Chapter Eight Risk Management: Financial Futures, Options, and Other Hedging Tools Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.

Chapter Eight

Risk Management: Financial Futures, Options, and Other Hedging Tools

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/IrwinBank Management and Financial Services, 7/e

Key Topics

•The Use of Derivatives

•Financial Futures Contracts

• Interest-Rate Options

•Caps, Floors, and Collars

8-2



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.

8-3



Managing Interest Rate Risk

•Derivatives Used to Manage Interest Rate Risk

▫Financial Futures Contracts

▫Forward Rate Agreements

▫Options on Interest Rates

▫Other hedging tools (Interest Rate Caps, Floors and

Collars

8-4



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.

• Financial futures are usually accounted for as off-

balance-sheet items.

8-5



Financial Futures Contract• cash (spot) markets and futures markets Interest Rate Futures

▫ In cash markets, sellers of financial assets remove the assets from

their balance sheet and account for the losses/gains on their

income statements. Buyers of financial assets add the item

purchased to their balance sheet.

▫ In futures markets buyers and sellers exchange a contract calling

for delivery of the underlying financial asset at a specified date in

the future. When the contract is created, neither the buyer nor the

seller is making a purchase or sale at that point in time, only an

agreement for the future.



Marked-to-market Mechanism• Initial margin.

▫ The initial margin is a minimum dollar amount per contract

specified by the exchange. This deposit may be in cash or in the

form of a security, such as a Treasury bill.

• Maintenance margin (the minimum specified by the exchange)

• The mark-to-market process takes place at the end of each

trading day. This mechanism allows traders to take a position

with a minimum investment of funds.



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

8-8



Short & Long Futures Hedge Process

• Short futures hedge process

▫ Today – Contract is Sold Through an Exchange

▫ Sometime in the Future – Contract is Purchased Through the

Same Exchange

• Long futures hedge process

▫ Today – Contract is purchased through an exchange

▫ Sometime in the Future – Contract is sold through the same

exchange

8-9



Short & Long Futures Hedge Process

• 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)



Financial Futures and Interest Rate Risk Management

•Measurement of interest rate risks

TA

TL * D - D D LA

IS Gap = IS Assets – IS Liabilities

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

8-11



Hedging with Futures Contracts

IS GAP Position Interest Rate Risk Futures Transaction

Positive rise None

Positive fall Long Hedge

Negative rise Short Hedge

Negative fall None




Duration GAP Position Interest Rate Futures Transaction

Positive rise Short Hedge

Positive fall None

Negative rise None

Negative fall Long Hedge




Avoiding Higher Borrowing Costs and Declining Asset Values

Use a Short Hedge: Sell Futures Contracts and then Purchase Similar

Contracts Later

Avoiding Lower Than Expected

Yields from Loans and Securities

Use a long Hedge: Buy Futures Contracts and then Sell Similar

Contracts Later



Hedging with Futures Contracts• Example 8-1: suppose a depository institution needed to raise 100

million from sales of deposits over the next 90 days, its marginal

cost of issuing the new deposits at a 10 percent annual rate would be

as follows:

• 100 million *0.1*(90/360)=2500,000

• However, if the interest rate climb to 10.5 percent, the marginal

deposit cost becomes

• 100 million *0.15* *(90/360)=2,625,000

• Amount of added fund-raising costs (and potential loss in profit):

125,000



Hedging with Futures Contracts• An offsetting financial futures transaction

▫ To counteract the potential profit loss of 125,000, management might

select the following financial futures transaction:

▫ Today : sell 100 90-day Eurodollar futures contracts trading at an IMM

index of 91.5.

▫ Price per 100= 100-((100-IMM index)*(90/360)=97.875

▫ 100 contracts=97,875,000

▫ Within next 90 days: buy 100 90-day Eurodollar futures contracts

trading on the day of purchase at IMM index of 91.

▫ 100 contracts =97,750,000

▫ Profit on the completion of sale and purchase of futures=125,000

▫ Result: higher deposit cost has been offset by a gain in futures.



