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Chapter Eight. Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management. 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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Chapter eight

Chapter Eight

Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management


Financial futures contract
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


The purpose of financial futures
The Purpose of Financial Futures

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


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)

The World’s Leading Futures and Option Exchanges


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



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)


Long futures hedge process
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)


Basis
Basis

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


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




Interest rate option
Interest Rate Option Trading

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.


Types of options
Types of Options Trading

  • 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


Most common option contracts used by banks
Most Common Option Contracts Used By Banks Trading

  • U.S. Treasury Bond Futures Options

  • Eurodollar Futures Option


Principal uses of option contracts
Principal Uses of Option Contracts Trading

  • Protection of a Security Portfolio

  • Hedging Against Positive or Negative Gap Positions


Federal funds options and futures
Federal Funds Options and Futures Trading

  • 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


Regulations for options and future contracts
Regulations For Options and Future Contracts Trading

  • OCC – Risk Management of Financial Derivatives: Comptrollers Handbook

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


Interest rate swap
Interest Rate Swap Trading

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


Quality swap
Quality Swap Trading

  • 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


Risks of interest rate swaps
Risks of Interest Rate Swaps Trading

  • Substantial Brokerage Fees

  • Credit Risk

  • Basis Risk

  • Interest Rate Risk


Netting
Netting Trading

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


Currency swap
Currency Swap Trading

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.


Interest rate cap
Interest Rate Cap Trading

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


Interest rate floor
Interest Rate Floor Trading

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


Interest rate collar
Interest Rate Collar Trading

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.


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