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Chapter Eight
Risk Management: Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management
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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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One of the most popular methods for neutralizing these gap risks is to buy and sell financial futures contracts McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
To Shift the Risk of Interest Rate Fluctuations from Risk-Averse Investors to Speculators
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Euronext.Liffe (Eurex) Sydney Futures Exchange Toronto Futures Exchange (TFE) South African Futures Exchange (SAFEX)
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Forward Contracts
Terms are negotiated between parties Do not necessarily involve standardized assets Require no cash exchange until expiration No marking to market
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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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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)
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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?
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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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Call Option
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Perfect Hedge
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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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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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Basis 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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e
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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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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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A Contract Setting the Lowest Interest Rate a Borrower is Allowed to Pay on a Flexible-Rate Loan
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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 institutions manager be likely to employ?
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.