Derivatives in ALM

Financial Derivatives

Swaps
Hedge Contracts
Forward Rate Agreements
Futures
Options
Caps, Floors and Collars

Swaps
Agreement between two counterparties to exchange
the cash flows.
Cash flows determined on a specific notional principal
for a maturity period and a specified interest rate.
Swap Structures.
Fixed for Floating swaps:
Plain vanilla swaps are fixed for floating rate coupon
payments
Used by banks for managing interest rate gap
strategies

Swaps
Swap Structures
Basis swaps:
Exchange payments between two floating rate
obligations by banks.
Used by bank to hedge risky exposures
through different floating interest rates.
Cross-currency swaps:
Interest payments between two currencies are
exchanged between two counterparties.
Used by banks to hedge interest risk exposure
across currencies.

Swap Contracts

An agreement between two parties to exchange

interest payments for a specific maturity on a
specified principle amount.

Two parties facing different types of interest rate risk

can exchange interest payments.

Swap Contracts

Banks act as swap dealers linking two parties with

different interest rate risk.

Banks offer swap structures for both fixed and floating

rate payers and earn a spread for their intermediary
service.

Swap Contracts

A firm with large financial liability will benefit if they

agree on a fixed rate payment for their liability.

A firm with a large financial asset position will benefit

if they agree on a floating rate payment for their asset.

Plain Vanilla Interest Rate Swap

SWAP Contract: Example 1

Company A wishes to borrow Rs.10 million at a fixed
rate for five years and has been offered 9% fixed rate
or 6-month MIBOR+1%.
Company B wishes to borrow Rs.10 million at a
floating rate for five years and has been offered 6month MIBOR + 0.4% or 8.50% fixed rate.
A Bank swaps the contracts for both the companies

Swap Contract: Example 2

Company A wants to borrow at floating rate while
company B wants to borrow at a fixed rate.
Available rates:
Company B - Floating rate - MIBOR+0.5%, Fixed -10.5%
Company A - Floating rate - MIBOR+0.25%, Fixed - 10%
A bank agrees to be a swap dealer for both the companies

Swap Contract: Example 3

Bank Details
FixedAssets

Deposits

Advances1,000,0003year
3monthDepositfor
at9%
1,000,000atMIBOR

Bank is liability sensitive and would lose if MIBOR

rates rise since the advances are funded by short term
deposits
Bank could agree to pay 8.60% fixed rate and receive
MIBOR for 3-years

Effect of Swap as a Hedge: Example 3

Receive 9% from loan and receive MIBOR from swap
deal
Pay 8.60% fixed rate on swap deal and pay MIBOR
for the deposit
Net rate spread for the bank 0.40% (9.00 8.60)
Risk due to increase in MIBOR rate is eliminated for
the bank in the swap structure

Risk Inherent in Swap deals

Swap contracts may lock in higher interest rates while

reducing the risk exposure.

Bank may have to bear the credit risk (inability of

either party of the swap contract not able to meet the
swap claim).

Hedge Contracts

Hedging results in entry of contracts that results in a

consistent return for the bank.

Hedge is entered into only when the bank has an

open position that needs to be protected.

Hedge results in a profit for the bank when hedged

expectations are encountered.

Hedge results in a notional loss for the bank when

hedged expectations do not happen.

Bankers as Hedgers in the Derivative Market

Banks are capable of reducing their risk exposure

through their derivative positions.

Risk reduction is achieved by the bank through the

offsetting of expected loss in the bank holding position
from derivative trading profits.

Hedge Position
Interest rate increases
Expected returns from pre committed loans /
investment falls
Negative gap position of the bank implies liability
sensitive bank would incur loss in income.
Desirable hedge position would be to sell futures
contract now and buy later resulting in derivative
profit.

Hedge Position

Interest rate declines

Banks borrowing cost increases since committed

deposit rates are higher than the current interest rates

Positive gap position of the bank implies that the asset

sensitive bank would incur loss in income.

