Tools for managing and hedging
against risk (Part 2)
Uses of Derivative Contracts
Due to their high exposure to various forms of risk, banks and their
principal competitors are among the heaviest users of derivative
contracts.
These risk-hedging instruments allow a financial firm to protect its
balance sheet and/or income and expense statement in case interest
rates, currency prices, or other financial variables move against the
hedger, resulting in significant losses.
Due to the presence of heavy regulation among financial-service
providers, bank usage of these risk-hedging instruments is among the
best documented in the business world.
Financial Futures Contracts: Promises of
Future Security Trades at a Preset Price
A financial futures contract is an agreement reached today between a
buyer and a seller that calls for delivery of a particular security in
exchange for cash at some future date.
Financial futures trade in futures markets considered off-balance-sheet
items on the financial statements
cash (or spot) markets and futures or foreword markets.
In cash markets, buyers and sellers exchange the financial asset for cash at the time
the price is set.
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 buyer nor seller is making a purchase or sale at that point in time,
only an agreement for the future.
When an investor buys or sells futures contracts at a designated price, it must deposit an
initial margin. The initial margin is a minimum dollar amount per contract specified by the
exchange where the trading occurs. This deposit may be in cash or in the form of a
security, such as a Treasury bill. The initial margin is the investor's equity in the position
when he or she buys (or sells) the contract. At the end of the first trading day, the
settlement price for that day (a price determined by the exchange, based on trades that
day) is compared with the price at which the trade occurred. If the price has increased,
the buyer of the contract has profited while the seller has lost an equal amount. Each
trader's account is marked,to, market. This means the equity account of the buyer
increases by the change in price, while the seller's equity position decreases by the
same amount. When a trader's equity position falls below the maintenance margin (the
minimum specified by the exchange) the trader must deposit additional funds to the
equity account to maintain his or her position, or the futures position is closed out within
24 hours. Ifprofits have accrued, the excess margin may be withdrawn. The mark-tomarket process takes place at the end of each trading day. This mechanism allows
traders to take a position with minimum investment of funds.
Purpose of Financial Futures Trading
Shift the risk of interest-rate fluctuations from risk-averse
investors (banks and insurance companies) to speculators
willing to accept and possibly profit from such risks.
On the exchange floor, f1oor brokers execute orders received
from the public to buy or sell these contacts at the best prices
available.
when a financial institution contacts an exchange broker and offers to
sell futures contracts ("go short" in futures)= promising to deliver the
securities underlying the contract to a buyer on a stipulated date at a
predetermined price.
A financial institution may enter the futures market as a buyer of
contracts ("go long" in futures), agreeing to accept delivery of the
underlying securities named in each contract or to pay cash to the
exchange clearing-house the day the contracts mature, based on their
price at that time.
Purpose of Financial Futures
Trading (Cont’d)
Futures contracts are also traded over the counter (OTC),
without the involvement of an exchange, which is often less
costly for traders (so-called forwards)
These forward contracts generally are more risky because no
exchange guarantees the settlement of each contract if one or the other
party to the contract defaults.
Liquidity risk is usually less for exchange-traded futures because of the
presence of substantial numbers of speculators and specialists on each
exchange who stand ready to make a market for the instruments traded
there.
Sample Market Prices for Interest-Rate
Futures
Selling price on a futures contract reflects what
investors expect cash prices to be on the day delivery of
the securities underlying the contract must be made.
A futures hedge against interest rate changes requires
to take an opposite position in the futures market from its
current position in the cash market.
Planning to buy bonds ("go long") in the cash market
today may try to protect the bonds' value by selling bond
contracts ("go short") in the futures market.
Futures contracts can also be used to protect returns
and costs on loans, deposits, money market
borrowings, and other financial assets.
The Short Hedge in Futures
A short hedge in financial futures arise
Market interest rates are expected to rise, boosting the cost of selling
deposits/borrowing in the money market and lowering the value of any bonds or
fixed-rate loans
This hedge would be structured to create profits from futures transactions
to offset losses experienced on a financial institution's balance sheet if
interest rates rise.
Selling futures contracts calling for the future delivery of the underlying
securities, choosing contracts expiring around the time new borrowings will
occur, when a fixed-rate loan is made, or when bonds are added to a financial
firm's portfolio.
Later, as borrowings and loans approach maturity or securities are sold and
before the first futures contract matures, a like amount of futures contracts will be
purchased on a futures exchange.
