Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

This chapter provides an overview of the use by commercial banks of derivative financial instrumentsfutures, options, and swapsto hedge their interest rate risk. It begins by explaining the nature of financial futures and contrasts futures with forward transactions. It then gives examples of the uses of futures to hedge a dollar gap position and contrasts a short futures position with a long position in the futures markets. It also discusses how futures can be used to hedge a duration gap. In both cases, it explains the problems and complexities involved in using futures, including their risks. The chapter then turns to a discussion of options, with emphasis on futures options. Characteristics of call and put options on futures contracts are explained as well as the payoff matrix for these positions. The use of call and put options to hedge interest rate risk is treated and comparisons are made with the use of futures for the same purpose. The chapter also discusses caps and floors as one use of options. The chapter concludes with a discussion of interest rate swaps and the potential use of swaps to manage interest rate risk as well as to lower the cost of funds. Outline of the Chapter Financial Futures Using Financial Futures Markets to Manage Interest Rate Risk Nature of Futures Contracts Example of a Futures Transaction Techniques in Using Financial Futures Using Interest Rate Futures to Hedge a Dollar Gap Position Using Interest Rate Futures to Hedge a Duration Gap Steps Involved in Hedging Complications in Using Financial Futures Using the Futures Options Market to Manage Interest Rate Risk Options Characteristics of Options Payoffs For Futures and Futures Options Contracts Hedging with Futures Options Micro and Macro Hedges Caps and Floors Interest Rate Swaps Interest Rate Swaps, the Quality Spread, and the Cost of Funds Swaps and Futures Summary

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

89

Key Terms and Concepts Questions Problems Case Problem: Hedging the Balance Sheet Key Terms and Concepts Basis risk Call option Call premium Cap Derivative securities Exchange clearinghouse Floor

Long position Long/short hedge Margin Marked-to-market Micro/macro hedge Put option Quality spread

Questions 6.1 What are financial futures contracts? What similarities exist among all futures contracts?

ANSWER: A financial futures contract is a standardized agreement to buy or sell a specified quantity of a financial instrument at a set price. All financial futures contracts have certain similarities in that they are standardized and traded on organized exchanges. 6.2 What is meant by a short position in financial futures? A long position? How is each affected by changes in interest rates?

ANSWER: A short position represents the sale of a futures contract. A long position represents the purchase of a futures contract. Since interest rates and the prices of fixed income instruments move inversely, a short position will benefit if interest rates increase but will be harmed by falling interest rates. Conversely, a long position will benefit from falling rates and will be harmed by rising rates. 6.3 Why can buyers and sellers of futures contracts ignore possible default by the other party?

ANSWER: Default risk on futures (but not forward) contracts is minimized by the role of the exchange clearinghouse in all futures contracts. The exchange clearinghouse is, in effect, the counterparty in each transaction. 6.4 What does mark-to-market mean?

ANSWER: Futures contracts are evaluated daily at their market values and gains or losses are added to or subtracted from the margin balance each day. 6.5 Distinguish between a micro hedge and a macro hedge. Are there any inherent conflicts in using both simultaneously in managing interest rate risk?

90

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

ANSWER: A micro hedge refers to a transaction whose goal is to hedge one specific asset or liability or one particular portion of the balance sheet. A macro hedge refers to a transaction whose goal is to hedge the interest rate risk exposure of the entire balance sheet. A degree of conflict exists between the micro hedge and the macro hedge in that management may reduce risk for a specific asset or portion of the balance sheet, but that action may increase the overall risk of the entire balance sheet. 6.6 How would a bank use interest rate futures to hedge a positive dollar gap? A negative dollar gap?

ANSWER: A bank with a positive dollar gap would benefit on-balance-sheet from rising interest rates but would lose from falling interest rates. It would hedge this risk by taking a long or buy position in the financial futures market. Thus, if interest rates increased it would lose in the futures market (but gain in the cash market). If, conversely, the bank has a negative dollar gap it would take a short position in the futures market. 6.7 How would a bank use interest rate futures to hedge a positive duration gap? A negative duration gap?

