Chapter Eight

Risk Management: Financial Futures, Options,

Swaps, and Other Hedging Tools

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 8-2

Key Topics
• The Use of Derivatives
• Financial Futures Contracts: Purpose and
Mechanics
• Short and Long Hedges
• Interest-Rate Options: Types of Contracts
and Mechanics
• Interest-Rate Swaps
• Regulations and Accounting Rules
• Caps, Floors, and Collars
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Derivatives

A Derivative is Any Instrument or

Contract that Derives its Value From
Another Underlying Asset, Instrument,
or Contract, Such as Treasury Bills and
Bonds and Eurodollar Deposits

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Managing Interest Rate Risk

• Derivatives Used to Manage Interest Rate
Risk
▫ Financial Futures Contracts
▫ Forward Rate Agreements
▫ Interest Rate Swaps
▫ Options on Interest Rates
 Interest Rate Caps
 Interest Rate Floors
 Interest Rate Collars
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 8-5

Financial Futures Contract

• An Agreement Between a Buyer and a Seller
Which Calls for the Delivery of a Particular
Financial Asset at a Set Price at Some Future
Date
• Futures Markets
▫ The Organized Exchanges Where Futures
Contracts are traded
• Interest Rate Futures
▫ Where the Underlying Asset is an Interest-
Bearing Security
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 8-6

Financial Futures Contracts

IS Gap = IS Assets – IS Liabilities

and

TL
D  DA - DL *
TA
Recall what happens when interest rates rise? Fall?

One of the most popular methods for neutralizing these gap

risks is to buy and sell financial futures contracts
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Background on Financial Futures

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

▫ Agrees to pay the underlying futures price

or take delivery of the underlying asset

▫ Buyers gain when futures prices rise and

lose when futures prices fall
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Background on Financial Futures

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

▫ Agrees to receive the underlying futures

price or to deliver the underlying asset

▫ Sellers gain when futures prices fall and

lose when futures prices rise
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The Purpose of Financial Futures

To Shift the Risk of Interest Rate

Fluctuations from Risk-Averse
Investors to Speculators

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The World’s Leading Futures and Option

Exchanges
• Chicago Board of • Euronext.Liffe
Trade (CBT) (Eurex)
• Chicago Board • Sydney Futures
Options Exchange Exchange
• Toronto Futures
• Singapore Exchange
Exchange (TFE)
LTD. (SGX) • South African
• Chicago Mercantile Futures Exchange
Exchange (CME) (SAFEX)

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Futures vs. Forward Contracts

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

▫ Forward Contracts
 Terms are negotiated between parties
 Do not necessarily involve standardized assets
 Require no cash exchange until expiration
 No marking to market

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 8-12

Most Common Financial Futures

Contracts

• U.S. Treasury Bond Futures Contracts

• Three-Month Eurodollar Time Deposit
Futures Contract
• 30-Day Federal Funds Futures Contracts
• One Month LIBOR Futures Contracts

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 8-13

Hedging with Futures Contracts

Avoiding Higher Use a Short Hedge: Sell


Borrowing Costs and Futures Contracts and
Declining Asset Values then Purchase Similar
Contracts Later


Avoiding Lower Than Use a long Hedge: Buy
Expected Yields from Futures Contracts and
Loans and Securities then Sell Similar
Contracts Later

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Short Futures Hedge Process

• Today – Contract is Sold Through an
Exchange

• Sometime in the Future – Contract is

Purchased Through the Same Exchange

• Results – The Two Contracts Are Cancelled

Out by the Futures Clearinghouse

• Gain or Loss is the Difference in the Price

Purchased for (At the End) and Price Sold For
(At the Beginning)
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Long Futures Hedge Process

• Today – Contract is Purchased Through an
Exchange

• Sometime in the Future – Contract is sold

Through the Same Exchange

• Results – The Two Contracts are Cancelled

by the Clearinghouse

• Gain or Loss is the Difference in the Price

Purchase For (At the Beginning) and the
Price Sold For (At the End)
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Basis Risk
The basis is the cash price of an asset minus
the corresponding futures price for the
same asset at a point in time
▫ For financial futures, the basis can be calculated as
the futures rate minus the spot rate

▫ It may be positive or negative, depending on whether

futures rates are above or below spot rates

▫ May swing widely in value far in advance of contract

expiration

Basis=Cash-market price (or interest rate) –

futures market price (or interest rate)
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Realized Return from Combining Cash

and Futures Market Trading
= Return Earned in the Cash Market

+/- Profit or Loss from Futures Trading

- Closing Basis Between Cash and Futures

Market

- Opening Basis Between Cash and Futures

Market
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 8-18

Change in the Market Value of the

Futures Contract

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Change in the Market Value of the

Futures Contract

i
Ft  F0  -D  F0  N 
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 8-20

Number of Futures Contracts

Needed

TL
(D A - D L * ) * TA
 TA
D F * Price of the Futures Contract

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 8-21

Quick Quiz
• What are financial futures contracts? Which
financial institutions use futures and other
derivatives for risk management?

