Microhedging Applications

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Microhedging Applications

• Microhedge
• The hedging of a transaction associated with a
  specific asset, liability or commitment
• Macrohedge
• Taking futures positions to reduce aggregate
  portfolio interest rate risk

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Microhedging Applications

• Banks are generally restricted in their use of
  financial futures for hedging purposes
• Banks must recognize futures on a micro basis by
  linking each futures transaction with a specific
  cash instrument or commitment
• Many analysts feel that such micro linkages force
  microhedges that may potentially increase a
  firms total risk because these hedges ignore all
  other portfolio components

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The Mechanics of Applying a Microhedge

• Determine the banks interest rate position
• Forecast the dollar flows or value expected in
  cash market transactions
• Choose the appropriate futures contract

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The Mechanics of Applying a Microhedge

• Determine the correct number of futures contracts
• Where
• NF number of futures contracts
• A Dollar value of cash flow to be hedged
• F Face value of futures contract
• Dc Maturity or duration of anticipated cash
  asset or liability
• Df Maturity or duration of futures contract

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The Mechanics of Applying a Microhedge

• Determine the Appropriate Time Frame for the
  Hedge
• Monitor Hedge Performance

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How do we get b?

• In the regression method, we regresss price
  changes in the cash market on price changes in
  the futures market. The relative volatility
  measure (b) that we use is the beta coefficient
  estimated from the simple linear regression model

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Example

• A bank has assets with a duration of 2 years and
  has total assets of 100 million. They want to
  hedge their assets using a futures contract with
  a duration of .5 years and a face value of
  100,000 to hedge. The bank anticipates that the
  volatility of the assets relative to the futures
  will be identical. The number of contracts that
  are needed is

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Macrohedging

• Hedging GAP or Earnings Sensitivity
• If GAP is positive (negative), the bank is asset
  (liability) sensitive and its net interest income
  rises (falls) when interest rates rise (falls)
  and falls (rises) when interest rates fall (rise)
• Positive GAP
• Use a long hedge
• Negative GAP
• Use a short hedge

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Hedging GAP or Earnings Sensitivity

• Positive GAP
• Use a long hedge
• If rates rise, the banks higher net interest
  income will be offset by losses on the futures
  position
• If rates fall, the banks lower net interest
  income will be offset by gains on the futures
  position

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Hedging GAP or Earnings Sensitivity

• Negative GAP
• Use a short hedge
• If rates rise, the banks lower net interest
  income will be offset by gains on the futures
  position
• If rates fall, the banks higher net interest
  income will be offset by losses on the futures
  position

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Hedging Duration GAP and EVE Sensitivity

• To eliminate interest rate risk, a bank could
  structure its portfolio so that its duration gap
  equals zero

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Macrohedge Ratio
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Example

• Suppose a bank has an asset duration of 5 years
  and a liability duration of 2.5 years. This bank
  has 1000 million in assets and 750 million in
  liabilities. They are planning on trading in a
  Treasury bond future which has a duration of 8.5
  years and which is selling right now for 99,000
  for a 100,000 contract. How many futures
  contracts does this bank need to fully hedge
  itself against interest rate risk?

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Accounting Requirements and Tax Implications

• Regulators generally limit a banks use of
  futures for hedging purposes
• If a bank has a dealer operation, it can use
  futures as part of its trading activities
• In such accounts, gains and losses on these
  futures must be marked-to-market, thereby
  affecting current income
• Microhedging
• To qualify as a hedge, a bank must show that a
  cash transaction exposes it to interest rate
  risk, a futures contract must lower the banks
  risk exposure, and the bank must designate the
  contract as a hedge