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Chapter Six. Risk Management: Financial Futures, Options, Swaps, and Other Hedging Tools. Key Topics. The Use of Derivatives Financial Futures Contracts: Purpose and Mechanics Interest-Rate Options: Types of Contracts and Mechanics Interest-Rate Swaps Regulations and Accounting Rules.

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chapter six

Chapter Six

Risk Management: Financial Futures,

Options, Swaps, and Other Hedging Tools

key topics
Key Topics
  • The Use of Derivatives
  • Financial Futures Contracts: Purpose and Mechanics
  • Interest-Rate Options: Types of Contracts and Mechanics
  • Interest-Rate Swaps
  • Regulations and Accounting Rules
introduction p 167 168
Introduction p. 167-168
  • The asset-liability management tools in this chapter are useful for banks sensitive to the risk of changes in market interest rates
  • Many of the risk management tools in this chapter are not only used by banks to cover their own interest rate risk, but are also sold to customers who need risk protection and generate fee income for the banks
  • Most of the financial instruments in this chapter are derivatives
    • They derive their value from the value and terms of underlying instruments
uses of derivative contracts among fdic insured banks p 168
Uses of Derivative Contracts Among FDIC-Insured Banks p. 168
  • Due to their high exposure to various forms of risk, banks and their competitors are among the heaviest users of derivative contracts
  • These risk-hedging instruments allow a financial firm to protect its balance sheet and/or income and expense statement in case interest rates, currency prices, or other financial variables move against the hedger
  • Hedging: A means of protection or defense, especially against financial loss. For example, protection against inflation (rising prices)
  • Approximately 15 percent of all banks operating in the United States reportedly employ the use of derivatives to manage risk in its various forms
uses of derivative contracts among fdic insured banks p 1681
Uses of Derivative Contracts Among FDIC-Insured Banks p. 168

Today the bulk of trading in derivatives is centered in the very largest banks worldwide

