Chapter Eight

Risk Management: Financial Futures,

Options, Swaps, and Other Hedging Tools
 Key Topics

 The Use of Derivatives

 Financial Futures Contracts: Purpose and Mechanics

 Short and Long Hedges

 Interest-Rate Options: Types of Contracts and

Mechanics
 Interest-Rate Swaps

 Regulations and Accounting Rules

 Caps, Floors, and Collars

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 Introduction
• The asset-liability management tools we explore here are
useful across a broad range of financial-service providers
sensitive to the risk of changes in market interest rates
• Many of the risk management tools in this chapter are not only
used by financial firms to cover their own interest rate risk,
but are also sold to customers who need risk protection and
generate fee income for the providers
• Most of the financial instruments in this chapter are
derivatives
▫ They derive their value from the value and terms of underlying
instruments

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 Uses of Derivative Contracts Among FDIC-
Insured Banks
• Due to their high exposure to various forms of risk, banks and their principal
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
• Approximately 15 percent of all banks operating in the United States
reportedly employ the use of derivatives to subdue risk in its various forms
▫ 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

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 EXHIBIT 8-1 Types of Derivative Contracts Used by Depository
Institutions to Manage Different Types of Risk
Exposure, 2010

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price

• In Chapter 7, we explored the nature of gaps between assets and liabilities

that are exposed to interest rate risk

• The preceding chapter developed one other measure of the difference

between risk-exposed assets and liabilities – the leverage-adjusted
duration gap

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)
• A financial futures contract is an agreement reached today between a buyer and
a seller that calls for delivery of a particular 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
• 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 underlying financial asset at a specified date in the future

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)
• 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 margin
▫ The initial margin is the investor’s equity in the position when he or she buys
(or sells) the contract
• 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

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 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 underlying futures price or take delivery of the
underlying asset
▫ Buyers gain when futures prices rise and lose when futures prices fall
• Sellers of futures contracts
▫ 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

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 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 fluctuations from risk-averse investors, such as
banks and insurance companies, to speculators 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

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)
• Futures contracts are also traded over the counter (OTC)
▫ Often less costly for traders
▫ These are most often called forward contracts
• Forward contracts
▫ Generally more risky – counterparty risk and liquidity risk
▫ 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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 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

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 EXHIBIT 8–2 Sample Market Prices for Interest-Rate
Futures in Recent Years

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)

• 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 the price sold for (at the beginning)

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)

• 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 purchase price (at the
beginning) and the price sold for (at the end)

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)
• The three most typical interest-rate hedging problems financial
firms face are
1. Protecting the value of securities and fixed-rate loans from losses due
to rising interest rates
2. Avoiding a rise in borrowing costs
3. Avoiding a fall in the interest returns expected from loans and
security holdings
• Where the financial institution faces a positive interest-sensitive
gap, it can protect against loss due to falling interest rates by
covering the gap with a long hedge
• If the institution is confronted with a negative interest-sensitive gap,
it can avoid unacceptable losses from rising market interest rates by
covering with a short hedge

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)

• Basis Risk
▫ The basis is the cash price of an asset minus the corresponding futures
price for the same asset at a point in time
▫ For financial futures, the basis can be calculated as the futures rate
minus the spot rate
▫ It may be positive or negative, depending on whether futures rates are
above or below spot rates
▫ May swing widely in value far in advance of contract expiration

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)

• Basis Risk with a Short Hedge

▫ You are concerned about the interest-rate risk exposure for bonds in a
financial institution’s securities portfolio
▫ You fear increasing interest rates that would decrease the value of those
bonds
▫ You have a long position in the cash market
▫ To hedge this possible increase in market interest rates, you could take a
short position in the futures market

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)

• Basis Risk with a Short Hedge

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)

• Basis Risk with a Long Hedge

▫ If you have concerns about declining interest rates, you could create a
long hedge
▫ To hedge the decrease in interest rates, you could take a long position
in the futures market

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)
• The real risk the user faces from hedging with futures stems from the
movement in basis that may occur over the life of a futures contract
because cash and futures prices are not perfectly synchronized with each
other
• The sensitivity of the market price of a financial futures contract depends,
in part, upon the duration of the security to be delivered under the futures
contract

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)

• If we rewrite this equation slightly we get an expression for the gain or

loss from the use of financial futures

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 EXHIBIT 8–3 Trade-Off Diagrams for Financial Futures
Contracts

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)

• How many futures contracts does a financial firm need to cover a given
size risk exposure?
▫ The objective is to offset the loss in net worth due to changes in market interest
rates with gains from trades in the futures market

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 Financial Futures Contracts: Promises of Future
Security Trades at a Preset Price (continued)

• If we set the change in net worth equal to the change in the futures position
value, we can solve for the number of futures contracts needed to fully
hedge a financial firm’s overall interest-rate risk exposure and protect its
net worth

