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

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Financial futures contract

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

The purpose of this chapter is to examine how financial futures, option, and swap contracts, as well as selected other asset-liability management techniques can be employed to help reduce a bank’s potential exposure to loss as market conditions change. We will also discover how swap contracts and other hedging tools can generate additional revenues for banks by providing risk-hedging services to their customers.

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 (CBOT)

Financial Exchange (FINEX)

New York Futures Exchange (NYFE)

Marche a Terme International De France (MATIF)

Singapore Exchange LTD. (SGX)

Chicago Mercantile Exchange (CME)

London International Financial Futures Exchange (LIFFE)

Sydney Futures Exchange

Toronto Futures Exchange (TFE)

The World’s Leading Futures and Option Exchanges

Most common financial futures contracts
Most Common Financial Futures Contracts

  • U.S. Treasury Bond Futures Contracts

  • U.S. Treasury Bill Futures Contracts

  • Three-Month Eurodollar Time Deposit Futures Contract

  • 30-Day Federal Funds Futures Contracts

  • One Month LIBOR Futures Contracts

Basis risk
Basis Risk

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 Bill Futures Options

  • Eurodollar Futures Option

  • U.S. Treasury Bond Option

  • LIBOR Futures Option

Principal uses of option contracts
Principal Uses of Option Contracts Trading

  • Protection of the Bond Portfolio

  • Hedging Against Positive or Negative Gap Positions

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 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.