  • Interest-rate risk is by far the most common target for derivatives, with foreign exchange (currency) risk running a distant second
  • The leading type of risk-hedging contracts are swaps, followed by financial futures and options
slide6
EXHIBIT 8-1 Types of Derivative Contracts Used by Depository Institutions to Manage Different Types of Risk Exposure, 2010 p. 169
financial futures contracts promises of future security trades at a preset price p 169
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price p. 169
  • In Chapter 5, we explored the nature of gaps between assets and liabilities that are exposed to interest rate risk
financial futures contracts promises of future security trades at a preset price continued p 169
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) p. 169
  • A financial futures contract is an agreement reached today between a buyer and a seller that calls for delivery of a security in exchange for cash at some future date
  • Financial futures trade in futures markets and are usually accounted for as off-balance-sheet items on the financial statements of financial-service firms
  • Sellers of financial assets remove the assets from their balance sheet and account for the losses or gains on their income statements
financial futures contracts promises of future security trades at a preset price continued p 170
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) p. 170
  • Buyers of financial assets add the item purchased to their balance sheet
  • In cash markets, buyers and sellers exchange the financial asset for cash at the time the price is set
  • In futures markets buyers and sellers exchange a contract calling for delivery of the financial asset at a specified date in the future
financial futures contracts promises of future security trades at a preset price continued p 1701
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) p. 170
  • When the contract is created, neither buyer nor seller is making a purchase or sale at that point in time, only an agreement for the future
  • When an investor buys or sells futures contracts at a designated price, it must deposit an initial amount (margin) of money
    • The initial margin is the investor’s equity in the position when he or she buys (or sells) the contract
financial futures contracts promises of future security trades at a preset price continued p 1702
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) p. 170
  • Each trader’s account is marked-to-market
    • When a trader’s equity position falls below the maintenance margin (the minimum specified by the exchange) the trader must deposit additional funds to the equity account to maintain his or her position, or the futures position is closed out within 24 hours
    • The mark-to-market process takes place at the end of each trading day
financial futures contracts promises of future security trades at a preset price continued
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
  • Buyers of futures contracts
    • A buyer of a futures contract is said to be long futures
    • Agrees to pay the asset’s futures price or take delivery of the asset
    • Buyers gain when futures prices rise and lose when futures prices fall
financial futures contracts promises of future security trades at a preset price continued1
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
  • Sellers of futures contracts
    • A seller of a futures contract is said to be short futures
    • Agrees to receive the asset’s futures price or to deliver the asset
    • Sellers gain when futures prices fall and lose when futures prices rise
financial futures contracts promises of future security trades at a preset price continued2
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
  • The financial futures markets are designed to shift the risk of interest-rate changes from investors who want to minimize risk, such as banks and insurance companies, to speculators/investors who are willing to accept and possibly profit from such risks
  • Futures contracts are traded on organized exchanges
    • For example, the Chicago Mercantile Exchange or the London Financial Futures Exchange
  • On the exchange floor, floor brokers execute orders received from the public to buy or sell these contacts at the best prices available
financial futures contracts promises of future security trades at a preset price continued3
Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued)
  • 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
interest rate options p 180 185
Interest-Rate Options p. 180-185
  • The interest-rate option grants a holder of securities the right to either
    • Place (put) those instruments with another investor at an agreed upon exercise price before the option expires or
    • Take delivery of securities (call) from another investor at a an agreed upon price before the option’s expiration date
  • In the put option, the option writer must stand ready to accept delivery of securities from the option buyer if the buyer requests
  • In the call option, the option writer must stand ready to deliver securities to the option buyer upon request
  • The fee that the buyer must pay for the privilege of being able to put securities to or call securities away from the option writer is known as the option premium
interest rate options continued
Interest-Rate Options (continued)
  • For standardized exchange-traded interest-rate options, the most activity occurs using options on futures, referred to as the futures options market
  • Most common option contracts used by banks
    • U.S. Treasury Bond Futures Options
      • Grant the options buyer the right to a short position (put) or a long position (call) involving one T-bond futures contract for each option
    • Eurodollar Futures Option
      • Give the buyer the right to deliver (put) or accept delivery (call) of one Eurodollar deposit futures contract for every option exercised
  • Exchange-traded futures options are generally set to expire in March, June, September, or December to conform to most futures contracts
interest rate options continued1
Interest-Rate Options (continued)
  • Most options today are used by money center (large) banks
  • They appear to be directed at two principal uses
    • Protecting a security portfolio through the use of put options to protect against falling security prices (rising interest rates)
      • There is no delivery obligation under an option contract so the user can benefit from keeping his or her securities if interest rates fall and security prices rise
    • Hedging against positive or negative gaps between interest-sensitive assets and interest-sensitive liabilities
      • For example, put options can be used to offset losses from a negative gap when interest rates rise, while call options can be used to offset a positive gap when interest rates fall
exhibit 8 5 payoff diagrams for put and call options purchased by a financial institution
EXHIBIT 8–5 Payoff Diagrams for Put and Call Options Purchased by a Financial Institution
regulations and accounting rules for bank futures and options trading p 186 187
Regulations and Accounting Rules for Bank Futures and Options Trading p. 186-187
  • Regulators expect a financial firm’s board of directors to provide oversight while senior management is responsible for the development of an appropriate risk-management system
  • The risk-management system is to be comprised of
    • Policies and procedures to control financial risk taking
    • Risk measurement and reporting systems
    • Independent oversight and control processes
  • The OCC requires the banks it supervises to measure and set limits with regards to nine different aspects of risk associated with derivatives
    • These risks are strategic risk, reputation risk, price risk, interest rate risk, liquidity risk, foreign exchange risk, credit risk, transaction risk, and compliance risk
interest rate swaps p 188 192
Interest-Rate Swaps p. 188-192
  • An interest-rate swap is a way to change a borrowing institution’s exposure to interest-rate fluctuations and achieve lower borrowing costs
  • Swap participants can convert from fixed to floating interest rates or from floating to fixed interest rates and more closely match the maturities of their liabilities to the maturities of their assets
    • The most popular short-term, floating rates used in interest rate swaps today include the London Interbank Offered Rate (LIBOR) on Eurodollar deposits, Treasury bill and bond rates, the prime bank rate, the Federal funds rate, and interest rates on CDs issued by depository institutions
interest rate swaps continued p 188 189
Interest-Rate Swaps (continued) p. 188-189
  • The principal amount of the loans, usually called the notional amount, is not exchanged
    • Only the net amount of interest due usually flows to one or the other party to the swap
    • The swap itself normally will not show up on a swap participant’s balance sheet
  • Actual defaults are limited
  • If a swap partner is rated BBB or lower, it may be impossible to find a counterparty to agree to the swap
    • Low-rated partner may be required to agree to a credit trigger clause
  • Basis risk and interest rate risk can be significant
chapter 6 summary
CHAPTER 6 SUMMARY
  • This chapter focused on derivatives - financial futures contracts such as, options and swaps that help banks deal with losses due to changing market interest rates.
  • Financial futures contracts are agreements to deliver bonds, treasury bills at a certain prices on a future date. These derivatives are more common because of their low cost.
  • Option contracts give owners the right to deliver (put) or take delivery of (call) of a stock at a specified (certain) price on or before a future date. Options provide risk protection should interest rates change.
  • Interest-rate swapsare agreements between 2 people or parties to exchange interest payments so that each party or person or bank can better match cash inflows and ourflows.
  • Derivatives are used more by large banks and insurance companies.
quick quiz
Quick Quiz