If market interest rates have risen significantly, the interest cost of borrowings
Example of short hedge in future
The securities portfolio of a bank contains $10 million in 6
percent, 15-year bonds and market yields increase from 6
percent to 6.5 percent. The market value of these bonds
decreases from $10 million to $9,525,452.07-a loss in the cash
market of $474,547.73.
This loss will be approximately offset by a price gain on the futures
contracts.
If the bank makes an offsetting sale and purchase of the same futures
contracts on a futures exchange, it then has no obligation either to
deliver or to take delivery of the securities named in the contracts.
The clearinghouse that keeps records for each futures exchange will
simply cancel the two offsetting transactions
The Long Hedge in Futures
Applied when a financial firm wishes to hedge itself against falling interest rates and when a cash
inflow is expected in the near future.
Suppose management expects to receive a sizable inflow of deposits a few weeks or months
from today but forecasts lower interest rates by that time.
This sounds favorable from a cost-of-funds point of view, but it is not favorable for the future growth of
revenues.
If management takes no action and the forecast turns out to be true, the financial institution will suffer an
opportunity loss (i.e., reduced potential earnings) because those expected deposits will have to be invested
in loans and securities bearing lower yields or having increased prices.
Example of the Long Hedge in
Futures
For instance, if the institution was going to buy $1 million (par
value) of 15-year, 6 percent bonds and interest rates dropped
from 6 percent to 5.5 percent, the price of these bonds would
increase from $1 million to $1,050,623.25, forcing the
institution to pay a higher price to acquire the bonds.
To offset this opportunity loss, management can use a long hedge:
Futures contracts can be purchased today and then sold in like amount
at approximately the same time deposits come flowing in.
The result will be a profit on the futures contracts if interest rates do
decline because those contracts will rise in value.
Using Long and Short Hedges to Protect
Income and Value
Basis Risk
Suppose 10-year U.S. government bonds are selling today in the cash
market for $95 per $100 bond while futures contracts on the same bonds
calling for delivery in six months are trading today at a price of $87 current
basis = $95 - $87 = $8 per contract
If the basis changes between the opening and closing of a futures position,
the result can be significant loss (subtracting from any gains a trader from the
cash market.
Basis risk is usually less than interest rate risk in the cash market, so
hedging reduces (but incompletely eliminate) overall risk exposure.
The dollar return from a hedge is the sum of changes in prices in the cash
market and changes in prices in the futures market
Basis Risk with a Short Hedge

Basis Risk with a Long Hedge
 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
a full percentage point from 7 to 8 percent. The Tbond has a duration of nine years
 The change in the value of one T-bond futures
contract would be - $8 385.98.
 the one percentage point rise in interest rates has
reduced the price of a $100,000 futures contract for
Treasury bonds to $91,314 ($99,700 - $8,386).
Trade-Off Diagrams for Financial Futures
Contracts
The long hedge in futures
First buying futures contracts (F0) and, then, if interest
rates fall, selling comparable contracts (Ft)·
The decline in interest rates will generate a gross profit of
Ft - F0 > 0 (less any taxes or broker commissions).
 The short hedge
first selling futures contracts (F0) and, then, if interest
rates rise, buying comparable futures contracts (Ft)
 The rise in interest rates will generate a profit of F0 - Ft >
0, net of any tax obligations created or traders'
commissions.
Help offsetting any losses resulting from a decline in the
market value of a financial institution's assets or a decline
in its net worth or in its net interest income due to adverse
changes in market interest rates.
Number of Futures Contracts Needed
How many futures contracts does a financial firm need to
cover a given size risk exposure?
How to offset the loss in net worth due to changes in
market interest rates with gains from trades in the futures
market?

Number of Futures Contracts
Needed
(Cont’d)
This financial firm has a positive duration gap of +2.16
years (or 4 years - $460/$500 million X 2 years),
Its assets have a longer average maturity than its liabilities.
If market interest rates rise, its assets will decline in value
by more than its liabilities, other factors held equal, reducing
the stockholders' investment (net worth).
To protect against an interest rate rise, this institution would
probably want to adopt a short hedge in T-bond futures
contracts, selling about 1,200 of these contracts initially.
An interest rate decline usually would call for a long hedge,
purchasing contracts on T-bonds or other securities.
Interest Rate Options
This option grants a holder of securities the right to
place (put) those instruments with another investor at a prespecified exercise
price before the option expires
take delivery of securities (call) from another investor at a prespecified price
before the option's expiration date.
