Commercial Bank Management

CHAPTER 3
TOOLS FOR MANAGING AND HEDGING AGAINST RISK

1
Learning Objectives

• Asset, Liability, and Funds management

• Market rates and interest-rate risk

• Interest-sensitive gap management

• Duration gap management

• The Use of Derivatives: Financial Futures, Options, Swaps, and Other Hedging Tools

2
Chapter 3: Tools for managing and hedging against risk

Risk management for changing interest rates: asset-liability management and

3.1
duration techniques
3.1.1 Asset, Liability, and Funds Management
3.1.2. Market Rates and Interest Rate Risk
3.1.3. Interest-Sensitive Gap Management
3.1.4. Duration Gap Management
Risk management: Financial Futures, Options, Swaps, and Other Hedging
3.2 Tools
3.2.1 Financial Futures Contracts
3.2.2. Interest-Rate Options
3.2.3. Interest-Rate Swaps
3.2.4. Caps, Floors, and Collars
3
4
3.1 Risk management for changing interest
rates: asset-liability management and
duration techniques

4
3.1.1 Asset-Liability Management Strategies

• Asset-Liability Management:
o Definition: coordinated and integrated decision making in managing asset and liability
portfolios
o Purpose: controlling a bank’s sensitivity to changes in market interest rates and limit its
losses in its net income or net worth.

5
3.1.1 Asset-Liability Management Strategies

• Historical strategies of asset-liability management:

o Asset management strategy: control assets – allocating funds in loans and
investments; no control over liabilities – taking the funds as solely determined by the
public
o Liability management strategy: control liabilities by changing rates and other terms

6
3.1.1 Asset-Liability Management Strategies

• The goal chart of asset-liability management

7
3.1.1 Asset-Liability Management Strategies

• Funds management strategy:

o Control over the volume, mix, and return or cost of both assets and liabilities
o Control over assets coordinated with control over liabilities to maximize the spread
between revenues and costs and control risk exposure
o Revenues and costs arising from both sides of the balance sheet (i.e., from both asset and
liability accounts)

8
3.1.1 Asset-Liability Management Strategies

• Financial institutions today sell a bundle of financial services, credit, payments, savings,
financial advice, and the like-that should each be priced to cover their cost of production. I
• ncome from managing the liability side of the balance sheet can help achieve profitability
goals as much as revenues generated from managing loans and other assets.
• Many financial firms carry out daily asset-liability management activities through asset-
liability committees (ALCO), usually composed of key officers representing different
departments of the firm.

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3.1.1 Asset-Liability Management Strategies

• Asset and Liability Management Committee

(ALCO):
o Composing of key officers representing
different departments
o Primary responsibility: interest rate risk
management
o Coordinating the bank’s strategies to achieve
the optimal risk/reward trade-off.

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3.1.2. Market Rates and Interest Rate Risk

• Forces Determining Interest Rates

• Banks - both supply and

demand for loanable funds
• Interest rates are
determined by the supply
& demand of the market
for loanable funds
• Interest rate risk: including
price risk & reinvestment
risk

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3.1.2. Market Rates and Interest Rate Risk

• The measurement of interest rates

o Yield to maturity

n
CFt
Market Price = å
t =1 (1 + YTM)
t

o Bank discount rate (DR)

𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑛 𝑙𝑜𝑎𝑛 𝑜𝑟 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 360

𝐷𝑅 = 𝑥
𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 𝑁𝑜 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦

12
3.1.2. Market Rates and Interest Rate Risk

• The Components of Interest Rates:

13
3.1.2. Market Rates and Interest Rate Risk

• Yield curves:
o Definition: Graphical picture of relationship between yields and maturities on
securities (at a single point in time, assuming ceteris paribus)

14
3.1.2. Market Rates and Interest Rate Risk

• Yield curves:
o Shape of the yield curve
ü Upward – long-term rates higher than short-term rates (economic expansion)
ü Downward – short-term rates higher than long-term rates (economic recession)
ü Horizontal – short-term and long-term rates the same
o Shape of the yield curve and the maturity gap
ü Typical maturity gap of a bank: longer maturities of assets (loans & securities) than
liabilities (deposits)
ü Upward sloping yield curve benefits banks, generating positive net interest margin
ü Downward and horizontal yield curve put negative pressure in bank earnings