ANSWER: With a positive duration gap, a bank would experience a decline in the market value of equity if interest rates increased (because the market value of assets would fall more than the market value of liabilities). It could help this exposure by taking a short position in financial futures. With such a position, increases in interest rates would produce gains in the futures market position that could be used to offset the losses in the cash market position. In contrast, a bank with a negative duration gap would hedge with a long position in the futures market. 6.8 What complications exist in using financial futures to hedge a bank portfolio?

ANSWER: The complications include the following: (1) the bank must use the futures markets within the limits prescribed by accounting and regulatory guidelinesmacro hedges are treated unfavorably from an accounting perspective; (2) most hedges exhibit basis risk, which particularly for cross hedges may be very significant; (3) the existing interest rate risk position of the bank may change due to deposit and loan changes outside the control of management, making an existing hedge position inappropriate. 6.9 What is a futures options contract? Compare and contrast a futures options contract with a futures contract.

ANSWER: A futures options contract is an option contract in which the deliverable is a futures contract, such as the Treasury bill futures contract. As with all options contracts, the holder has the right but not the obligation to take delivery (call option) or make delivery (put option). 6.10 Compare and contrast the characteristics and uses of put and call futures options contracts.

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

91

ANSWER: If the bank had a portfolio position where it would be harmed if interest rates increased, it could hedge this position by selling call options on futures or buying put options. If the bank sold a call, and interest rates increased, the potential gain is limited to the call premium. However, if it bought a put, the gain is not limited, as would be the case if the bank were to sell financial futures. In contrast, if interest rates fell and the bank had sold a call option on futures, its potential loss would be unlimited as would be the case if it sold financial futures. The loss on the purchase of a put option, though, is limited to the put premium. 6.11 Explain how futures options contracts can be used to hedge interest rate risk.

ANSWER: As discussed in question 8.10, a bank that would be harmed if interest rates increased could hedge this risk by selling call options on futures or buying put option on futures. In contrast, if the bank was in a position in its portfolio where it would lose if interest rates fell it could hedge by buying a call option on futures or selling a put option. 6.12 What is an interest rate swap? How can it be used to hedge interest rate risk?

ANSWER: A swap is an agreement between two parties to exchange cash flows. Swaps are used to reduce interest rate and currency risk. In an interest rate swap, one party usually pays a fixed amount (based upon notional principal) and receives a floating or variable payment while the other party pays floating and receives fixed. 6.13 Compare a swap with a swaption.

ANSWER: A swaption is an option on a swap. The buyer of a swaption has the right but not the obligation to enter into an interest rate swap at terms specified in the contract. As with any option, the buyer pays a premium to the seller of the swaption. 6.14 Compare the pros and cons of futures, futures options, and swaps as devices to hedge interest rate risk.

ANSWER: The principal advantages of swaps over futures are twofold. First, swaps may be customized to meet the exact needs of the bank. Second, the swap can be established for a longterm arrangement. In contrast, financial futures are standardized contracts that have a limited number of specified delivery dates and deliverable financial instruments. Most important, futures contracts are generally only for delivery dates at three-month intervals that extend only up to 2.5 years in the future. In terms of disadvantages, swaps have counterparty risk while futures and options do not due to the role of the clearinghouse. Swaps may be difficult to unwind while futures and options positions can be executed and terminated at any time. Futures and options are subject to some degree of management discretion and daily oversight which can lead to mistakes of one kind or another while swaps are managed by a financial intermediary charged with a fiduciary responsibility to properly manage the swap payments. Comparisons of swaps with futures options are similar to swaps versus futures, except that option purchases provide the right but not the obligation to take or make delivery, and thus provide a different payoff than futures.

92

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

6.15

What is an interest rate cap? How is it used? Compare it with a floor.

