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
• Short and Long Hedges
• Interest-Rate Options
• Interest-Rate Swaps
• Caps, Floors, and Collars

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Uses of Derivative Contracts Among FDIC-Insured Banks
• Due to their high exposure to various forms of risk, banks are among the heaviest
users of derivative contracts

• These risk-hedging instruments allow a bank to protect its balance sheet and/or
income statement in case interest rates, currency prices, or other financial variables
move against the hedger

• Approximately 15 percent of all banks operating in the United States employ the use
of derivatives to eliminate risk

• Derivatives used to hedge interest-rate risk, currency risk, credit risk, etc.

• Types of derivatives used are swaps, futures/forwards, and options

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 Financial Futures Contracts
• A financial futures contract is an agreement reached today between a buyer and
a seller that calls for delivery of a specific security in exchange for cash at
some future date

• Financial futures trade in futures markets and are usually accounted for as off-
balance-sheet items on the financial statements of banks

• In cash markets, buyers and sellers exchange the financial asset for cash at the
time the price is set

• In futures markets, buyers and sellers exchange a contract calling for delivery
of the underlying financial asset at a specified date in the future

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 Financial Futures Contracts
• When the contract is created, neither buyer nor seller is making a purchase
or sale at that point in time, only an agreement for the future

• When an investor buys or sells futures contracts at a designated price, it

must deposit an initial margin (called investor’s equity position)

• Each trader’s account is marked-to-market

▫ At the end of first day, the settlement price is compared with the price of
contract: if the price has increased the buyer has profited while the seller has
lost an equal amount
▫ When a trader’s equity position falls below the maintenance margin (the
minimum specified by the exchange) the trader must deposit additional funds to
the equity account to maintain his or her position, or the position is closed out
within 24 hours
▫ This mark-to-market process takes place at the end of each trading day
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 Financial Futures Contracts
• Buyers of futures contracts
▫ A buyer of a futures contract is said to be long futures
▫ Agrees to pay the underlying futures price and take delivery of the
underlying asset
▫ Buyers gain when futures prices rise and lose when futures prices fall

• Sellers of futures contracts

▫ A seller of a futures contract is said to be short futures
▫ Agrees to receive the underlying futures price and to deliver the
underlying asset
▫ Sellers gain when futures prices fall and lose when futures prices rise

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 Financial Futures Contracts
• 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 the price sold for (at the beginning)

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 Financial Futures Contracts
• 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 purchase price (at the
beginning) and the price sold for (at the end)

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 How to Employ Futures Contracts in Banking
• The three most typical interest-rate hedging problems financial
firms face are
1. Protecting the value of securities and fixed-rate loans from losses due
to rising interest rates (price risk)
2. Avoiding a rise in borrowing costs (price risk)
3. Avoiding investing funds in lower-yielding earning assets
(reinvestment risk)
• Where the 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
• If the bank faces a negative interest-sensitive gap, it can avoid
unacceptable losses from rising market interest rates by covering
with a short hedge
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How to Employ Futures Contracts in Banking
• Short on Futures
▫ If interest rates are expected to rise then price of bonds will fall,
and borrowing costs will rise

▫ The hedge position would be to sell futures contracts.

• Long on Futures
▫ A bank may still worry about a decrease in interest rates if
receiving some cash inflows in the near future.

▫ A decrease in the interest rates would mean that the cash inflows
will be invested at a lower rate

▫ The hedge position would be to buy futures contracts.

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 How to Employ Futures Contracts in Banking
• Avoiding: 1)Higher Borrowing Costs, or 2)Declining
Asset Values because of a rise in interest rates
• Use a Short Hedge: Sell Futures Contracts and then
cancel with a subsequent purchase of similar futures
contracts

• Avoiding: Lower Than Expected Yields from Loans and

Securities because of a decline in interest rates
• Use a long Hedge: Buy Futures Contracts then cancel
with a subsequent sale of similar futures contracts

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Hedging
• Positive IS GAP will lose any time interest rates will decline.
Therefore the bank should hedge against a decline in interest
rates by covering the gap with a long hedge of approximately
the same dollar amount as the gap.

• Negative IS GAP will lose any time interest rates will

increase. Therefore the bank should hedge against a rise in
interest rates by covering the gap with short hedge of
approximately the same dollar amount as the gap.

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 Short Futures Hedge Process
• Today – You start by owning bonds and fear that an increase in interest rates will
lower the value of the bonds.
• Today- Contract is Sold Through an Exchange. The bank has an obligation to
deliver bonds in six months.
• Six months later – Contract is Purchased Through the Same Exchange.
• Now the bank has the original bonds, a sold contract and a bought contract.