Desirable hedge position would be to buy futures

contract now and sell later resulting in derivative profit.

Hedge Positions

Hedge: Long Futures:

loss when rates falls

Hedge: Short Futures:

loss when rates rise

Steps for Entering into Derivative Position

Identify the balance sheet risk exposure position.
Formulate expectations on the present risk exposure.
Verify the regulatory norms and the banks internal
risk policies.
Select the futures contract to be entered into by the
bank.
Determine the number of futures contract to deal
(Hedge Ratio).

Determining the Number of Future contracts

(D

W D L ) A
D F PF

NF =Numberoffuturecontracts
DA =DurationofAssets; W =WeightDL =DurationofLiabilities
A =TotalAssetValue
DF =DurationofFutures;PF =PriceofFuturescontract

Steps for Entering into Derivative Position

Transacting in the futures contract in the market.
Identify when to withdraw from the futures position.
Reverse the trade.
Wait for the contract to expire.
Accept or take delivery by closing out the trade.

Micro Hedge Applications for Banks

Micro hedging refers to hedging of a specific asset,

liability or a specific commitment by the bank.
Micro hedging can be used to take futures position to
reduce aggregate portfolio risk.
Portfolio risk is measured through GAP analysis or
duration gap analysis.

Micro Hedge Applications for Banks

Banks as per regulatory framework are compelled to

link hedged futures trade to a specific instrument or
commitment of the bank.

Example: A bank hedging interest rate commitments

on one year certificate of deposits entered into a
hedge in that year.

Hedge Implications: Example (Bank Cost)

First Deposit:
The 3-month deposit for 1000,000 at 2.00%

5,000

Next Deposit:
The 3-month deposit at 2.50%

6,250

1,250

Total expense for the Bank

11,250

Hedge Implications: Example (Bank Profit)

Initial Futures Position:
Sell six-month interest rate futures at 3.00%
Contract price (100-3.00 = 97.00)
Next Futures Trade:
Buy six-month interest rate futures at 3.50%
Contract price (100-3.50 = 96.50)
Net profit
(97.00-96.50) 50 Basis points
1,250

Hedge Implications: Example (Net Cost to Bank)

Effective 6-month deposit cost

11,250 1,250 12
12
x
1.00 % x
1,000,000
6
6
2.00 %

Forward Rate Agreements

Forward Rate Agreements (FRAs)

Over The Counter (OTC) products that are futures

contract for financial products.

Customized contracts to meet needs of participants.

Marked to market requirements are not present,

hence has a risk of default.

Forward Rate Agreements

Buyer of FRA agrees to pay a fixed rate coupon and

receive a floating rate coupon on a notional amount at
a specified future date.

Seller of FRA agrees to pay a floating rate coupon

and receive a fixed rate coupon on a notional amount
at a specified future date.

Forward Rate Agreements

Buyer of FRA will receive cash when the actual

interest rate at settlement date is higher than the
exercise rate.

Buyer of FRA will pay cash when the actual interest

rate at settlement date is lower than the exercise rate.

Forward Rate Agreements

Seller of the FRA will receive cash when the actual

interest rate is less than the exercise rate.

Seller of the FRA will pay cash when the actual

interest rate is higher than the exercise rate.

Forward Rate Agreement Example

Bank A buys a FRA of 3 Vs. 6 at 7% on a

Rs.1,000,000 notional amount from Bank B

Forward rate agreement entered into by Bank A is to

pay a fixed rate of 7% and receive a floating rate of 3month MIBOR with a maturity date of 6 months on the
notional amount of Rs.1,000,000.

Cash flow at the end of 6 months will be determined

by comparing the 3-month MIBOR rate with the fixed
rate of 7%.