Number of Futures Contracts Needed

• how many futures contracts does a financial firm need to cover a given size risk exposure?

• The objective is to offset the loss in net worth due to changes in market interest rates with gains from trades in the futures market.

• We quantify the change in net worth from an increase in interest rates as follows:

8-17

* * *1A L

TL iNW D D TA

TA i




0

0

0

* * *1

* *1

* *

*

t

A L

F

A L

F

Number of futures contracts needed

NW

F F

TL iD D TA

TA ii

D Fi

TLD D TA

TAD F




• Example 8-2: suppose a 100,000 par value Treasury bond futures contract is traded at a price of 99,700 initially but then interest rates on T-bonds increase from 7 to 8 percent. If the T-bond has a duration of nine years, then the change in the value of one T-bond futures contract would be

0.019 *99,700*

1 0.078385.98

Change in market value of a T bond futures contract

years



Number of Futures Contracts Needed• Example 8-3: suppose a bank has an average asset duration of four

years, an average liability duration of two years, total assets of 500 million, and total liabilities of 460 million. Suppose that the bank plans to trade in Treasury bond futures contracts. The T-bond named in the futures contracts have a duration of nine years and the T-bond current

price is 99,700 per 100,000 contract. Then this institution would need about

4604 *2 *500

5009 *99,700

1,200

years years millionN

years

contracts



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

price (or interest rate)• Basis risk with a short hedge

0 0

0 0

Re

=

Re

= -

t t

t t

turn from a combined cash and futures position

C C F F

arrange the above formula

C F C F



Basis Risk

•Basis risk with a long hedge

0 0

0 0

Re

=

Re

= -

t t

t t

turn from a combined cash and futures position

C C F F

arrange the above formula

C F C F



Option (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.



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

8-24



Call Option-Gain (Loss)

St

-Premium

Allow the option to expire

S0-Strike price

Exercise the option

S1-Breakeven point

Exercise the option

Profit

Loss

Seller

Buyer

Premium



Call Option-Gain (Loss) of Buyers

St Gain/Loss

0 ＜ St ＜S0

Loss=Option premium (not exercise the option)

S0≤St ＜ S1 Loss= (St- S0)-Option premium (exercise the option )

St=S1 Breakeven point: (St- S0)=Option premium (exercise the

option )

St ＞ S1 Gain= (St- S0)-Option premium (exercise the option )



Put Option-Gain (Loss) Profit

Loss

Buyer

Seller

S0-Strike price

S1-Breakeven point

-Premium

Premium

Allow the option to expire

Exercise the option



Put Option-Gain (Loss) of Buyers

St Gain/Loss

St ＞ S0 Loss=Option premium (not exercise the option)

S1 ＜ St ≤ S0 Loss= (St- S0)-Option premium (exercise the option )

St=S1 Breakeven point: (St- S0)=Option premium (exercise the

option )

0 ＜ St ＜S1

Gain= (St- S0)-Option premium (exercise the option )



8-29



8-30



Principal Uses of Option Contracts

IS GAP Position Interest Rate Option Transaction

Positive rise None

Positive fall Buy Put/Sell Call

Negative rise Buy Call/Sell Put

Negative fall None



Principal Uses of Option Contracts

Duration GAP Position Interest Rate Option Transaction

Positive rise Buy Call/Sell Put

Positive fall None

Negative rise None

Negative fall Buy Put/Sell Call



Other Hedging Tools

• Interest Rate Cap▫ Protects the holder from rising interest rates. Borrowers are

assured their loan rate will not rise above the Cap Rate.

• Interest Rate Floor▫ A Contract Setting the Lowest Interest Rate a Borrower is

Allowed to Pay on a Flexible-Rate Loan

• Interest Rate Collar▫ A Contract Setting the Maximum and Minimum Interest Rates. It

Combines an Interest Rate Cap and Floor into One Contract.

8-33

Chapter Eight Risk Management: Financial Futures, Options, and Other Hedging Tools Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.

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