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3.1.2. Market Rates and Interest Rate Risk

• Interest rate risk: is the potential loss from unexpected changes in interest rates which
can significantly alter a bank’s profitability and market value of equity, including:
o Reinvestment risk: If interest rates change, the bank will have to reinvest the cash flows
from assets or refinance rolled-over liabilities at a different interest rate in the future.
o Price risk: If interest rates change, the market values of assets and liabilities also change.

è What is the risk for banks when interest increases/decreases?

16
3.1.2. Market Rates and Interest Rate Risk

• Interest rate risk:

o Example:
A bank makes a $10,000 four-year car loan to a customer at fixed rate of 8.5%. The bank
initially funds the car loan with a one-year $10,000 CD at a cost of 4.5%. The bank’s initial
spread is 4%. What is the bank’s risk?

4 year Car Loan 8.50%

1 Year CD 4.50%
4.00%

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3.1.3 Interest-Sensitive Gap Management

• Goal of interest rate hedging: to insulate the bank from the damaging effects of
fluctuating interest rates on profits (net income).
o Must concentrate on those interest-sensitive assets and liabilities
o To protect profits against adverse interest rate changes, management seeks to hold fixed
the net interest margin (NIM)

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3.1.3 Interest-Sensitive Gap Management

• For example, suppose a large international bank records $4 billion in interest revenues
from its loans and security investments and $2.6 billion in interest expenses paid out to
attract borrowed funds. If this bank holds $40 billion in earning assets. Calculate its net
interest margin.

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3.1.3 Interest-Sensitive Gap Management

• Practice: First National Bank of Bannerville has posted interest revenues of $63 million
and interest costs from all of its borrowings of $42 million. If this bank possesses $700
million in total earning assets, what is First National's net interest margin?
• Suppose the bank's interest revenues and interest costs double, while its earning assets
increase by 50 percent. What will happen to its net interest margin?

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3.1.3 Interest-Sensitive Gap Management

• Answer:

If interest revenues and interest costs double while earning assets grow by 50 percent, the
net interest margin will change as follows:

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3.1.3 Interest-Sensitive Gap Management

• If the interest cost of borrowed funds rises faster than income from loans and securities, a
financial firm's NIM will be squeezed, with likely adverse effects on profits.
• If interest rates fall and cause income from loans and securities to decline faster than
interest costs on borrowings, the NIM will again be squeezed.
• Management must struggle continuously to find ways to ensure that borrowing costs do
not rise significantly relative to interest income and threaten the margin of a financial firm.

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3.1.3 Interest-Sensitive Gap Management

• Factors affecting NIM:

o Changes in the level of interest rates
o Changes in the spread between assets and liabilities
o Changes in the volume of interest-sensitive assets and liabilities
o Changes in the mix of interest-sensitive assets and liabilities

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3.1.3 Interest-Sensitive Gap Management

• Among the most popular interest rate hedging strategies in use today is interest-sensitive
gap management.
• Gap management techniques require management to perform an analysis of the maturities
and repricing opportunities associated with interest-bearing assets and with interest-
bearing liabilities.
• If management feels its institution is excessively exposed to interest rate risk, it will try to
match as closely as possible the volume of assets that can be repriced as interest rates
change with the volume of liabilities whose rates can also be adjusted with market
conditions during the same time period.

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3.1.3 Interest-Sensitive Gap Management

v Dollar interest-sensitive gap:

o Analysis of the maturities and repricing opportunities associated with interest-bearing
assets & interest-bearing liabilities
o Zero gap:

What is a repriceable asset? A

repriceable liability?