Forward Rate Agreement - Example

Equivalent 3-month MIBOR is 8% at the end of 6 months.
Here Bank A will receive from Bank B the return from the deal
Actual interest amount from the deal is
3
0.08-0.07
x

x 1,000,000 = 2,500
12

Interest amount represents the payment that will be made three

months latter at the maturity of the instrument (present value)
will be identified as

2,500 x
=2,452
1+0.08 3


12

Forward Rate Agreement - Example

Equivalent 3-month MIBOR is 6% at the end of 6 months.
Here Bank A will pay to Bank B the balance
Actual interest amount from the computed as
0.07 -0.06 x

3
x 1,000,000 = 2,500
12

Interest amount represents the payment that will be made

three months latter at the maturity of the instrument
(present value) will be identified as

2,500 x
=2,463
1+0.06 3


12

Example of a Bank Deal

A quote of 9.50% - 10.00% against 3 month MIBOR for 3

v/s 6 FRA

The market maker:

Agrees to pay (bid) 9.50% fixed and receive the 3 month
MIBOR determined 3 months later.

Agrees to receive (ask/offer) 10.00% fixed and pay the 3

month MIBOR determined 3 months later.

Futures

Futures are standardized contracts.

Traded at any point of time.
Trading with longer maturities through contract
extensions permitted.
Delivery of a range of futures securities.
Mark to market and margin requirements avoids
default risk from the contract.
Need not have compulsory physical deliver.
Netting of long and short position of same trader.

Futures
Commitment between two parties on the quantity and
price of a standardized financial or commodity
product.
Buyers of futures (long futures) contracts agree to pay
the futures price and take delivery of the product.
Sellers of futures (short futures) contracts agree to
receive the futures price and deliver the product.

Futures Profile

A) Profit or loss for buyer of futures

B) Profit or loss for seller of futures

Options

Limits the loss to the buyer of the option contract.

Options have several contract prices to enable

liquidity of trades.

Seller of the option takes the risk of the buyer of the

option.

Options provide the buyer with the advantage of

exercising the contract only when it is favourable for
the buyer.

Options

Purchase a Put Option / Sell a Call Option

Rising deposit cost and other borrowings.
Falling value of assets or return.
Offset loss from negative gaps.
Purchase a Call Option / Sell a Put Option
Falling yield on assets.
Offset loss from positive gaps.

Options Profile

A) Profit or loss for buyer of

call option and buyer of futures

B) Profit or loss for buyer of put

option and seller of futures

Caps, Floors and Collars

Caps can be entered into by banks to protect them

from rising borrowing costs.

Floors protect the banks at times of falling interest

rates.

Banks can purchase caps and sell floors to protect

against fluctuation in interest rates within a rate
expectation.

Caps
Variable rate borrowers are the users of interest rate caps.
Caps ensure that the banks can have a predetermined
interest rate beyond which the borrowing rates will not
increase.
Cost of the cap is termed as the premium payment to be
made on the instrument.
Premium for an interest rate cap depends on the cap rate
compared to current market interest rates.

Caps

Floors
Variable rate investors are the users of interest rate floors.
Floors set the minimum interest rate the investor will
receive on their investments.
Interest rate floor contracts ensure that the receipt is not
less than a pre-determined level of the floor contract on
investment.
Cost of the floor is the premium payment on the contract.
Premium for an interest rate floor depends on the floor rate
compared to current market interest rates.

Floors

Collars
Variable rate borrowers use interest rate collars.
Collars give holders the benefit of borrowing by
setting the minimum and maximum interest rate they
will pay on their borrowings.
An interest rate collar combines an interest rate cap
and an interest rate floor contract.
Interest rate collar ensures that payment is capped
and at the same time no reduction below the
minimum is set on the contract.

Collars

Cost of the collar contract is the premium payment.

Premium for an interest rate collar depends on the
rate parameters when compared to current market
interest rates and the frequency of payments agreed
upon.

Collar

Derivative Position to Hedge

Duration gap gives the sensitivity of the balance

sheet.

Hedging position could simulate a zero duration gap

for the bank.

Liability Structure of a Bank

Asset Structure of a Bank

Derivative Structure of a Bank

Impact of Interest Rate Change on the Bank