copyright © 2004 by thomson southwestern all rights reserved. 11-1 interest rate risk management...

Copyright © 2004 by Thomson Southwestern All rights reserved.

11-1

Interest Rate Risk Management

Interest Rates and Foreign Currency Futures Chapter 11


11-2

Managing Interest Rate Risk

Volatility of interest rates since the mid-1970s• Greater than individual financial institutions could

manage• Led to the demise of many depository institutions• Led to the creation of interest rate swaps in 1980s

Globex initiated in 1992• Electronic futures trading system• 24 hour trading around the world

Eurex in 1990, Eurex US in 2004E-cbot electronic trading platform in 2003


11-3

Financial Institutions and Financial Futures

Volume of derivatives used to manage interest rate risk rising very quickly

Highly concentrated in largest banksNotionals:

• Dealer Notionals: Derivatives traded for customers and other parties (over 96% of derivatives held)

• End-User Notionals: Derivatives used for a bank’s own risk management needs (under 4% of derivatives held)


11-4Derivative Contracts by Type

All Commercial BanksYear ends 1991 - 2002, Most recent four quarters - 2003

*In billions of dollars; notional amount of futures, total exchange traded options, total over the counter options, total forwards, and total swaps. Note that data after 1994 do not include spot fx in the total notional amount of derivatives.

Credit derivatives were reported for the first time in the first quarter of 1997. Currently, the Call Report does not differentiate credit derivatives by product and thus they have been added as a separate category. As of 1997, credit derivatives have been included in the sum of total derivatives in this chart.

Data Source: Call Reports. OCC Bank Derivatives Report: Third Quarter 2003 (http://www.occ.treas.gov/ftp/deriv/dq403.pdf)

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

55,000

60,000

65,000

70,000

75,000

Interest Rate Foreign Exch Other Derivs CreditDerivatives

TOTAL

$ B

illion

s

91 Q4 92 Q4 93 Q4 94 Q4 95 Q4 96 Q4 97 Q4 98 Q4

99Q4 00Q4 01Q4 02Q4 03Q1 03Q2 03Q3 03Q4


11-5

Derivative Contracts by ProductAll Commercial Banks


Credit derivatives were reported for the first time in the first quarter of 1997. Currently, the Call Report does not differentiate credit derivatives by product and thus they have been added as a separate category. As of 1997, credit derivatives have been included in the sum of total derivatives in this chart.


Year ends 1991 - 2002, Most recent four quarters - 2003

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

55,000

60,000

65,000

70,000

75,000

Futures &Forwards

Swaps Options CreditDerivatives

TOTAL

$ B

illi

on

s

91 Q4 92 Q4 93 Q4 94 Q4 95 Q4 96 Q4 97 Q4 98 Q4

99Q4 00Q4 01Q4 02Q4 03Q1 03Q2 03Q3 03Q4


11-6Derivatives, Notionals by Type of

UserInsured Commercial Banks

Total NotionalsDealer Notionals

End-User Notionals

Note: Dotted line indicates that beginning in 1Q95, spot foreign exchange was not included in the definition of total derivatives.Note: Categories do not include credit derivatives.


0

10

20

30

40

50

60

70

80

19901991199219931994199519961997199819992000200120022003

$ T

rilli

ons


11-7

Seven Banks With Most Derivatives Dominate Holdings

All Commercial Banks, Fourth Quarter 2003


Credit derivatives were reported for the first time in the first quarter of 1997. Currently, the Call Report does not differentiate credit derivatives by product and thus they have been added as a separate category.


0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

55,000

60,000

65,000

70,000

75,000

Futures & Fwrds Swaps Options Credit Derivatives TOTAL

$ B

illion

s

Top 7 Banks Rest 566 Banks


11-8

Futures Contracts

Futures Contract: A commitment to buy or sell a specific commodity

of designated quality at a specified price and date in the future (the delivery date)

Commodities include:Financial Non-financialInterest-bearing assets Agricultural

goodsStock & other financial indices MetalsForeign currencies


11-9

Hedging versus Speculation

Reasons to be in futures market• Buyer who wishes to take delivery at a future

date and wants the price certain now• Seller who wishes to deliver contract at a future

date and wants the price certain now• Hedgers wishing to avoid risk• Speculators wishing to take risk and make a

profit

Difference between hedging and speculation is motivation


11-10

Financial Futures Contracts

Three Financial Commodities• Interest-bearing asset• Stock or bond index• Foreign currency

