Measuring%20and%20Managing%20Interest%20Rate%20Risk

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Measuring and Managing Interest Rate Risk

• Week 9 October 19, 2005

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Interest rate risk

• Future interest rates will affect value of all
  assets and liabilities, both real and financial
  assets and financial liabilities
• No one knows future interest rates
• Predictions of econometric models and the Lucas
  critique
• Supply and demand factors (e.g. bond calendar)
  reflect expectations used in planning
• Rational expectations and market rates

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Interest Rate Risk

• Interest rates change constantly
• Each element of rates change real rate,
  inflation premium, term premium, and risk premium
• Market participants have varying degrees of
  sensitivity to changes in components of rates
• One way to view interest-rate risk is in terms of
  balance sheet risk

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Balance Sheet Risk
Assets Liabilities and Equity
Real Assets Inventories Equipment Plant
Land Financial Assets Receivables Money Bonds
Stock
Financial Liabilities Payables Short-term
notes Mortgages Bonds Preferred stock Common
Stock
Increasing duration
Increasing duration
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Hedging Balance Sheet Risk

• Hedging on balance sheet
• Matching duration of assets and liabilities
• Changing duration of assets and/or liabilities
  through swaps
• Floating rate securities with short re-pricing
  intervals have short durations
• Hedging off balance sheet
• Futures, forward contracts, and options

Weighted average asset duration Weighted
average liability duration
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Swaps

• Exchange of future cash flows based on movement
  of some asset or price
• Interest rates
• Exchange rates
• Commodity prices or other contingencies
• Swaps are all over-the-counter contracts
• Two contracting entities are called
  counter-parties
• Financial institution can take both sides

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Swap example
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Interest Rate SwapPlain vanilla, LIBOR_at_5.5
1/2 5 fixed
Company A (receive floating)
Company B (receive fixed)
2.5mm
2.75mm
1/2 6-month LIBOR
Notional Amount 100 mm
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Definition of Derivatives

• Derivatives are contracts
• Commit parties to certain actions/payments in the
  future
• The payment/action depends on outcomes of
  pre-specified events in the future
• In most cases, the major cash flow or costly
  action will or may occur in the future, not in
  the present
• Contracts can be standardized or negotiated

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Types of Derivative Contracts

• Three basic types of contracts
• Futures or forwards
• Options
• Swaps
• Many basic underlying assets
• Commodities
• Currencies
• Financial assets like fixed incomes or residual
  claims

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Derivatives Value Derived from Prices of Other
Assets

• Stock market or equity price, commodity price,
  exchange and interest rate derivatives
• Swaps, forwards and futures, options, and
  swap-options (or swaptions)
• Traded and over-the-counter derivatives
• Derivative are a zero-sum game
• Credit risk in derivatives is performance risk,
  not notional value risk

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Exposure to Risk

• A general term to describe a firms exposure to a
  particular risk (e.g. a commodity price) is to
  classify the exposure as long or short
• Long exposure means that the firm will benefit
  from increases in prices or values
• Short exposure means that the firm will benefit
  from decreases in prices or values

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Long Exposure

• A firm (or individual) is long if at the time of
  the risk assessment if it has or will have an
  asset or commodity. As examples
• The firm owns assets, as in inventories of raw
  materials or finished goods
• The firm produces a commodity or product, as in
  an agribusiness raising wheat or livestock
• The firm will take possession in the future or a
  commodity or an asset
• The firm has bought a commodity or asset

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Short Exposure

• A firm (or individual) is short if at the time of
  the risk assessment if it needs or will need an
  asset or commodity. As examples
• The firm is planning or has promised to deliver
  raw materials or finished goods
• The firm uses a commodity or product in
  production as inputs, like steel or lumber
• The firm will have possession in the future or a
  commodity or an asset it does not need or needs
  to sell
• The firm has sold a commodity or asset and must
  deliver

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Exposure to Risks
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Examples of Exposure

• Farmer with wheat is long wheat
• Honey Baked Ham is short pork before Easter
  selling season
• Treasurer with excess cash in three months is
  short investments
• Company needing cash in nine months is long
  financial assets (its liabilities are others
  assets) to sell

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Price Exposure in a Diagram
Profit
Profit
Long
0
0
P0
P0
Loss
Loss
Short
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Futures Contracts

• Wall Street Journal tables
• Standardized contracts
• Quantity and quality
• Delivery date
• Last trading date
• Deliverables
• Clearing house is counter-party
• Margin requirements, mark to market

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Forward vs. Futures Contracts

• Bilateral contract (usually with a financial firm
  as counter-party)
• Terms are tailor made to needs of client, not
  standardized
• No exchange of cash until maturity of contract
• Over-the-counter market not as liquid as
  organized exchange

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Managing Risk with Futures

• Offset price or interest rate risk with contract
  which moves in opposite direction
• Cross diagonally in the box
• Identify contract with price or interest rate
  which moves as close as possible with the price
  or interest rate exposure
• Imperfect correlation is basis risk
• Not using futures or forwards can be speculation

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Hedging
Corporation Planning to Borrow
Honey-Baked Hedge
Borrowing Hedge
Honey-Baked Plan Now
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Options (Definition)

• An option is the right (not the obligation) to
  buy or sell an asset at a fixed price before a
  given date
• call is right to buy, put is right to sell
• strike or exercise price is a fixed price which
  determines conversion value
• expiration date
• Options on stocks, commodities, real estate, and
  future contracts

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Interpreting Option Quotationsin the Wall Street
Journal

• Listed option quotations versus
  over-the-counter options
• Stock versus commodity
• Futures options versus asset options
• Strike/Expiration of Call/Put
• Volume, last, and open interest
• LEAPs and index options

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Call Options Profits at Maturity
Profit
Payoff to Buyer
0
Asset Value
Strike Price
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Call Writers (Sellers) Profits
Profit
Strike Price
Asset Value
0
Possible Cost to Writer
Loss
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Option Value Sensitivityto Price Changes in
Assets
Buy Call
Buy Put
S
S
Write Call
Write Put
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Option Values

• Conversion value asset value - strike price
• Option premium Option value - conversion value
• Factors determining option premiums
• Time to maturity
• Asset value
• Strike price
• Volatility
• Interest rate

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Value of Call Options
Profit
Option Premium
0
Asset Value
Strike Price
In the Money
Out of the Money
At the Money
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Caps, floors, and collars

• If a borrower has a loan commitment with a cap
  (maximum rate), this is the same as a put option
  on a note
• If at the same time, a borrower commits to pay a
  floor or minimum rate, this is the same as
  writing a call
• A collar is a cap and a floor

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Collars Cap 6, floor 4

• Profit

0
9400
9500
9600
Loss
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Replication Futures with Options
Profit
Profit
Buy Call
Long
0
0
P0
P0
Loss
Loss
Write Put
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Other option developments

• Credit risk options
• Casualty risk options
• Requirements for developing an option
• Interest
• Calculable payoffs
• Enforceable

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Next week Oct. 26, 2005

• Provide me with one-page description of group
  project, including (1) problem to be addressed,
  (2) analytical framework to be used, and (3) data
  analysis and sources to be employed to address
  problem in (1)
• Read Chapters 10 and 11 and review contents of
  Instruments of the Money Market