Transcript Rose - Middle Tennessee State University

Chapter Eight
Using Financial Futures, Options,
Swaps, and Other Hedging Tools in
Asset-Liability Management
McGraw-Hill/Irwin
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All Rights Reserved
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
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8-2
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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
• Chicago Board of
Trade (CBT)
• Chicago Board
Options Exchange
• Singapore Exchange
LTD. (SGX)
• Chicago Mercantile
Exchange (CME)
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• Euronext.Liffe
(Eurex)
• Sydney Futures
Exchange
• Toronto Futures
Exchange (TFE)
• South African
Futures Exchange
(SAFEX)
8-4
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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
Avoiding Higher
Borrowing Costs
and Declining
Asset Values
Avoiding Lower
Than Expected
Yields from Loans
and Securities
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

Use a Short Hedge:
Sell Futures
Contracts and then
Purchase Similar
Contracts Later
Use a long Hedge:
Buy Futures
Contracts and then
Sell Similar
Contracts Later 8-6
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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 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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Basis
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
= 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
i
Ft  F0  -D  F0  N 
(1  i)
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8-11
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Number of Futures Contracts
Needed
TL
(DA - D L *
)*T A
TA

D F * P riceof t heFut ures Cont ract
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8-12
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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
McGraw-Hill/Irwin
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Most Common Option Contracts
Used By Banks
• U.S. Treasury Bond Futures Options
• Eurodollar Futures Option
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8-15
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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
• 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
• OCC – Risk Management of Financial
Derivatives: Comptrollers Handbook
• FASB – Statement 133 – Accounting for
Derivatives Instruments and Hedging
Activities
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8-18
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Interest 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 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 Swaps
• Substantial Brokerage Fees
• Credit Risk
• Basis Risk
• Interest Rate Risk
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Netting
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 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 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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8-24
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Interest Rate Floor
A Contract Setting the Lowest
Interest Rate a Borrower is Allowed
to Pay on a Flexible-Rate Loan
McGraw-Hill/Irwin
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8-25
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Interest 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.
McGraw-Hill/Irwin
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