In the put option, the option writer must stand ready to accept delivery of
securities from the option buyer if the latter requests.
In the call option, the option writer must stand ready to deliver securities to
the option buyer upon request.
the option premium is the fee that the buyer must pay for the privilege of
being able to put securities to or call securities away from the option writer
How do options differ from futures
contracts
Options do not obligate any party to deliver securities.
Options grant the right to deliver or take delivery, but not the
obligation to do so.
 The option buyer can (1) exercise the option, (2) sell the option to
another buyer, or (3) simply allow the option to expire.
Interest-rate options are traded mostly in over-the-counter markets
where the exercise date and price can be tailored to the needs of
the option buyer.
For standardized exchange-traded interest-rate options, the most
activity occurs using options on futures, referred to as the futures
options market.
The buyer of a call futures option has the
right, but not the obligation, to take a long
position in the futures market at the exercise
(strike) price any time prior to expiration of the
option contract.
The buyer of a put futures option has the
right, but not the obligation, to take a short
position in the futures market at the exercise
(strike) price any time prior to expiration of the
option.
The futures price is highly correlated with the
underlying cash price; hence, futures on
options can be used to hedge interest rate risk.
Payoff Diagrams
for Put and Call
Options
Purchased by a
Financial
Institution
Payoff
Diagrams for
Put and Call
Options
Written by a
Financial Firm
Interest Rate
Swaps
Neither firm lends money to the other.
The principal amount of the loans, usually
called the notional amount, is not
exchanged.
Each party to the swap must still pay off its
own debt.
Only the net amount of interest due usually
flows to one or the other party to the swap,
depending on how high short-term interest
rates in the market rise relative to long-term
interest rates on each interest-due date.
The swap itself normally will not show up
on a swap participant's balance sheet,
though it can reduce interest rate risk
associated with the assets and liabilities on
that balance sheet.
Some notes!
Master swap agreements spell out the rights and responsibilities of each swap partner,
thereby simplifying negotiation of an agreement and improving the liquidity of the
international swap market.
Reverse swaps can also be arranged, in which a new swap agreement offsets the
effects of an existing swap contract.
Many swap agreements today contain termination options, allowing either party to end
the agreement for a fee.
Other swaps carry interest-rate ceilings, interest-rate minimums, or both ceilings and
minimums, which may limit the risk of large changes in interest-rate payments.
There may also be escape clauses and "swaptions," which are options for one or both
parties to make certain changes in the agreement, take out a new option, or cancel an
existing swap agreement.
Disadvantages
Swaps may carry substantial brokerage fees, credit risk, basis risk, and interest
rate risk
With credit risk, either or both parties to a swap may go bankrupt or fail to
honor their half of the swap agreement
A third party with a top credit rating may be willing to guarantee the agreed-upon
interest payments through a letter of credit if the swap partner seeking the guarantee
pays a suitable fee.
The lower-rated swap partner may be asked to post collateral to strengthen the
contract, even among high-credit-quality participants.
If a swap partner is rated BBB or lower, it may be impossible to find a counterparty to
agree to the swap
The low-rated partner may be required to agree to a credit trigger clause, which
allows the other partner to terminate the contract should the lower-rated borrower's
credit rating deteriorate
Disadvantages
Basis risk arises if interest rates embedded to in the terms of a swap
(long-term bond rate and a floating short-term rata) are not exactly the
same interest rates as those attached to all the assets and liabilities
that either or both swap partners hold.
An interest-rate swap cannot hedge away all interest rate risk for both parties to
the agreement
Swaps may carry substantial interest rate risk.
If the yield curve slopes upward, the swap buyer expecting to pay a greater
amount of net interest cost during the early years of a swap contract and receive
greater amounts of net interest income from the swap seller, toward the end of
the swap contract.
This could encourage the seller to default on the swap agreement near the end
of the contract, possibly forcing the swap buyer to negotiate a new agreement
with a new partner under less-favorable conditions.
Swap dealers, which account for most contracts in the market, work to limit their
interest rate risk exposure by setting up offsetting swap contracts with a variety
of partners.
Interest-rate cap
An interest-rate cap protects its holder against rising market interest
rates.
In return for paying an up-front premium, borrowers are assured that
institutions lending them money cannot increase their loan rate above the
level of the cap.
