chapter eight risk management: financial futures, options, and other hedging tools copyright © 2010...
TRANSCRIPT
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
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/IrwinBank Management and Financial Services, 7/e
Key Topics
•The Use of Derivatives
•Financial Futures Contracts
• Interest-Rate Options
•Caps, Floors, and Collars
8-2
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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.
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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
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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
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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.
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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.
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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
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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
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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)
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Financial Futures and Interest Rate Risk Management
•Measurement of interest rate risks
TA
TL * D - D D LA
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
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Hedging with Futures Contracts
IS GAP Position Interest Rate Risk Futures Transaction
Positive rise None
Positive fall Long Hedge
Negative rise Short Hedge
Negative fall None
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Hedging with Futures Contracts
Duration GAP Position Interest Rate Futures Transaction
Positive rise Short Hedge
Positive fall None
Negative rise None
Negative fall Long Hedge
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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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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
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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.
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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
* * *1A L
TL iNW D D TA
TA i
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Number of Futures Contracts Needed
0
0
0
* * *1
* *1
* *
*
t
A L
F
A L
F
Number of futures contracts needed
NW
F F
TL iD D TA
TA ii
D Fi
TLD D TA
TAD F
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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
0.019 *99,700*
1 0.078385.98
Change in market value of a T bond futures contract
years
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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
4604 *2 *500
5009 *99,700
1,200
years years millionN
years
contracts
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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
0 0
0 0
Re
=
Re
= -
t t
t t
turn from a combined cash and futures position
C C F F
arrange the above formula
C F C F
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Basis Risk
•Basis risk with a long hedge
0 0
0 0
Re
=
Re
= -
t t
t t
turn from a combined cash and futures position
C C F F
arrange the above formula
C F C F
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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.
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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
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Call Option-Gain (Loss)
St
-Premium
Allow the option to expire
S0-Strike price
Exercise the option
S1-Breakeven point
Exercise the option
Profit
Loss
Seller
Buyer
Premium
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Call Option-Gain (Loss) of Buyers
St Gain/Loss
0 < St <S0
Loss=Option premium (not exercise the option)
S0≤St < S1 Loss= (St- S0)-Option premium (exercise the option )
St=S1 Breakeven point: (St- S0)=Option premium (exercise the
option )
St > S1 Gain= (St- S0)-Option premium (exercise the option )
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Put Option-Gain (Loss) Profit
Loss
Buyer
Seller
S0-Strike price
S1-Breakeven point
-Premium
Premium
Allow the option to expire
Exercise the option
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Put Option-Gain (Loss) of Buyers
St Gain/Loss
St > S0 Loss=Option premium (not exercise the option)
S1 < St ≤ S0 Loss= (St- S0)-Option premium (exercise the option )
St=S1 Breakeven point: (St- S0)=Option premium (exercise the
option )
0 < St <S1
Gain= (St- S0)-Option premium (exercise the option )
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8-29
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8-30
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Principal Uses of Option Contracts
IS GAP Position Interest Rate Option Transaction
Positive rise None
Positive fall Buy Put/Sell Call
Negative rise Buy Call/Sell Put
Negative fall None
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Principal Uses of Option Contracts
Duration GAP Position Interest Rate Option Transaction
Positive rise Buy Call/Sell Put
Positive fall None
Negative rise None
Negative fall Buy Put/Sell Call
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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