Economia degli intemediari finanziari 2/ed - Anthony Saunders, Marcia Millon Cornett, Mario Anolli

Managing Risk with Derivative Securities
Chapter NAVIGATOR

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O U T L I N E
Derivative Securities Used to Manage Risk: Chapter Overview Forward and Futures Contracts Hedging with Forward Contracts Hedging with Futures Contracts Options Basic Features of Options Actual Interest Rate Options Hedging with Options Caps, Floors, and Collars Risks Associated with Futures, Fowards, and Options Swaps Hedging with Interest Rate Swaps Currency Swaps Credit Risk Concerns with Swaps Comparison of Hedging Methods Writing versus Buying Options Futures versus Options Hedging Swaps versus Forwards, Futures, and Options Derivative Trading Policies of Regulator Appendix 23A: Hedging with Futures Contracts (at www.mhhe.com/sc3e) Appendix 23B: Hedging with Options (at www.mhhe.com/sc3e) Appendix 23C: Hedging with Caps, Floors, and Collars [at www.mhhe.com/sc3e]

1. 2. 3. 4. 5. 6.

How can risk be hedged with forward contracts? How can risk be hedged with futures contracts? What is the difference between a microhedge and a macrohedge? How can risk be hedged with option contracts? How can risk be hedged with swap contracts? How do the different hedging methods compare?

DERIVATIVE SECURITIES USED TO MANAGE RISK: CHAPTER OVERVIEW
Chapters 20 through 22 described ways financial institutions (FIs) measure and manage various risks on the balance sheet. Rather than managing risk by making on-balance-sheet changes, FIs are increasingly turning to off-balance-sheet instruments such as forwards, futures, options, and swaps to hedge these risks. As the use of these derivatives has increased, so have the fees and revenues FIs have generated. For example, revenue from derivatives transactions at commercial banks averaged $11.27 billion per year from 1999 to 2004. We discussed the basic characteristics of derivative securities and derivative securities markets in Chapter 10. This chapter considers the role that derivative securities contracts play in managing an FI’s interest rate risk, foreign exchange, and credit risk exposures. Although large banks and other FIs are responsible for a significant amount of derivatives trading activity, FIs of all sizes have used these instruments to hedge their asset-liability risk exposures.

FORWARD AND FUTURES CONTRACTS
To present the essential nature and characteristics of forward and futures contracts, we first review the comparison of these derivative contracts with spot contracts (see also Chapter 10).

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Economia degli intemediari finanziari 2/ed - Anthony Saunders, Marcia Millon Cornett, Mario Anolli

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Part 5 Risk Management in Financial Institutions

spot contract
An agreement to transact involving the immediate exchange of assets and funds.

Spot Contract. A spot contract is an agreement between a buyer and a seller at time 0, when the seller of the asset agrees to deliver it immediately for cash and the buyer agrees to pay in cash for that asset.1 Thus, the unique feature of a spot contract is the immediate and simultaneous exchange of cash for securities, or what is often called delivery versus payment. A spot bond quote of $97 for a 20-year maturity bond means that the buyer must pay the seller $97 per $100 of face value for immediate delivery of the 20-year bond.2 Forward Contract. A forward contract is a contractual agreement between a buyer and a seller, at time 0, to exchange a prespecified asset for cash at some later date. For example, in a three-month forward contract to deliver 20-year bonds, the buyer and seller agree on a price and amount today (time 0), but the delivery (or exchange) of the 20-year bond for cash does not occur until three months hence. If the forward price agreed to at time 0 was $97 per $100 of face value, in three months’ time the seller delivers $100 of 20-year bonds and receives $97 from the buyer. This is the price the buyer must pay and the seller must accept no matter what happens to the spot price of 20-year bonds during the three months between the time the contract was entered into and the time the bonds are delivered for payment. As of December 2004, commercial banks held $7.97 trillion in forward contracts off their balance sheets. Forward contracts often involve underlying assets that are nonstandardized (e.g., sixmonth pure discount bonds). As a result, the buyer and seller involved in a forward contract must locate and deal directly with each other to set the terms of the contract rather than transacting the sale in a centralized market. Accordingly, once a party has agreed to a forward position, canceling the deal prior to expiration is generally difficult (although an offsetting forward contract can normally be arranged). Futures Contract. A futures contract is usually arranged by an organized exchange. It is an agreement between a buyer and a seller at time 0 to exchange a standardized, prespecified asset for cash at some later date. As such, a futures contract is very similar to a forward contract. The difference relates to the price, which in a forward contract is fixed over the life of the contract ($97 per $100 of face value with payment in three months), but a futures contract is marked to market daily. This means that the contract’s price and the future contract holder’s account are adjusted each day as the futures price for the contract changes. Therefore, actual daily cash settlements occur between the buyer and seller in response to this marking-to-market process, i.e., gains and losses must be realized daily. This can be compared to a forward contract for which cash payment from buyer to seller occurs only at the end of the contract period.3 In December 2004, commercial banks held $3.41 trillion in futures contracts off their balance sheets.

forward contract
An agreement to transact involving the future exchange of a set amount of assets at a set price.

futures contract
An agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily.

marked to market
Describes the prices on outstanding futures contracts that are adjusted each day to reflect current futures market conditions.

Hedging with Forward Contracts

naive hedge
A hedge of a cash asset on a direct dollar-for-dollar basis with a forward or futures contract.

1

To understand the usefulness of forward contracts in hedging an FI’s interest rate risk, consider a simple example of a naive hedge (a hedge of a cash asset on a direct dollar-for-dollar basis with a forward or futures contract). Suppose that an FI portfolio manager holds a 20-year, $1 million face value government bond on the balance sheet. At time 0, the market values these bonds at $97 per $100 of face value, or $970,000 in total. Assume that the manager receives a forecast that interest rates are expected to rise by 2 percent from their current level of 8 percent to 10 percent over the

1. Technically, physical settlement and delivery may take place one or two days after the contractual spot agreement in bond markets. In equity markets, delivery and cash settlement normally occur three business days after the spot contract agreement, so-called T 3. 2. Throughout this chapter, as we refer to the prices of various securities, we do not include the transaction fees charged by brokers and dealers for conducting trades for investors and hedgers. 3. Another difference between forwards and futures is that forward contracts are bilateral contracts subject to counterparty default risk, but the default risk on futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against credit or default risk.

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or change in bond values ( P). After the rise in interest rates.333 (cost of purchasing bonds in the spot market at t month 3 for delivery to the forward buyer) $161. from the duration equation of Chapter 3:4 P R D P 1 R where P P D R R Capital loss on bond ? Initial value of bond position $970. the portfolio manager can find a buyer willing to pay $97 for every $100 of 20-year bonds delivered in three months’ time. the reason for the hedge is the lack of ability to perfectly predict interest rate changes. to reduce the risk of capital loss to zero—the manager may hedge this position by taking an off-balance-sheet hedge. For simplicity. and deliver these bonds to the forward contract buyer. Now consider what happens to the FI portfolio manager if the gloomy forecast of a 2 percent rise in interest rates is accurate. Remember that the forward contract buyer agreed to pay $97 per $100 of face value for the $1 million of face value bonds delivered. the on-balance-sheet loss of $161. 5.667.08 P $970.Anthony Saunders. such as selling $1 million face value of 20-year bonds for forward delivery in three months’ time. Marcia Millon Cornett. a loss (gain) on the balance sheet is offset by a partial or complete gain (loss) on the forward contract.000. Having read Chapters 3 and 22.67 percent. the success of a hedge does not hinge on the manager’s ability to accurately forecast interest rates. the FI portfolio manager expects to incur a capital loss on the bond of $161. rising interest rates mean that bond prices will fall.000 As a result. Rather.833 per $100 face value.667 from selling the forward contract. Thus. the manager stands to make a capital loss on the bond portfolio. forwards are one example of off-balance-sheet items (see Chapter 12). however. the portfolio manager makes a profit on the forward transaction of: $970.02 b 1. To offset this loss—in fact.000 P a . The portfolio manager’s bond position has fallen in value by 16.667—as a percentage loss ( P/P) 16. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 631 next three months. As a result.67%—or a drop in price from $97 per $100 face value to $80. . Thus. it does not appear on the balance sheet.08 $161.000 Duration of the bond 9 years Change in forecast yield .02 b 1.r. the manager can buy $1 million face value of 20-year bonds in the spot market at $80.667 As you can see.02 1 plus the current yield on 20-year bond 1.5 Suppose that at time 0. In fact. equal to a capital loss of $161.000 (price paid by forward buyer to forward seller) $808.08 a . for any change in interest rates.l. Knowing that if the predicted change in interest rates is correct.833 per $100 of face value. Copyright © 2007 .667 1 9 9 $970. Indeed. the manager can predict a capital loss. a total cost of $808. we ignore issues relating to convexity here (see Chapter 22).333. which records only current and past transactions. or $970. the manager is an expert on duration and has calculated the 20-year maturity bond’s duration to be exactly nine years. Since a forward contract involves the delivery of bonds at a future time period.667 is exactly offset by the offbalance-sheet gain of $161.The McGraw-Hill Companies s.Economia degli intemediari finanziari 2/ed . The hedge allows the FI manager to protect 4.