Alternatively, the borrower may purchase an interest-rate cap from a
third party, with that party promising to reimburse borrowers for any
additional interest they owe their creditors beyond the cap.
If a lending institution sells a rate cap to one of its borrowing customers,
it takes on interest rate risk from that customer but earns a fee (premium)
as compensation for added risk taking.
If a lender takes on a large volume of cap agreements it can reduce its
overall risk exposure by using another hedging device, such as an
interest-rate swap.
Example of cap interest rate
A bank purchases a cap of 11 percent from an insurance company on its
borrowings of $100 million in the Eurodollar market for one year.
Suppose interest rates in this market rise to 12 percent for the year. The financial
institution selling the cap will reimburse the bank purchasing the cap the additional
1 percent in interest costs due to the recent rise in interest rates.
the bank will receive a rebate for a year
the bank's effective borrowing rate can float over time but it will never exceed 11
percent.
Financial firms buy interest-rate caps when conditions arise that could generate
losses
finds itself funding fixed rate assets with floating-rate liabilities,
possesses longer-term assets than liabilities
holds a large portfolio of bonds that will drop in value when market interest
Interest-Rate Floors
 An interest-rate floor
under its loans so that,
no matter how far loan
rates
decline,
it is
guaranteed
some
minimum rate of return.
Interest-rate
floors
arises when a financial
firm sells an interest rate
floor to its customers who
hold securities but are
concerned that the yields
on those securities might
fall
to
unacceptable
levels
A lender extending a $10 million floating-rate loan to one of its
corporate customers for a year at prime insists on a minimum (floor)
interest rate on this loan of 7 percent. If the prime rate drops below
the floor to 6 percent for one year, the customer will pay not only the
6 percent prime rate (or $10 million X 0.06 = $600,000 in interest)
but also pay out an interest rebate to the lender of
Through this hedging device the lender is guaranteed, assuming the
borrower doesn't default, a minimum return of 7 percent on its loan.
Interest rate collar
Combining in one agreement a rate floor and a rate cap.
Many banks, security firms, and other institutions sell collars as a
separate fee-based service for the loans they make to their
customers.
A customer who has just received a $100 million loan may ask the lender
for a collar on the loan's prime rate between 11 percent and 7 percent.
The lender will pay its customer's added interest cost if prime rises above
11 percent, while the customer reimburses the lender if prime drops below
7 percent.
In effect, the collar's purchaser pays a premium for a rate cap while
receiving a premium for accepting a rate floor.
The net premium paid for the collar can be positive or negative, depending
upon the outlook for interest rates and the risk aversion of borrower and
Securitization
A method of packaging the cashflow from an asset into an
investment security (not collateral) and selling it to investors
The purpose of securitisation:
Capital management
Liquidity management
Interest rate risk management
Selling the loans off the statement of financial position
Securitization
process
New model!
Securitization and P2P lending
Brazil is a typical case
Fintech balance sheet lending
A specific licensing framework
Sales of Loans to Raise Funds and Reduce
Risk
Not only can loans be used as
collateral for issuing securities
to raise new funds, but the
individual loans themselves can
be sold to new owners.
Loan sales are carried out
today by financial firms of
widely varying sizes.
Reasons behind Loan Sales
Reducing lower-yielding assets to make room for higher-yielding assets when interest rates
rise.
Increasing a lender's liquidity, better preparing the institution for deposit withdrawals or other
cash needs.
Removing both credit risk and interest rate risk from the lender's balance sheet and may
generate fee income up front.
helping management maintain a better balance between growth of capital and the acceptance
of risk in the lending function.
Helping lenders please regulators, who have put considerable pressure on heavily regulated
institutions to get rid of their riskiest assets and strengthen their capital in recent years
Making some loans without taking in deposits and cover deposit withdrawals merely by selling
loans.
less needing for deposit insurance or for borrowing from their central bank.
Because loan sales are so similar to issuing securities, this financing device blurs the
distinction between financial intermediaries and finance companies
The Risks in Loan Sales
Selling off its soundest loans, leaving its portfolio heavily stocked with poorer-quality loans.
Trigger the attention of regulators, and the lending institution may find itself facing demands
from regulatory agencies to strengthen its capital.
The seller will agree to give the loan purchaser recourse to the seller for all or a portion of any
sold loans that become delinquent.
the purchaser gets a put option, allowing him or her to sell a troubled loan back to its originator.

