and floors or may purchase a cap and sell a floor
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31. Other New Derivatives for Financial Institution Management
Insurance Derivatives
Options Contracts for Insured Losses from Catastrophic Events
Credit Derivatives
Total Return Swaps
Credit Swaps
Differences between a Total Rate of Return Swap and a Credit Swap
Other Types of Credit Swaps
Credit-linked notes
First-to-default swaps
Index swaps
Credit –linked note
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