Chapter Eight
Risk Management: Financial Futures, Options,
Swaps, and Other Hedging Tools
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Key Topics
• The Use of Derivatives
• Financial Futures Contracts: Purpose and
Mechanics
• Short and Long Hedges
• Interest-Rate Options: Types of Contracts
and Mechanics
• Interest-Rate Swaps
• Regulations and Accounting Rules
• Caps, Floors, and Collars
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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
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Managing Interest Rate Risk
• Derivatives Used to Manage Interest Rate
Risk
▫ Financial Futures Contracts
▫ Forward Rate Agreements
▫ Interest Rate Swaps
▫ Options on Interest Rates
 Interest Rate Caps
 Interest Rate Floors
 Interest Rate Collars
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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
• Futures Markets
▫ The Organized Exchanges Where Futures
Contracts are traded
• Interest Rate Futures
▫ Where the Underlying Asset is an InterestBearing Security
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Financial Futures Contracts
IS Gap = IS Assets – IS Liabilities
and
D  DA
TL
- DL *
TA
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
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Background on Financial Futures
• Buyers
▫ A buyer of a futures contract is said to be
long futures
▫ Agrees to pay the underlying futures price
or take delivery of the underlying asset
▫ Buyers gain when futures prices rise and
lose when futures prices fall
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Background on Financial Futures
• Sellers
▫ A seller of a futures contract is said to be
short futures
▫ Agrees to receive the underlying futures
price or to deliver the underlying asset
▫ Sellers gain when futures prices fall and
lose when futures prices rise
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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 (CBT)
• Chicago Board
Options Exchange
• Singapore Exchange
LTD. (SGX)
• Chicago Mercantile
Exchange (CME)
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• Euronext.Liffe
(Eurex)
• Sydney Futures
Exchange
• Toronto Futures
Exchange (TFE)
• South African
Futures Exchange
(SAFEX)
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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
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Most Common Financial Futures
Contracts
• U.S. Treasury Bond Futures Contracts
• Three-Month Eurodollar Time Deposit
Futures Contract
• 30-Day Federal Funds Futures Contracts
• One Month LIBOR Futures Contracts
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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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Short Futures Hedge Process
• Today – Contract is Sold Through an
Exchange
• Sometime in the Future – Contract is
Purchased Through the Same Exchange
• 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)
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Long Futures Hedge Process
• Today – Contract is Purchased Through an
Exchange
• Sometime in the Future – Contract is sold
Through the Same Exchange
• Results – The Two Contracts are Cancelled
by the Clearinghouse
• Gain or Loss is the Difference in the Price
Purchase For (At the Beginning) and the
Price Sold For (At the End)
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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
▫ For financial futures, the basis can be calculated as
the futures rate minus the spot rate
▫ It may be positive or negative, depending on whether
futures rates are above or below spot rates
▫ May swing widely in value far in advance of contract
expiration
Basis=Cash-market price (or interest rate) –
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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Change in the Market Value of the
Futures Contract
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Change in the Market Value of the
Futures Contract
i
Ft  F0  -D  F0  N 
(1  i)
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Number of Futures Contracts
Needed
TL
(DA - D L *
)*T A
TA

D F * P riceof t heFut ures Cont ract
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Quick Quiz
• What are financial futures contracts? Which
financial institutions use futures and other
derivatives for risk management?
• How can financial futures help financial
service firms deal with interest rate risk?
• What futures transactions would most likely
be used in a period of rising interest rates?
Falling interest rates?
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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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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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Most Common Option Contracts
Used By Banks
• U.S. Treasury Bond Futures Options
• Eurodollar Futures Option
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Principal Uses of Option Contracts
• 1. Protecting a security portfolio through the use of put
options to insulate against falling security prices (rising
interest rates); however, there is no delivery obligation
under an option contract so the user can benefit from
keeping his or her securities if interest rates fall and
security prices rise
• 2. Hedging against positive or negative gaps between
interest-sensitive assets and interest- sensitive
liabilities; for example, put options can be used to
offset losses from a negative gap when interest rates
rise, while call options can be used to offset a positive
gap when interest rates fall.
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Speculation vs. Hedging
• With financial futures, risk often cannot be
eliminated, only reduced.
▫ Traders normally assume basis risk in that
the basis might change adversely between
the time the hedge is initiated and closed
• Perfect Hedge
▫ The gains (losses) from the futures position
perfectly offset the losses (gains) on the spot
position at each price
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Federal Funds Options and Futures
• Represents the Consensus Opinion Of the
Likely Future Course of Market Interest
Rates
• Public Trading for Futures Contract Began
at the CBOT in 1988
• Public Trading on Options Contracts Began
in 2003
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Regulations For Options and Future
Contracts
• OCC – Risk Management of Financial
Derivatives: Comptrollers Handbook
• FASB – Statement 133 – Accounting for
Derivatives Instruments and Hedging
Activities
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Interest Rate Swap
A Contract Between Two Parties to
Exchange Interest Payments in an
Effort to Save Money and Hedge
Against Interest-Rate Risk
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Interest –Rate Swap
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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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Further…
• Firms with a negative GAP can reduce risk
by making a fixed-rate interest payment in
exchange for a floating-rate interest receipt
• Firms with a positive GAP take the opposite
position, by making floating-interest
payments in exchange for a fixed-rate
receipt
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Risks of Interest Rate Swaps
• Substantial Brokerage Fees
• Credit Risk
▫ The counterparty may default on the exchange of
the interest payments
▫ Only the interest payment exchange is at risk,
not the principal
• Basis Risk
▫ A swap’s reference interest rates are not the
same as those attached to all the assets and
liabilities (LIBOR, bond rates, etc.), so rates do
not change exactly the same -> some risk
remains
• Interest Rate Risk
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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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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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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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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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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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Quick Quiz
• Explain what is involved in a put option?
• What is a call option?
• Suppose market interest rates were
expected to rise. What type of option would
normally be used?
• If rates were expected to fall, what type of
option would a financial institution’s
manager be likely to employ?
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