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3.1.3 Interest-Sensitive Gap Management

v Dollar interest-sensitive gap :

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3.1.3 Interest-Sensitive Gap Management

• What happens when the amount of repriceable assets does not equal the amount of repriceable
liabilities?
Clearly, a gap then exists between these interest-sensitive assets and interest-sensitive
liabilities.
• A gap exits: the amount of repriceable assets is different from that of repriceable liabilities

Interest-Sensitive Gap = Interest-Sensitive Assets –

Interest Sensitive Liabilities

27
3.1.3 Interest-Sensitive Gap Management

• For example: If interest-sensitive assets (ISA) are $150 million and interest-sensitive
liabilities (ISL) are $200 million, then
Dollar IS GAP= ISA - ISL= $150 million - $200 million= -$50 million.
• An institution whose Interest-Sensitive Gap is positive is asset sensitive, while a negative
Interest-Sensitive Gap describes a liability-sensitive condition.

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3.1.3 Interest-Sensitive Gap Management

o For Asset-sensitive bank having positive gap:

Ø If interest rates rise, NIM will increase because the interest revenue generated by assets
will increase more than the cost of borrowed funds. Other things being equal, this
financial firm will experience an increase in its net interest income .
Ø If interest rates fall , NIM will decline as interest revenues from assets drop by more
than interest expenses associated with liabilities. The financial firm with a positive gap
will lose net interest income if interest rates fall.

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3.1.3 Interest-Sensitive Gap Management

o For Liability-sensitive bank having negative gap:

Ø Rising interest rates will lower this institution’s NIM, because the rising cost associated
with interest-sensitive liabilities will exceed increases in interest revenue from interest-
sensitive assets.
Ø Falling interest rates will generate a higher interest margin and probably greater
earnings as well, because borrowing costs will decline by more than interest revenues.

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3.1.3 Interest-Sensitive Gap Management

• To sum up, gap positions and the effect of interest rate changes on the bank:

o Asset-sensitive bank o Liability-sensitive bank

Ø Interest rates rise: NIM rises Ø Interest rates rise: NIM falls
Ø Interest rates fall: NIM falls Ø Interest rates fall: NIM rises

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3.1.3 Interest-Sensitive Gap Management

• There are several ways to measure the interest-sensitive gap (IS GAP).
Ø The Dollar IS GAP
Ø The Relative IS GAP ratio
Ø Interest Sensitivity Ratio (ISR).

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3.1.3 Interest-Sensitive Gap Management

Ø Relative IS GAP ratio

Ø Relative IS GAP > 0: asset-sensitive bank

Ø Relative IS GAP < 0: liability-sensitive bank

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3.1.3 Interest-Sensitive Gap Management

Ø Interest Sensitivity Ratio (ISR): to compare the ratio of ISA to ISL

Ø ISR > 1: asset-sensitive bank

Ø ISR < 1: liability-sensitive bank

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3.1.3 Interest-Sensitive Gap Management

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3.1.3 Interest-Sensitive Gap Management

• Example: Expected Balance Sheet for Hypothetical Bank

Assets Yield Liabilities Cost
Rate sensitive $ 1.000 8,0% $ 1.200 4,0%
Fixed rate $ 700 11,0% $ 440 6,0%
Non earning $ 300 $ 200
$ 1.840
Equity
$ 160
Total $ 2.000 $ 2.000

Calculate NII, NIM and Interest-rate Gap

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3.1.3 Interest-Sensitive Gap Management

• Example: Expected Balance Sheet for Hypothetical Bank

Assets Yield Liabilities Cost
Rate sensitive $ 1,000 8.0% $ 1,200 4.0%
Fixed rate $ 700 11.0% $ 440 6.0%
Non earning $ 300 $ 200
$ 1,840
Equity
$ 160
Total $ 2,000 $ 2,000

NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440)

NII = 157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86%
GAP = 1000 - 1200 = -200

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3.1.3 Interest-Sensitive Gap Management

Can a bank with zero gap completely hedge its NIM?

o No as practically the interest rates attached to assets and liabilities are not perfectly
correlated in the real world
Ø E.g: Loan interest rates tend to lag behind interest rates on many money market
borrowings.
Ø So interest revenues often tend to grow more slowly than interest expenses during
economic expansions, while interest expenses tend to fall more rapidly than interest
revenues during economic downturns.

