Chapter Eight
Using Financial Futures, Options,
Swaps, and Other Hedging Tools in
Asset-Liability Management
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved
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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-2
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Purpose of Financial
Futures
To Shift the Risk of Interest Rate
Fluctuations from Risk-Averse
Investors to Speculators
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-3
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
• Euronext.Liffe
(Eurex)
• Sydney Futures
Exchange
• Toronto Futures
Exchange (TFE)
• South African
Futures Exchange
(SAFEX)
8-4
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-5
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Hedging with Futures Contracts
Avoiding Higher
Borrowing Costs
and Declining
Asset Values
Avoiding Lower
Than Expected
Yields from Loans
and Securities
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e


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 8-6
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-7
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-8
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Basis
Cash-Market Price (or Interest Rate)
Less the Futures-Market Price (or
Interest Rate)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-9
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-10
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Change in the Market Value of
the Futures Contract
i
Ft  F0  -D  F0  N 
(1  i)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-11
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Number of Futures Contracts
Needed
TL
(D A - D L *
) * TA
TA

D F * Price of the Futures Contract
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-12
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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.
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-13
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-14
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Most Common Option Contracts
Used By Banks
• U.S. Treasury Bond Futures Options
• Eurodollar Futures Option
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-15
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Principal Uses of Option
Contracts
• Protection of a Security Portfolio
• Hedging Against Positive or
Negative Gap Positions
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-16
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-17
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Regulations For Options and
Future Contracts
• OCC – Risk Management of Financial
Derivatives: Comptrollers Handbook
• FASB – Statement 133 – Accounting for
Derivatives Instruments and Hedging
Activities
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-18
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Interest Rate Swap
A Contract Between Two Parties to
Exchange Interest Payments in an
Effort to Save Money and Hedge
Against Interest-Rate Risk
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-19
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-20
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Risks of Interest Rate Swaps
• Substantial Brokerage Fees
• Credit Risk
• Basis Risk
• Interest Rate Risk
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-21
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-22
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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.
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-23
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-24
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Interest Rate Floor
A Contract Setting the Lowest
Interest Rate a Borrower is Allowed
to Pay on a Flexible-Rate Loan
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-25
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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.
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
8-26
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.