1. Chapter Eight Risk Management: Financial Futures,
Options, Swaps, and Other Hedging Tools

2. Key Topics The Use of Derivatives
Financial Futures Contracts: Purpose and Mechanics
Short and Long Hedges
Interest-Rate Options: Types of Contracts and Mechanics
Interest-Rate Swaps
Regulations and Accounting Rules
Caps, Floors, and Collars

3. Introduction
The asset-liability management tools we explore here are useful across a broad range of financial-service providers sensitive to the risk of changes in market interest rates
Many of the risk management tools in this chapter are not only used by financial firms to cover their own interest rate risk, but are also sold to customers who need risk protection and generate fee income for the providers
Most of the financial instruments in this chapter are derivatives
They derive their value from the value and terms of underlying instruments

4. Uses of Derivative Contracts Among FDIC-Insured Banks
Due to their high exposure to various forms of risk, banks and their principal competitors are among the heaviest users of derivative contracts
These risk-hedging instruments allow a financial firm to protect its balance sheet and/or income and expense statement in case interest rates, currency prices, or other financial variables move against the hedger
Approximately 15 percent of all banks operating in the United States reportedly employ the use of derivatives to subdue risk in its various forms
Today the bulk of trading in derivatives is centered in the very largest banks worldwide
Interest-rate risk is by far the most common target for derivatives, with foreign exchange (currency) risk running a distant second
The leading type of risk-hedging contracts are swaps, followed by financial futures and options

5. EXHIBIT 8-1 Types of Derivative Contracts Used by Depository Institutions to Manage Different Types of Risk Exposure, 2010

6. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price
In Chapter 7, we explored the nature of gaps between assets and liabilities that are exposed to interest rate risk
The preceding chapter developed one other measure of the difference between risk-exposed assets and liabilities – the leverage-adjusted duration gap

7. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
A financial futures contract is an agreement reached today between a buyer and a seller that calls for delivery of a particular security in exchange for cash at some future date
Financial futures trade in futures markets and are usually accounted for as off-balance-sheet items on the financial statements of financial-service firms
Sellers of financial assets remove the assets from their balance sheet and account for the losses or gains on their income statements
Buyers of financial assets add the item purchased to their balance sheet
In cash markets, buyers and sellers exchange the financial asset for cash at the time the price is set
In futures markets buyers and sellers exchange a contract calling for delivery of the underlying financial asset at a specified date in the future

8. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
When the contract is created, neither buyer nor seller is making a purchase or sale at that point in time, only an agreement for the future
When an investor buys or sells futures contracts at a designated price, it must deposit an initial margin
The initial margin is the investor’s equity in the position when he or she buys (or sells) the contract
Each trader’s account is marked-to-market
When a trader’s equity position falls below the maintenance margin (the minimum specified by the exchange) the trader must deposit additional funds to the equity account to maintain his or her position, or the futures position is closed out within 24 hours
The mark-to-market process takes place at the end of each trading day

9. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Buyers of futures contracts
A buyer of a futures contract is said to be long futures
Agrees to pay the underlying futures price or take delivery of the underlying asset
Buyers gain when futures prices rise and lose when futures prices fall
Sellers of futures contracts
A seller of a futures contract is said to be short futures
Agrees to receive the underlying futures price or to deliver the underlying asset
Sellers gain when futures prices fall and lose when futures prices rise

10. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
The financial futures markets are designed to shift the risk of interest-rate fluctuations from risk-averse investors, such as banks and insurance companies, to speculators willing to accept and possibly profit from such risks
Futures contracts are traded on organized exchanges
For example, the Chicago Mercantile Exchange or the London Financial Futures Exchange
On the exchange floor, floor brokers execute orders received from the public to buy or sell these contacts at the best prices available

11. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Futures contracts are also traded over the counter (OTC)
Often less costly for traders
These are most often called forward contracts
Forward contracts
Generally more risky – counterparty risk and liquidity risk
Terms are negotiated between parties
Do not necessarily involve standardized assets
Require no cash exchange until expiration
No marking to market

12. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Most common financial futures contracts
U.S. Treasury Bond Futures Contracts
Three-Month Eurodollar Time Deposit Futures Contract
30-Day Federal Funds Futures Contracts
One Month LIBOR Futures Contracts

13. EXHIBIT 8–2 Sample Market Prices for Interest-Rate Futures in Recent Years

14. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Short Futures Hedge Process
Today – contract is sold through an exchange
Sometime in the future – contract is purchased through the same exchange
Results – the two contracts are cancelled out by the futures clearinghouse
Gain or loss is the difference in the price purchased for (at the end) and the price sold for (at the beginning)

15. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Long Futures Hedge Process
Today – contract is purchased through an exchange
Sometime in the future – contract is sold through the same exchange
Results – the two contracts are cancelled by the clearinghouse
Gain or loss is the difference in the purchase price (at the beginning) and the price sold for (at the end)

16. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
The three most typical interest-rate hedging problems financial firms face are
Protecting the value of securities and fixed-rate loans from losses due to rising interest rates
Avoiding a rise in borrowing costs
Avoiding a fall in the interest returns expected from loans and security holdings
Where the financial institution faces a positive interest-sensitive gap, it can protect against loss due to falling interest rates by covering the gap with a long hedge
If the institution is confronted with a negative interest-sensitive gap, it can avoid unacceptable losses from rising market interest rates by covering with a short hedge

17. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Basis Risk
The basis is the cash price of an asset minus the corresponding futures price for the same asset at a point in time
For financial futures, the basis can be calculated as the futures rate minus the spot rate
It may be positive or negative, depending on whether futures rates are above or below spot rates
May swing widely in value far in advance of contract expiration

18. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Basis Risk with a Short Hedge
You are concerned about the interest-rate risk exposure for bonds in a financial institution’s securities portfolio
You fear increasing interest rates that would decrease the value of those bonds
You have a long position in the cash market
To hedge this possible increase in market interest rates, you could take a short position in the futures market

19. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Basis Risk with a Short Hedge

20. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
Basis Risk with a Long Hedge
If you have concerns about declining interest rates, you could create a long hedge
To hedge the decrease in interest rates, you could take a long position in the futures market

21. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
The real risk the user faces from hedging with futures stems from the movement in basis that may occur over the life of a futures contract because cash and futures prices are not perfectly synchronized with each other
The sensitivity of the market price of a financial futures contract depends, in part, upon the duration of the security to be delivered under the futures contract

22. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
If we rewrite this equation slightly we get an expression for the gain or loss from the use of financial futures

23. EXHIBIT 8–3 Trade-Off Diagrams for Financial Futures Contracts

24. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
How many futures contracts does a financial firm need to cover a given size risk exposure?
The objective is to offset the loss in net worth due to changes in market interest rates with gains from trades in the futures market

25. Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
If we set the change in net worth equal to the change in the futures position value, we can solve for the number of futures contracts needed to fully hedge a financial firm’s overall interest-rate risk exposure and protect its net worth

26. Interest-Rate Options
The interest-rate option grants a holder of securities the right to either
Place (put) those instruments with another investor at a prespecified exercise price before the option expires or
Take delivery of securities (call) from another investor at a prespecified price before the option’s expiration date
In the put option, the option writer must stand ready to accept delivery of securities from the option buyer if the latter requests
In the call option, the option writer must stand ready to deliver securities to the option buyer upon request
The fee that the buyer must pay for the privilege of being able to put securities to or call securities away from the option writer is known as the option premium

27. Interest-Rate Options (continued)
For standardized exchange-traded interest-rate options, the most activity occurs using options on futures, referred to as the futures options market
Most common option contracts used by banks
U.S. Treasury Bond Futures Options
Grant the options buyer the right to a short position (put) or a long position (call) involving one T-bond futures contract for each option
Eurodollar Futures Option
Give the buyer the right to deliver (put) or accept delivery (call) of one Eurodollar deposit futures contract for every option exercised
Exchange-traded futures options are generally set to expire in March, June, September, or December to conform to most futures contracts

28. EXHIBIT 8–4 Futures Options Sample Prices

29. Interest-Rate Options (continued)
Most options today are used by money center banks
They appear to be directed at two principal uses
Protecting a security portfolio through the use of put options to insulate against falling security prices (rising interest rates)
There is no delivery obligation under an option contract so the user can benefit from keeping his or her securities if interest rates fall and security prices rise
Hedging against positive or negative gaps between interest- sensitive assets and interest-sensitive liabilities
For example, put options can be used to offset losses from a negative gap when interest rates rise, while call options can be used to offset a positive gap when interest rates fall

30. EXHIBIT 8–5 Payoff Diagrams for Put and Call Options Purchased by a Financial Institution

31. EXHIBIT 8–6 Payoff Diagrams for Put and Call Options Written by a Financial Firm

32. Regulations and Accounting Rules for Bank Futures and Options Trading
Regulators expect a financial firm’s board of directors to provide oversight while senior management is responsible for the development of an appropriate risk-management system
The risk-management system is to be comprised of
Policies and procedures to control financial risk taking
Risk measurement and reporting systems
Independent oversight and control processes
The OCC requires the banks it supervises to measure and set limits with regards to nine different aspects of risk associated with derivatives
These risks are strategic risk, reputation risk, price risk, interest rate risk, liquidity risk, foreign exchange risk, credit risk, transaction risk, and compliance risk