1.What are financial futures contracts? Slide 8 p 169. Which financial institutions use futures and other derivatives for risk management? Slide 4 p. 168

2. How can financial futures help financial service firms deal with interest rate risk? Bottom of page 170

3. What futures transactions would most likely be used in a period of rising interest rates? Falling interest rates? P. 176

4. Explain what is involved in a put option. Slide 16 p. 182

5. What is a call option? Slide 16 p. 183

6. What rules and regulations have recently been imposed on the use of futures, options, and other derivatives? Slide 21 p. 187

7. What is the purpose of an interest-rate swap? Slide 22 p. 188

8. What are the principal advantages (p. 188) and, disadvantages (p. 190) of interest-rate swaps?

derivatives definition and example
Derivatives – Definition and Example
  • The DefinitionDerivatives are financial products with value that come from an asset or set of assets. These can be stocks, debt issues or almost anything. A derivative's value is based on an asset, but ownership of a derivative doesn't mean ownership of the asset. We will look at some examples.
  • The Barnyard Basics Of Derivatives – The Future of Healthy Hen Farms and it’s owner Gail. A Futures Contract P. 170
  • Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market, with all the sporadic reports of bird flu coming out of the east. Gail wants a way to protect her business against another spell of bad news. Gail meets with an investor who enters into a futures contract with her.
derivatives example gail happy hen farms
Derivatives Example – Gail & Happy Hen Farms

Healthy Hen Farms

Owner Gail

Investor Joe

Investor Joe agrees to pay $30 per bird when the birds are ready for slaughter in six months' time, regardless of the market price. If, at that time, the price is above $30, the investor will get the benefit as Joe will be able to buy the birds for less than market cost and sell them on the market at a higher price for a gain.

