Managing Interest Rate &
Exchange Rate Risk
Hedging and Speculation
• Part of operating a bank’s securities portfolio is to
hedge the risks inherent in a bank’s balance
sheets.
– Hedge: Take a position in the securities markets to
offset risk associated with portfolio or balance sheet
position.
– Many hedges are derivatives (a financial instrument
whose value is determined by specific features of the
underlying asset or investment).
•
•
•
•
Forwards
Futures
Options
Swaps
Speculators trade to take on
risk and make profits.
Futures & Interest Rate Risk
• Banks and other investors use these
derivatives to insure against interest rate risk.
CBOT
Agricultural
Interest Rates
Corn
30 Year U.S. Treasury Bonds
Ethanol
10 Year U.S. Treasury Notes
Oats
5 Year U.S. Treasury Notes
Rough Rice
2 Year U.S. Treasury Notes
Wheat
10 Year Interest Rate Swap
Soybeans
5 Year Interest Rate Swap
Soybean Meal
30 Day Federal Funds
Soybean Oil
10 Year Municipal Note Index
Soybean Crush
mini-sized Eurodollar
South American Soybeans
mini-sized Defered Month Eurodollar
mini-sized Corn
mini-sized Wheat
mini-sized Soybeans
CME
CME
CME
CME
CME
CME
CME
CME
CME
CME
CME
CME
CME
CME
CME
CME
10-year Swap Rate
13 Week US T-Bill
2-year Swap Rate
5 Year Eurodollar Bundle
5-year Swap Rate
Consumer Price Index
Eurodollar
Euroyen
Euroyen-LIBOR
Eurozone Harmonized Index of Consumer Price
Fed Fund Turn Rate
Japanese Government Bond
LIBOR
Mexican 28 Day TIIE
Mexican 91 Day Cetes
Interest Rate Futures
• Each contract specifies:
– A delivery date.
– A type of asset (including maturity and, if
appropriate, a coupon rate)
• Maturity date means # of periods from delivery
date to maturity date.
– A fixed quantity (referring to face value).
– A sale price for the future
CME–
13Additional
Week US T-Bill Futures
Details
Trade Unit
3-month (13-week) U.S. Treasury Bills having a face value at maturity of $1,000,000
Contract Listing
Mar, Jun, Sep, Dec,
Futures Price
• For original interest rate derivatives, the future
price is a contractual price for actual delivery of
some security
• In efficient markets theory, the price of a future is
the market’s forecast of the spot rate on the
underlying security at the expiration date.
– If buyer expects spot price to be lower, wait and buy in
spot market.
– If seller expects spot price to be higher, wait and sell in
spot market.
Instruments Less than 1 Year
• Deposit-like Money market instruments such as
Negotiable CD’s, Eurodeposits, etc. are often
quoted with a 360 day year with face value
determined by initial deposit.
• Assume that the maturity is D days with a yield
of d360 . At the beginning, the investor will pay
Face. At the end of D days, the issuer will pay
initial Face plus interest
Payoff  (1  d 360 
D
)  Face
360
• To calculate true annualized yield, convert to a
365 year
365

d 365

 


d 365
360 365
d 
; i  1+

360


365


Days






Days 
1
Instruments Less than 1 Year
• Yields for discount bonds sold at a price in
money markets are usually reported on a
discount basis: d 360   Par - Price  360 ;
db



 D
Par
• Calculate Bond equivalent rate &
annualized yield
365

Days



365
dbe



d365
360 365 Par
be
 d db 

; i  1+

360 Price


365


Days






1
Example
• You buy a 91 day Eurodeposit for $1 million.
Broker quotes you a rate of 10%. Par value
is
91 

Par  $1  1  .1 
 1.025277778;

360 

365
d 365  .1
 0.101388889
360
 0.101388889 

i = 1+
365


91


365
91
 1  0.105313096
• You buy a 91 day
Exchange fund bill
with a face value of
$1 million. Broker
quotes you a rate on
a discount basis of
10%. Price is
 Par - Price  360  1 - Price  360
360
d db
 .1  