Role of the Clearinghouse• Party to all transactions• Guarantees contract performance• Default risk assumed by clearinghouse• Handles all bookkeeping• Regulates all transactions


11-11

The Developing Global Marketplace

Major exchanges• Chicago Board of Trade• Chicago Mercantile Exchange• London International Financial Futures Exchange• Marché a Terme International de France• The Tokyo International Financial Futures

Exchange• The Singapore International Monetary Exchange• The Sydney Futures Exchange• The Deutsche Terminbourse

Electronic exchanges


11-12

The Margin

Initial margin and maintenance marginCash deposit to take a positionOften <5% of contract valueDifferent for each contractSet by the exchangeDaily resettlement


11-13

Limits on Price Changes

Contract price change per day is limited• Intent is to limit traders’ exposure to risk• No trades can occur outside the price limit that

day• However, risk still exists and price can rise or

fall the limit the next day with no trade taking place

Several days in a row of “limit moves” can wipe out an entire position


11-14

Interest rate futures are available on a variety of underlying instruments. Face values and other specifications differ, and the choice of contracts depends on the cash instrument to be hedged.

T-bill future 13-week T-bill $1 million None Mar., Jun.,Sept., Dec.

3-month None, settled in cash $1 million None Mar., Jun.,Eurodollar based on prevailing Sept., Dec.futures rate on 3-month

Eurodollar time depositT-note futures 2-year, 5-year, 10-year $100,000 or Varies 1 to Mar., Jun.,

T-notes $200,000 3 points Sept., Dec.T-bond futures 8% T-bonds, minimum $100,000 3 points Mar,. Jun.,

maturity of 15 years Sept., Dec.Municipal None, settled in cash $1,000 times $3,000 Mar., Jun., Bond Index based on Bond Buyer value of Sept., Dec.

Municipal Bond Index index

Name of Contract Underlying

Instrument

Face Value of Contract

DailyPrice Limit

Standard Delivery Months

FEATURES OF SELECTED INTEREST RATE

CONTRACTS


11-15

30-day None, settled in cash $5 million 150 basis points Every MonthFed Funds based on monthly from previous futures averages of daily settlement price

fed funds rateLIBOR None, settled in cash $3 million None First 12 conse-

based on the prevailing cutive monthsLIBOR rate on 1-month beginning

withEurodollar time deposit current month

FEATURES OF SELECTED INTEREST RATE CONTRACTS


11-16

Hedging

To protect (hedge) against reinvestment risk of a fall in interest rates and an opportunity loss on such a spot position, a futures hedge would involve taking a long position in futures (contact to buy securities in the future at the current futures price).

To hedge against the risk of a rise in interest rates (price risk) and a loss on such a spot position, a futures hedge would involve taking a short position in futures (contract to sell securities at the current futures price)


11-17

Long Hedge

A trader buys a futures contract, incurring an obligation either to• take delivery of the securities at the pre-

established price on some future date; or • sell the contract, closing out the position

through the clearinghouse before delivery.A trader will profit from a long hedge if

interest rates fall.• A trader that takes delivery can sell the

securities at a higher price in the spot market than the purchase price written into the futures contract.

• If the contract is closed out before the delivery date, the contract selling price will be higher than the purchase price.


11-18

Short Hedge

A trader sells a futures contract, incurring an obligation either to:• deliver the underlying securities at some future

point; or • close the futures contract out before the delivery

date by purchasing an offsetting contract.A trader will profit with a short hedge if interest

rates rise while holding the contract.• The trader will be able to buy the securities for

delivery at a lower price in the spot market than the selling price agreed upon in the contract.

• If the contract is closed out, the contract selling price will be higher than the purchase price.


11-19

Suppose that, in June 2001, the manager of a money market portfolio expects interest rates to decline.

New funds, to be received and invested in 90 days (September 2001), will suffer from the drop in yields, and the manager would like to reduce the effects on portfolio returns.

The manager expects an inflow of $10 million in September. The discount yield currently available on 91-day T-bills is 10%.

Long Hedge Illustrated


11-20

Cash Market

A long hedge is chosen in anticipation of interest rate declines and requires the purchase of interest rate futures contracts. If the forecast is correct, the profits on the hedge will help to offset the losses in the cash market.I.