If the price goes below $30, then Gail will get the benefit because she will be able to sell her birds for more than the current market price, or more than what she would get for the birds in the open market.

example healthy hen farms
Example – Healthy Hen Farms
  • By entering into a futures contract, Gail is protected from price changes in the market, as she has locked in a price of $30 per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but she will be protected if the price falls to $10 on news of a bird flu outbreak. By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations.
  • Now we will learn about an INTEREST RATE SWAP
  • Gail has decided that it's time to take Healthy Hen Farms to the next level. She has already acquired all the smaller farms near her and is looking at opening her own processing plant. She tries to get more financing, but the lender, Lenny, rejects her.
i nterest rate swap introducing lenny p 188
Interest Rate Swap – Introducing Lenny p. 188

Lenny the Lender

Gail and a larger Healthy Hen Farm Business

The reason Lenny rejects Gail is that to

take over other farms she financed her

takeovers with a large variable-rateloan,

and the lender is worried that, if interest

rates rise, Gail won't be able to pay her debts. Lenny tells Gail that he will only

lend to her if she can convert the loan to a fixed-rate. Unfortunately, her other

lenders refuse to change her current loan terms because they are hoping

interest rates will increase too. ENTER SAM

Sam has a fixed-rate loan about

the same size as Gail’s and he wants

to change it to a variable-rateloan

because he hopes interest rates will go down in the future.

SAM THE RESTAURANT OWNER

GAIL & HEALTHY H EN FARMS

gail and sam swap loans
GAIL AND SAM SWAP LOANS
  • Gail and Sam decide to swap loans. They work out a deal in which Gail's payments go toward Sam's loan and his payments go toward Gail's loan. Although the names on the loans haven't changed, their contract allows them both to get the type of loan they want.
  • Each person still pays their same loan amount and must still pay off their debt. And they pay a fee to a bank or financial provider to do the swap. What they are swapping is the interest rate only.
  • On each payment due date Gail and Sam exchange only the Net difference between the interest payments each owes the other person.
  • This is a bit risky for both of them because if one of them defaults or goes bankrupt, it may require a payment for which either Gail of Sam may be unprepared. However, it allows them to modify their loans to meet their individual needs.
buying debt derivatives and how it works
BUYING DEBT – DERIVATIVES AND HOW IT WORKS

LENNY THE LENDER

  • With Gail now having a fixed rate loan, is now willing to

make a larger loan to Gail so she can expand or grow

her Healthy Hen Farms business. Lenny is also happy to

be getting a return on his money.

ENTER Dale is Lenny’s friend and he asks Dale for a loan because he wants to start a film company. Lenny knows

Dale has a lot of collateral and that the loan would be at a higher interest rate because of the more volatile nature of the movie industry, so he's kicking himself for loaning all of his money to Gail.

Lenny turns Gail's loan into a credit derivative and sells it to a speculator at a discount to the true value. Although Lenny doesn't see the full return on the loan, he gets his money back and can now loan it out again to his friend Dale.

DALE THE MOVIE MAKER

derivatives and the fee benefit
Derivatives and the Fee Benefit
  • Lenny likes this system so much that he continues to spin out (make) his loans as credit derivatives, taking modest returns in exchange for less risk of default and more liquidity.

How this works: Lenny sells his fixed rate loan he made to Gail which is at a much lower interest rate than he could make to his friend Dale. Because, Dale’s loan is more risky the interest rate is much higher and since Dale has good collateral Lenny knows he can collect if Dale defaults on his loan. Lenny also makes a fee for selling Gail’s fixed rate loan.

options
OPTIONS

HEN

  • Years later, Healthy Hen Farms Corporation and CEO

Gail, is a publicly traded corporation (HEN) and is

  • America’s largest poultry (chicken) producer. Gail and Sam, remember him ? They both are looking forward to a good retirement. Sam bought quite a few shares of HEN. In fact, he has more than $100,000 invested in the company. Sam is getting nervous because he is worried that another shock, perhaps another case of bird flu, might wipe out a huge chunk of his retirement money. Sam starts looking for someone to take the risk “off his shoulders”. Lenny, financier extraordinaire 非凡 (fēifán) and an active writer of options, agrees to “give him a hand”, HELP HIM OUT!
options calls and puts p 180 186
OPTIONS – CALLS AND PUTS P. 180 - 186
  • Lenny outlines a deal in which Sam pays Lenny a fee to for the right (but not the obligation) to sell Lenny the HEN shares in a year's time at their current price of $25 per share. If the share prices plummet (go down in price by a big price), Lenny protects Sam from the loss of his retirement savings. Lenny is OK because he has been collecting the fees and can handle the risk. This is called a put option, but it can be done in reverse by someone agreeing to buy a stock in the future at a fixed price (called a call option).

