1

Risk Management in ALM

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8-2

Session Discussion

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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8-3

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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8-4

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

D DA

TL
- 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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8-7

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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8-8

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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8-9

The Purpose of Financial Futures

To Shift the Risk of Interest Rate Fluctuations

from Risk-Averse Investors to Speculators

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8-10

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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8-11

Hedging with Futures Contracts

Avoiding Higher
Borrowing Costs and
Declining Asset Values

Avoiding Lower Than

Expected Yields from
Loans and Securities

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Use a Short Hedge:

Sell Futures
Contracts and then
Purchase Similar
Contracts Later

Use a long Hedge:

Buy Futures
Contracts and then
Sell Similar Contracts
Later

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8-12

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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8-13

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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8-14

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 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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8-15

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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8-16

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
(1 i)

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8-18

Number of Futures Contracts Needed

TL
(D A - D L *
) * TA
TA

D F * Price of the Futures Contract

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8-19

Put Option
Types of Options

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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8-20

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 interestsensitive 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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21

One Situation
One bank plans to issue Rs.150 mill. of
180 days int. bearing deposits. Int. may
increase from 6.5% to 7% per annum. How
the bank can hedge by using option?
Strike price of interest rate futures is 9500.
Due to interest rate hike, index on interest
rate futures fall to 9400. Option premium
for strike price of 9500 is 50 times Rs.25.
one contract is of Rs.1 million.

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8-22

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8-23

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8-24

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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8-25

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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8-26

Interest Rate Swap

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8-27

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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8-28

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 floatinginterest payments in exchange for a fixedrate receipt
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8-29

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 swaps 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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8-30

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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8-31

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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8-32

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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8-33

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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