Thus. Macrohedging occurs when an FI manager wishes to use futures or other derivative securities to hedge the entire balance sheet duration gap. 3 basis risk A residual risk that occurs because the movement in a spot (cash) asset’s price is not perfectly correlated with the movement in the price of the asset delivered under a futures or forward contract. an FI would like to reduce its interest rate or other risk exposures to their lowest possible level by buying or selling sufficient futures to offset the interest rate risk exposure of its whole balance sheet or cash positions in each asset and liability. many FIs choose to bear some interest rate risk as well as credit and FX risks because of their comparative advantage as FIs (see Chapter 1). However. 3 macrohedging Hedging the entire duration gap of an FI. Marcia Millon Cornett. This can result in a very different aggregate futures position than when an FI manager disregards this netting or portfolio effect and hedges only individual asset and liability positions on a one-to-one basis. in the parlance of finance. Mario Anolli 632 Part 5 Risk Management in Financial Institutions immunize To fully hedge or protect an FI against adverse movements in interest rates (or asset prices).6 The Choice between Microhedging and Macrohedging. and C. Note that macrohedging and microhedging can lead to quite different hedging strategies and results. the FI’s net interest rate exposure is zero.r. T. The earlier example of exactly matching the asset in the portfolio with the deliverable security underlying the forward contract (20-year bonds) was unrealistic.Anthony Saunders.” Bankers Magazine. Microhedging. This risk occurs mainly because the prices of the assets or liabilities that an FI wishes to hedge are imperfectly correlated over time with the prices on the futures or forward contract used to hedge risk. 45–48. federal regulation. since reducing risk also reduces expected return. accounting rules.The McGraw-Hill Companies s. Ideally. Before looking at futures contracts.l. Munter. takes a short (sell) position in futures contracts on CDs or T-bills. Moores found that macrohedges provided better hedge performance than microhedges in a number of different interest rate environments. An example of microhedging on the liability side of the balance sheet occurs when an FI. Clancy. “Macrohedging Bank Investment Portfolios. November–December 1994. Macrohedging. or. Risk-Return Considerations. K. In particular.” in Advances in Accounting (1986). not all FI managers seek to do this. the usual situation produces a residual “unhedgeable” risk termed basis risk. against interest rate changes even if they are not perfectly predicted. attempting to lock in a cost of funds to protect itself against a possible rise in short-term interest rates. pp. See “Accounting for Financial Futures: A Question of Risk Reduction. . it has immunized its assets against interest rate risk. and for depository institutions. we explain the difference between microhedging and macrohedging. pp. we earlier considered a simple example of microhedging asset-side portfolio risk in which an FI manager wanted to insulate the value of the institution’s bond portfolio fully against a rise in interest rates. An FI is microhedging when it employs a futures or a forward contract to hedge a particular asset or liability risk. These include riskreturn considerations. 51–70. See also R. 6. D. a macrohedge takes a whole portfolio view and allows for individual asset and liability interest sensitivities or durations to net out each other. Several factors affect an FI’s choice between microhedging and macrohedging interest rate risk. the FI manager often tries to pick a futures or forward contract whose underlying deliverable asset closely matches the asset (or liability) position being hedged. this reduction might be achieved by macrohedging the duration gap. Copyright © 2007 . In microhedging. This contrasts with microhedging in which an FI manager identifies specific assets and liabilities and seeks individual futures and other derivative contracts to hedge those individual risks. H. microhedging Using a futures (forward) contract to hedge a specific asset or liability. P. Rather than taking a fully hedged position. For example. Because such exact matching often cannot be achieved.Economia degli intemediari finanziari 2/ed . For example. Stoebe. Hedging with Futures Contracts 2 Even though some hedging of interest rate risk does take place using forward contracts—such as forward rate agreements commonly used by insurance companies and banks prior to mortgage loan originations—most FIs hedge interest rate risk either at the micro level (called microhedging) or at the macro level (called macrohedging) using futures contracts.

Table 23–1 shows part of an interest rate futures quote from The Wall Street Journal for January 10. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 633 For example. An example is using a T-bond futures contract to hedge an FI’s holdings of long-term bonds as investments. As a result. 15–17. the FI manager may decide to remain unhedged or even to overhedge by selling more futures than the cash or on-balance-sheet position requires.S. an FI manager may choose to selectively hedge only a portion of the FI’s balance sheet positions (microhedge) rather than take large positions on futures contracts needed to hedge the entire balance sheet (macrohedge). in part. The Financial Accounting Standards Board (FASB)—the main regulator of accounting standards—has made a number of rulings regarding the accounting and tax treatment of futures transactions. The key is to take a position in the futures market to offset a loss on the balance sheet due to a move in interest rates with a gain in the futures market. 2005.gov 7. the risk-based capital requirements favor the use of futures over forwards. pp. although regulators may view this as speculative.federalreserve. The number of futures contracts that an FI should buy or sell in a microhedge depends on the interest rate risk exposure created by a particular asset or liability on the balance sheet. Accounting Rules and Hedging Strategies. See “Called to Account. In 1997. (2) establish trading limits. Overall. as Chapter 13 discusses. 9. FASB Statement No. an FI manager may generate expectations regarding future interest rates before deciding on a futures position. Thus.org www. managerial objectives. by contrast. or microhedge. Policies of Bank Regulators. To the dismay of some legislators in Congress and regulators.treas. Thus.” Risk Magazine.9 Microhedging with Futures. The main bank regulators—the Federal Reserve. Alternatively.” GAO/GGD-00-3 (October 1999). the use of derivative securities in some nondepository FIs—especially hedge funds— remains virtually unregulated. Additionally. the FDIC. companies that hold or issue derivatives must report their trading objectives and strategies in public document disclosures such as annual reports. These guidelines require a bank to (1) establish internal guidelines regarding its hedging activity. for 96. and the Comptroller of the Currency—have issued uniform guidelines for banks taking positions in futures and forwards. “Accounting for Futures Contracts” (1984) is probably the most important.7 In hedge accounting. Copyright © 2007 .Anthony Saunders. Other things being equal.gov www. the manager may selectively hedge only a portion of its balance sheet position.occ. on managerial interest rate expectations. 80.gov www. U. See “Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systematic Risk. or the yield on the Eurodollar CD contract deliverable in www. the FASB required that all gains and losses on derivatives used to hedge assets and liabilities on the balance sheet be recognized immediately as earnings. August 1996. the fully hedged position becomes one of several choices depending.Economia degli intemediari finanziari 2/ed .l. 8. although on a practical basis. regulatory policy is to encourage the use of futures for hedging and to discourage their use for speculation. 2005 (see also Table 10–5).fasb.8 Because of the volatility in earnings that futures introduce as they are marked to market. and the nature of the return-risk tradeoff from hedging. futures contracts are not subject to the risk-based capital requirements imposed by regulators on depository institutions.fdic. Finally.The McGraw-Hill Companies s. the 1997 ruling effectively requires derivatives to be marked to market. a futures position is a hedge transaction if it can be linked to a particular asset or liability. over-the-counter forward contracts are potentially subject to capital requirements because of the presence of counterparty risk (see below).r. together with the offsetting gain or loss on the hedged item. .72 percent of the face value of the Eurodollar CD contract. and (3) disclose large contract positions that materially affect a bank’s risk to shareholders and outside investors. Marcia Millon Cornett. it is often difficult to distinguish between the two. In this list. a June 2005 Eurodollar futures contract can be bought (long) or sold (short) on January 10.

wsj. p.com/sc3e) presents mathematical details and numerical examples of hedging with futures contracts.The McGraw-Hill Companies s. losses are incurred on the futures position—that is. the short hedger loses. there is no interest rate risk exposure and thus there is no need to hedge. Inc.000. Similarly. the long hedger loses. a short position in the futures 1. How a naive hedge works? A long position in the futures market produces a profit when interest rates fall 4. The difference between a futures market is the appropriate hedge when the FI stands to lose on the balance sheet if contract and a forward contract? interest rates are expected to rise (e.10 In fact.Economia degli intemediari finanziari 2/ed . is graphically described in Figure 23–1. Marcia Millon Cornett. fixed-rate certificates of deposit. In this case. We assume that the balance sheet has no liability of equal size and maturity (or duration) as the CD.mhhe. the FI holds Eurodollar CDs in its asset port2. © 2005 Dow Jones & Company. any loss in value from a change in the between a spot contract and yield on an asset on the balance sheet over the period of the hedge is exactly offset a forward contract are? by a gain on the short position in the Eurodollar futures contract (see Figure 23–2). a long position is the appropriate hedge when the FI stands to lose on the against a particular risk”? balance sheet if interest rates are expected to fall.28 percent (100% 96.Anthony Saunders. if the FI is perfectly hedged.72%). A short position in the D O Y O U U N D E R S TA N D ? futures will produce a profit when interest rates rise (meaning that the value of the underlying Eurodollar contract decreases). When a futures position is a hedge transaction according to and short position. 12. if rates rise and futures prices drop. so a position in one contract can be taken at a price of $967. 11. Mario Anolli 634 Part 5 Risk Management in Financial Institutions TABLE 23–1 Futures Contracts on Interest Rates. 10. any loss in value from the CD could be offset with an equivalent decrease in value from the liability. The subsequent profit or loss from a position in June 2005 Eurodollar futures taken on January 10. Reprinted by permission of The Wall Street Journal.200. Copyright © 2007 . What is meant by the phrase (meaning that the value of the underlying Eurodollar CD contract increases). This might be the case when the FI is financing itself with long-term.com June 2005 will be 3. . 2005.11 “an FI has immunized its portfolio Therefore.r.000. 2005 Source: The Wall Street Journal. 3. All Rights Reserved Worldwide. if rates fall and futures prices rise. If the FI has such a liability. The minimum contract size on one of these futures is $1. Therefore.g.. www. 2005. January 11. January 10.l. What the major differences folio). C11. Notice that if rates move in an opposite direction from that expected. Appendix 23A to this chapter located at the book’s Web site FASB rules? (www.12 Table 23–2 summarizes the long 5.

