Futures and Futures and ForwardsForwards

Chapter 23

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin

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Overview

Derivative securities have become increasingly important as FIs seek methods to hedge risk exposures. The growth of derivative usage is not without controversy since misuse can increase risk. This chapter explores the role of futures and forwards in risk management.

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Futures and Forwards

Second largest group of interest rate derivatives in terms of notional value and largest group of FX derivatives. Swaps are the largest.

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Derivatives

Rapid growth of derivatives use has been controversial Orange County, California Bankers Trust Allfirst Bank (Allied Irish)

As of 2000, FASB requires that derivatives be marked to market Transparency of losses and gains on financial

statements

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Web Resources

For further information on the web, visit

FASB www.fasb.org

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Spot and Forward Contracts

Spot Contract Agreement at t=0 for immediate delivery and

immediate payment. Forward Contract

Agreement to exchange an asset at a specified future date for a price which is set at t=0.

Counterparty risk

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Futures Contracts

Futures Contract similar to a forward contract except: Marked to market Exchange traded

Rapid growth of off market trading systems Standardized contracts

Smaller denomination than forward Lower default risk than forward contracts.

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Hedging Interest Rate Risk

Example: 20-year $1 million face value bond. Current price = $970,000. Interest rates expected to increase from 8% to 10% over next 3 months.

From duration model, change in bond value:

P/P = -D R/(1+R)

P/ $970,000 = -9 [.02/1.08]

P = -$161,666.67

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Example continued: Naive hedge

Hedged by selling 3 months forward at forward price of $970,000.

Suppose interest rate rises from 8%to 10%.

$970,000 - $808,333 =$161,667

(forward (spot price

price) at t=3 months) Exactly offsets the on-balance-sheet loss. Immunized.

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Hedging with futures

Futures more commonly used than forwards. Microhedging

Individual assets. Macrohedging

Hedging entire duration gap Found more effective and generally lower cost.

Basis risk Exact matching is uncommon Standardized delivery dates of futures reduces

likelihood of exact matching.

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Routine versus Selective Hedging

Routine hedging: reduces interest rate risk to lowest possible level.

Low risk - low return. Selective hedging: manager may selectively

hedge based on expectations of future interest rates and risk preferences.

Partially hedge duration gap or individual assets or liabilities

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Macrohedging with Futures

Number of futures contracts depends on interest rate exposure and risk-return tradeoff.

E = -[DA - kDL] × A × [R/(1+R)]

Suppose: DA = 5 years, DL = 3 years and interest rate expected to rise from 10% to 11%. A = $100 million.

E = -(5 - (.9)(3)) $100 (.01/1.1) = -$2.091 million.

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Risk-Minimizing Futures Position

Sensitivity of the futures contract:

F/F = -DF [R/(1+R)]

Or,

F = -DF × [R/(1+R)] × F and

F = NF × PF

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Risk-Minimizing Futures Position

Fully hedged requires

F = E

DF(NF × PF) = (DA - kDL) × A

Number of futures to sell:

NF = (DA- kDL)A/(DF × PF)

Perfect hedge may be impossible since number of contracts must be rounded down.

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Payoff profiles

Short Position Long Position

Futures Price

Futures Price

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Futures Price Quotes

T-bond futures contract: $100,000 face value

T-bill futures contract: $1,000,000 face value quote is price per $100 of face value Example: 112 23/32 for T-bond indicates

purchase price of $112,718.75 per contract Delivery options

Conversion factors used to compute invoice price if bond other than the benchmark bond delivered

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Basis Risk

Spot and futures prices are not perfectly correlated.

We assumed in our example that

R/(1+R) = RF/(1+RF) Basis risk remains when this condition does

not hold. Adjusting for basis risk,

NF = (DA- kDL)A/(DF × PF × br) where

br = [RF/(1+RF)]/ [R/(1+R)]

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Hedging FX Risk

Hedging of FX exposure parallels hedging of interest rate risk.

If spot and futures prices are not perfectly correlated, then basis risk remains.

Tailing the hedge Interest income effects of marking to market

allows hedger to reduce number of futures contracts that must be sold to hedge

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Basis Risk

In order to adjust for basis risk, we require the hedge ratio,

h = St/ft

Nf = (Long asset position × estimate of h)/(size of one contract).

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Estimating the Hedge Ratio

The hedge ratio may be estimated using ordinary least squares regression:

St = + ft + ut

The hedge ratio, h will be equal to the coefficient . The R2 from the regression reveals the effectiveness of the hedge.

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Hedging Credit Risk

More FIs fail due to credit-risk exposures than to either interest-rate or FX exposures.

In recent years, development of derivatives for hedging credit risk has accelerated. Credit forwards, credit options and credit swaps.

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Credit Forwards

Credit forwards hedge against decline in credit quality of borrower. Common buyers are insurance companies. Common sellers are banks. Specifies a credit spread on a benchmark bond

issued by a borrower. Example: BBB bond at time of origination may have

2% spread over U.S. Treasury of same maturity.

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Credit Forwards

CSF defines agreed forward credit spread at time contract written

CST = actual credit spread at maturity of forward

Credit Spread Credit Spread Credit Spread

at End Seller Buyer

CST> CSF Receives Pays

(CST - CSF)MD(A) (CST -C SF)MD(A)

CSF>CST Pays Receives

(CSF - CST)MD(A) (CSF - CST)MD(A)

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Futures and Catastrophe Risk

CBOT introduced futures and options for catastrophe insurance. Contract volume is rising. Catastrophe futures to allow PC insurers to

hedge against extreme losses such as hurricanes.

Payoff linked to loss ratio (insured losses to premiums)

Example: Payoff = contract size × realized loss ratio – contract size × contracted futures loss ratio. $25,000 × 1.5 - $25,000 – 0.8 = $17,500 per contract.

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Regulatory Policy

Three levels of regulation: Permissible activities Supervisory oversight of permissible activities Overall integrity and compliance

Functional regulators SEC and CFTC

As of 2000, derivative positions must be marked-to-market.

Exchange traded futures not subject to capital requirements: OTC forwards potentially subject to capital requirements

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Regulatory Policy for Banks

Federal Reserve, FDIC and OCC require banks Establish internal guidelines regarding hedging. Establish trading limits. Disclose large contract positions that materially

affect bank risk to shareholders and outside investors.

Discourage speculation and encourage hedging Allfirst/Allied Irish: Existing (and apparently

inadequate) policies were circumvented via fraud and deceit.

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Federal Reserve www.federalreserve.gov

Chicago Board of Trade www.cbot.org

Chicago Mercantile Exchange www.cme.com

CFTC www.cftc.gov

FDIC www.fdic.gov

FASB www.fasb.org

OCC www.ustreas.gov

SEC www.sec.gov

Pertinent websites