Risk Management:

Financial Derivatives,
Asset-Backed
Securities, Loan Sales
FIN 4812 - MAA
 8-2

Derivatives
A derivative is any instrument or contract that
derives its value from another underlying asset,
instrument, or contract, such as treasury bills and
bonds and eurodollar deposits
 8-3

Managing Interest Rate Risk

• Derivatives Used to Manage Interest Rate Risk
• Financial Futures Contracts
• Forward Rate Agreements
• Interest Rate Swaps
• Options on Interest Rates
• Interest Rate Caps
• Interest Rate Floors
• Interest Rate Collars
 8-4

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
• Futures Markets
• The Organized Exchanges Where Futures Contracts are traded
• Interest Rate Futures
• Where the Underlying Asset is an Interest-Bearing Security
 8-5

Financial Futures Contracts

IS Gap = IS Assets – IS Liabilities

and

Recall what happens when interest rates rise? Fall?

One of the most popular methods for neutralizing these gap

risks is to buy and sell financial futures contracts
 8-6

Background on Financial Futures

• Buyers
• A buyer of a futures contract is said to be long
futures

• Agrees to pay the underlying futures price or take

delivery of the underlying asset

• Buyers gain when futures prices rise and lose when

futures prices fall
 8-7

Background on Financial Futures

• Sellers
• A seller of a futures contract is said to be short
futures

• Agrees to receive the underlying futures price or to

deliver the underlying asset

• Sellers gain when futures prices fall and lose when

futures prices rise
 8-8

The Purpose of Financial Futures

To Shift the Risk of Interest Rate Fluctuations

from Risk-Averse Investors to Speculators
 8-9

Futures vs. Forward Contracts

• Futures Contracts
• Traded on formal exchanges (CBOT, CME, etc.)
• Involve standardized instruments
• Positions require a daily marking to market

• Forward Contracts
• Terms are negotiated between parties
• Do not necessarily involve standardized assets
• Require no cash exchange until expiration
• No marking to market
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Hedging with Futures Contracts

Avoiding Higher Use a Short Hedge: Sell
Borrowing Costs and Futures Contracts and
Declining Asset Values then Purchase Similar
Contracts Later

Avoiding Lower Than Use a long Hedge: Buy

Expected Yields from Futures Contracts and
Loans and Securities then Sell Similar
Contracts Later
 8-11

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)
 8-12

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)
Problems
• Trust bank has $100 million in floating rate loans and securities. Interest rates
today on comparable investments stand at 9 percent but are expected to fall
to 6 percent by the next month(30 days). Concerned about the possible fall in
yields from loans and securities, management wishes to use a futures contract.
What type of contract would you recommend? If the bank does not cover the
interest rate risk involved, how much potential profit/loss could the bank
experience?
 8-14

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.
 8-15

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
 8-16

Principal Uses of Option Contracts

• 1. Protecting a security portfolio through the use of put options to
insulate against falling security prices (rising interest rates);
however, 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

• 2. 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.
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Speculation vs. Hedging

• With financial futures, risk often cannot be eliminated, only reduced.
• Traders normally assume basis risk in that the basis might change adversely
between the time the hedge is initiated and closed

• Perfect Hedge
• The gains (losses) from the futures position perfectly offset the losses (gains)
on the spot position at each price
Problems
• Hokie Savings wants to purchase a portfolio of home mortgage loans with an
expected average return of 6.5 percent. Management is concerned that
interest rates will drop and the cost of the portfolio will increase from the
current price of $50 million. In six months when the funds become available to
purchase the loan portfolio, market interest rates are expected to be in the 5.5
percent range. Treasury bond options are available today at a quote of 10,900
(i.e., $109,000 per $100,000 contract), upon payment of a $700 premium, and
are forecast to drop to $99,000 per contract. Should Hokie buy puts or calls?
What before-tax profits could Hokie earn per contract on this transaction?
 9-21

Securitization of Loans

The Pooling of a Group of Similar Loans and

Issuing Securities Against the Pool Whose Return
Depends on the Stream of Interest and Principal
Payments Generated by the Loans
 9-22

The Heart of the

Securitization Process
 9-23

Securitization Process
• Originator – Bank or Lender Who Makes the Loan
• Issuer – Special Purpose Entity That Issues the Securities
• Credit Rating Agency – Rates the Securities
• Security Underwriter or Investment Banker Helps Issue Securities
• Trustee – Makes Sure Issuer Fulfills All Their Obligations
• Servicer- Collects Payments on the Securitized Loans
 9-24

Key Players in the Securitization Process

 9-25

Advantages of Securitization
• Diversifies a Bank’s Credit Risk Exposure
• Creates Liquid Assets Out of Illiquid Assets
• Transforms These Assets into New Sources of Capital
• Allows the Bank to Hold a More Geographically Diversified Loan Portfolio
• Allows the Bank to Better Manage Interest Rate Risk
• Allows the Bank to Generate Fee Income
 9-26

Problems with Securitization

• May Not Reduce a Bank’s Capital Requirements
• Prepayment Risk
• May Increase Competition for the Best Quality Loans
• May Increase Competition for Deposits
• Credit Crisis of 2007-2009 showed that the “bankruptcy remote” SPE
arrangements can get into trouble if the underlying loans go bad
• GSEs: Ethical Controversies Around Fannie Mae and Freddie Mac
 9-27

Types of Securitized Assets

• Residential Mortgages – the beginnings of securitization
▫ The role of GSEs (GNMA, FNMA, FHLMC)
▫ Riskier CMOs

• Home Equity Loans

• Automobile Loans (CARs)
• Commercial Mortgages
• Small Business Administration Loans
• Mobile Home Loans
• Credit Card Receivables
• Truck Leases
• Computer Leases
 9-28

Loan Sales
Selling Loan Contracts Held by an Institution in
Order to Raise New Cash
 9-29

The Impact of Loan Sales

 9-30

Types of Loan Sales

• Participation Loans
▫ Where an Outside Party Purchases a Loan. They Generally Have No Influence
Over the Loan Terms

• Assignments
▫ Ownership of the Loan is Transferred to the Buyer of the Loan. The Buyer Has
a Direct Claim Against the Borrower.

• Loan Strip
▫ Short-Dated Pieces of Longer Term Loans, Maturing in a Few Days or Weeks
 9-31

Reasons Behind Loan Sales

• Way to rid the bank of lower-yielding assets to make room for higher-
yielding assets when interest rates rise
• Way to increase marketability and liquidity of assets
• Way to eliminate credit and interest rate risk
• Way to generate fee income
• Purchasing bank can diversify loan portfolio and reduce risk
 9-32

Risks In Loan Sales

• Best Quality Loans are the Easiest to Sell Which May Increase Volatility of
Earnings for the Bank Which Sells the Loans

• Loan Purchased From Another Bank Can Turn Bad Just as Easily As One
From Their Own Bank

• Loan Sales are Cyclical