72% Payoff Loss Futures Price FIGURE 23–2 FI Value Change On and Off the Balance Sheet from a Perfect Short Hedge Value Change Gain Change in Capital Value Due to Change in Asset Value 97% Asset Price at End of Hedge Value Change Loss Change in Capital Value Due to Hedge Position Asset Price at Beginning of Hedge TABLE 23–2 Summary of Gains and Losses on Microhedges Using Futures Contracts Type of Hedge Long hedge (buy) Short hedge (sell) Change in Interest Rates Decrease Increase Cash Market Loss Loss Futures Market Gain Gain OPTIONS This section discusses the role of options in hedging interest rate risk. and caps. collars. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 635 FIGURE 23–1 Profit or Loss on a Futures Position in Eurodollar Futures. and floors (see Chapter 10). FIs have a wide variety of option products to use in hedging.Economia degli intemediari finanziari 2/ed .The McGraw-Hill Companies s.l. In December 2004.72% Payoff Loss Futures Price 0 96. Taken on January 10. including exchange-traded options. options embedded in securities. Marcia Millon Cornett.r. 2005 Payoff Gain Short Position Futures Futures Prices Fall Prices Rise (rates rise) (rates fall) Payoff Gain Long Position Futures Futures Prices Fall Prices Rise (rates rise) (rates fall) 0 96. over-thecounter (OTC) options.13 trillion in Copyright © 2007 .Anthony Saunders. Not only have the types of option products increased in recent years but the use of options has increased as well. commercial banks held $3. .

in fact. 13.Economia degli intemediari finanziari 2/ed .r. 14. The two basic option contracts are puts and calls. Marcia Millon Cornett. Notice two important things about bond call options in Figure 23–3: 1.The McGraw-Hill Companies s. As interest rates fall. CP) made to purchase the call option.. If rates rise so that bond prices fall below the exercise price.e. Thus. Thus. bond prices fall and the potential for a negative payoff (loss) for the buyer of the call option increases. their value is only a fraction of the underlying security). the more rates fall (the higher bond prices rise). bond prices rise. this often results in options being the preferred hedging instruments over futures contracts. the buyer’s losses are truncated by the amount of the up-front premium payment (call premium. buying a call option is a strategy to take when interest rates are expected to fall. As interest rates rise. and writing (selling) a put. we consider bond options whose payoff values are inversely linked to interest rate movements in a manner similar to bond prices and interest rates in general (see Chapter 3). we summarize their return payoffs in terms of interest rate movements (see Chapter 10 for the details). an FI could potentially be a buyer or seller (writer) of each. We begin by reviewing the four basic option strategies: buying a call. Options can. the call buyer is not obligated to exercise the option. This does not necessarily mean that options are less risky than spot or futures positions.62 trillion in OTC options as part of their off-balance-sheet exposures. . 2. be riskier than other investments since they exist for only a limited period of time and are leveraged investments (i. and the call option buyer has a large profit potential.l. To compare an option position to a spot position one must consider an equal dollar investment in the two positions over a common period of time. Copyright © 2007 . However. Mario Anolli 636 Part 5 Risk Management in Financial Institutions FIGURE 23–3 Payoff Gain Payoff Function for the Buyer of a Call Option on a Bond Payoff Function 0 CP EP EP CP Bond Price Payoff Loss exchange trade options and $14. writing (selling) a call. EP.Anthony Saunders. The first strategy of buying (or taking a long position in) a call option on a bond is shown in Figure 23–3. Specifically. Buying a Call Option on a Bond. Notice that unlike interest rate futures. the larger the profit on the exercise of the option.13 Basic Features of Options In describing the features of the four basic option strategies that FIs might employ to hedge interest rate risk. whose prices and payoffs move symmetrically with changes in the level of interest rates. the payoffs on bond call options move asymmetrically with changes in interest rates.14 As we discuss below. buying a put.

these losses could be very large. Thus. the probability that the writer will take a loss increases. the potential for the writer of the call to receive a positive payoff or profit increases. the put buyer does not have to exercise the option. the maximum loss is limited to the size of the up-front put premium (PP).The McGraw-Hill Companies s. Since bond prices are theoretically unbounded in the upward direction. although they must return to par at maturity. the probability that the buyer of a put will lose increases. forcing the option writer to sell the underlying bonds. buying a put option is a strategy to take when interest rates are expected to rise. writing a call option is a strategy to take when interest rates are expected to rise. EP. When interest rates rise and bond prices fall. When interest rates fall and bond prices rise. 2. Copyright © 2007 . Thus. and the larger the profit on the exercise of the option. The call buyer is less likely to exercise the option. Buying a Put Option on a Bond.l. if bond prices fall. Thus.Anthony Saunders. If rates fall so that bond prices rise above the exercise price. shown in Figure 23–5. EP. the put option buyer has unlimited profit potential. this results in the writing of a call option being unacceptable as a strategy to use when hedging interest rate risk. As discussed below. the more the bond prices fall. Marcia Millon Cornett. Notice two important things about this payoff function: 1. 2. however. The call buyer will exercise the option. When interest rates rise and bond prices fall. which would force the option writer to sell the underlying bond at the exercise price. the probability that the buyer of the put will make a profit from exercising the option increases. the buyer of the put option can purchase bonds in the bond market at that price and put them (sell them) back to the writer of the put at the higher exercise price. When interest rates fall and bond prices rise. As a result. because profits are limited but losses are unlimited. the higher the rates rise.Economia degli intemediari finanziari 2/ed . Caution is warranted. Thus. The second strategy is writing (or taking a short position in) a call option on a bond shown in Figure 23–4. . The third strategy is buying (or taking a long position in) a put option on a bond. However. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 637 FIGURE 23–4 Payoff Gain CP Payoff Function for the Writer of a Call Option on a Bond 0 EP EP CP Bond Price Payoff Function Payoff Loss Writing a Call Option on a Bond. Note the following: 1.r. this profit has a maximum equal to the call premium (CP) charged up front to the buyer of the option.

However.r. The put buyer is less likely to exercise the option. Note the following: 1. When interest rates fall and bond prices rise. Marcia Millon Cornett.Economia degli intemediari finanziari 2/ed .. shown in Figure 23–6. the investor could potentially lose his or her entire investment in the option). profits are limited and losses are potentially unlimited (i. When interest rates rise and bond prices fall. Mario Anolli 638 Part 5 Risk Management in Financial Institutions FIGURE 23–5 Payoff Gain Payoff Function for the Buyer of a Put Option on a Bond 0 PP Payoff Loss EP PP EP Bond Price Payoff Function Writing a Put Option on a Bond. Thus. forcing the option writer to buy the underlying bond at the exercise price.Anthony Saunders. However. Since bond prices are theoretically unbounded in the downward direction. 2. the writer has an enhanced probability of making a profit. As with the writing of a call option (and discussed below). the writer of the put is exposed to potentially large losses. writing a put option is a strategy to take when interest rates are expected to fall.The McGraw-Hill Companies s.l. the writer’s maximum profit is constrained to equal the put premium (PP). The put buyer will exercise the option. this results in the writing of a put option being unacceptable as a strategy to use when hedging interest rate risk.e. FIGURE 23–6 Payoff Gain Payoff Function for the Writer of a Put Option on a Bond PP Payoff Function 0 EP PP EP Bond Price Payoff Loss Copyright © 2007 . these losses can be unlimited. EP. which would force the option writer to buy the underlying bond. The fourth strategy is writing (or taking a short position in) a put option on a bond. .