• How can financial futures help financial

service firms deal with interest rate risk?

• What futures transactions would most likely

be used in a period of rising interest rates?
Falling interest rates?
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 8-22

Interest Rate Option

It Grants the Holder of the Option the

Right but Not the Obligation to Buy or
Sell Specific Financial Instruments at
an Agreed Upon Price.

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Types of Options

• Put Option
▫ Gives the Holder of the Option the
Right to Sell the Financial Instrument
at a Set Price
• Call Option
▫ Gives the Holder of the Option the
Right to Purchase the Financial
Instrument at a Set Price
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 8-24

Most Common Option Contracts

Used By Banks

• U.S. Treasury Bond Futures Options

• Eurodollar Futures Option

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Principal Uses of Option Contracts

• 1. Protecting a security portfolio through the use of put
options to insulate against falling security prices (rising
interest rates); however, there is no delivery obligation
under an option contract so the user can benefit from
keeping his or her securities if interest rates fall and
security prices rise

• 2. Hedging against positive or negative gaps between

interest-sensitive assets and interest- sensitive
liabilities; for example, put options can be used to
offset losses from a negative gap when interest rates
rise, while call options can be used to offset a positive
gap when interest rates fall.
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Speculation vs. Hedging

• With financial futures, risk often cannot be
eliminated, only reduced.
▫ Traders normally assume basis risk in that
the basis might change adversely between
the time the hedge is initiated and closed
• Perfect Hedge
▫ The gains (losses) from the futures position
perfectly offset the losses (gains) on the spot
position at each price

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Federal Funds Options and Futures

• Represents the Consensus Opinion Of the

Likely Future Course of Market Interest
Rates
• Public Trading for Futures Contract Began at
the CBOT in 1988
• Public Trading on Options Contracts Began
in 2003

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 8-30

Regulations For Options and Future

Contracts

• OCC – Risk Management of Financial

Derivatives: Comptrollers Handbook
• FASB – Statement 133 – Accounting for
Derivatives Instruments and Hedging
Activities

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Interest Rate Swap

A Contract Between Two Parties to

Exchange Interest Payments in an
Effort to Save Money and Hedge
Against Interest-Rate Risk

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Interest –Rate Swap

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Quality Swap

• Borrower with Lower Credit Rating

Pays Fixed Payments of Borrower with
Higher Credit Rating
• Borrower with Higher Credit Rating
Pays Short-Term Floating Rate
Payments of Borrower with Lower
Credit Rating

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Further…
• Firms with a negative GAP can reduce risk
by making a fixed-rate interest payment in
exchange for a floating-rate interest receipt

• Firms with a positive GAP take the opposite

position, by making floating-interest
payments in exchange for a fixed-rate
receipt

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Risks of Interest Rate Swaps

• Substantial Brokerage Fees
• Credit Risk
▫ The counterparty may default on the exchange of
the interest payments
▫ Only the interest payment exchange is at risk, not
the principal
• Basis Risk
▫ A swap’s reference interest rates are not the
same as those attached to all the assets and
liabilities (LIBOR, bond rates, etc.), so rates do
not change exactly the same -> some risk
remains
• Interest Rate Risk
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Netting

The Swap Parties Only Swap the Net

Difference Between the Interest
Payments. This Reduces the Potential
Damage if One Party Defaults on its
Obligation

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Currency Swap

An Agreement Between Two Parties,

Each Owing Funds to Other
Contractors Denominated in Different
Currencies, to Exchange the Needed
Currencies with Each Other and Honor
Their Respective Contracts.

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Interest Rate Cap

Protects the Holder from Rising

Interest Rates. For an Up Front Fee
Borrowers are Assured Their Loan Rate
Will Not Rise Above the Cap Rate

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Interest Rate Floor

A Contract Setting the Lowest Interest

Rate a Borrower is Allowed to Pay on a
Flexible-Rate Loan

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Interest Rate Collar

A Contract Setting the Maximum and

Minimum Interest Rates That May Be
Assessed on a Flexible-Rate Loan. It
Combines an Interest Rate Cap and
Floor into One Contract.

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Quick Quiz

• Explain what is involved in a put option?

• What is a call option?
• Suppose market interest rates were
expected to rise. What type of option would
normally be used?
• If rates were expected to fall, what type of
option would a financial institution’s
manager be likely to employ?
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