11-1
Interest Rate Risk Management
Interest Rates and Foreign Currency Futures
Chapter 11
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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 2004
E-cbot electronic trading platform in 2003
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11-3
Financial Institutions and Financial
Futures
Volume of derivatives used to manage interest rate
risk rising very quickly
Highly concentrated in largest banks
Notionals:
•
•
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)
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11-4
Derivative Contracts by Type
All Commercial Banks
Year ends 1991 - 2002, Most recent four quarters - 2003
75,000
91 Q4
92 Q4
93 Q4
94 Q4
95 Q4
96 Q4
97 Q4
98 Q4
70,000
99Q4
00Q4
01Q4
02Q4
03Q1
03Q2
03Q3
03Q4
65,000
60,000
55,000
45,000
40,000
35,000
$ Billions
50,000
30,000
25,000
20,000
15,000
10,000
5,000
0
Interest Rate
Foreign Exch
Other Derivs
Credit
Derivatives
TOTAL
*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)
Copyright © 2004 by Thomson Southwestern
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11-5
Derivative Contracts by Product
All Commercial Banks
Year ends 1991 - 2002, Most recent four quarters - 2003
75,000
91 Q4
92 Q4
93 Q4
94 Q4
95 Q4
96 Q4
97 Q4
98 Q4
70,000
99Q4
00Q4
01Q4
02Q4
03Q1
03Q2
03Q3
03Q4
65,000
60,000
50,000
45,000
40,000
$ Billions
55,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
Futures &
Forwards
Swaps
Options
Credit
Derivatives
TOTAL
*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)
Copyright © 2004 by Thomson Southwestern
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11-6
Derivatives, Notionals by Type of User
Insured Commercial Banks
80
70
50
40
Total Notionals
Dealer Notionals
30
$ Trillions
60
20
End-User Notionals
10
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
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.
Data Source: Call Reports. OCC Bank Derivatives Report: Third Quarter 2003 (http://www.occ.treas.gov/ftp/deriv/dq403.pdf)
Copyright © 2004 by Thomson Southwestern
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11-7
Seven Banks With Most Derivatives
Dominate Holdings
All Commercial Banks, Fourth Quarter 2003
75,000
70,000
Top 7 Banks
Rest 566 Banks
65,000
60,000
55,000
45,000
40,000
35,000
$ Billions
50,000
30,000
25,000
20,000
15,000
10,000
5,000
0
Futures & Fwrds
Swaps
Options
Credit Derivatives
TOTAL
*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.
Data Source: Call Reports. OCC Bank Derivatives Report: Third Quarter 2003 (http://www.occ.treas.gov/ftp/deriv/dq403.pdf)
Copyright © 2004 by Thomson Southwestern
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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
Interest-bearing assets
Stock & other financial indices
Foreign currencies
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Non-financial
Agricultural goods
Metals
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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
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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
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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
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11-12
The Margin
Initial margin and maintenance margin
Cash deposit to take a position
Often <5% of contract value
Different for each contract
Set by the exchange
Daily resettlement
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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
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FEATURES OF SELECTED
INTEREST RATE CONTRACTS
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.
Name of
Contract
Underlying Instrument
Face Value
of Contract
Daily
Price Limit
T-bill future
13-week T-bill
$1 million
None
3-month
Eurodollar
futures
None, settled in cash
based on prevailing
rate on 3-month
Eurodollar time deposit
2-year, 5-year, 10-year
T-notes
8% T-bonds, minimum
maturity of 15 years
None, settled in cash
based on Bond Buyer
Municipal Bond Index
$1 million
None
$100,000 or
$200,000
$100,000
Varies 1 to
3 points
3 points
$1,000 times
value of
index
$3,000
T-note futures
T-bond futures
Municipal
Bond Index
Copyright © 2004 by Thomson Southwestern
Standard
Delivery Months
Mar., Jun.,
Sept., Dec.
Mar., Jun.,
Sept., Dec.
Mar., Jun.,
Sept., Dec.
Mar,. Jun.,
Sept., Dec.
Mar., Jun.,
Sept., Dec.
All rights reserved.
11-15
FEATURES OF SELECTED
INTEREST RATE CONTRACTS
30-day
Fed Funds
futures
LIBOR
None, settled in cash
based on monthly
averages of daily
fed funds rate
None, settled in cash
based on the prevailing
LIBOR rate on 1-month
Eurodollar time deposit
Copyright © 2004 by Thomson Southwestern
$5 million
150 basis points
from previous
settlement price
Every Month
$3 million
None
First 12 consecutive months
beginning with
current month
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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)
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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.
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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.
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11-19
Long Hedge Illustrated
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%.
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THE LONG HEDGE
(FORECAST: FALLING RATES)
11-20
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.
Cash Market
June
T-bill discount yield at 10%
Price of 91-day T-bill, $10m par:
$9,747,222a
September
T-bill discount yield at 8%
Price of 91-day T-bill, $10m par:
$9,797,778
Copyright © 2004 by Thomson Southwestern
Futures Market
Buy 10 T-bill contracts for September
delivery at 10% discount yield.
Value of Contracts:
$9,750,000b
Sell 10 T-bill contracts at 8%
discount yield
Value of contracts
$9,800,000
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11-21
THE LONG HEDGE (continued)
II.
Cash Market Loss
June Cost
September Cost
9,750,000
Loss
III.
Futures Market Gain
$9,747,222
($ 50,556)
Net Loss:($556)c
September Sale
9,797,778
Gain
$9,800,000
June Purchase
$
50,000
Effective Discount Yield with the Hedge
$10,000,000  ($9,797,778  $50,000) 360