• Results – The Two Contracts Are Cancelled Out by the Futures Clearinghouse;
but a gain or loss may result because of differences in the price.
• If interest rates rise, you lose on your bonds that you own originally.
• This loss is partially offset by the gain on the futures contract.
• The bank sells when the interest rate is low (price is high) and buys when the
interest rate is high (and price is low).

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 Long Futures Hedge Process
• Today – You fear that a lower interest rate will lower the yield on the loaned
money
• Today- Contract is Bought Through an Exchange. The bank has an obligation
to take delivery of bonds in six months.
• Six months later – Contract is Sold Through the Same Exchange.
• Results – The Two Contracts Are Cancelled Out by the Futures
Clearinghouse; but a gain or loss may result because of differences in the
price.
• If interest rates decline, then security prices will rise. Then the bank should be
able to sell the contracts at a Higher price than what they paid for them six
month earlier.
• The resulting gain will partially offset some of the loss in revenue due to
lower interest rates on loans.

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 Financial Futures Contracts:
• Sensitivity of the market price of a futures contract
• The sensitivity of the market price of a financial futures contract is a
function of underlying assets and interest rates

i
(Ft  F0 ) / F0  -D 
(1  i)
i
Ft  F0  -D  F0  N 
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Number of Futures Contracts Needed
• A bank needs to buy enough futures contract such
that the change in the Net worth of the bank is equal
to the change in the market value of the futures
contract.

TL
(D A - D L * ) * TA
 TA
D F * Price of the Futures Contract

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 Interest-Rate Options
• Interest-rate options grant the right to deliver or take delivery, but
not the obligation
• The option buyer can exercise the option, sell the option to another
buyer, or allow the option to expire
• The buyer of a call (put) futures option has the right to take a long
(short) position in the future market at the exercise price any time
prior to expiration date
• Options on futures can be used to hedge interest rate risk
▫ If interest rates are to increase (bond price to decline) buyer of put (call)
will (not) exercise
▫ If interest rates are to decrease (bond price to decline) buyer of call
(put) will (not) exercise

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 Interest-Rate Options (continued)
• Most common option contracts used by banks

▫ U.S. Treasury Bond Futures Options

▫ Grant the options buyer the right to a short position (put) or a long
position (call) involving one T-bond futures contract for each option

▫ Eurodollar Futures Options

▫ Give the buyer the right to deliver (put) or accept delivery (call) of one
Eurodollar deposit futures contract for every option exercised

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An example on Call options on Futures
• Say there is a bank that is expecting CF and is fearing a DROP in
interest rates (because that means that the bank will have to buy bonds
at higher price and earn lower return).
• The bank may buy the option on a futures contract to buy the bonds at
the exercise price.
• If interest rates do fall and prices increase above the exercise price then
the bank will use the option.
• Its profit will be market price – strike price – option premium.
• This profit will partially offset any loss interest rates on the bonds in
the cash markets if interest rates fall.
• If interest rates do not fall, but actually increase then the option will go
un-exercised. The bank’s loss will be equal to the premium. This loss
will be offset by the CF that will be invested at the higher interest
rates.

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 EXHIBIT 8–5 Payoff Diagrams for Put and Call Options
Purchased by a Financial Institution

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 EXHIBIT 8–6 Payoff Diagrams for Put and Call
Options Written by a Financial Firm

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 Interest-Rate Swaps
• An interest-rate swap is a way to change a borrowing institution’s
exposure to interest-rate fluctuations and achieve lower borrowing
costs
• Swap participants can convert from fixed to floating interest rates or
from floating to fixed interest rates and more closely match the
maturities of their liabilities to the maturities of their assets
▫ The most popular short-term, floating rates used in interest rate swaps
today include the London Interbank Offered Rate (LIBOR) on
Eurodollar deposits, Treasury bill and bond rates, the prime bank rate,
the Federal funds rate, and interest rates on CDs issued by depository
institutions

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 Caps, Floors, and Collars (Other Tools)
• Interest-Rate Caps

▫ It protects its holder against rising interest rates

▫ Borrowers pay premium and in return are assured that

institution lending them money cannot increase their loan
rate above the level of cap

Reimburse Amount = (Market i – Cap Rate) * Amount Borrowed

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 Caps, Floors, and Collars (Other Tools)
• Interest-Rate Floors

▫ It guarantees some minimum rate of return

▫ It protects a bank losing earnings following falling in

interest rates

Reimburse Amount = (Floor Rate - Market i) * Amount Borrowed

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 Caps, Floors, and Collars (Other Tools)
• Interest-Rate Collars

▫ It 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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 Quick Quiz
• What are financial futures contracts?

• What futures transactions would most likely be used in a period

of rising interest rates? Falling interest rates?

• Explain what is involved in a put option. What is a call option?

• What is the purpose of an interest-rate swap?

• How can financial-service providers make use of interest-rate

caps, floors, and collars to generate revenue and help manage
interest rate risk?
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