J. K. Dietrich - FBE 524 - Fall, 2005
Measuring and Managing Interest Rate Risk
Week 9 – October 19, 2005
J. K. Dietrich - FBE 524 - Fall, 2005
Interest rate risk
Future interest rates will affect value of all assets and liabilities, both real and financial assets and financial liabilities
No one knows future interest rates– Predictions of econometric models and the Lucas
critique– Supply and demand factors (e.g. bond calendar)
reflect expectations used in planning– Rational expectations and market rates
J. K. Dietrich - FBE 524 - Fall, 2005
Interest Rate Risk
Interest rates change constantly– Each element of rates change: real rate,
inflation premium, term premium, and risk premium
– Market participants have varying degrees of sensitivity to changes in components of rates
One way to view interest-rate risk is in terms of balance sheet risk
J. K. Dietrich - FBE 524 - Fall, 2005
Balance Sheet Risk
Real AssetsInventoriesEquipmentPlant Land
Financial AssetsReceivablesMoneyBondsStock
Financial LiabilitiesPayablesShort-term notesMortgagesBondsPreferred stock
Common Stock
Assets Liabilities and Equity
Incr
easi
ng
dura
tion
Incr
easi
ng
dura
tion
J. K. Dietrich - FBE 524 - Fall, 2005
Hedging Balance Sheet Risk
Hedging on balance sheet– Matching duration of assets and liabilities:
– Changing duration of assets and/or liabilities through swaps
– Floating rate securities with short re-pricing intervals have short durations
Hedging off balance sheet– Futures, forward contracts, and options
Weighted average asset duration = Weighted average liability duration
J. K. Dietrich - FBE 524 - Fall, 2005
Swaps
Exchange of future cash flows based on movement of some asset or price– Interest rates– Exchange rates– Commodity prices or other contingencies
Swaps are all over-the-counter contracts Two contracting entities are called counter-parties Financial institution can take both sides
J. K. Dietrich - FBE 524 - Fall, 2005
Interest Rate Swap:Plain vanilla, [email protected]%
Company A(receive floating)
Company B(receive fixed)
Notional Amount$100 mm
$2.5mm$2.75mm
1/2 5% fixed
1/2 6-month LIBOR
J. K. Dietrich - FBE 524 - Fall, 2005
Definition of Derivatives Derivatives are contracts
– Commit parties to certain actions/payments in the future
– The payment/action depends on outcomes of pre-specified events in the future
In most cases, the major cash flow or costly action will or may occur in the future, not in the present
Contracts can be standardized or negotiated
J. K. Dietrich - FBE 524 - Fall, 2005
Types of Derivative Contracts
Three basic types of contracts– Futures or forwards– Options– Swaps
Many basic underlying assets– Commodities– Currencies– Financial assets like fixed incomes or residual claims
J. K. Dietrich - FBE 524 - Fall, 2005
Derivatives = Value Derived from Prices of Other Assets
Stock market or equity price, commodity price, exchange and interest rate derivatives
Swaps, forwards and futures, options, and swap-options (or swaptions)
Traded and over-the-counter derivatives Derivative are a zero-sum game Credit risk in derivatives is performance
risk, not notional value risk
J. K. Dietrich - FBE 524 - Fall, 2005
Exposure to Risk
A general term to describe a firm’s exposure to a particular risk (e.g. a commodity price) is to classify the exposure as long or short
Long exposure means that the firm will benefit from increases in prices or values
Short exposure means that the firm will benefit from decreases in prices or values
J. K. Dietrich - FBE 524 - Fall, 2005
Long Exposure
A firm (or individual) is long if at the time of the risk assessment if it has or will have an asset or commodity. As examples– The firm owns assets, as in inventories of raw
materials or finished goods– The firm produces a commodity or product, as
in an agribusiness raising wheat or livestock– The firm will take possession in the future or a
commodity or an asset– The firm has bought a commodity or asset
J. K. Dietrich - FBE 524 - Fall, 2005
Short Exposure A firm (or individual) is short if at the time
of the risk assessment if it needs or will need an asset or commodity. As examples– The firm is planning or has promised to deliver
raw materials or finished goods – The firm uses a commodity or product in
production as inputs, like steel or lumber– The firm will have possession in the future or a
commodity or an asset it does not need or needs to sell
