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Chapter EightChapter Eight

Using Financial Futures, Options, Swaps, and Other

Hedging Tools in Asset-Liability Management

Using Financial Futures, Options, Swaps, and Other

Hedging Tools in Asset-Liability Management

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Financial Futures ContractFinancial 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

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The Purpose of Financial Futures

The Purpose of Financial Futures

To Shift the Risk of Interest Rate Fluctuations from Risk-Averse Investors to Speculators

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The World’s Leading Futures and Option Exchanges

The World’s Leading Futures and Option Exchanges

• Chicago Board of Trade (CBT)

• Chicago Board Options Exchange

• Singapore Exchange LTD. (SGX)

• Chicago Mercantile Exchange (CME)

• Euronext.Liffe (Eurex)

• Sydney Futures Exchange

• Toronto Futures Exchange (TFE)

• South African Futures Exchange (SAFEX)

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Most Common Financial Futures Contracts

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

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Hedging with Futures Contracts

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

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Short 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

• 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)

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Long Futures Hedge ProcessLong 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 Price Purchase For (At the Beginning) and the Price Sold For (At the End)

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BasisBasis

Cash-Market Price (or Interest Rate) Less the Futures-Market Price (or Interest Rate)

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Realized Return from Combining Cash and Futures

Market Trading

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

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Change in the Market Value of the Futures Contract

Change in the Market Value of the Futures Contract

i)(1

i NF -DFF 00t

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Number of Futures Contracts NeededNumber of Futures Contracts Needed

Contract Futures theof Price * D

TA *) TATL

* D - (D

F

LA

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Interest Rate OptionInterest 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.

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Types of OptionsTypes 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

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Most Common Option Contracts Used By Banks

Most Common Option Contracts Used By Banks

• U.S. Treasury Bond Futures Options

• Eurodollar Futures Option

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Principal Uses of Option Contracts

Principal Uses of Option Contracts

• Protection of a Security Portfolio• Hedging Against Positive or

Negative Gap Positions

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Federal Funds Options and Futures

Federal Funds Options and Futures

• Represents the Consensus Opinion Of the Likely Future Course of Market Interest Rates

• Public Trading for Futures Contract Began at the CBOT in 1988

• Public Trading on Options Contracts Began in 2003

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Regulations For Options and Future Contracts

Regulations For Options and Future Contracts

• OCC – Risk Management of Financial Derivatives: Comptrollers Handbook

• FASB – Statement 133 – Accounting for Derivatives Instruments and Hedging Activities

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Interest Rate SwapInterest Rate Swap

A Contract Between Two Parties to Exchange Interest Payments in an Effort to Save Money and Hedge Against Interest-Rate Risk

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Quality SwapQuality 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

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Risks of Interest Rate SwapsRisks of Interest Rate Swaps

• Substantial Brokerage Fees• Credit Risk• Basis Risk• Interest Rate Risk

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NettingNetting

The Swap Parties Only Swap the Net Difference Between the Interest Payments. This Reduces the Potential Damage if One Party Defaults on its Obligation

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Currency SwapCurrency Swap

An Agreement Between Two Parties, Each Owing Funds to Other Contractors Denominated in Different Currencies, to Exchange the Needed Currencies with Each Other and Honor Their Respective Contracts.

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Interest Rate CapInterest Rate Cap

Protects the Holder from Rising Interest Rates. For an Up Front Fee Borrowers are Assured Their Loan Rate Will Not Rise Above the Cap Rate

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Interest Rate FloorInterest Rate Floor

A Contract Setting the Lowest Interest Rate a Borrower is Allowed to Pay on a Flexible-Rate Loan

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Interest Rate CollarInterest Rate Collar

A Contract Setting the Maximum and Minimum Interest Rates That May Be Assessed on a Flexible-Rate Loan. It Combines an Interest Rate Cap and Floor into One Contract.