www.liffe.cbt. Reprinted by permission of The Wall Street Journal. Note in Figure 23–8 that buying a put option truncates the downside losses on the bond following interest rate rises to some maximum amount and scales down the upside profits by the cost of bond price risk insurance— the put premium—leaving some positive upside profit potential. Figure 23–7 shows the gross payoff of a bond and the payoff from buying a put option on it. Table 23–3.Anthony Saunders. 2005 Source: The Wall Street Journal.com www.com FIs have a wide variety of OTC and exchange-traded options available.com Copyright © 2007 .r.Economia degli intemediari finanziari 2/ed . Mario Anolli Chapter 23 Managing Risk with Derivative Securities 639 Actual Interest Rate Options www. Marcia Millon Cornett. any losses on the bond (as rates rise and bond values decrease) are offset with profits from the put option that was bought (points to the left of point X in Figure 23–7). January 10. Inc. If rates fall. All Rights Reserved Worldwide. We discussed these contracts and the operations of the markets in detail in Chapter 10. Figure 23–8 shows the net overall payoff from the bond investment combined with the put option hedge. 2005. . C11.The McGraw-Hill Companies s. p.cme. Hedging with Options 4 Figures 23–7 and 23–8 describe graphically the way that buying a put option on a bond can potentially hedge the interest rate risk exposure of an FI that holds bonds as part of its asset investment portfolio. Notice too that the combination of being long in the bond and buying a put option on a bond mimics the payoff TABLE 23–3 Futures Options on Interest Rates. 2005. the bond value increases.l. © 2005 Dow Jones & Company. reports exchange-traded interest rate futures options traded on the Chicago Board of Trade (CBT) and the Chicago Mercantile Exchange (CME) on January 10. yet the accompanying losses on the purchased put option positions are limited to the option premiums paid (points to the right of point X). In this case. January 11.com www.wsj. from Table 10–8 and The Wall Street Journal’s business section.

Mario Anolli 640 Part 5 Risk Management in Financial Institutions FIGURE 23–7 Payoff Gain Buying a Put Option to Hedge the Interest Rate Risk on a Bond Payoff Function of a Bond in an FI’s Portfolio 0 X Bond Price –PP Payoff Function from Buying a Put on a Bond Payoff Loss function of buying a call option (compare Figures 23–3 and 23–8).com/sc3e) presents mathematical details and numerical examples of hedging with options. and collars are derivative securities that have many uses. an FI can buy a call option on a bond to hedge interest rate risk exposure from a bond that is part of the FI’s liability portfolio.l. and Collars As discussed in Chapter 10. caps.mhhe. Floors. Marcia Millon Cornett.Economia degli intemediari finanziari 2/ed . especially in helping an FI hedge interest rate risk exposure as well as risks FIGURE 23–8 Net Payoff Gain Net Payoff of Buying a Bond Put and Investing in a Bond Net Payoff Function 0 X Bond Price Payoff Loss Copyright © 2007 . Appendix 23B to this chapter located at the book’s Web site (www. .r. Caps. Conversely. foreign exchange risk. and credit risk of an FI as well.Anthony Saunders. floors. Option contracts can also be used to hedge the aggregate duration gap exposure (macrohedge).The McGraw-Hill Companies s.

leaving the FI 2. RISKS ASSOCIATED WITH FUTURES. affect the payoff from buying a call option on a bond? How they Contingent credit risk is likely to be present when FIs expand their positions in affect the payoff from writing a forward. or DA kDL 0. As a result. By contrast.mhhe. futures. Futures contracts. or—in a macrohedging context—their duration gap is greater than zero. or affect the payoff from buying a exchange rates. and a collar used to hedge exchange contract that promises to deliver £10 million in three months’ time at the interest rate risk? exchange rate $1. the seller of the cap—usually a bank—compensates the buyer—for example. futures. this happens if they are funding assets with floating-rate liabilities such as notes indexed to the LIBOR (or some other cost of funds) and they have fixed-rate assets or they are net long in bonds. prices. The idea here is that the FI wants to hedge itself against rising rates but wants to finance the cost of the cap.880 billion derivatives held by the user banks.P. What the outcome is if an FI hedges by buying put options on ally by negotiating parties such as two FIs and all cash flows are required to be paid futures and interest rates rise at one time (on contract maturity). Allied Irish Banks suffered a $750 million loss D O Y O U U N D E R S TA N D ? on its derivative positions due to trades by a rogue employee in the early 2000s. This type affect the payoff from writing a put option on a bond? of default risk is much more serious for forward contracts than for futures contracts. bond prices fall)? arrangements with no external guarantees should one or the other party default on 4. This is so because forward contracts are nonstandard contracts entered into bilater3. and 1. such defaults are most likely to occur when the counterparty put option on a bond? How they is losing heavily on the contract and the FI is in the money on the contract. and collars. with three big dealer banks (J. AND OPTIONS Financial institutions can be either users of derivative contracts for hedging and other purposes or dealers that act as counterparties in trades with customers for a fee. FI managers use them like options to hedge the interest rate risk of an FI’s portfolios. Usually.e. FIs purchase interest rate caps if they are exposed to losses when interest rates rise. a the contract. these securities entail risk for the user banks.90 when the 5. or DA kDL 0. As with caps. futures contracts are standardized contracts with forwards. In general.Economia degli intemediari finanziari 2/ed . and option contracts.Anthony Saunders. For example. Marcia Millon Cornett.The McGraw-Hill Companies s. the seller of the floor compensates the buyer in return for an up-front premium. and Citigroup) accounting for some 90 percent of the $87. floor agreements can have one or many exercise dates.70 to £1 if the cost to purchase £1 for delivery is $1. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 641 unique to its individual customers. How interest rate increases options trading. make commitments to deliver Copyright © 2007 . . One way to do this is to sell a floor and use the premiums on the floor to pay the premium on the purchased cap. Finally. Specifically. these three over-the-counter instruments are special cases of options. Thus. Buying a floor is similar to buying a put option on interest rates. This section discusses the various types of risk involved with futures. approximately 680 banks were users of derivatives. like forward contracts. This risk relates to the fact that the countercall option on a bond? party to one of these contracts may default on payment obligations. FIs purchase collars when they are concerned about excessive volatility of interest rates or more commonly to finance cap or floor positions. if interest rates rise above the cap rate. and guaranteed by organized exchanges such as the New York Futures Exchange options? (NYFE). floors. For example. they are essentially over-the-counter (i. Bank of America. How interest rate increases unhedged and having to replace the contract at today’s interest rates. At the end of 2004. Buying a cap means buying a call option or a succession of call options on interest rates. Appendix 23C to this chapter located at the book’s Web site (www. Further.. another FI—in return for an up-front premium. Morgan Chase. Thus. A collar occurs when an FI takes a simultaneous position in a cap and a floor. forwards. The difference between a cap. The risks involved with hedging forward contract matures.l.com/sc3e) presents details and examples of hedging with calls.r. such as buying a cap and selling a floor. FORWARDS. FIs purchase floors when they have fixed costs of debt and have variable rates (returns) on assets or they are net short in bonds. However. buying an interest rate cap is like buying insurance against an (excessive) increase in interest rates. If interest rates fall below the floor rate. By contrast. the contract seller might default on a forward foreign floor.

(3) price limits that spread extreme price fluctuations over time. SWAPS The market for swaps has grown enormously in recent years—the value of swap contracts outstanding by U. the default risk of a futures contract is less than that of a forward contract for at least four reasons: (1) daily marking to market of futures. however. the savings bank had to rely on short-term certificates of deposit 15. Option contracts can also be traded by an FI over the counter (OTC) or bought/sold on organized exchanges. Banks often index most large commercial and industrial loans to either LIBOR or the federal funds rate in the money market. In this section. The five generic types of swaps. say. . If the options are standardized options traded on exchanges. we consider the role of the two major generic types of swaps—interest rate and currency—in hedging FI risk. and (4) default guarantees by the futures exchange itself.15 In addition. If they are specialized options purchased OTC such as interest rate caps. in order of their notional principal. This reduces the duration gap between the bank’s assets and liabilities. the duration of its assets is shorter than that of its liabilities. Consider two FIs: the first is a money center bank that has raised $100 million of its funds by issuing four-year. If a counterparty were to default on a futures contract. enter into a swap agreement to make the floating-rate payment side of a swap agreement. Alternatively. commercial banks was $56. LIBOR plus 2. currency swaps.41 trillion in December 2004. and equity swaps (see Chapter 10). such as bond options.16 The instrument underlying the swap may change. DA kDL 0 One way for the bank to hedge this exposure is to shorten the duration or interest rate sensitivity of its liabilities by transforming them into short-term floating-rate liabilities that better match the rate sensitivity of its asset portfolio. the money center bank has a negative duration gap. There are also swaptions. As a result of having floating-rate loans and fixed-rate liabilities in its asset-liability structure.The McGraw-Hill Companies s. but the basic principle of a swap agreement is the same in that it involves the transacting parties restructuring asset or liability cash flows in a preferred direction. default risk is reduced by the daily marking to market of future contracts.Anthony Saunders.. The second party of the swap is a thrift institution (savings bank) that has invested $100 million in fixed-rate residential mortgages of long duration. we use a simple example. Mario Anolli 642 Part 5 Risk Management in Financial Institutions foreign exchange (or some other asset) at some future date. a fixed rate of 10 percent) at some time in the future in return for the payment of an up-front premium. More specifically. The proceeds of these deposits would be used to pay off the medium-term notes. they are virtually default risk free. which are options to enter into a swap agreement at some preagreed contract terms (e. medium-term notes with 10 percent annual fixed coupons rather than relying on short-term deposits to raise funds (see Table 23–4). 16. On the balance sheet. credit risk swaps. To finance this residential mortgage portfolio. (2) margin requirements on futures that act as a security bond. the bank could attract an additional $100 million in short-term deposits that are indexed to the LIBOR rate (at. The bank can make changes either on or off the balance sheet. We then examine the credit risk characteristics of these instruments. are interest rate swaps. Marcia Millon Cornett.l. commodity swaps. futures are essentially default risk free. the bank makes commercial and industrial (C&I) loans whose rates are indexed to annual changes in the London Interbank Offered Rate (LIBOR). On the asset side of its portfolio. This prevents the accumulation of losses and gains that occur with forward contracts.S. Copyright © 2007 . unless a systematic financial market collapse threatens the exchange itself.r.5 percent) in a manner similar to its loans. Thus. some element of default risk exists. the bank could go off the balance sheet and sell an interest rate swap—that is. Hedging with Interest Rate Swaps 5 To explain the role of a swap transaction in hedging FI interest rate risk. the exchange assumes the defaulting party’s position and payment obligations.g.Economia degli intemediari finanziari 2/ed .