– The firm has sold a commodity or asset and must deliver
J. K. Dietrich - FBE 524 - Fall, 2005
Exposure to Risks
Time/Situation
Present orPresent Plan
Future TimePeriod
Have,Will Have, orWill Receive
LONG LONG
Need,Will Need, orWill Deliver
SHORT SHORT
J. K. Dietrich - FBE 524 - Fall, 2005
Examples of Exposure
Farmer with wheat is long wheat Honey Baked Ham is short pork before
Easter selling season Treasurer with excess cash in three months is
short investments Company needing cash in nine months is
long financial assets (its liabilities are others’ assets) to sell
J. K. Dietrich - FBE 524 - Fall, 2005
Price Exposure in a Diagram
P0 P0
Long
Short
Profit
Loss
0 0
Profit
Loss
J. K. Dietrich - FBE 524 - Fall, 2005
Futures Contracts
Wall Street Journal tables Standardized contracts
– Quantity and quality– Delivery date– Last trading date– Deliverables
Clearing house is counter-party Margin requirements, mark to market
J. K. Dietrich - FBE 524 - Fall, 2005
Forward vs. Futures Contracts
Bilateral contract (usually with a financial firm as counter-party)
Terms are tailor made to needs of client, not standardized
No exchange of cash until maturity of contract
Over-the-counter market not as liquid as organized exchange
J. K. Dietrich - FBE 524 - Fall, 2005
Managing Risk with Futures
Offset price or interest rate risk with contract which moves in opposite direction
“Cross diagonally in the box” Identify contract with price or interest rate
which moves as close as possible with the price or interest rate exposure
Imperfect correlation is basis risk Not using futures or forwards can be speculation
J. K. Dietrich - FBE 524 - Fall, 2005
Hedging
Time/Situation
Present orPresent Plan
Future TimePeriod
Have,Will Have, orWill Receive
LONG LONG
Need,Will Need, orWill Deliver
SHORT SHORT
Honey-BakedPlan Now
Honey-BakedHedge
Corporation Planning to Borrow
Borrowing Hedge
J. K. Dietrich - FBE 524 - Fall, 2005
Options (Definition)
An option is the right (not the obligation) to buy or sell an asset at a fixed price before a given date– call is right to buy, put is right to sell– strike or exercise price is a fixed price which
determines conversion value– expiration date
Options on stocks, commodities, real estate, and future contracts
J. K. Dietrich - FBE 524 - Fall, 2005
Interpreting Option Quotationsin the Wall Street Journal
Listed option quotations versus “over-the-counter” options
Stock versus commodity Futures options versus asset options Strike/Expiration of Call/Put Volume, last, and open interest LEAPs and index options
J. K. Dietrich - FBE 524 - Fall, 2005
Call Options Profits at Maturity
0Strike Price
Profit
Asset Value
Payoffto Buyer
J. K. Dietrich - FBE 524 - Fall, 2005
Call Writer’s (Seller’s) Profits
0Strike Price
Profit
Loss
Asset Value
Possible Cost to Writer
J. K. Dietrich - FBE 524 - Fall, 2005
Option Value Sensitivityto Price Changes in Assets
Write Put Write Call
Buy Put Buy Call
S S
J. K. Dietrich - FBE 524 - Fall, 2005
Option Values
Conversion value = asset value - strike price Option premium = Option value - conversion
value Factors determining option premiums
» Time to maturity
» Asset value
» Strike price
» Volatility
» Interest rate
J. K. Dietrich - FBE 524 - Fall, 2005
Value of Call Options
0
Profit
Asset Value
OptionPremium
Strike Price
“Out of the Money”“At the Money”
“In the Money”
J. K. Dietrich - FBE 524 - Fall, 2005
Caps, floors, and collars
If a borrower has a loan commitment with a cap (maximum rate), this is the same as a put option on a note
If at the same time, a borrower commits to pay a floor or minimum rate, this is the same as writing a call
A collar is a cap and a floor
J. K. Dietrich - FBE 524 - Fall, 2005
Replication Futures with Options
P0 P0
LongProfit
Loss
0 0
Profit
Loss
Buy Call
Write Put
J. K. Dietrich - FBE 524 - Fall, 2005
Other option developments
Credit risk options Casualty risk options Requirements for developing an option
– Interest– Calculable payoffs– Enforceable
J. K. Dietrich - FBE 524 - Fall, 2005
Next week: Oct. 26, 2005 Provide me with one-page description of
group project, including (1) problem to be addressed, (2) analytical framework to be used, and (3) data analysis and sources to be employed to address problem in (1)
Read Chapters 10 and 11 and review contents of Instruments of the Money Market
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