BNFN 501 ASSET AND LIABILITY MANAGEMENT

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BNFN 501ASSET AND LIABILITY MANAGEMENT

• WEEK 6 7
• FINANCIAL FUTURES
• OPTIONS, SWAPS AND OTHER ASSET LIABILITY
  MANAGEMENT TECHNIQUES
• ROSE (1999), CHAPTER 8

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• The Purpose of This Chapter
• Banks asset liability managers are especially
  concerned about stabilizing their margin the
  spread between their institutions interest
  revenues and interest expenses , and about
  protecting a banks net worth the value of the
  stockholders investment in the bank. This
  chapter explores several of the most widely used
  tools for dealing with bank exposure to interest
  rate risk, including financial futures and option
  contracts, interest rate swaps, loan options and
  interest rate insurance.

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Interest-Sensitive Gap / Duration Gap

• Interest-sensitive interest-sensitive
  interest sensitive
• gap assets liabilities
• average average
• Duration gap (dollar-weighted) -
  (dollar-weighted)
• duration of assets duration of
  liabilities
• x Total liabilities
• Total assets

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Interest-Sensitive Gap / Duration Gap

• If a bank is asset sensitive, it will suffer a
  decline in its net interest margin if market
  interest rates fall.
• If a bank is liability sensitive, it will
  experience a decrease in its net interest margin
  when interest rates rise.
• If a bank has positive duration gap, it will
  suffer a decline in its net worth if the market
  interest rates rise.
• If a bank has a negative duration gap, it will
  suffer a decline in its net worth if the market
  interest rates fall.

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FINANCIAL FUTURES CONTRACTSPromises of Future
Security Trades at a Set Price

• One of the most popular methods of neutralizing
  these gap risks is to buy and sell financial
  futures contracts.
• Nature of financial Futures
• A financial futures contract is an agreement
  between a buyer and a seller reached today that
  calls for the delivery of a particular security
  in exchange for cash at some future date.

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• Purpose of Financial Futures Trading
• The financial futures markets are designed to
  shift the risk of interest rate fluctuations from
  risk-averse investors, such as commercial banks,
  to speculators willing to accept and possibly
  profit from such risk.
• Futures contracts are traded on organized
  exchanges, such as the Chicago Board of Trade,
  the Chicago Mercantile Exchange, or the London
  Futures Exchange).

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• When a bank contacts an exchange broker and
  offers to sell futures contracts, we call this
  the bank wishes to go short in futures.
• When a bank enter the futures markets as a buyer
  of futures contracts we call this the bank
  wishes to go long in futures.

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• The most popular financial futures contracts
  traded by banks today include the following
• 1.The US Treasury bond futures contract
• 100,000 denomination bond, minimum maturity 15
  years, coupon rate 8 , future contracts are
  extend up to two years and it is deliverable 4
  times a year,March, June, September, December.
• 2.The US Treasury bill futures contracts
• 90 day, 1 million denomination T-bills,
  contracts mature in March, June, September, and
  December.

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• 3.The three-month Eurodollar time deposits
• Traded in million units. Prices of these
  contracts are quoted as an index equal to 100
  minus the current LIBOR rate on short-term
  deposits.
• 4.The 30-day Federal Funds futures contracts
• Traded in units of 5 million with an index
  price equal to 100 less the prevailing Federal
  funds interest rate.
• 5.The one-month LIBOR futures contract
• Traded in 3 million units and quoted as an
  index price of 100 less the one-month Eurodollar
  time deposit interest rate.

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• A futures hedge against interest rate changes
  generally requires a bank to take an opposite
  position in the futures market from its current
  position in the cash (immediate delivery)
  market.
• Thus, a bank 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. Then if bond prices fall
  in the cash market there will be an offsetting
  profit in the futures market, minimizing the loss
  due to changing interest rates.