Marcia Millon Cornett. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 643 TABLE 23–4 Money Center Bank Balance Sheet Assets C&I loans (rate indexed to LIBOR) Liabilities Medium-term notes (coupons fixed at 10% annually) $100 million $100 million TABLE 23–5 Savings Bank Balance Sheet Assets Fixed-rate mortgages $100 million Liabilities Short-term CDs (one year) $100 million with an average duration of one year (see Table 23–5). The opposing balance sheet and interest rate risk exposures of the money center bank and the savings bank provide the necessary conditions for an interest rate swap agreement between the two parties. say. .Economia degli intemediari finanziari 2/ed . it is likely that an FI—another bank or an investment bank—would act as either a broker or an agent. However. By acting as a principal as well as an agent.l. On the balance sheet. when a third-party FI fully intermediates the swap. one with the money center bank and one with the savings bank. 12 percent). The proceeds of the sale of the notes can be used to pay off the CDs and reduce the repricing gap. However. The annual coupon cost of these note liabilities is 10 percent. the credit risk exposure of a swap to an FI is somewhat less than that on a loan (this is discussed later in this chapter). This swap agreement can be arranged directly between the parties. The money center bank’s problem is that the variable return on its assets may be insufficient to cover the cost of meeting these fixed coupon payments if market interest rates fall. The savings bank could hedge its interest rate risk exposure by transforming the short-term floating-rate nature of its liabilities into fixed-rate liabilities that better match the long-term maturity (duration) structure of its assets. the thrift could issue longterm notes with a maturity equal or close to that on the mortgages (at. the fixed returns on the savings bank’s mortgage asset portfolio may be insufficient to cover the interest cost of its CDs should market rates Copyright © 2007 . By comparison. Consequently. the notional (or face) value of the swap is $100 million—equal to the assumed size of the money center bank’s medium-term note issue—and the four-year maturity is equal to the maturity of its note liabilities. we consider an example below of a plain vanilla fixed-floating rate swap (a standard swap agreement without any special features) in which a third-party intermediary acts as a simple broker or agent by bringing together two DIs with opposing interest rate risk exposures to enter into a swap agreement or contract. EXAMPLE 23–1 Expected Cash Flows on an Interest Rate Swap In this example. the FI can add a credit risk premium to the fee. Conceptually. For simplicity. receiving a fee for bringing the two parties together or to intermediate fully by accepting the credit risk exposure and guaranteeing the cash flows underlying the swap contract. the savings bank’s asset-liability balance sheet structure is the reverse of the money center bank’s: DA kDL 0 plain vanilla A standard agreement without any special features. take the fixed-payment side of a swap agreement. that FI is really entering into two separate swap agreements. Alternatively.r. On maturity.Anthony Saunders. the thrift can buy a swap—that is. these CDs must be rolled over at the current market rate.The McGraw-Hill Companies s.

. fixed-rate liability notes into a variable-rate liability matching the variability of returns on its C&I loans. Marcia Millon Cornett. As a result of the swap.r. Copyright © 2007 . the money center bank has transformed its four-year. the expected net financing costs for the FIs are listed in Table 23–6. the money center bank sends annual payments indexed to the oneyear LIBOR to help the savings bank cover the cost of refinancing its one-year renewable CDs. In return. For example. 10 percent notes) LIBOR+2 Percent Short-Term Liabilities (1-year CDs) rise.Economia degli intemediari finanziari 2/ed .17 We depict this fixed–floating rate swap transaction in Figure 23–9. Had it gone to the debt market. the swap agreement might dictate that the savings bank send fixed payments of 10 percent per annum of the notional $100 million value of the swap to the money center bank to allow the money center bank to cover fully the coupon interest payments on its note issue. As a result. The savings bank also has transformed its variable-rate CDs into fixed-rate payments similar to those received on its fixed-rate mortgages—it has successfully microhedged.The McGraw-Hill Companies s.Anthony Saunders. Further. Suppose that the money center bank agrees to send the savings bank annual payments at the end of each year equal to one-year LIBOR plus 2 percent. the money center bank effectively pays LIBOR plus 2 percent for its financing. These rates implicitly assume that this is the cheapest way each party can hedge its interest rate exposure. LIBOR plus 2 percent is the lowest-cost way that the money center bank can transform its fixed-rate liabilities into floating-rate liabilities. the money center bank would pay LIBOR plus 2.l. only the money center bank is really fully hedged. This happens because the annual 10 percent payments it receives from the savings bank at the end of each year allows it to meet the promised 10 percent coupon rate payments to its note holders regardless of the return it receives on its 17. Mario Anolli 644 Part 5 Risk Management in Financial Institutions TABLE 23–6 Financing Cost Resulting from Interest Rate Swap (in millions of dollars) Money Center Bank Cash outflows from balance sheet financing Cash inflows from swap Cash outflows from swap Net cash flows Rate available on Variable-rate debt Fixed-rate debt Savings Bank 10% $100 10% $100 (LIBOR 2%) $100 (LIBOR LIBOR 2%) 21⁄2% $100 (8% (CD Rate) $100 (LIBOR 2%) $100 10% $100 CD Rate LIBOR) $100 12% FIGURE 23–9 Fixed–Floating Rate Swap Money Center Bank Short-Term Assets (C&I indexed loans) Cash Flows from Swap 10 Percent Fixed Savings Bank Long-Term Assets (fixed-rate mortgages) Long-Term Liabilities (4-year.5 percent with the swap). Note in Example 23–1 that in the absence of default/credit risk. through the interest rate swap.5 percent (a savings of .

it is usual to include only interest rate payments.18 We summarize this 18.S. say. Its asset returns would be sensitive to LIBOR movements while its swap payments were indexed to U. using the proceeds to pay off the $100 million of four-year. Consider a U. an FI in the United Kingdom has all its assets denominated in pounds. FIs can enter into a currency swap by which the U. and U. 10.l. Assume that the dollar/pound exchange rate is fixed at $2/£1. . medium-term British pound notes that have a fixed annual coupon of 10 percent. the U. medium-term pound notes. (For interest rate swaps. These two FIs are exposed to opposing currency risks. FI sends annual dollar payments to the U. FI is exposed to the risk that the dollar will appreciate against the pound. It is financing part of its asset portfolio with a £50 million issue of four-year. The savings bank might be better hedged by requiring the money center bank to send it floating payments based on U. making it more difficult to cover the dollar coupon and principal payments on its four-year. The proceeds of the sale can be used to pay off the £50 million of four-year. FI’s pound note issue.K. say. The U.Economia degli intemediari finanziari 2/ed . 10. it is partly funding those assets with a $100 million issue of four-year. Similarly. which would make it more costly to cover the annual coupon interest payments and the principal repayment on its pound-denominated notes.5 percent). EXAMPLE 23–2 Expected Cash Flows on a Fixed–Fixed Currency Swap Off the balance sheet. $100 million note issue from the pound cash flows on its assets.S. FI can issue £50 million in four-year. FI to cover the interest and principal payments on its dollar note issue. Swaps are long-term contracts that can also be used to hedge an FI’s exposure to currency risk. Fixed-Fixed Currency Swaps. the U. In a currency swap.S. By contrast. The FIs can hedge the exposures either on or off the balance sheet. medium-term dollar notes (at. To do this. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 645 variable-rate assets. FI can issue $100 million in four-year. the plus 2 percent add-on to LIBOR may be insufficient to hedge the savings bank’s cost of funds.K.Anthony Saunders. medium-term dollar notes with a fixed annual coupon of 10 percent. thus.S.K. FI is exposed to the risk that the dollar will depreciate against the pound over the next four years. the credit/default risk premium on the savings bank’s CDs may increase over time. mediumterm dollar notes.r. the savings bank receives variable-rate payments based on LIBOR plus 2 percent.The McGraw-Hill Companies s.S.S. it is usual to include both principal and interest payments as part of the swap agreement. FI with all of its fixed-rate assets denominated in dollars. On the balance sheet. Second. CD rates do not exactly match the movements of LIBOR rates over time since the former are determined in the domestic money market and the latter in the Eurodollar market. the U. FI sends annual payments in pounds to cover the coupon and principal repayments of the U. The following section considers a plain vanilla example of how currency swaps can immunize FIs against foreign exchange rate risk when they mismatch the currencies of their assets and liabilities. Marcia Millon Cornett.S. the money center bank would probably require additional compensation since it would then bear basis risk. It is quite possible that the CD rate that the savings bank must pay on its deposit liabilities does not exactly track the LIBOR-indexed payments sent by the money center bank—that is. the savings bank is subject to basis risk exposure on the swap contract. CD rates. On the other hand.5 percent). the U. medium-term pound notes (at. This basis risk can come from two sources. Currency Swaps currency swap A swap used to hedge against foreign exchange rate risk from mismatched currencies on assets and liabilities.S. By comparison. and the U.K.) The reason for this is that both principal and interest are exposed to foreign exchange risk. First. domestic CD rates rather than on LIBOR.K. Both FIs have taken actions on the balance sheet so that they are no longer exposed to movements in the exchange rate between the two currencies. Copyright © 2007 .