Standby Credit Letters to Reduce the Risk of
Nonpayment or Nonperformance
A standby credit letter is a contingent obligation of the letter's issuer.
The key advantages to a financial institution issuing SLCs
Letters of credit earn a fee for providing the service
They aid a customer, who can usually borrow more cheaply when armed with the
guarantee, without using up the guaranteeing institution's scarce reserves.
Such guarantees usually can be issued at relatively low cost because the issuer
may already know the financial condition of its standby credit customer
The probability usually is low that the issuer of an SLC will ever be called upon to
pay.
The Structure of SLCs
SLCs are not listed on the issuer's or
the beneficiary's balance sheet.
This is because a standby is only a
contingent liability.
Delivery of funds to the beneficiary
can occur only if something
unexpected happens to the account
party
Moreover, the beneficiary can claim
funds from the issuer only if the
beneficiary meets all the conditions
laid down in the SLC.
The Value and Pricing of Standby Letters
An account party will seek an SLC
if the issuer's fee for providing the guarantee is less
than the value assigned to the guarantee by the
beneficiary.
If P is the price of the standby, NL is the cost of a
nonguaranteed loan, and GL is the cost of a loan
backed by a standby guarantee, then a borrower is
likely to seek an SLC if P< (NL-GL)
Sources of Risk with Standbys
The issuing institution may not be able to cover its
commitment, resulting in default.
An issuing institution cannot be forced to pay off on an SLC if
doing so would force it to violate regulations (e.g., a lender's
legal lending limit).
A beneficiary cannot legally obtain reimbursement from the
issuer unless all of the conditions required for successful
presentation of a credit letter are met.
Substantial interest rate and liquidity risks If the issuer is
compelled to pay under a credit letter without prior notice, it may
be forced to raise substantial amounts of funds at unfavorable
interest rates.
Credit Swap
The dealer levies a fee for the service of bringing these two swap
partners together and may also guarantee each swap partner's
performance for an additional charge.
Each participating bank may have the opportunity to further
spread out the risk in its loan portfolio, especially if the lenders
involved are located in different market areas
Total Return Swap
Bank B bears the credit risk associated with Bank A’s loan even though it is
not the owner.
This swap may terminate early if the borrower defaults on the loan.
Credit Options
Guarding against losses in the value of a credit asset or helps to offset
higher borrowing costs that may occur due to changes in credit ratings.
Hedging against a rise in borrowing costs due to a change in the borrower's
default risk or credit rating
Credit Default
Swaps (CDSs)
Credit-Linked Notes
A credit-linked note grants its issuer the privilege of lowering the amount of
loan repayments it must make if some significant factor changes.
Suppose a finance company borrows through a bond issue to support a
group of real estate loans it intends to make and agrees to pay the investors
buying these bonds a 10 percent annual coupon payment (e.g., $100 a year
for each $1,000 par-value bond).
The credit-linked note agreement carries the stipulation that if defaults on
the loans made with the borrowed funds rise significantly (perhaps above 7
percent of all the loans outstanding), then the note-issuing lender will only
have to pay a 7 percent coupon rate (e.g., $70 a year per $1,000 bond).
The lender has taken on credit-related insurance from investors who bought
into its bond issue.
Collateralized Debt Obligations
Pools of high-yield corporate bonds, stock, commercial mortgages, or
other financial instruments contributed by businesses interested in
strengthening their balance sheets and raising new funds.
Notes (claims) of varying grade are sold to investors seeking income
from the pooled assets.
The claims sold are divided into tranches similar to those created for the
securitization of home mortgages, from the most risky tranche offering the
highest potential return to the least risky ("senior") tranche with lowest
expected returns.
synthetic COOs rest on pools of credit derivatives (especially credit
default swaps) that mainly ensure against defaults on corporate bonds.
Creators of synthetic CDOs do not have to buy and pool actual bonds, but can create
synthetic instruments and generate revenues from selling and trading them
Risks Associated with Credit Derivatives
A partner to each swap or option may fail to perform, in which
case a new swap partner has to be found to hedge its credit
risk exposure.
Credit risk agreements are not legal or are improperly drawn
and parties to the derivative contract may lose all or a portion
of its risk protection.
Heavily regulated institutions that employ credit derivatives
today.
These contracts are likely to be more regulated in the future
due to the global recession, although no one knows for sure
how regulators' attitudes toward these instruments might
change with time.
Many unknowns plague this complex risk-management