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• The Short Hedge in Futures
• Suppose interest rates are expected to rise,
  increasing the cost of deposits or the cost of a
  banks borrowings in the money market and
  lowering the value of any bonds or fixed rate
  loans that the bank holds or expects to buy. In
  this instance a short hedge in financial futures
  can be used. The bank will sell contracts, and a
  like amount of futures contracts will be
  purchased on a futures exchange.
• If market interest rates have risen
  significantly, the interest cost of bank
  borrowings will increase and the value of any
  fixed rate loans and securities held by the bank
  will decline. However, those losses will be
  approximately offset by a price gain on the
  futures contracts.

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• The Long Hedge in Futures
• There are times when a bank wishes to hedge
  itself against falling interest rates. Falling
  interest rates sounds favorable from a cost of
  funds point of view, but it is not favorable for
  the future growth of bank revenues. If management
  takes no action and the forecast turns out to be
  true, the bank will suffer an opportunity loss
  (i.e. reduced potential earnings) because
  expected deposits will have to be invested in
  loans and securities bearing lower yields.
• .

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The Long Hedge in Futures (Cont.)

• 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

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• Using Long and Short Hedges to Protect Bank
  Income and Value
• The three most typical interest rate hedging
  problems faced by banks are
• protecting the value of their securities and
  fixed rate loans from losses due to rising
  interest rates
• avoiding a rise in bank borrowing costs
• avoiding a fall in the interest rates expected
  from bank loans and security holdings

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• Appropriate hedging strategies using financial
  futures
• Avoiding higher
• borrowing cost
• and declining
• asset values

Use a short (or selling) hedge sell futures and
then cancel with a subsequent purchase of similar
futures contracts
Use a long (or buying) hedge buy futures and
then cancel with a subsequent sale of similar
contracts
Avoiding lower than expected yields from loans
and security investments
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• Where bank faces a positive
  interest-sensitive gap, it can protect against
  loss due to falling interest rates by covering
  the gap with a long hedge (buy and then sell
  futures) of the same dollar amount as the gap.
• Where the bank faces negative interest
  sensitive gap, it can avoid unacceptable losses
  from rising interest rates by covering with a
  short hedge (sell and then buy futures)
  approximately matching the amount of the gap.

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Basis Risk

• There are some significant limitations to
  financial futures as interest rate hedging
  devices, among them a special form of risk known
  as basis risk.
• Basis is the difference in interest rates or
  prices between the cash (immediate delivery)
  market and the futures (postponed-delivery)
  market.
• Basis Cash market price (or interest rate)
• - Futures market price (or interest rate)
• when both are measured at the same moment in time.

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• Example Suppose 10-year US 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.
• Then the current basis 95-87 8 per contract
• If the basis changes between the opening and
  closing of a futures position, the result can be
  a loss.

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• Example
• A futures contract calling for delivery of
  Treasury bills in 90 days is currently selling at
  an interest yield of 4, while yields on Treasury
  bills available for immediate delivery currently
  stand at 4.60 . What is the basis for the T-bill
  futures contracts?
• The basis for these bill contract is currently
• 4.60 - 4 60 basis points

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return earned in the cash
market
Realized return to a bank from a combined cash
and futures market trading operation
profit or loss from futures trading


_
Closing basis between the cash and futures
markets
Opening basis between the cash and futures
markets
_
_
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• The sensitivity of the market price of a
  financial futures contract depends, in part, upon
  the duration of the security to be delivered
  under the futures contract.
• ?P ?r
• - D x
• P 1 r
• positive or negative ?r
• change in
• futures contract -D x P x
• value 1 r
• The negative sign in the above equation shows
  that when interest rates rise the market value
  (price) of futures contracts must fall.