. the two parties normally agree on a fixed exchange rate for the cash flows at the beginning of the period.r.bis. we can also produce a fixed–floating currency swap that is a hybrid of the two plain vanilla swaps we have considered so far.19 In this example.S. By combining an interest rate swap of the fixed–floating type described earlier with a currency swap. 10 percent coupon) currency swap in Figure 23–10 and Table 23–7. FI transforms fixedrate pound liabilities into fixed-rate dollar liabilities that better match the fixed-rate dollar cash flows from its asset portfolio. this exchange rate reflects the contracting parties’ expectations as to future exchange rate movements. the fixed exchange rate is $2/£1. Credit Risk Concerns with Swaps www.5% FIGURE 23–10 U.S.S.Economia degli intemediari finanziari 2/ed .Anthony Saunders. Mario Anolli 646 Part 5 Risk Management in Financial Institutions TABLE 23–7 Financing Costs Resulting from the Fixed–Fixed Currency Swap Agreement (in millions of dollars) U. FI 10% 10% 10% 10% $100 $100 £50 £50 10. the U. FI Cash outflows from balance sheet financing Cash inflows from swap Cash outflows from swap Net cash flows Rate available on Dollar-denominated notes Pound-denominated notes 10% 10% 10% 10% £50 £50 $100 $100 U.The McGraw-Hill Companies s.5 percent to do this. Had they gone to the market. Both FIs effectively obtain financing at 10 percent while hedging against exchange rate risk. The fear was that in a long-term OTC swap-type contract.l. Marcia Millon Cornett. Copyright © 2007 . the U.K. FI Fixed-Rate Dollar Assets Fixed–Fixed Pound/Dollar Currency Swap Cash Flows from Swap U. Further. As with interest rate swaps. In undertaking this exchange of cash flows. As a result of the swap.org The growth of the over-the-counter (OTC) swap market was one of the major factors underlying the imposition of the BIS risk-based capital requirements in January 1993 (see Chapter 13). FI transforms fixed-rate dollar liabilities into fixed-rate pound liabilities that better match the pound fixed-rate cash flows from its asset portfolio. the losing or 19.5% 10. FI Fixed-Rate Pound Assets Dollars £ Fixed-Rate Pound Liabilities (£50 million. both FIs transform the pattern of their payments at a lower rate than had they made changes on the balance sheet.K. 10 percent coupon) Pounds $ Fixed-Rate Dollar Liabilities ($100 million. they would have paid 10. Similarly.K.

When swaps are made between parties of different credit standings so that one party perceives a significant risk of default by the other party. Copyright © 2007 .).The McGraw-Hill Companies s. Remember that a swap contract is like a succession of forward contracts.5m. Of the two reasons for this. is the default risk on swaps? Is it high or low? Is it the same as or different from the credit risk on loans? In fact.Economia degli intemediari finanziari 2/ed . one party makes a fixed payment and the other makes a floating payment. What. Standby Letters of Credit. the standby letter of credit party would provide the swap payments in lieu of the defaulting party. the savings bank pays a net cash flow of $4.5m. we look at some general features of the different types of contracts that may lead to an FI preferring one derivative instrument over another. This suggests that the default risk on such interest rate swaps is less than on a regular loan. but interest rate swaps involve swaps of interest payments only measured against some notional (or face) principal value.21 COMPARISON OF HEDGING METHODS 6 As described above. Netting and Swaps. ( (3. This netting of payments implies that the default exposure of the in-the-money party is limited to the net payment rather than either the total fixed or floating payment itself. swap participants deal with the credit risk of counterparties by setting bilateral limits on the notional amount of swaps entered into (similar to credit rationing on loans) and adjusting the fixed and/or floating rates by including credit risk premiums.. fixed-rate payer may have to pay an additional spread to a high credit-quality.5m. one is economic and the other is regulatory. the credit risk on swaps and the credit risk on loans differ in three major ways. respectively. and one party makes a single payment for the net difference to the other. 1. Thus. ( 10% $100m.Anthony Saunders. Rather. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 647 www. than have both FIs receive cash and pay cash. currency. On each swap payment date. each party calculates the net difference between the two payments. which sets codes and standards for swap markets) imposed a risk-based capital requirement for banks to hold against their interest rate. in which both its interest and principal payments are exposed to credit risk.20 We discuss these differences next. Consequently. so that the credit risk on a swap is much less than that on a loan of equivalent dollar size. and other swaps. In this section. Marcia Millon Cornett. an FI has many alternative derivative instruments with which it can hedge a particular risk. if the LIBOR rate on the first swap payment date is 3. from Table 23–6 the money center bank’s cash inflows and cash outflows from the swap are $10m. a low credit-quality. the poor-quality credit risk party may be required to buy a standby letter of credit (or another form of performance guarantee) from a third-party high-quality (AAA-rated) FI so that should default occur. In general. What the major differences between the credit risk on swaps and the credit risk on loans are? Payment Flows Are Interest.5% 2%) $100m. however. As with loans. in Example 23–1. Conversely.org out-of-the-money counterparty would have incentives to default on such contracts to deter current and future losses. the savings bank’s cash inflows and outflows from the swap are $5. 20.l. the D O Y O U U N D E R S TA N D ? cash flows from the swap are netted.) and $5. respectively. . One factor that mitigates the credit risk on swaps is the netting of swap payments. For example.isda. the BIS (with significant input and support from the global trade association the International Swaps and Derivatives Association (ISDA). 21. Writing versus Buying Options Many FIs prefer to buy rather than write options. exactly.5 percent.r. For instance. This raises the following questions. and $10m. to be received by the money center bank. What the difference between an interest rate swap and a currency swap is? 2. floating-rate payer. not Principal. Another solution employed by market participants is to use collateral to mark to market a swap contract in a way similar to marking futures to market to prevent credit risk building up over time. Currency swaps involve swaps of interest and principal. We summarize these in Table 23–8.

hedging the FI’s risk by buying a put option on a bond generally offers the manager a more attractive alternative. Regulatory Reasons. Note that writing the call may hedge the FI when rates fall and bond prices rise—that is. Mario Anolli 648 Part 5 Risk Management in Financial Institutions TABLE 23–8 Comparison of Hedging Methods Writing versus Buying Options • Writing options truncates upside profit potential while downside loss potential is unlimited.Anthony Saunders. Swaps and forwards require payments only at times specified in the swap or forward agreement. Indeed. • Swap and forward contracts are subject to default risk. Refer again to Figures 23–7 and 23–8. • Buying options truncates downside loss potential while upside profit potential is unlimited.l. Regulators consider writing options. the FI is unable to offset the associated capital value loss on the bond with profits from writing options. naked options Option positions that do not identifiably hedge an underlying asset or liability. Figure 23–11 indicates this. By contrast. • Swaps can be written for relatively long time horizons. unlike with futures hedging. Many FIs also buy options rather than write options for regulatory reasons.Economia degli intemediari finanziari 2/ed . especially naked options. Futures and option contracts do not trade for more than two or three years into the future and active trading in these contracts generally extends to contracts with a maturity of less than one year. the actual price or interest rate movement on the underlying asset may move against the option writer.r. the increase in the value of the bond is offset by losses on the written call. bank regulators prohibit commercial banks from writing puts or calls in certain areas of risk management. • Options hedging protects the FI against value losses when interest rates move against the on-balance-sheet securities. and most options. Copyright © 2007 . • Futures contracts are marked to market daily. the upside profit potential is truncated but the downside losses are not. In writing an option. However. When the reverse occurs and interest rates rise. are standardized contracts with fixed principal amounts. Swaps (and forwards) are OTC contracts negotiated directly by the counterparties to the contract. to be risky because of their unlimited loss potential. If the decrease in the bond value is larger than the premium income (to the left of point A in Figure 23–11). Economic Reasons for Not Writing Options. Futures versus Options Hedging • Futures hedging produces symmetric gains and losses when interest rates move against the on-balance-sheet securities. does not fully reduce value gains when interest rates move in favor of on-balance-sheet securities. On an expected basis. • Commercial banks are prohibited by regulators from writing options in certain areas of risk management. An FI is long in a bond in its portfolio and seeks to hedge the interest rate risk on that bond by writing a bond call option. which do not identifiably hedge an underlying asset or liability position. Although such risks may be offset by writing a large number of options at different exercise prices and/or hedging an underlying portfolio of bonds. It is this actual price or rate change that leads to the possibility of unlimited losses. This occurs because the upside profit (per call written) is truncated and equals the premium income (C ). and Options • Futures. but. Most futures and option contracts are not subject to default risk. the writing of an appropriate call or put option would lead to a fair rate of return.The McGraw-Hill Companies s. The net overall payoff from the bond investment combined with the put option hedge truncates the downside losses on the bond following interest rate rises to some maximum amount and scales down the upside profits by the put premium. . Marcia Millon Cornett. as well as when interest rates move in favor of on-balance-sheet securities. Swaps versus Forwards. the writer’s downside risk exposure may still be significant. Futures. the FI’s profits from writing the call may be insufficient to offset the loss on its bonds.