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 Interest-Rate Options
• The interest-rate option grants a holder of securities the right to
either
1. Place (put) those instruments with another investor at a prespecified
exercise price before the option expires or
2. Take delivery of securities (call) from another investor at a
prespecified 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 latter 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

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 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

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 EXHIBIT 8–4 Futures Options Sample Prices

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 Interest-Rate Options (continued)
• Most options today are used by money center banks
• They appear to be directed at two principal uses
1. Protecting a security portfolio through the use of put options to
insulate 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
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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 EXHIBIT 8–5 Payoff Diagrams for Put and Call Options
Purchased by a Financial Institution

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 EXHIBIT 8–6 Payoff Diagrams for Put and Call
Options Written by a Financial Firm

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 Regulations and Accounting Rules for Bank
Futures and Options Trading
• 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
1. Policies and procedures to control financial risk taking
2. Risk measurement and reporting systems
3. 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

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 Regulations and Accounting Rules for Bank
Futures and Options Trading (continued)
• In 1998, the Financial Accounting Standards Board (FASB)
introduced Statement 133 (FAS 133)
▫ “Accounting for Derivative Instruments and Hedging Activities”
• FAS 133 requires that all derivatives be recorded on the balance
sheet as assets or liabilities at their fair value
▫ With regard to interest rate risk, FAS 133 recognized two types of
hedges: a fair value hedge and a cash flow hedge
▫ The objective of a fair value hedge is to offset losses due to changes in the
value of an asset or liability
▫ Cash flow hedges try to reduce risk associated with future cash flows
(interest on loans or interest payments on debt)

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 Interest-Rate Swaps
• 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

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 Interest-Rate Swaps (continued)
• Quality Swap
▫ 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
• Reverse Swap
▫ A new swap agreement offsets the effects of an existing swap contract
• “Swaptions”
▫ Options for one or both parties to make certain changes in the
agreement, take out a new option, or cancel an existing swap agreement

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 EXHIBIT 8–7 The Interest-Rate Swap

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 Interest-Rate Swaps (continued)
• 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

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 Caps, Floors, and Collars

• An interest-rate cap protects its holder against rising market

interest rates
▫ In return for paying an up-front premium, borrowers are assured
that institutions lending them money cannot increase their loan
rate above the level of the cap
▫ Alternatively, the borrower may purchase an interest-rate cap
from a third party, with that party promising to reimburse
borrowers for any additional interest they owe their creditors
beyond the cap

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 Caps, Floors, and Collars (continued)

• Interest-Rate Cap Example

▫ A bank purchases a cap of 11 percent on its borrowings of $100 million
in the Eurodollar market for one year
▫ Suppose interest rates in this market rise to 12 percent for the year
▫ The financial institution selling the cap will reimburse the bank
purchasing the cap the additional 1 percent in interest

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 Caps, Floors, and Collars (continued)

• Financial-service providers can also lose earnings in periods of

falling interest rates, especially when rates on floating-rate loans
decline
• A lending institution can establish an interest-rate floor under its
loans so that, no matter how far loan rates tumble, it is guaranteed
some minimum rate of return

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 Caps, Floors, and Collars (continued)

• Interest-Rate Floor Example

▫ Suppose a lender extends a $10 million floating-rate loan to one of its
corporate customers for a year at prime insists on a minimum (floor)
interest rate on this loan of 7 percent
▫ If the prime rate drops below the floor to 6 percent for one year, the
customer will pay not only the 6 percent prime rate but also pay out an
interest rebate to the lender of

▫ Assuming the borrower does not default, lender assured a minimum

return of 7 percent on its loan
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 Caps, Floors, and Collars (continued)

• Lending institutions and their borrowing customers also make heavy use of
the interest-rate collar
▫ Combines in one agreement a rate floor and a rate cap
• Interest-Rate Collar Example
▫ A customer who has just received a $100 million loan and asks for a collar on
the loan’s prime rate between 11 percent and 7 percent
▫ The lender will pay its customer’s added interest cost if prime rises above 11
percent, while the customer reimburses the lender if prime drops below 7
percent
▫ The collar’s purchaser pays a premium for a rate cap while receiving a premium
for accepting a rate floor
▫ The net premium paid for the collar can be positive or negative, depending upon
the outlook for interest rates and the risk aversion of borrower and lender at the
time of the agreement

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 Quick Quiz
• What are financial futures contracts? Which financial institutions
use futures and other derivatives for risk management? How can
financial futures help financial service firms deal with interest rate
risk?
• What futures transactions would most likely be used in a period of
rising interest rates? Falling interest rates?
• Explain what is involved in a put option. What is a call option?
What is an option on a futures contract?
• What is the purpose of an interest-rate swap?
• How can financial-service providers make use of interest-rate caps,
floors, and collars to generate revenue and help manage interest rate
risk?

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