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• Example
• 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 .
  If the T-bond has a duration of 9 years , then
  the change in the value of the T-bond futures
  contracts would be
• Change in 0.01
• market value of -9 x 99,700 x
• futures contracts (1 0.07)
• -8,385.98

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Exhibit 8-1 Payoff Diagrams for Financial
Futures Contracts

• Profit Profit

.
area of profit
area of profit
F0
0
0
F0
Fn
Ft
Loss
Loss
The long hedge in financial futures Buy futures
in expectation of falling interest rates then
sell comparable contracts
The short hedge in financial futures sell
futures in expectation of rising interest rates ,
then buy comparable contracts
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• Exhibit 8.1- Summary
• The long hedge in financial futures consist of
  first buying futures contracts (at price F0 )
  and then if interest rates fall, selling
  comparable futures contracts (in which case the
  futures price moves toward Ft). The decline in
  interest rates will generate a gross profit of
  Ft F0gt0 .
• The short hedge in futures consists of first
  selling futures contracts (at a price F0) and
  then, if interest rates rise, buying comparable
  futures contracts (whose price may move to Fn).
  The rise in interest rates will generate a net
  profit of F0 Fn gt 0.

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• These profitable trades can be used to help
  offset any losses resulting from a decline in the
  market value of bank assets or a decline in a
  banks net worth, or in its net interest income
  due to adverse changes in market interest rates.

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• Example
• What kind of futures hedge would be appropriate
  in each of the following situations
• A bank fears that rising deposit interest rates
  will result in losses on fixed-rate loans?
• A bank holds a large block of floating-rate loans
  and market interest rates are falling?
• A projected rise in market rates of interest
  threatens the value of the banks bond portfolio?

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• Example Suppose a bank wishes to sell 150
  million in new deposits next month. Interest
  rates today on comparable deposits stand at 8,
  but are expected to rise to 8.25 next month.
• a) Concerned about the possible rise in borrowing
  cost , management wishes to use a futures
  contract. What kind of contract would you
  recommend?
• b) If the bank does not cover the interest rate
  risk involved, how much in lost potential profits
  could the bank experience?
• a) The bank should use a short hedge to avoid
  potential loss.
• 150 million x 0.08 x 30/360 1 million
• 150 million x 0.0825 x 30/360 1.031
  million
• The potential loss is 0.0313 million

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Regulations and Accounting Rules for Bank Futures
Trading

• Federal banking agencies in US require that
  American banks put in writing their guidelines
  for hedging using financial futures, set up
  limits as to the type and volume of futures
  trading, and fully disclose any large positions
  in financial futures that could significantly
  affect each banks risk exposure to its
  stockholders. Under US regulations any gains or
  losses from futures trading must be coincidental
  to the main purpose of this trading, which is to
  hedge against interest rate risk rather than to
  speculate in futures or security prices.

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INTEREST RATE OPTIONS

• It Grants the Holder of the Option the Right to
• 1. Put Place Instruments with Another
  Investor at a Set Price Before the
  Expiration Date
• 2. Call Take Delivery of Instruments from
  Another Investor at a Set Price Before the
  Expiration Date

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Most Common Option Contracts Used By Banks

• U.S. Treasury Bill Futures Option
• Eurodollar Futures Option
• U.S. Treasury Bond Option
• LIBOR Futures Option

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• Put Option (To offset Rising Interest Rates)
• Buyer receives from an option writer the right to
  sell and deliver securities, loans, or futures
  contracts to the writer at an agreed-upon strike
  price up to a specified date in return for paying
  a fee (premium) to the option writer.
• If interest rates rise, the market value of the
  optioned securities, loans or futures contracts
  will fall. This will results in a gain for the
  option buyer, because he can now purchase the
  optioned securities , loans, or contracts at a
  lower market price and deliver them to the option
  writer at the higher strike price. Commissions
  and any resulting tax liability will reduce the
  size of the buyers gain.

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• Example of a Put Option Transaction
• A bank plans to issue 150 million in new 180 day
  interest bearing deposits at the end of the week
  but is concerned that CD rates in the market,
  which now stand at 6.5 (annual yield) will rise
  to 7 .
• An increase in deposit interest rates of this
  magnitude will result in an additional 375,000
  in interest costs on the 150 million in new CDs
  possibly eroding any potential bank profits from
  lending and investing the funds provided by
  issuing the CDs.