Futures Market

JuneT-bill discount yield at 10% Buy 10 T-bill contracts for

SeptemberPrice of 91-day T-bill, $10m par: delivery at 10% discount yield.

$9,747,222a Value of Contracts:$9,750,000b

SeptemberT-bill discount yield at 8% Sell 10 T-bill contracts at 8%Price of 91-day T-bill, $10m par: discount yield

$9,797,778 Value of contracts$9,800,000

THE LONG HEDGE (FORECAST: FALLING RATES)


11-21

Cash Market Loss Futures Market Gain

II.

June Cost $9,747,222 September Sale $9,800,000September Cost 9,797,778 June Purchase

9,750,000Loss ($ 50,556) Gain $ 50,000

Net Loss:($556)c

9.978%

III.

Effective Discount Yield with the Hedge

91

360

000,000,10$

)000,50$778,797,9($000,000,10$

a At a discount yield of 10%, the price of a 91-day T-bill is:

222,747,9$360

)91(10.01000,000,10$P0

b T-bill futures contracts are standardized at 90-day maturities, resulting in a price different from the one calculated in the cash market.

c Excludes transactions cost, brokers’ fees, and the opportunity cost of the margin deposit.

THE LONG HEDGE (continued)


11-22

Suppose that in September a financial institution wants to hedge $5 million in short-term CDs whose owners are expected to roll them over in 90 days.

If market yields go up, the thrift must offer a higher rate on its CDs to remain competitive, reducing NIM.

Losses can be reduced by selling T-bill futures contracts.

CD rates are expected to increase from 7% to 9%.

Short Hedge Illustrated


11-23

A short hedge is chosen in anticipation of interest rate increases and requires the sale of interest rate futures contracts. If the forecast is correct, the profits on the hedge will help to offset the losses in the cash market.

Cash Market Futures MarketI.

September CD rate: 7% Sell 5 T-bill contracts for December

Interest cost on $5m in deposits: delivery at 7% discount yield. $87,500 Value of Contracts:

$4,912,500December

CD rate: 9% Buy 5 T-bill contracts at 9% Interest cost on $5m in deposits: discount yield

$112,500 Value of contracts$4,887,500

THE SHORT HEDGE (FORECAST: RISING

RATES)


11-24

Futures Market GainCash Market Loss

II.

September Interest $ 87,500 September Sale $4,912,500December Interest 112,500 December Purchase 4,887,500

Loss ($ 25,000) Gain $ 25,000Net Benefit of Hedge: $0aIII.

Net Interest Cost and Effective CD Rate

$112,500 $25,000

$87,500 360

$5,000,000 91

$87,500

.0692 or 6.92%

a Excludes transactions cost, brokers’ fees and the opportunity cost of the margin

THE SHORT HEDGE (FORECAST: RISING

RATES)


11-25

Basis Risk

Basis Risk: The basis is the difference between the current price of a hedged asset and the current price of a futures contract. The more nearly identical the characteristics of the hedged asset and the futures contract, the more stable the basis.

Basis = PSt - PFt

Traders who hedge positions in the cash markets with futures are exposed to basis risk, a fact that must be considered in the hedging decision


11-26

The Cross Hedge and Basis Risk

A cross hedge is a futures hedge is constructed on an instrument other than the cash market security

(Example: hedging a corporate bond portfolio with T-bond futures)

Cross hedges have greater basis risk than when the same security is involved in both sides of the transaction

If a short-term instrument was hedged with a futures contract on long-term securities, or vice versa, the basis risk would be even greater

A perfect hedge is difficult to achieve with a cross hedge


11-27

The Hedge Ratio

The Hedge Ratio

• HR is the Hedge Ratio• Cov (∆PSt, ∆PF) is the covariance between

changes in sport prices and change in future prices• σ² ∆PF is the variance in changes in future prices

Hedge ratio is the beta of a regression of past price changes (cash) against past price changes (futures)

2

( , ) St F

F

Cov P PHR

P


11-28

Choosing The Optimal Number of Contracts

Number of futures contracts to be purchased or sold, NF, is:

where V = total market value of securities to be hedged F = the market value of a single futures contract

V X HR

FFN


11-29

Suppose that a portfolio manager anticipating a decline in interest rates over the next three months, wishes to protect the yield on an investment of $15 million in T-bills and that a T-bill futures contract is now selling for $989,500. If the hedge ratio between the T-bills and the T-bill futures contracts has been estimated through regression analysis to be .93, how many contracts should be used in the hedge?