ANSWER: An interest rate cap is a contract that reduces the exposure of a floating rate borrower (e.g., a liability sensitive bank) to increases in interest rates. It is essentially a series of interest rate call options in which the writer guarantees the buyer (i.e., the bank) that the writer will pay the buyer any additional interest cost that results from rising interest rates. In contrast, an interest rate floor is a contract that limits the exposure of the buyer to downward movements in interest rates. An interest rate floor is a series of interest rate put options by which the writer guarantees the buyer (i.e., the bank) that the writer will pay to the bank an amount that increases as the level of interest rates fall. It should be mentioned that the options discussed here are in interest rate terms, which is opposite to their interpretation from a price standpoint (i.e., a call option on the interest rate is equivalent to a put option on the price of the debt security). 6.16 Your bank is liability sensitive. To protect itself against rising interest rates, management purchased 10 caps from a large investment bank firm. Each contract had a notional value of $1,000,000, a strike price (based on three-month Treasury bill rates) of 7% (rate was currently 6%), and a one-year maturity. Over the next year interest rates in Treasury bills fell, reaching 3% at the end of the year, the cap expired without benefit, and the bank lost the full premium of $46,000. Did management err in its decision to purchase the cap?

ANSWER: No, the bank bought insurance against a negative event. The negative event did not occur. 6.17 After reviewing Baker Library's Guide to Hedge Funds at http://www.library.hbs. edu/hedgefunds.htm, write a one page description of hedge funds and their risk management operations. The International Swap Dealers Associations (ISDA) website at http://www.isda.org/ contains the information on futures, options, and swaps. Print out the latest statistics on the volume of these contracts and discuss the derivatives market trends. Go to the Chicago Board of Trades website at http://www.cbot.com/ourproducts/financial/index.html to see the list of financial contracts traded there. Pick one of the products in the list and print out its contract specifications.

6.18

6.19

Problems 6.1 Suppose that an investor holds a $1,000,000 91-day T-bill futures contract. It is market to market on the close of the last day of trading at $95.00. What is the settlement price?

ANSWER: The settlement price is: $1,000,000(91 x 0.05 x $1,000,000)/360 = $987,361.11.

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

93

6.2

Assume that on April 1 your bank plans to issue a 3-month Eurodollar CD in July. On April 1, the bank could issue a 3-month Eurodollar CD for 7.02%. The corresponding rate for the 6-month Eurodollar contract (due in September) was 7.58%. (a) (b) What position should the bank take in the Eurodollar market? Suppose that the bank took a position in Eurodollar futures on April 1 and that it closes out its position in July when the futures rate is 7.82%. In that situation, has the bank achieved its objective with the hedge?

ANSWER (a)

Since rates are expected to rise (and prices fall), the bank should go short in Euro CD futures contracts. Gains on the futures position would offset the higher borrowing rates the bank must pay on 3-month Euro CDs in July. Yes. The higher level of interest rates in July implies that the short position in Euro CDs would have been profitable.

(b)

6.3

Suppose that your bank has a commitment to make a fixed rate loan in three months at the existing rate. In order to hedge against the prospect of rising interest rates, the bank takes a position in the futures options markets. What position should it take? The relevant information is as follows: T-bill futures prices 89 Put option 90 Premium $2500 What will be the net gain to the bank if T-bill futures prices fall to 85? Increase to 93?

ANSWER: If T-bill futures prices fall to 85, the put option could be exercised at 90 for a gain of 5, or $50,000. After paying the premium, the net gain would be $47,500. If T-bill futures prices rise to 93, the put option would not be exercised. The loss would equal the premium paid for the option, or $2,500. 6.4 A bank has a spot market asset duration of 1.0 and a liability side duration of 0.50. It seeks to reduce the duration of the asset side to 0.25 using a short T-bill futures hedging strategy. The present value of cash flows on assets is $4,000. If the selling price of the futures contracts is $98.00, how many T-bill futures contracts are needed to achieve a duration equal to 0.50 for the portfolio containing both spot market assets and futures contracts.

ANSWER: Using equation (8.2) in the text, and following the example in equation (8.3), we have: 0.50 = 1.0 + 0.50(Nf)($98.00)/$4,000, such that Nf = -10 or 10 contracts.

94

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

6.5

Corporation XYZ obtains a ceiling agreement from a bank for a five-year loan of $20 million at a rate of 7% (tied to LIBOR). An upfront fee of 2% is paid by XYZ for the guarantee that rates will not exceed 10%. (a) If LIBOR goes to 12%, calculate the quarterly compensation the bank must pay XYZ. (b) What kind of option is this for the bank? XYZ? When is it in the money?

