1. Chapter Eight Risk Management: Financial Futures, Options, and Other Hedging Tools Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

2. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Key Topics The Use of Derivatives Financial Futures Contracts Interest-Rate Options Caps, Floors, and Collars 8-2

3. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Derivatives A derivative is any instrument or contract that derives its value from another underlying asset, instrument, or contract, such as Treasury bills and bonds and Eurodollar deposits. 8-3

4. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Managing Interest Rate Risk Derivatives Used to Manage Interest Rate Risk ▫ Financial Futures Contracts ▫ Forward Rate Agreements ▫ Options on Interest Rates ▫ Other hedging tools (Interest Rate Caps, Floors and Collars 8-4

5. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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. Financial futures are usually accounted for as off- balance-sheet items. 8-5

6. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Financial Futures Contract cash (spot) markets and futures markets Interest Rate Futures ▫ In cash markets, sellers of financial assets remove the assets from their balance sheet and account for the losses/gains on their income statements. Buyers of financial assets add the item purchased to their balance sheet. ▫ In futures markets buyers and sellers exchange a contract calling for delivery of the underlying financial asset at a specified date in the future. When the contract is created, neither the buyer nor the seller is making a purchase or sale at that point in time, only an agreement for the future.

7. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Marked-to-market Mechanism Initial margin. ▫ The initial margin is a minimum dollar amount per contract specified by the exchange. This deposit may be in cash or in the form of a security, such as a Treasury bill. Maintenance margin (the minimum specified by the exchange) The mark-to-market process takes place at the end of each trading day. This mechanism allows traders to take a position with a minimum investment of funds.

8. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Futures vs. Forward Contracts ▫ Futures Contracts  Traded on formal exchanges (CBOT, CME, etc.)  Involve standardized instruments  Positions require a daily marking to market ▫ Forward Contracts  Terms are negotiated between parties  Do not necessarily involve standardized assets  Require no cash exchange until expiration  No marking to market 8-8

9. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Short & Long Futures Hedge Process Short futures hedge process ▫ Today – Contract is Sold Through an Exchange ▫ Sometime in the Future – Contract is Purchased Through the Same Exchange Long futures hedge process ▫ Today – Contract is purchased through an exchange ▫ Sometime in the Future – Contract is sold through the same exchange 8-9

10. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Short & Long Futures Hedge Process 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 price sold for (at the beginning)

11. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Financial Futures and Interest Rate Risk Management Measurement of interest rate risks IS Gap = IS Assets – IS Liabilities Recall what happens when interest rates rise? Fall? One of the most popular methods for neutralizing these gap risks is to buy and sell financial futures contracts 8-11

12. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Hedging with Futures Contracts IS GAP PositionInterest Rate RiskFutures Transaction PositiveriseNone PositivefallLong Hedge NegativeriseShort Hedge NegativefallNone

13. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Hedging with Futures Contracts Duration GAP PositionInterest RateFutures Transaction PositiveriseShort Hedge PositivefallNone NegativeriseNone NegativefallLong Hedge

14. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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

15. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Hedging with Futures Contracts Example 8-1: suppose a depository institution needed to raise 100 million from sales of deposits over the next 90 days, its marginal cost of issuing the new deposits at a 10 percent annual rate would be as follows: 100 million *0.1*(90/360)=2500,000 However, if the interest rate climb to 10.5 percent, the marginal deposit cost becomes 100 million *0.15* *(90/360)=2,625,000 Amount of added fund-raising costs (and potential loss in profit): 125,000

16. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Hedging with Futures Contracts An offsetting financial futures transaction ▫ To counteract the potential profit loss of 125,000, management might select the following financial futures transaction: ▫ Today : sell 100 90-day Eurodollar futures contracts trading at an IMM index of 91.5. ▫ Price per 100= 100-((100-IMM index)*(90/360)=97.875 ▫ 100 contracts=97,875,000 ▫ Within next 90 days: buy 100 90-day Eurodollar futures contracts trading on the day of purchase at IMM index of 91. ▫ 100 contracts =97,750,000 ▫ Profit on the completion of sale and purchase of futures=125,000 ▫ Result: higher deposit cost has been offset by a gain in futures.

17. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Number of Futures Contracts Needed 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. We quantify the change in net worth from an increase in interest rates as follows: 8-17

18. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Number of Futures Contracts Needed

19. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Number of Futures Contracts Needed Example 8-2: suppose a 100,000 par value Treasury bond futures contract is traded at a price of 99,700 initially but then interest rates on T-bonds increase from 7 to 8 percent. If the T-bond has a duration of nine years, then the change in the value of one T-bond futures contract would be

20. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Number of Futures Contracts Needed Example 8-3: suppose a bank has an average asset duration of four years, an average liability duration of two years, total assets of 500 million, and total liabilities of 460 million. Suppose that the bank plans to trade in Treasury bond futures contracts. The T-bond named in the futures contracts have a duration of nine years and the T-bond current price is 99,700 per 100,000 contract. Then this institution would need about

21. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 Basis=Cash-market price (or interest rate) – futures market price (or interest rate) Basis risk with a short hedge

22. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Basis Risk Basis risk with a long hedge

23. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Option (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.

24. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 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 8-24

25. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Call Option-Gain (Loss) St -Premium Allow the option to expire S 0 -Strike price Exercise the option S 1 -Breakeven point Exercise the option Profit Loss Seller Buyer Premium

26. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Call Option-Gain (Loss) of Buyers StGain/Loss 0 ＜ St ＜ S 0 Loss=Option premium (not exercise the option) S 0 ≤St ＜ S 1 Loss= (St- S 0 )-Option premium (exercise the option ) St= S 1 Breakeven point: (St- S 0 )=Option premium (exercise the option ) St ＞ S 1 Gain= (St- S 0 )-Option premium (exercise the option )

27. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Put Option-Gain (Loss) Profit Loss Buyer Seller S 0 -Strike price S 1 -Breakeven point -Premium Premium Allow the option to expire Exercise the option

28. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Put Option-Gain (Loss) of Buyers StGain/Loss St ＞ S 0 Loss=Option premium (not exercise the option) S 1 ＜ St ≤ S 0 Loss= (St- S 0 )-Option premium (exercise the option ) St= S 1 Breakeven point: (St- S 0 )=Option premium (exercise the option ) 0 ＜ St ＜ S 1 Gain= (St- S 0 )-Option premium (exercise the option )

29. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 8-29

30. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 8-30

31. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Principal Uses of Option Contracts IS GAP PositionInterest RateOption Transaction PositiveriseNone PositivefallBuy Put/Sell Call NegativeriseBuy Call/Sell Put NegativefallNone

32. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Principal Uses of Option Contracts Duration GAP PositionInterest RateOption Transaction PositiveriseBuy Call/Sell Put PositivefallNone NegativeriseNone NegativefallBuy Put/Sell Call

33. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Bank Management and Financial Services, 7/e Other Hedging Tools Interest Rate Cap ▫ Protects the holder from rising interest rates. Borrowers are assured their loan rate will not rise above the Cap Rate. Interest Rate Floor ▫ A Contract Setting the Lowest Interest Rate a Borrower is Allowed to Pay on a Flexible-Rate Loan Interest Rate Collar ▫ A Contract Setting the Maximum and Minimum Interest Rates. It Combines an Interest Rate Cap and Floor into One Contract. 8-33