FV HR $15,000,000 0.93

N F $989,500

14.09

8

Example


11-30Factors Affecting the

Outcome of the Hedge

Differences in the past covariance and the covariance during the hedge.

Fractional amounts of futures contracts can not be traded

In the example the hedger would buy 14 contracts


11-31

Macro Hedges at Depository Institutions

Used to hedge the entire funding gap or duration gap

With a negative funding gap (i.e., a positive duration gap), if interest rates rise, the institution’s NII and the market value of its equity falls Hedge the loss by taking a short position in futures that would

produce a gain to offset the institution’s expected loss

With a positive funding gap (i.e., a negative duration gap), an institution is exposed to losses if interest rates fall Hedge the loss by taking a long position in futures that would

produce a gain to offset the expected loss

Macro hedges require:• a detailed knowledge of a bank’s total exposure to interest rate

risk

• a relatively large transaction in the futures market


11-32

Futures as a Supplement to Gap Management

Macro Hedges versus Micro Hedges

Hedging a Funding Gap


11-33

Regulatory Restrictions and Financial Reporting

Depository institutions • can not use futures as income-generating investments

for speculative purposes• Must have an effective hedging policy at a high

management level

All financial institutions• Must monitor and report risk due to derivatives• Manage and carefully control their use

Accounting Rules1. The asset or liability to be hedged exposes the

institution to interest rate risk2. The futures contract chosen reduces interest rate risk,

is designated as hedge, and has price movements highly correlated with the instrument being hedged


11-34

More Detailed Reporting

Under FAS 133, four key rules1. All “standalone and qualifying embedded derivatives”

must be marked to market and reported on the valance sheet

2. Gains and losses for changes in the value of derivatives must be reported to earnings immediately unless the derivative is part of a qualifying hedge (based on meeting rigorous criteria regarding its effectiveness).

3. If a hedge is considered qualified but is not perfect, the amount that is not perfect must be reported on the firm’s income statement

4. Firms must fully describe their derivative and hedging activities in the footnotes of their financial statements


11-35

Other Futures Issues

Concern over risks• Using futures to manage risk or to speculate• A few large banks make the market

Hedging is very complex

Reporting (disclosing) futures activities so risk can be estimated is difficult


11-36

Foreign Currency Futures

Used to hedge exchange rate risk

Contract prices quoted as• Direct rates

◦ Japanese Yen, Canadian Dollar, British Pound, Swiss Franc, Australian Dollar, Mexican Peso, Euro

• Cross rates◦ Euro/Japanese Yen, Euro/British Pound


11-37Comparison of Forward and Futures Currency

MarketsFutures Contracts

• Standardized• Default risk free

• Available only for a few currencies

• Liquid due to secondary market

Forward Contracts• Custom-designed• No clearinghouse to

bear default risk• Can be written for any

currency• No secondary market


11-38

Suppose a U.S. bank made a formal commitment on December 2, 2003 to loan a Swiss customer 1 million Swiss francs on January 2, 2003 (i.e., in one month). At that time, the bank plans to convert dollars into Swiss francs, but management recognizes the risk of exchange rate fluctuations over the period.

Currency Futures Illustrated


11-39HEDGING WITH CURRENCY FUTURES CONTRACTS

(FORECAST: FALLING DOLLAR)Currency futures contracts may be used to protect against a decline in the value of the dollar. A long hedge, requiring the purchase of currency futures results in a gain if the value of the dollar falls against the currency on which the futures contract is written, but results in a loss when the value of the dollar strengthens.I. Hedging in December

Cash MarketDecember 2Dollars required to purchase 1 million Buy 8 March contracts at $0.7783

Swiss francs at $0.7760 = $776,000 Value of Contracts:125,000 × 8 × $0.7783 =

$778,300Results in January January 2Dollars required to purchase 1 million Sell 8 March contracts at $0.8893

Swiss francs at $0.8883 = $888,300 Value of contracts: 125,000 × 8 × $0.8893 =

$889,300II. Net Results of Hedge in January

Futures Market

Cash Market Gain Future Market Loss

December “cost” $776,000 December purchase $778,300January cost (888,300) January sale 889,300

Loss ($112,300) Gain $111,000Net Hedging Error ($1,300)

copyright © 2004 by thomson southwestern all rights reserved. 11-1 interest rate risk management...

Documents