The Bottom LineHealthy Hen Farms remains stable until Sam and Gail have both pulled their money out for retirement. Lenny profits from the fees and his booming trade as a financier.

Thus ends the story of Gail, Sam and Lenny and I hope you have learned how derivatives, swaps, futures and options work.

conclusion of the tale of gail and healthy hen farms
CONCLUSION OF THE TALE OF GAIL AND HEALTHY HEN FARMS
  • In this tale, you can see how derivatives can move risk (and the accompanying rewards) from the risk averse (avoiders)to the risk seekers. Although Warren Buffett once called derivatives, "financial weapons of mass destruction," derivatives can be very useful tools, provided they are used properly. Like all other financial instruments, derivatives have their own set of pros and cons, but they also hold unique potential to enhance the functionality of the overall financial system.
quiz questions and answers
QUIZ QUESTIONS AND ANSWERS

1. What are financial futures contracts? Which financial institutions use futures and other derivatives for risk management?

A: Financial futures contracts is an agreement calling for the delivery of specific types of securities at a set price on a specific future date. Financial futures contract help to hedge interest rate risk and are thus, used by any bank or financial institution that is subject to interest rate risk.

2. How can financial futures help financial service firms deal with interest rate risk?

A: Financial futures allow banks and other financial institutions to deal with interest rate risk by reducing risk exposure from unexpected price changes. The financial futures markets are designed to shift the risk of interest rate fluctuations from risk-averse investors to speculators willing to accept and possibly profit from such risks.

quiz questions and answers1
QUIZ QUESTIONS AND ANSWERS

3. What futures transactions would most likely be used in a period of rising interest rates? Falling interest rates?

A: Rising interest rates generally call for a short hedge, while falling interest rates usually call for some form of long hedge.

4. Explain what is involved in a put option. A: A put option allows its holder to sell securities to the option writer at a specified price. The buyer of a put option expects market prices to decline in the future or market interest rates to increase. The writer of the contract expects market prices to stay the same or rise in the future.

5. What is a call option?A: A call option permits the option holder to purchase specific securities at a guaranteed price from the writer of the option contract. The buyer of the call option expects market prices to rise in the future or expects interest rates to fall in the future. The writer of the contract expects market prices to stay the same or fall in the future.

quiz questions and answers2
QUIZ QUESTIONS AND ANSWERS

6. What rules and regulations have recently been imposed on the use of futures, options, and other derivatives? A: Each bank has to implement a proper risk management system comprised of (1) policies and procedures to control financial risk taking, (2) risk measurement and reporting systems and (3) independent oversight and control processes.

7. What is the purpose of an interest-rate swap? A: Swaps are often employed to deal with asset-liability maturity mismatches. The purpose of an interest rate swap is to change an institution's exposure to interest rate changes and achieve lower borrowing costs. Swap participants can change from fixed to floating interest rates or from floating to fixed interest rates and more closely match the maturities of their liabilities to the maturities of their assets.

quiz questions and answers3
QUIZ QUESTIONS AND ANSWERS

8. What are the principal advantages and, disadvantages of interest-rate swaps? A: The principal advantage of an interest-rate swap is the reduction of interest-rate risk of both parties to the swap by allowing each party to better balance asset and liability maturities and cash-flow patterns. Another advantage of swaps is that they usually reduce interest costs for one or both parties to the swap. Moreover, swaps can be negotiated to cover virtually any period of time or borrowing instrument desired, though most fall into the 3-year to 10-year range. They are also easy to carry out, usually negotiated and agreed to over the telephone or via e-mail through a broker or dealer

However, the principal disadvantage of swaps is they may carry substantial brokerage fees, credit risk, interest rate risk, and, basis risk.