$10,000,000
91
a At
9.978%
a discount yield of 10%, the price of a 91-day T-bill is:
 0.10(91) 
P0  $10,000,000 1 
 $9,747,222

360


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.
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11-22
Short Hedge Illustrated
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%.
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11-23
THE SHORT HEDGE
(FORECAST: RISING RATES)
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.
I.
Cash Market
September
CD rate: 7%
Interest cost on $5m in deposits:
$87,500
December
CD rate: 9%
Interest cost on $5m in deposits:
$112,500
Copyright © 2004 by Thomson Southwestern
Futures Market
Sell 5 T-bill contracts for December
delivery at 7% discount yield.
Value of Contracts:
$4,912,500
Buy 5 T-bill contracts at 9%
discount yield
Value of contracts
$4,887,500
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11-24
THE SHORT HEDGE
(FORECAST: RISING RATES)
II.
Cash Market Loss
September Interest
$ 87,500
December Interest
112,500
Loss
($ 25,000)
Net Benefit of Hedge: $0a
Futures Market Gain
September Sale
$4,912,500
December Purchase 4,887,500
Gain
$ 25,000
III.
Net Interest Cost and Effective CD Rate
$112,500  $25,000  $87,500
$87,500
360


$5,000,000 91
a Excludes
.0692 or 6.92%
transactions cost, brokers’ fees and the opportunity cost of the margin
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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
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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
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11-27
The Hedge Ratio
The Hedge Ratio
Cov (PSt , PF )
HR 
2 PF
•
•
•
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)
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11-28
Choosing The Optimal Number of
Contracts
Number of futures contracts to be purchased or
sold, NF, is:
NF
V X HR

F
where V = total market value of securities to be hedged
F = the market value of a single futures contract
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11-29
Example
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?
V  HR
$15,000,000  0.93
NF 

 14.098
F
$989,500
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11-30
Factors 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
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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
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11-32
Futures as a Supplement
to Gap Management
Macro Hedges versus Micro Hedges
Hedging a Funding Gap
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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 Rules
1. The asset or liability to be hedged exposes the institution to
interest rate risk
2. The futures contract chosen reduces interest rate risk, is
designated as hedge, and has price movements highly
correlated with the instrument being hedged
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11-34
More Detailed Reporting
Under FAS 133, four key rules
1. 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
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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
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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
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11-37
Comparison of Forward and
Futures Currency Markets
Futures Contracts
Forward Contracts
• Standardized
• Default risk free
•
•
• Available only for a few
currencies
• Liquid due to secondary
market
•
Copyright © 2004 by Thomson Southwestern
•
Custom-designed
No clearinghouse to bear
default risk
Can be written for any
currency
No secondary market
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11-38
Currency Futures Illustrated
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.
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11-39
HEDGING 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 Market
December 2
Dollars required to purchase 1 million
Swiss francs at $0.7760 = $776,000
Results in January
January 2
Dollars required to purchase 1 million
Swiss francs at $0.8883 = $888,300
II. Net Results of Hedge in January
Cash Market Gain
December “cost”
January cost
Loss
Futures Market
Buy 8 March contracts at $0.7783
Value of Contracts:
125,000 × 8 × $0.7783 = $778,300
Sell 8 March contracts at $0.8893
Value of contracts:
125,000 × 8 × $0.8893 = $889,300
Future Market Loss
$776,000
December purchase
(888,300)
January sale
($112,300)
Gain
Net Hedging Error ($1,300)
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$778,300
889,300
$111,000
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