If the FI gains value on the bond due to an interest rate decrease (to the right of point X ). compare the payoff gains illustrated in Figure 23–12 (for futures contracts) with those in Figure 23–7 (for option contracts). . A hedge with futures contracts produces symmetric gains and losses with interest rate increases and decreases. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 649 FIGURE 23–11 Writing a Call Option to Hedge the Interest Rate Risk on a Bond Payoff Gain Payoff Function of a Bond in an FI’s Portfolio C 0 Bond Price X A –C Payoff Loss Payoff Function from Writing a Call Option on a Bond Futures versus Options Hedging To understand the factors that impact the choice between using futures rather than options contracts to hedge.Anthony Saunders.l.The McGraw-Hill Companies s.r.Economia degli intemediari finanziari 2/ed . Marcia Millon Cornett. a loss on the futures contract offsets this gain. FIGURE 23–12 Buying a Futures Contract to Hedge the Interest Rate Risk on a Bond Payoff Gain Payoff Function of a Bond in an FI’s Portfolio 0 X Bond Price Payoff Loss Payoff Function from Selling a Futures Contract on a Bond Copyright © 2007 . That is. if the FI in Figure 23–12 loses value on the bond resulting from an interest rate increase (to the left of point X ). it enjoys a gain on the futures contract to offset this loss.

This feature allows for flexibility in the principal amount of the swap contract. in Figure 23–7. many FIs prefer option-type contracts to future/forward type contracts. some significant contractual differences between swaps and forwards. In this respect. does not fully reduce value gains when interest rates move in favor of on-balance-sheet securities.l. the option hedge protects the FI against value losses when interest rates move against the on-balance-sheet securities but. futures and many options are standardized contracts with fixed principal amounts. swaps are comparable to forwards. regulators attempt to judge the overall integrity of each institution engaging in derivative activities by assessing the capital adequacy of the institutions and by enforcing regulations to ensure compliance with those capital requirements. all of the derivative instruments can be viewed as relatively low-cost hedging alternatives when compared to changing the overall composition of the FI’s balance sheet of assets and liabilities. Indeed. futures. DERIVATIVE TRADING POLICIES OF REGULATORS Derivatives are subject to three levels of institutional regulation. Finally. futures.The McGraw-Hill Companies s. conceptually a swap is just a succession of forward rate contracts. Swap and forward contracts are negotiated between two counterparties. are OTC contracts negotiated directly by the counterparties to the contract. sometimes as long that an FI might choose to buy as 20 years. Thus. and options. if the FI gains value on the bond due to an interest rate decrease (to the right of point X ). Futures. Thus. What the regulatory reasons are Third. Swaps (and forwards). institutions engaging in those activities are subjected to supervisory oversight. and should one party fail to abide by the terms of the contract. on the other hand. however. Third. if the FI loses value on the bond due to an interest rate increase (to the left of point X ). The SEC regulates all securities traded on national securities exchanges. the counterparty incurs this default risk. First. while swaps and forwards require payments only at times specified in the swap or forward agreement. futures. a hedge with an option contract offsets losses but only partly offsets gains—gains and losses from hedging with options are no longer symmetric for interest rate increases and decreases. The Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) are often viewed as “functional” regulators. Futures and option contracts do not trade for more than two or three options rather than write them? years into the future and active trading in these contracts generally extends to 3. futures and (exchange-traded) options are subject to default risk only when the entire exchange has a default risk problem. Second. Swaps versus Forwards. Thus. There are. Thus. are guaranteed by the exchange on which they trade. once permissible activities have been specified. For example. the gain is offset only to the extent that the FI loses the fixed option premium (because it never exercises the option). futures contracts are marked D O Y O U U N D E R S TA N D ? to market daily. However. Thus. however. unlike futures hedging. a gain on the option contract offsets the loss. 2. First. What the differences are contracts with a maturity of less than one year. hedging risk exposure with futures 1. swap and forward contracts are subject to default risk. while balance sheet? most futures and option contracts are not. regulators of derivatives specify “permissible activities” that institutions may engage in. Mario Anolli 650 Part 5 Risk Management in Financial Institutions By comparison. including several exchange-traded derivatives. Futures and option contracts. and option contracts that assist the FI manager in his or her choice of hedging method. The SEC’s Copyright © 2007 . Marcia Millon Cornett.r.Economia degli intemediari finanziari 2/ed . forwards. swaps provide the FI with between swaps. and Options We have shown in this chapter that swaps can be used to alter the cash flows of an FI from a particular asset and liability structure. What the economic reasons are can result in large cash inflows and outflows for the FI if price movements result that FIs do not write options? in margin calls at the end of the day as a result of this marking-to-market process. and option contracts in better long-term contractual protection against risk exposures than futures and hedging risk exposure on an FI’s options. Further. .Anthony Saunders. swaps can be written for relatively long time horizons. Second.

the risk-based capital requirements favor the use of futures over forwards. forwards. To the extent that swap activity is part of a bank’s overall business. to regulations imposed by the Federal Reserve. the FDIC. It therefore regulates all national futures exchanges. These guidelines require a bank to (1) establish internal guidelines regarding its hedging activity. we outlined the regulatory procedures governing derivatives. the FDIC. although on a practical basis distinguishing between the two is often difficult. A number of characteristics such as maturity. marking to market. Finally. and capital requirements differentiate these products and make one or the other more attractive to any particular FI manager. 2000. the policy of regulators is to encourage the use of futures for hedging and to discourage their use for speculation. futures. because commercial banks are the major swap dealers. In particular. flexibility. This means that FIs must immediately recognize all gains and losses on such contracts and disclose those gains and losses to shareholders and regulators.mhhe. flexibility. The CFTC’s regulations include minimum capital requirements for traders. and liquidity that make them attractive alternatives relative to shorter-term hedging vehicles such as futures. Swaps have special features of long maturity. We saw that while they are close substitutes. as well as all futures and options on futures. exchange-traded futures contracts are not subject to risk-based capital requirements. indirectly. and swaps. Copyright © 2007 . Marcia Millon Cornett.Economia degli intemediari finanziari 2/ed . SUMMARY This chapter analyzed the risk-management role of forwards. These (off-balance-sheet) derivative securities provide FIs with a low-cost alternative to managing risk exposure directly on the balance sheet. liquidity. and the Comptroller of the Currency—also have issued uniform guidelines for banks taking positions in futures and forwards. by contrast. Other things being equal. Further. no central governing body oversees swap market operations. swap markets are monitored for abuses and the risk exposure they add to the bank. the main regulator of accounting standards (the FASB) required all FIs (and nonfinancial firms) to reflect the mark-to-market value of their derivative positions in their financial statements.The McGraw-Hill Companies s. and derivative trading by FIs are? other bank regulatory agencies charged with monitoring bank risk. As of January 1. and minimum standards for clearinghouse organizations. options. Overall. we noted that the unique nature of the asymmetric payoff structure of option-type contracts often makes them more attractive to FIs than other hedging instruments such as forwards and futures. We then evaluated the role of swaps as risk-management vehicles for FIs.r. and options.com/sc3e . firms must show whether they are using derivatives to hedge risks connected to their business or whether they are just taking an open risky position. the swap markets are 2. (2) establish trading limits. and (3) disclose large contract positions that materially affect bank risk to shareholders and outside investors. We analyzed the major types of swaps. antifraud and antimanipulation regulations. reporting and transparency requirements. We first looked at the use of forwards and futures contracts as hedging instruments. D O Y O U U N D E R S TA N D ? In contrast to futures and options markets. as noted in Chapter 13. www. they are not perfect substitutes. The CFTC also has jurisdiction over all exchange-traded derivative securities.Anthony Saunders. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 651 regulation of derivatives includes price reporting requirements and margin requirements. We next discussed the use of option-type contracts available to FI managers to hedge interest rate risk. Finally.l. swap markets are governed by very 1. Howwhich derivatives are subject? ever. The main bank regulators—the Federal Reserve. The three levels of regulation to little regulation. Who the main regulators of subject. such as interest rate and currency swaps. OTC forward contracts are potentially subject to capital requirements.