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• In order to reduce the potential loss from these
  higher borrowing costs the banks asset-liability
  manager contacts a dealer willing to write a put
  option on Eurodollar deposit futures contracts at
  a strike price of 960.000 (on a 1 million
  contract) for a fee (premium) of 5,000.
• If interest rates rise as predicted, the market
  value of the Eurodollar futures will fall below
  96, perhaps to 94 (or 940,000 on a 1 million
  contract). If the market price of the futures
  contracts drops far enough, the put option will
  be exercised because it is now in the
  moneysince the security named in the put option
  has fallen in value below its strike price. The
  banks asset liability manager can now buy the
  cheaper Eurodollar contracts in the market and
  deliver them at the options higher strike price.

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• Before tax profit on put option transaction
• Before -tax
• profit on put 960,000 940,000 5,000
• 15,000 per contract
• The 15,000 option profit per futures contract
  will at least partially offset the higher
  borrowing cost should interest rates rise.

Before-tax profit on put option
_
_
Options strike price
Security market price
Option premium

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Call Option to Offset Falling Interest Rates

• Buyer receives the right from an option writer to
  buy and take delivery of securities, loans or
  futures contracts from the writer at a mutually
  agreeable strike price on or before a specific
  expiration date in return for paying a premium to
  the writer.
• If interest rates fall, the market value of the
  optioned securities, loans or contracts must
  rise. Exercising the call option gives the buyer
  a gain, because he will acquire securities,
  loans, or contracts whose value exceeds the
  strike price that the buyer must pay. Commissions
  and taxes will reduce the size of the buyers
  gain.

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Example of a Call Option Transaction

• A bank plans to purchase 50 million in treasury
  bonds in a few days and hopes to earn an interest
  return of 8 . The banks investment officer
  fears a drop in market interest rates before she
  is ready to buy, so she asks a security dealer to
  write a call option on Treasury bonds at a strike
  price of 95,000 for each 100,000 bond. The
  investment officer had to pay the dealer a
  premium of 500 to write this call option.

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• If market interest rates fall as predicted, the
  T-bonds market price may climb up to 97,000 per
  100,000 bond, permitting the investment officer
  to demand delivery of the bonds at the cheaper
  price of 95,000. The call option would then be
  in the money because the securities market
  price is above the options strike price of
  95,000.
• Before tax profit on this call option transaction
  is
• security market price strike price option
  premium
• 97,000 - 95,000 - 500 1,500
  per bond
• Projected profit will partially offset any loss
  in interest return experienced on the bonds
  traded in the cash market if interest rates fall.

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How do options differ from financial futures
contracts?

• 1. Unlike futures contracts, options do not
  obligate any party to deliver securities. They
  grant the right to deliver or take delivery, not
  the obligation to do so.
• The option buyer can a) exercise the option,
• b) sell the option to another buyer, c) simply
  allow the option to expire
• 2. Because of the option premium, the fee paid to
  the option writer, options tend to be more
  expensive than financial futures contracts.

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• Banks can both buy and sell (write) options, but
  are usually buyers of puts and calls rather than
  sellers (writers) of these instruments. The
  reason is the much greater risk faced by option
  writers than by option buyers. An option sellers
  potential profit is limited to the premium it
  charges to the buyer, but its potential loss if
  interest rates move against the seller is much
  greater.
• Regulations in US prohibit banks from writing put
  and call options in some high risk areas.

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INTEREST RATE SWAPS

• An interest rate swap is, two borrowers swap
  interest payments. Swaps are often employed to
  deal with asset-liability maturity mismatches.
• This is a way to change an institutions
  exposure to interest rate fluctuations and
  achieve lower borrowing costs. Swap participants
  can convert from fixed to floating rates or from
  floating to fixed rates and more closely match
  the maturities of their assets and liabilities.
• In addition, a bank arranging a swap for its
  customers earns fee income for serving as an
  intermediary and may earn additional fees if it
  agrees to guarantee a swap agreement against
  default.