33. Regulations and Accounting Rules for Bank Futures and Options Trading (continued)
In 1998, the Financial Accounting Standards Board (FASB) introduced Statement 133 (FAS 133)
“Accounting for Derivative Instruments and Hedging Activities”
FAS 133 requires that all derivatives be recorded on the balance sheet as assets or liabilities at their fair value
With regard to interest rate risk, FAS 133 recognized two types of hedges: a fair value hedge and a cash flow hedge
The objective of a fair value hedge is to offset losses due to changes in the value of an asset or liability
Cash flow hedges try to reduce risk associated with future cash flows (interest on loans or interest payments on debt)

34. Interest-Rate Swaps
An interest-rate swap is a way to change a borrowing institution’s exposure to interest-rate fluctuations and achieve lower borrowing costs
Swap participants can convert from fixed to floating interest rates or from floating to fixed interest rates and more closely match the maturities of their liabilities to the maturities of their assets
The most popular short-term, floating rates used in interest rate swaps today include the London Interbank Offered Rate (LIBOR) on Eurodollar deposits, Treasury bill and bond rates, the prime bank rate, the Federal funds rate, and interest rates on CDs issued by depository institutions

35. Interest-Rate Swaps (continued)
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
Reverse Swap
A new swap agreement offsets the effects of an existing swap contract
“Swaptions”
Options for one or both parties to make certain changes in the agreement, take out a new option, or cancel an existing swap agreement

36. EXHIBIT 8–7 The Interest-Rate Swap

37. Interest-Rate Swaps (continued)
The principal amount of the loans, usually called the notional amount, is not exchanged
Only the net amount of interest due usually flows to one or the other party to the swap
The swap itself normally will not show up on a swap participant’s balance sheet
Actual defaults are limited
If a swap partner is rated BBB or lower, it may be impossible to find a counterparty to agree to the swap
Low-rated partner may be required to agree to a credit trigger clause
Basis risk and interest rate risk can be significant

38. Caps, Floors, and Collars
An interest-rate cap protects its holder against rising market interest rates
In return for paying an up-front premium, borrowers are assured that institutions lending them money cannot increase their loan rate above the level of the cap
Alternatively, the borrower may purchase an interest-rate cap from a third party, with that party promising to reimburse borrowers for any additional interest they owe their creditors beyond the cap

39. Caps, Floors, and Collars (continued)
Interest-Rate Cap Example
A bank purchases a cap of 11 percent on its borrowings of $100 million in the Eurodollar market for one year
Suppose interest rates in this market rise to 12 percent for the year
The financial institution selling the cap will reimburse the bank purchasing the cap the additional 1 percent in interest

40. Caps, Floors, and Collars (continued)
Financial-service providers can also lose earnings in periods of falling interest rates, especially when rates on floating-rate loans decline
A lending institution can establish an interest-rate floor under its loans so that, no matter how far loan rates tumble, it is guaranteed some minimum rate of return

41. Caps, Floors, and Collars (continued)
Interest-Rate Floor Example
Suppose a lender extends a $10 million floating-rate loan to one of its corporate customers for a year at prime insists on a minimum (floor) interest rate on this loan of 7 percent
If the prime rate drops below the floor to 6 percent for one year, the customer will pay not only the 6 percent prime rate but also pay out an interest rebate to the lender of
Assuming the borrower does not default, lender assured a minimum return of 7 percent on its loan

42. Caps, Floors, and Collars (continued)
Lending institutions and their borrowing customers also make heavy use of the interest-rate collar
Combines in one agreement a rate floor and a rate cap
Interest-Rate Collar Example
A customer who has just received a $100 million loan and asks for a collar on the loan’s prime rate between 11 percent and 7 percent
The lender will pay its customer’s added interest cost if prime rises above 11 percent, while the customer reimburses the lender if prime drops below 7 percent
The collar’s purchaser pays a premium for a rate cap while receiving a premium for accepting a rate floor
The net premium paid for the collar can be positive or negative, depending upon the outlook for interest rates and the risk aversion of borrower and lender at the time of the agreement

43. Quick Quiz
What are financial futures contracts? Which financial institutions use futures and other derivatives for risk management? How can financial futures help financial service firms deal with interest rate risk?
What futures transactions would most likely be used in a period of rising interest rates? Falling interest rates?
Explain what is involved in a put option. What is a call option? What is an option on a futures contract?
What is the purpose of an interest-rate swap?
How can financial-service providers make use of interest-rate caps, floors, and collars to generate revenue and help manage interest rate risk?