Par
D
1
91




91
Price=1-(.1
)  0.974722222
360
365
1
365
dbe
 .1

 0.104018239
360 0.974722222
 0.104018239 

i  i = 1+
365


91 

365
91
 1  0.108150428
Describing the Price
• ST-Bond Derivatives: Seller must deliver bonds
with designated face value and maturity. Buyer
must deliver some money. That money is the
futures price. The framework that the buyers
use to describe this price is the implied bankers
discount yield d*.
– Posted Price: 100∙(1-d*)
d  Days
– Actual Price: Contractual Volume∙(1- 360 )
*
– Negative relationship between actual yield in the
spot market and the ultimate profitability of the
future to the buyer.
Example
On February 6th, the listed price of a 90 day Tbill
future was with delivery at end of Feb. was
95.56
• This implies d* = .044. Given Days = 90, the
actual price was $1,000,000*(1-.011)=
US$989,000.
• Assume that by end of February, discount yield
on spot 3month Treasuries is d* = .048. Then
the spot price would be US$988,000.
• Buyer of future having locked in a higher price,
would then sell cheap Tbill in spot market losing
$1000!
Interest Rate Derivatives
• Interest Rate
– Some interest futures are not based on actual
bond, but are based on interest rates in
interbank or time deposit markets.
Problem: No bond to deliver.
– At settlement, no actual financial instrument
changes hands. Instead, an artificial security
is created using the interest rate as d.
– If the actual interest rate is different from d*,
then buyer/seller exchange cash with
clearinghouse on the difference.
Example
• On February 6th, the price of a 3 month Euro
deposit future with delivery at end of Feb. was
95.56
• This implies d* = .044. Given n = 90, the actual
price was $1,000,000*(1-.011)= US$989,000.
• Assume that by end of February, Euro deposit
rate is d = .048. Then the spot price would be
US$988,000.
• Buyer of future must pay 1000 to clearinghouse.
• Two types of contracts
on HK EX
•1 Month HIBOR
HKEX Website
HK: HKEX: 3 Month HIBOR Futures: 3rd Month: Settlem ent Price
Basis point
100
98
96
94
92
•3 Month HIBOR
HKEX Website
90
88
86
25-May-1998
24-Apr-2000
25-Mar-2002
23-Feb-2004
23-Jan-2006
HK: HKEX: 3 Year Ex Fund Note Futures: 1st Mth: Settlem ent Price
NA
112
•3 Year Exchange Fund Bonds
HKEX Website
111
110
109
108
107
106
105
104
103
102
25-Mar-2002
30-Dec-2002
6-Oct-2003
12-Jul-2004
18-Apr-2005
23-Jan-2006
Positions: Short vs. Long
• A long position: When the bank (or other investor)
buys a future contract (i.e. promise to pay a
certain price for the contracted volume of
securities upon delivery).
– A long position in treasury bill futures hedges against
the risk of an interest rate fall. If interest rates fall, bond
prices rise. The owner of a long position will be able to
buy securities at less than their market price.
• A short position: When the bank (or other
investor) sells a future contract (i.e. promises to
deliver the contracted volume of securities upon
payment of a predetermined price).
– A short position in treasury bill futures hedges against
the risk of an interest rate rise. If interest rates rise,
bond prices fall. The owner of a short position will be
able to sell bonds above the market price making
profits.
Example: Short Hedge
• Deposit rates/ExFundbill rates are 5%. A bank
finances a 2-year 7% loan $1,000,000 with 1
year time deposits. NIM = 2%, NII = $20,000
