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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Risk Management: Financial Futures,
Options, Swaps, and Other Hedging Tools
Today the bulk of trading in derivatives is centered in the very largest banks worldwide
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?
Healthy Hen Farms
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.
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
LENNY THE LENDER
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
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.
Gail, is a publicly traded corporation (HEN) and is
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.
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.
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.
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.
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.