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3.1.3 Interest-Sensitive Gap Management

• Important decisions under gap management:

ü Choose the time period during which NIM is to be managed
ü Choose a target level, i.e. freezing or increasing NIM.
ü If management wishes to increase the NIM, it must either develop a correct interest rate
forecast or find ways to reallocate earning assets and liabilities
ü Determine the volume of interest-sensitive assets and liabilities it wants the financial firm to
hold

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3.1.3 Interest-Sensitive Gap Management

• Steps in gap analysis:

o Develop an interest rate forecast
o Select a series of “time buckets” or intervals for determining when assets and liabilities will
re-price
o Group assets and liabilities into these “buckets”
o Calculate the GAP for each “bucket ”
o Forecast the change in net interest income given an assumed change in interest rates

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3.1.3 Interest-Sensitive Gap Management

• A useful overall measure of interest rate risk exposure is the cumulative gap.
• Cumulative gap: the total difference in Dollars between bank Assets and Liabilities which can
be repriced over a designated time period
• For example, suppose that a bank has $100 million in earning assets and $200 million in
liabilities subject to an interest rate change each month over the next six months. Then its
cumulative gap must be:
Answer:
Cumulative gap = ($100 million in earning assets per month x 6) - ($200 million in
liabilities per month x 6)
= -$600 million

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3.1.3 Interest-Sensitive Gap Management

• Cumulative gap: Based on cumulative gap concept, we can calculate approximately

how NII will be affected by an interest rate change.

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3.1.3 Interest-Sensitive Gap Management

• Computer-based techniques and maturity buckets:

(Read textbook Example in Table 7-1 for more details)

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3.1.3 Interest-Sensitive Gap Management

v Aggressive interest-sensitive gap management:

• Some financial firms shade their interest-sensitive gaps toward either asset sensitivity or
liability sensitivity, depending on their degree of confidence in their own interest rate
forecasts. This is often referred to as aggressive GAP management
•

44
3.1.3 Interest-Sensitive Gap Management

• Aggressive interest-sensitive gap management:

Some financial firms shade their interest-sensitive gaps toward either asset sensitivity or
liability sensitivity, depending on their degree of confidence in their own interest rate
forecasts. This is often referred to as aggressive GAP management

• Defensive interest-sensitive gap management:

Set interest-sensitive GAP as close to zero as possible to reduce the expected volatility of NII

45
3.1.3 Interest-Sensitive Gap Management

• Problems with interest-sensitive gap management:

o Interest paid on liabilities tend to move faster than interest earned on assets
o Interest rate attached to bank assets and liabilities do not move at the same speed as market
interest rates
o Point at which some assets and liabilities are re-priced is not easy to identify
o Not considering the impact of changing interest rates on equity position

46
3.1.3 Interest-Sensitive Gap Management
Exercises:
1. Commerce National Bank reports interest-sensitive assets of $870 million and interest-
sensitive liabilities of $625 million during the coming month. Is the bank asset sensitive or
liability sensitive? What is likely to happen to the bank’s net interest margin if interest rates
rise? If they fall?
Answer:
• Because interest-sensitive assets are larger than liabilities by $245 million the bank is
asset sensitive
• If interest rates rise, the bank’s NIM should rise as asset revenues increase by more
than the resulting increase in liability costs. On the other hand, if interest rates fall, the
bank’s NIM will fall as asset revenues decline faster than liability costs.

47
3.1.3 Interest-Sensitive Gap Management

Exercises:
2. People’s Savings Bank, a thrift institutions, has a cumulative gap for the coming year of
+$135 million, and interest rates are expected to fall by two and a half percentage points.
a. Calculate the expected change in net interest income (NIM) that this thrift institution
might experience.
b. What will occur in net interest income if interest rates rise by one and a quarter
percentage points?

48
3.1.3 Interest-Sensitive Gap Management

Exercises:
2. People’s Savings Bank, a thrift institutions, has a cumulative gap for the coming year of
+$135 million, and interest rates are expected to fall by two and a half percentage points.