– This creates interest rate risk: if interest rates rise,
NIM will narrow. What if bank wants to insure against
the possibility that interest rates will rise to 7% which
would eliminate NII?
• Clearing House offers 1year HIBOR future with
volume of $1,000,000 at rate of 95 (i.e. d* = .05).
– Take a short position on 1 contract with a delivery
date of 1 year. {Promise to deliver 1year CD’s w/face
value of $10000000 in 1 year}. What happens if
interest rates rise to 7%? What happens if interest
rate fall to 3%?
Futures Prices
• Closing Accounts: If investor wants to get rid of
futures contract, they can settle it at the current
price of the future rather than wait to settle at the
spot price on delivery day.
• Margin: Most exchanges require futures markets
participants to keep a small account at
clearinghouse
• Marking to Market: When price changes at the
end of one trading day to the next, changes in
the value of open future positions are added to
or subtracted from the account.
Options
• Option - is an agreement giving its holder
the right (but not the obligation) to buy or
sell a specified asset, over a limited time
period, at a specified price (exercise price
or strike price) in exchange for a premium
payment.
– Call Options
– Put Options
• Call Option- an
agreement in which the
option writer sells the
holder the right to buy a
specified asset on or
before a future date.
• The buyer of the call
expects the price of the
asset to increase over the
life of the option,
eventually exceeding the
exercise price. (i.e. the
buyer expects interest
rates to fall)
• The value of the option
rises as the price of the
asset rises.
• Put Option- an
agreement in which the
option writer sells the
holder the right to sell a
specified asset on or
before a future date at the
strike price.
• The buyer of the put
expects the price of the
asset to fall below the
strike price. (i.e. the buyer
expects interest rates to
rise).
• The value of the option
rises as the price of the
asset declines.
Floating Rate Loans
• Interest rate on mortgage loans in HK vary over
time with some base short-term interest rate.
FLOAT
BASE
yt
 yt
 % premium
• In terms of interest rate risk, (though not liquidity
or credit risk) mortgage loans are short-term
instruments.
• Banks typically use short-term government bill
rate, interbank rate, or government discount rate
as base rate. In HK, banks set their own base
rate.
Hedging Practices of HK Banks
Outstanding Amounts Off Balance Sheet Interest Rate Derivatives
80000
70000
Mill. HK$
60000
50000
40000
Hang Seng
30000
BEA
20000
10000
0
Swaps
Futures
Options
Dealing
Hedging
Swaps
Interest Rate Swaps
• One bank may have a comparative advantage in
raising funds in short-term markets and lending
in long-term markets. Another financial institution
may have an advantage in raising funds in longterm markets and have short-term investment
opportunities.
• Solution 1: To reduce on-balance sheet interest
rate risk, each institution may raise funds in
ways not to their best advantage.
• Solution 2: To trade revenue streams on assets
and/or cost stream on liabilities.
Interest Rate Swaps
• “Plain Vanilla” Interest Swap
– Two parties agree on a notional amount of principal
(which does not change hands).
– One party will pay the counterparty a fixed interest in
every period.
– The counterparty will pay the first a floating interest