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• Under the terms of an agreement called a quality
  swap, a borrower with a lower credit rating
  enters into an agreement to exchange interest
  payments with a borrower having a higher credit
  rating . In this case the low-credit-rated
  borrower agrees to pay the high-credit-rated
  borrowers fixed long-term borrowing cost. In
  effect, the low-credit rated borrower receives a
  long-term loan at a much lower interest cost than
  the low-rated borrower could obtain alone.

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• At the same time, the borrower with the higher
  credit rating covers all or a portion of the
  lower-rated borrowers short-term floating loan
  rate, thus converting a fixed long-term into a
  more flexible and possibly cheaper short-term
  interest rate.
• In interest rate swaps, 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.

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• In summary, the high-credit-rated borrower gets a
  long-term fixed-rate loan, but pays a floating
  interest rate to the low-credit-rated borrower,
  in turn the low credit rated borrower gets a
  short term, floating rate loan, but pays a fixed
  interest rate to the high-credit-rated-borrower.

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• Often the lower-rated borrower (such as a savings
  and loan or insurance company) has longer
  duration assets than liabilities, while the
  higher-rated borrower may have longer duration
  liabilities than assets (such as a commercial
  bank). Through the swap agreement each party
  achieves cash outflows in the form of interest
  costs on liabilities that more closely match the
  interest revenues generated by its assets.

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• Reverse Swaps The effects of an existing swap
  contract can be offset with a new swap agreement.
  This is called reverse swap.
• Many swap agreements today contain termination
  options, allowing either party to end the
  agreement for a fee.
• Other swaps carry interest rate ceilings (caps),
  interest rate minimums (floors) or both ceilings
  and floors (collars), which limit the risk of
  large changes in interest rate payments.

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Risks of Interest Rate Swaps

• Substantial Brokerage Fees
• Credit Risk (either parties to a swap may go
  bankrupt or fail to honor the swap agreement)
• Basis Risk(as a swaps reference interest rate
  changes, it may not change in exactly the same
  proportion as the interest rates attached to the
  swap buyers and sellers various assets and
  liabilities. Therefore swap can not hedge away
  all interest rate risk for both parties)

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• Interest Rate Risk Swaps can also carry
  substantial interest rate risk. For example, if
  the yield curve slopes upward, the swap buyer
  (who pays the fixed interest rate) normally would
  expect to pay a greater amount of interest cost
  during the early years of a swap contract and to
  receive greater amounts of interest income from
  the swap seller (who pays the floating interest
  rate) toward the end of the swap contract.

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• CAPS, FLOORS AND COLLARS
• Interest Rate Caps 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.

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• Example A bank purchases a cap of 11 from
  another financial institutions on its borrowings
  of 100 million in the Eurodollar market for one
  year. Suppose interest rates in this market rise
  to 12 for the year. Then the institution selling
  the cap will reimburse the bank purchasing the
  cap the additional 1 in interest costs due to
  the recent rise in market interest rates.
• In terms of dollars the bank will receive a
  rebate of
• 12 -11 x 100 million 1 million

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• Interest Rate Floors Banks can also lose
  earnings in periods of falling interest rates,
  especially when rates on floating rate loans
  decline. A bank can insist on establishing an
  interest rate floor under its loans so that, no
  matter how far loan rates tumble, it is
  guaranteed some minimum rate of return.
• Interest Rate Collars Both banks and their
  borrowing customers also make use of the interest
  rate collar, which combines in one agreement a
  rate floor and a rate cap. Many banks sell
  collars as a separate fee-based service for the
  loans they make to their customers.

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• For example, a customer who has just received a
  100 million loan may ask the bank for a collar on
  the loans prime rate between 11 -7.