CHAPTER SEVEN
Using Financial Futures, Options,
Swaps, and Other Hedging Tools in
Asset-Liability Management
The purpose of this chapter is to examine how
financial futures, option, and swap contracts, as
well as selected other asset-liability management
techniques can be employed to help reduce a
bank’s potential exposure to loss as market
conditions change. We will also discover how
swap contracts and other hedging tools can
generate additional revenues for banks by
providing risk-hedging services to their customers.
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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
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The Purpose of Financial Futures
To Shift the Risk of Interest Rate
Fluctuations from Risk-Averse Investors to
Speculators
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The World’s Leading Futures and
Option Exchanges
Chicago Board of Trade
(CBOT)
Financial Exchange
(FINEX)
New York Futures
Exchange (NYFE)
Marche a Terme
International De France
(MATIF)
Singapore Exchange LTD.
(SGX)
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Chicago Mercantile
Exchange (CME)
London International
Financial Futures
Exchange (LIFFE)
Sydney Futures Exchange
Toronto Futures Exchange
(TFE)
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Most Common Financial Futures
Contracts
U.S. Treasury Bond Futures Contracts
U.S. Treasury Bill Futures Contracts
Three-Month Eurodollar Time Deposit
Futures Contract
30-Day Federal Funds Futures Contracts
One Month LIBOR Futures Contracts
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7-7
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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7-8
Basis Risk
Cash-Market Price (or Interest Rate) Less
the Futures-Market Price (or Interest Rate)
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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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7-10
Number of Futures Contracts
Needed
TL
(D A - D L *
) * TA
TA

D F * Price of the Futures Contract
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7-11
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.
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7-12
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
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7-13
Most Common Option Contracts
Used By Banks
U.S. Treasury Bill Futures Options
Eurodollar Futures Option
U.S. Treasury Bond Option
LIBOR Futures Option
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7-14
Principal Uses of Option Contracts
Protection of the Bond Portfolio
Hedging Against Positive or Negative Gap
Positions
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7-15
Interest Rate Swap
A Contract Between Two Parties to
Exchange Interest Payments in an Effort to
Save Money and Hedge Against InterestRate Risk
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7-16
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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7-17
Risks of Interest Rate Swaps
Substantial Brokerage Fees
Credit Risk
Basis Risk
Interest Rate Risk
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7-18
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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7-19
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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7-20
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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7-21
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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7-22
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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