ANSWER: (a) The bank must pay XYZ (12% 10%)($20,000,000)(0.25) = $100,000. (b) This is a call option for the bank, who is the buyer. XYZ is the writer of the option. It is in the money when interest rates rise above 10%.

6.6

Given a forward rate agreement (FRA) on bonds and a purchase price of 90 for delivery in three months. (a) If the price of the bonds is 100 on the delivery date, what is the profit (loss) of the bank? (b) What type of option is analogous to this example.

ANSWER: The gain to the bank is (100-90)/90 times the amount invested in the bonds. The bank, in effect, purchased a call option on the bond that was in the money at the time of the delivery of the bonds. 6.7 Bank A and Bank B have the following opportunities for borrowing in the short-term (floating rate) and long-term (fixed rate) markets. Bank A Bank B Floating Rate T-Bill + 1.0% T Bill + 2.0% Fixed Rate 8% 10.5% Bank A has a positive dollar gap and Bank B has a negative dollar gap. Show that both banks can benefit from a swap in the sense of lowering their interest rate risk. Can they also lower their cost of funds? ANSWER: Bank A wants to receive fixed and pay floating. Bank B wants to receive floating and pay fixed. If Bank A and Bank B exchange flows in this manner it will reduce the interest rate risk of both parties. Since the relative credit quality spreads are different in the two markets (Bank A has a 1% advantage in the floating rate market and a 2.5% advantage in the fixed rate market), both parties can lower their cost of funds through the swap as well as reduce their interest rate risk. Pick swap terms and show this to be true. One such is the following (but there are others). Bank A pays T-Bill and receives 8%, and B receives T-Bill and pays 8%. In this case, the cost of funds to A is T-Bill with the swap (versus T Bill + 1.0% without the swap) and for B it is 10% with the swap (versus 10.5% without the swap). 6.8 State Bank purchased a $10,000,000 floor from a large investment banking firm. The floor has a 4% strike price (based upon the 3-month Treasury bill) and 3-month determination date. Assuming that the 3-month Treasury bill rate is 2.5% at the

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

95

determination date, what is the payment under the contract? Does the bank receive or make payments? Assuming that the bank paid $50,000 for the contact, has the bank gained from the transaction? ANSWER: Under the contract, the payment to State Bank is equal to: (4% 2.5%)($10,000,000)(0.25) = $37,500. At this point the bank has not gained due to paying $50,000 to purchase the put option and receiving $37,500 at the first determination date. 6.9 Consider a fixed-for-floating LIBOR swap with a notional principal of $200 million and a fixed rate of 7%. Suppose that the swap cash flows are determined at six-month intervals (t = 0, 1, 2, 3, etc.). Suppose that LIBOR turns out to be: t LIBOR 0 4.25 1 5.25 2 6.75 3 7.25 4 8.00 5 9.00 6 10.00 What would be the net payments for the counterparties on each of the settlement days? ANSWER:
Net Payment

Time 0 1 2 3 4 5 6 6.10

Fixed Rate Paper $2.75 million 1.75 million 0.25 million +0.25 million +1.00 million +2.00 million +3.00 million

Floating Rate Paper $+2.75 million +1.75 million +0.25 million 0.25 million 1.00 million 2.00 million 3.00 million

Assume the date is August 7, YearX and the you have the following information: (1) the September 13-week T-bill futures discount is 10.49% (which matures on December 20), and (2) the spot quote on September 20 for 13-week T-bills maturing December 20 is 10.39%. (a) Assuming a long position in the futures market, what is the purchase price of the T-bill futures contract? (Note: there are 43 days from August 7 date to September 20 and 9.91% is the applicable 13-week T-bill rate in this period.) (b) Assuming a long position in the spot market, what is the purchase price of the T-bills using the spot quote? (c) What would happen if the futures and spot prices of T-bills differed by an amount larger than the transactions costs of buying and selling them?

96

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

ANSWER: (a) The purchase price of the long contract in T-bill futures is $100/(1.1049) 0.25 = $97.54 (where 0.25 = 91 days/360 days). Discounting this future payment back to August 7, we have $97.54/(1.0991) 0.12 = $96.44 (where 0.12 = 43 days/360 days). (b) The purchase price is $100/(1.1039)0.37 = $96.41 (where 0.37 = (43 + 91 days)/360 days). (c) The small difference in price between the futures and spot markets is due transactions costs. If the difference was greater than the transactions costs, it would be profitable to buy and sell futures and spot T-bill contracts until arbitrage drives their price close to one another again.