Answer:
a. For the decrease in interest rates:
Expected Change in Net Interest Income = $135 million * (-0.025) = -$3.38 million
b. For the increase in interest rates:
Expected Change in Net Interest Income = $135 million * (+0.0125) = +$1.69 million

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3.1.4 Duration Gap Management

What Is Duration?

• Duration is a value- and time-weighted measure of maturity that considers the timing of
all cash inflows from earning assets and all cash outflows associated with liabilities.
• It measures the average maturity of a promised stream of future cash payments (such as
the payment streams that a financial firm expects to receive from its loans and security
investments or the stream of interest payments it must pay out to its depositors).
• In effect, duration measures the average time needed to recover the funds committed to
an investment.

50
3.1.4 Duration Gap Management

v Calculate the duration (D) of an individual financial instru- ment, such as a loan, security,
deposit, or nondeposit borrowing:

(1)

Where: D stands for the instrument's duration in years and fractions of a year
t represents the period of time in which each flow of cash off the instrument
CF indicates the volume of each expected flow of cash in each time period (t)
YTM is the instrument's current yield to maturity.

52
3.1.4 Duration Gap Management

v Calculate the duration (D)

• The denominator of the formula (1) is equivalent to the instrument's current market
value (price). So, the duration formula can be abbreviated to this form:

(2)

Where: D stands for the instrument's duration in years and fractions of a year
t represents the period of time in which each flow of cash off the instrument
CF indicates the volume of each expected flow of cash in each time period (t)
YTM is the instrument's current yield to maturity.

53
3.1.4 Duration Gap Management

Example: Suppose that a bank grants a loan to one of its customers for a term of five years.
The customer promises the bank an annual interest payment of 10 percent. The face (par)
value of the loan is $1,000, which is also its current market value (price). What is this loan
duration?
Answer:

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3.1.4 Duration Gap Management

Example (cont):

55
3.1.4 Duration Gap Management

v Duration (D):
o A bank with longer-duration assets than liabilities will suffer a greater decline in Net
worth (NW) when market interest rates rise (than a bank with short-term asset duration
or matching the duration of liabilities with assets)
o Equating asset and liability durations à stabilize NW from interest rate risk.

56
3.1.4 Duration Gap Management

v Price Sensitivity to Changes in Interest Rates and Duration:

• The % change in the market price of an asset/liability is equal to its duration times the
relative change in interest rates attached to that particular asset or liability:

DP Di
» -D*
P (1 + i)
where
: the percentage change in market price
: the relative change in interest rates associated with the asset or liability.
: duration, and the negative sign attached to it reminds us that market prices and interest rates on
financial instruments move in opposite directions

57
3.1.4 Duration Gap Management

v Price Sensitivity to Changes in Interest Rates and Duration:

• Example: A bond held by a savings institution with a duration of 4 years and a current
market value (price) of $1,000. Market interest rates attached to comparable bonds are
about 10% currently, but recent forecasts suggest that market rates may rise to 11%. If this
forecast turns out to be correct, what percentage change will occur in the bond’s market
value?
Answer:

58
3.1.4 Duration Gap Management

v Using Duration to Hedge against Interest Rate Risk

• Financial-service provider interested in fully hedging against interest rate fluctuations
wants to choose assets and liabilities such that:

so that the duration gap is as close to zero as possible:

59
3.1.4 Duration Gap Management

• Dollar-weighted duration of asset portfolio (DA):

n
D A = å w i * D Ai
i =1

wi = the dollar amount of the ith asset divided by total assets

DAi = the duration of the ith asset in the portfolio

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3.1.4 Duration Gap Management

• Dollar-weighted duration of liability portfolio (DL):

n
D L = å w i * D Li
i =1
wi = the dollar amount of the ith liability divided by total assets
DAi = the duration of the ith liability in the portfolio

61
3.1.4 Duration Gap Management

• Leverage adjusted duration gap:

TL
D = DA - DL *
TA
o D: Leverage-adjusted duration gap
o TL: the total liabilities divided
o TA: the total assets
The larger the leverage-adjusted duration gap, the more sensitive will be the net worth to a
change in interest rates

62
3.1.4 Duration Gap Management

• Change in the value of a bank’s net worth:

é Di ù é Di ù
DNW = ê- D A * * Aú - ê- D L * * Lú
ë (1 + i) û ë (1 + i) û

63
3.1.4 Duration Gap Management

• Change in the value of a bank’s net worth:

Example: A financial firm has an average duration in its assets of three years, an average
liability duration of two years, total liabilities of $100 million, and total assets of $120 million.
Interest rates were originally 10 percent, but suddenly they rise to 12 percent. What is the
impact on the bank’s NW?

Answer:

64
3.1.4 Duration Gap Management

v Impact of changing interest rates on a bank’s net worth:

65
3.1.4 Duration Gap Management

v Aggressive duration gap management strategy:

v Defensive duration gap management strategy: zero leverage-adjusted duration gap

(portfolio immunization; duration gap = 0)

66
3.1.4 Duration Gap Management

v Limitations of duration gap management

• Finding assets and liabilities of the same duration can be difficult
• Some assets and liabilities may have patterns of cash flows that are not well defined
• Customer prepayments may distort the expected cash flows in duration
• Customer defaults may distort the expected cash flows in duration
• Convexity can cause problems

67
3.2. Risk management: Financial Futures,
Options, Swaps, and Other Hedging Tools

68
3.2.1. Financial Futures Contracts

• Definition: 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.
• Purpose: 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.

69
3.2.1. Financial Futures Contracts

v The most popular financial futures contracts are:

• U.S. Treasury bond futures contract
• Futures contracts on three-month Eurodollar time deposits
• 30-day Federal funds futures contracts
• One-month LIBOR futures contract

70
3.2.1. Financial Futures Contracts

71
3.2.1. Financial Futures Contracts

Source: CME Group, 2023

72
3.2.1. Financial Futures Contracts

v The Short Hedge in Futures:

• Used when market interest rates are expected to rise à increased cost of borrowings
• Structured to create profits from futures transactions in order to offset losses
experienced on a bank’s balance sheet if interest rates do rise.
• The asset-liability manager will sell futures contracts calling for the future delivery of the
underlying securities, choosing contracts expiring around the time new borrowings will
occur (if the bank holds a fixed-rate loan or a bond).
• Later, as borrowings and loans approach maturity or securities are sold and before the
first futures contract matures, a like amount of futures contracts will be purchased on a
futures exchange.

73
3.2.1. Financial Futures Contracts

v The Short Hedge in Futures:

• For instance, suppose the securities portfolio of a bank contains $10 million in 6 percent, 15-
year bonds and market yields increase from 6 percent to 6.5 percent.
+ The market value of these bonds decreases from $10 million to $9,525,452.07-a loss in the
cash market of $474,547.73.
+ However, this loss will be approximately offset by a price gain on the futures contracts.
+ Moreover, if the bank makes an offsetting sale and purchase of the same futures contracts
on a futures exchange, it then has no obligation either to deliver or to take delivery of the
securities named in the contracts (The clearinghouse that keeps records for each futures
exchange will simply cancel the two offsetting transactions)

74
3.2.1. Financial Futures Contracts

v The Long Hedge in Futures:

o Used when market interest rates are expected to decline & cash inflow (e.g: new
deposit) is expected in the near future
o If management takes no action and the forecast turns out to be true, the financial
institution will suffer an opportunity loss (i.e., reduced potential earnings).
o Management can use a long hedge: Futures contracts can be purchased today and then
sold in like amount at approximately the same time deposits come flowing in.
o The result will be a profit on the futures contracts if interest rates do decline because
those contracts will rise in value.

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3.2.1. Financial Futures Contracts

v Using Long and Short Hedges to Protect Income and Value:

76
3.2.1. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o The objective is to offset the loss in NW due to changes in market interest rates with
gains from trades in the futures market.