Answer the following: a. Click on “Publications. What are some of the major differences between futures and forward contracts? 2. options. Marcia Millon Cornett. What are the three largest banks dealing in derivatives and what percentage of the total derivatives market does each comprise? QUESTIONS 1. so presently plenty of two-month forward contracts for 15-year bonds are available at 104. A U. The FI’s market analyst is predicting that the Federal Reserve will raise interest rates within the next two months and doing so will raise the yield on the bond to 8 percent. and swaps outstanding? 3. Assume that the Treasury bond futures price falls to 94. bond that is priced at 104 and yields 7 percent. e. b. A mutual fund plans to sell its holding of stock in a German company. a. The FI plans to sell the bond but for tax purposes must wait two months.000 par value. When and how can an FI use options on T-bonds to hedge its assets and liabilities against interest rate declines? c. futures.The McGraw-Hill Companies s.occ. What is the impact on the Treasury bond price if interest rates increase 50 basis points annually (25 basis points semiannually)? c. 4. d.r. the loan is payable in euros. 3.000.com/sc3e Copyright © 2007 .” This will bring the file onto your computer that contains the relevant data. Questions 1. The FI would like to hedge against this interest rate forecast with an appropriate position in a forward contract. What is the duration of a 20-year 8 percent coupon (paid semiannually) Treasury bond (deliverable against the Treasury bond futures contract) selling at par? b. The bond has a duration of eight years. in what kind of hedge is it engaged? c. a. What are the two ways to use call and put options on T-bonds to generate positive cash flows when interest rates decline? b. c. a. Is it more appropriate for FIs to hedge against a decline in interest rates with long calls or short puts? www. the hedge will protect the FI from loss. f. Most other analysts are predicting no change in interest rates. 6. Derivative Fact Sheet. A finance company has assets with a duration of 6 years and liabilities with a duration of 13 years.treas. What is the meaning of the following Treasury bond futures price quote: 101-13? 5. In each of the following cases.Economia degli intemediari finanziari 2/ed . $10. An FI holds a 15-year. Click on “Tables.” Click on “Qrtrly. An insurance company plans to buy bonds in two months.” Click on the most recent date. A thrift is going to sell Treasury securities next month. What is the notional amount of forwards. Suppose that you purchase a Treasury bond futures contract at $95 per $100 of face value.Anthony Saunders. indicate whether it would be appropriate for an FI to buy or sell a forward contract to hedge the appropriate risk. If an FI purchases this contract. Assume that the Treasury bond futures price rises to 97. Answer the following. Mario Anolli 652 Part 5 Risk Management in Financial Institutions SEARCH THE SITE Go to the Web site of the Office of the Comptroller of the Currency at www.S. What is the total notional amount of derivatives outstanding? 2. What will this position be? Show that if rates rise by 1 percent as forecast. . Mark your position to market. What is your loss or gain? d. What is your obligation when you purchase this futures contract? b. A commercial bank plans to issue CDs in three months.l.gov and find the most recent data on the notional amount of the various types of derivatives contracts outstanding at commercial banks using the following steps. bank lends to a French company.mhhe.

It invests the funds in a six-month Swedish krona bond paying 7. The current spot rate of U. Consider Table 23–3.S. An insurance company owns $50 million of floating-rate bonds yielding LIBOR plus 1 percent. 9. dollar is expected to appreciate against the pound to £1. These loans are financed by $50 million of fixed-rate guaranteed investment contracts (GICs) costing 10 percent. respectively. Bank 2 can issue five-year CDs at an annual fixed rate of 13 percent or at a variable rate of LIBOR 3 percent. March T-bond calls at 112. What happens to the price of a call when: (1) The exercise price increases? (2) The time until expiration increases? b. Marcia Millon Cornett. £1. f. The proceeds of the CD are lent to a British company for three years at a fixed rate of 9 percent.S. c. What type of opportunities or obligations does the manager have? 11. If the U. Suppose that a pension fund manager anticipates the purchase of a 20-year 8 percent coupon T-bond at the end of two years. c.5 percent per year. A U. What are the prices paid for the following futures options: a. the loan is payable in euros. it is equally probable that interest rates will increase or decrease 1 percent. 16. what is an example of a feasible swap? 14. Contrast the use of financial futures options with the use of options on cash instruments to construct interest rate hedges. In each of the following cases. a. Distinguish between a swap seller and a swap buyer. An insurance company plans to buy bonds in two months.The McGraw-Hill Companies s. They are financed by $200 million of CDs with a variable rate of T-bill plus 3 percent. Is this expected to be a profitable transaction ex ante? What are the cash flows if exchange rates are unchanged over the next three years? What is the risk exposure of the bank’s underlying cash position? How can the British bank reduce that risk exposure? b. b. dollars is £1. 13.1810/SKr. Suppose that an FI manager writes a call option on a T-bond futures contract with an exercise price of 114 at a quoted price of 0-55. e. A finance company has $50 million of auto loans with a fixed rate of 14 percent. dollar payments for British pound payments at the current spot exchange rate. Mario Anolli Chapter 23 Managing Risk with Derivative Securities 653 7. three-year Eurodollar CD at a fixed annual rate of 7 percent. What happens to the price of the put when these two variables increase? 10.Anthony Saunders. Propose a swap that would result in each FI having the same type of assets and liabilities (i. A commercial bank has $200 million of floating-rate loans yielding the T-bill rate plus 2 percent. How can the FI use futures and forward contracts to macrohedge? 20. what are the cash flows on the swap? What are the cash flows on the entire hedged position? Assume that the U. a. The six-month forward rate on the Swedish krona is being quoted at $0.mhhe. What is the FI’s duration gap? b. and the other has assets and liabilities all tied to some floating rate).Economia degli intemediari finanziari 2/ed . bank lends to a French company. What is the pension fund manager’s interest rate risk exposure? b. What is the net spread earned on this investment if the bank covers its foreign exchange exposure using the forward market? b. How can the pension fund manager use options to hedge that interest rate risk exposure? 12. a. What is the comparative advantage of the two banks? c. What are some practical difficulties in arranging this swap? 15. If the finance company is going to be the swap buyer and the insurance company the swap seller. c. These loans are financed by $200 million of fixed-rate deposits costing 9 percent. the T-bond will pay interest semiannually. April 5-year T-note puts at 10850. How does hedging with options differ from hedging with forward or futures contracts? 18. it is selling at par.com/sc3e a. a.18/SKr. A mutual fund plans to sell its holding of stock in a German company. what will be the cash flows on this transaction? c. dollar appreciates at the same rates as in part (b). 19. The spot exchange rate of pounds for U. 8. Is a mutually beneficial swap possible between the two banks? b.e. one has fixed assets and fixed liabilities. Show that this swap would be acceptable to both parties.65/$1. b.S. When purchased in two years. d. A finance company has assets with a duration of 6 years and liabilities with a duration of 13 years.S.50/US$. At that time. At what forward rate will the spread be only 1 percent per year? Copyright © 2007 . Consider Table 23–3 again. indicate whether it is appropriate for an FI to buy a put or a call option in order to hedge the appropriate risk. What is the FI’s interest rate risk exposure? c. Consider the following FI’s balance sheet: Assets ($000) Duration 10 years Liabilities ($000) Duration 2 years $860 Equity 90 $950 www.815/$1.00/$1 over the next three years.l.S. Discuss the type of interest rate risk each FI faces. a. A savings association has $200 million of mortgages with a fixed rate of 13 percent.r.S. A thrift plans to sell Treasury securities next month. b. and £2. dollars for Swedish krona is $0. . Currently. They are financed by $50 million of debt with a variable rate of LIBOR plus 4 percent. March Eurodollar calls at 9700. Bank 1 can issue five-year CDs at an annual rate of 11 percent fixed or at a variable rate of LIBOR 2 percent..5 percent per year. A British bank issues a $100 million. a. d. If the British bank swaps U. What is an example of a feasible swap? 17. A commercial bank plans to issue CDs in three months. a. A bank purchases a six-month $1 million Eurodollar deposit at an interest rate of 6. Interest rates are assumed to change only once every year at year end.

mhhe.Economia degli intemediari finanziari 2/ed .mhhe.com/sc3e APPENDIX 23C: Hedging with Caps.The McGraw-Hill Companies s.mhhe.mhhe. Floors. Mario Anolli 654 Part 5 Risk Management in Financial Institutions APPENDIX 23A: Hedging with Futur es Contracts View this appendix at www. . and Collars View this appendix at www.com/sc3e Copyright © 2007 . Marcia Millon Cornett.r.Anthony Saunders.l.com/sc3e www.com/sc3e APPENDIX 23B: Hedging with Options View this appendix at www.

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