1. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter 8 8 Using Financial Futures and Options in Bank Asset- Liability Management The purpose of this chapter is to examine how financial futures contracts can be employed to help reduce a bank’s potential exposure to loss due to changing interest rates and other forces in the economy.

3. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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

4. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Purpose of Financial Futures To Shift the Risk of Interest Rate Fluctuations from Risk-Averse Investors to Speculators

5. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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)

6. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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

7. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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

8. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Basis Risk Cash-Market Price (or Interest Rate) Less the Futures-Market Price (or Interest Rate)

9. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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

10. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Number of Futures Contracts Needed

11. Copyright © 2002 by 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.

12. Copyright © 2002 by 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

13. Copyright © 2002 by 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

14. Copyright © 2002 by 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