77
3.2.1. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o Setting the change in NW equal to the change in the futures position value, we have:

78
3.2.1. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o Example: a financial-services provider has an average asset duration of four years, an
average liability duration of two years, total assets of $500 million, and total liabilities of
$460 million at a given point in time. Suppose, too, that the firm plans to trade in
Treasury bond futures contracts. The T-bonds named in the futures contracts have a
duration of nine years, and the T-bonds' current price is $99,700 per $100,000 contract.
What is the number of futures contracts needed to cover risk exposure?

79
3.2.1. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o Example: a financial-services provider has an average asset duration of four years, an average liability
duration of two years, total assets of $500 million, and total liabilities of $460 million at a given point
in time. Suppose, too, that the firm plans to trade in Treasury bond futures contracts. The T-bonds
named in the futures contracts have a duration of nine years, and the T-bonds' current price is
$99,700 per $100,000 contract. What is the number of futures contracts needed to cover risk
exposure?

80
3.2.2. Interest-Rate Options

• The interest-rate options: grant 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.
• Option premium: 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
• Exercise (strike) price: the price to put/call the security in the future, stated clearly in the
option contract

81
3.2.2. Interest-Rate Options

• Using Options to Protect Income:

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3.2.2. Interest-Rate Options

• Using Options to Protect Income:

83
3.2.2. Interest-Rate Options

• Using Options to Protect Income:

84
3.2.2. Interest-Rate Options

• Using Options to Protect Income:

85
3.2.3. Interest-Rate Swaps

• An interest-rate swap: a way to change a bank’s exposure to interest-rate fluctuations and

achieve lower borrowing costs
o E.g: converting 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.
o A bank can earns fee income (usually amounting to 0.25-0.5% of the amount involved)
for arranging a swap for a customer

86
3.2.3. Interest-Rate Swaps

87
3.2.3. Interest-Rate Swaps

• Using interest-rate swaps for asset-liability management:

Firm A: Firm B:

Short-term assets with Long-term assets with fixed

flexible yields SWAP rates of return

Long-term liabilities carrying Shorter-term liabilities

fixed interest rates

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3.2.3. Interest-Rate Swaps

• Why use interest-rate swaps?

o Retiring old debt and issuing new securities with more favorable characteristics can be
expensive and risky. New borrowing may have to take place in an environment of higher
interest rates.
o Underwriting costs, registration fees, time delays, and regulations often severely limit
how far any business firm can go in attempting to restructure its balance sheet.
o Swaps can be negotiated to cover virtually any period of time desired, though most fall
into the 3-year to 10-year range. They are also easy to carry out, usually negotiated and
agreed to over the telephone or via e-mail through a broker or dealer.

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3.2.4. Caps, Floors, and Collars

• Interest-rate caps:
o Protecting its holder against rising market interest rates.
o Borrowers are assured that lenders cannot increase loan rate above the cap interest rate
by paying an upfront premium/fee.
o Alternatively, the borrower may purchase an interest-rate cap from a third party who
promises to reimburse borrowers for any additional interest beyond the cap.

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3.2.4. Caps, Floors, and Collars

• Interest-rate caps:
o Typical conditions when a bank buy interest-rate caps:
Ø When it has fixed-rate assets with floating-rate liabilities
Ø When it possesses longer-term assets than liabilities
Ø When it holds a large portfolio of bonds that will drop in value when market interest
rates rise.

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3.2.4. Caps, Floors, and Collars

• Interest-rate floors:
o Guaranteeing minimum rate of return for lenders/investors, used in periods of falling
interest rates
o Banks use interest-rate floors most often when their liabilities have longer maturities
than their assets or when they are funding floating-rate assets with fixed-rate debts.

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3.2.4. Caps, Floors, and Collars

• Interest-rate collars:
o An agreement combining a rate floor and a rate cap
o E.g: a customer who has just received a $100 million loan may ask the lender for a collar
on the loan's prime rate between 11 percent and 7 percent. In this instance, 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.
o In effect, the collar's purchaser pays a premium for a rate cap while receiving a premium
for accepting a rate floor.

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 Q&A session
Thank you for listening!

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