rate as a markup over LIBOR.
– Only the net difference in interest is actually paid.
SWAP
Futures
OTC
Flexible Size
and Settlement
Available for
Longer Maturities
Exchange Traded
Standard Sized Contracts
Fixed Settlement Days
Most are Short-term
Exotic Swaps: New
types of swaps invented
all the time
Swaps Importance Growing
Quickly
180000
160000
140000
120000
Forward rate agreements
100000
Swaps
80000
OPTIONS
60000
FUTURES
40000
20000
Jun.05
Dec.04
Jun.04
Dec.03
Jun.03
Dec.02
Jun.02
Dec.01
Jun.01
Dec.00
Jun.00
Dec.99
Jun.99
Dec.98
Jun.98
0
AMOUNTS OUTSTANDING WORLDWIDE OF OTC
SINGLE-CURRENCY INTEREST RATE DERIVATIVES
(In billions of US dollars)
Pricing Swaps
• Swaps are subject to counter-party risk.
• Plain vanilla swaps are usually
intermediated by swaps dealers with good
credit.
– Floating rates are typically 3 month LIBOR.
– Fixed interest rate payments are the rate of
Treasury bonds (in HK, exchange fund bills)
plus some spread.
• Typically, 3 month Tbills & LIBOR are very close.
• Dealers quote bid & offer
Example from Bank Management
by Koch & McDonald
Term
2 years
3 years
4 years
5 years
7 years
10 years
20 years
30 years
US Treasuries (%)
3.53
3.81
4.29
4.66
4.91
5.28
5.5
5.73
Swap Spread
42.5
64.5
66.5
57.5
69.5
64
76.5
56.5
Swap Rates
Bid
Offer
3.95
3.96
4.45
4.46
4.95
4.96
5.23
5.24
5.6
5.61
5.915
5.925
6.26
6.27
6.29
6.3
• If you will agree to pay dealer 3 month LIBOR for 5
years, he will agree to pay you a fixed rate of 5.23.
• If you will agree to pay dealer a fixed interest rate of
5.23, he will agree to pay you 3 month LIBOR.
Bid/Offer Rates on US
EURO
USD
YEN
YEARS
BID
ASK
BID
ASK
BID
ASK
2
5
10
20
30
4.12
4.08
4.16
4.3
4.3
4.15
4.11
4.19
4.33
4.33
5.01
4.95
5.08
5.23
5.24
5.04
4.98
5.11
5.26
5.27
0.91
1.3
1.74
2.22
2.41
0.94
1.33
1.77
2.25
2.44
• If you will agree to pay dealer 3 month LIBOR for 5
years, he will agree to pay you a fixed rate of 4.95.
• If you will agree to pay dealer a fixed interest rate of
4.98, he will agree to pay you 3 month LIBOR.
Swap Applications
• Microhedge: Hedge a specific Asset or
Liability
• Macrohedge: Hedge aggregate rate
sensitivity. If bank has a positive
aggregate duration gap, bank can
synthetically immunize by engaging in Pay
Fixed/Received Floating Swaps.
Final Exam
• Thursday, March 27th 9-12pm. Room
2303
• Style: Approximately 25% multiple choice
problems, 25% short answer problems,
50% longer problems similar to the
homework problems.
Group Project
• Wednesday, March 19thth 9-12am
• 7 projects: 10-20 minutes each
• Powerpoints/slides?
Order
1.
2.
3.
4.
5.
6.
Fan li, Qian Zhiyi, Liu Jielan, Wei Zhenhui, Wei Qian,
Cui Lu
Wang hongxia, Chan Wanyu, Yang Linfang, Zhang
Hui, Lam Kit Yung, Chen Qian
Wang Siye, Pao Wing Kin, Xie Xuhong, Deng Qiyan,
Zhang Jing, Xie Jun
Hu Lin, Hu Xiaoyan, Jin ye, Zhang yan, Chen Shuo
Ye He, Chen Rui, Chan Chi Yeung, Wang Xuan, Lin
Xiaotao,
Li Ka Man, Zhu Xiaolei, Deng Haibo, Jiang Kun, Pang
Ming, Leung Wai Yan
1.
2.
3.
4.
5.
6.
7.
Xue, Yuhan; Zhou, Yi; He Miao; Yang Liuqing; Zhou
Sinan
Debin Xu; Jing Zhang; Xiaoxing Wang; Mao Ye;
Jingying Yu.
Yang Linyan; Liu Yu; Peng Jia; Xia Yingying; Li Juan;
Liang Feng
Mu Chen; Fu Binbin; Jing Jing; Penghang Ren; Yichao
Wu
Zhao Xin Ho; Danwei Liu; Jing Zhao; Xiao Yin Liu
Yang Zhiming; Zheng Canhao, Lin YuanYuan; Li Yan;
Yang Guanlin; Liu Shasha
Hao Jie, Li Yu; Jing Sun; Yan Li, Xiang Hong Tang;
Song Huo Dong