CASE PROBLEM Hedging the Balance Sheet (Solution) The schedule of loan and CD payments and receipts for a 10% one-year loan and 8% 90-day CDs is as follows: Day 0 90 180 270 360 Loan: Receipts $1,000 Payments $909.09 CD: Receipts $909.09 $926.75 $944.76 $963.11 Payments $926.75 $944.76 $963.11 $981.82 Net receipts $18.18 Present value of net receipts = $18.18/1.10 = $16.53 increase in net worth. Assuming further that the above date is September 15 and that you sell 13-week T-bill futures in December, March, and June as a hedge on the CDs, the price of the T-bill futures contract is $1,000/(1.10).25 = $976.45 (i.e., 90/360 = .25). If interest rates do not change, First Savings would purchase T-bills in the spot market and sell T-bills in the futures market on the delivery date, such that the following receipts and payments are generated: Day 0 90 180 270 360 Assets (futures): Receipts $976.45 $976.45 $976.45 Liabilities (spot): Payments $976.45 $976.45 $976.45 Net receipts $0 $0 $0 Thus, if interest rates do not change, First Savings will experience an increase in net worth of $16.53 minus the cost of the T-bills futures hedge. If interest rates rise by 2%, the present value of the net receipts for First Savings Association would be as follows:

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

97

Day Assets: Loans Receipts Payments Futures Receipts Liabilities: CDs Receipts Payments Net receipts without futures Futures payments (price = $100/1.12)0.25 Net receipts with futures Total net receipts

90

180

270

360

$1,000 $909.09 $976.45 $976.45 $976.45

$909.09

$926.75 $926.75

$949.10 $949.10

$971.98 $971.98

$995.42

$0

$0 $972.07 $4.38

$0 $972.07 $4.38 $4.38

$0 $972.07 $4.38 $4.38

$4.58

$0

$4.38

$4.58

The present value (using a 12% discount rate) of the total receipts is $16.52. By comparison, with no change in interest rates, the net receipts were $18.18/1.10 = $16.53. Thus, the futures hedge would have been very effective in the event interest rates increased. If interest rates declined rather than increased, the futures position would lose money and offset the cash position gains from decreased CD costs. A put option on the futures contract would allow the institution to sell futures if interest rates increase (and hedge higher CD costs) but not sell futures if interest rates decrease (and CD costs decline such that a cash market gain is obtained). The put premium would have to be factored into the above calculations as an additional cost of the hedging strategy. An advantage of the put option is that no margin from the purchaser is required. If the institution used the futures hedge without the option, it would have to carry a margin with the market clearinghouse. Thus, although the option has a cost, this cost may be lower than the present value of expected margin losses that may occur on the futures contract alone. It is generally recommended that balance sheet hedging strategies should look at the big picture and hedge the overall risk of the balance sheet. If a hedge contract for each individual asset or liability was employed, the task of hedging the balance sheet would be unnecessarily complicated by too many futures contracts. Also, due to basis risk, extensive micro hedging could produce results over time that are inferior to a macro hedge.

98

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

True-False 6.1 A futures contract is a standardized agreement to buy or sell a specified quantity of a financial instrument on a specified future date at a set price. ANSWER: True The buyer of a futures contract is said to have a long position ANSWER: True The seller of a futures contract is said to have a short position ANSWER: True Futures contracts are standardized but NOT usually traded on an organized exchange. ANSWER: False The margin on a futures contract represents the amount that the buyer of the contract borrowed from a broker. ANSWER: False Credit risk on a futures contract is reduced substantially by the exchange clearinghouse. ANSWER: True Futures contracts are marked-to-market at the end of each month. ANSWER: False Delivery of the underlying financial instrument occurs for most futures transactions. ANSWER: False A long or buy hedge would usually be used if the bank would be harmed in the cash market by rising interest rates. ANSWER: False A short of sell hedge would usually be used if the bank would be harmed in the cash market by rising interest rates. ANSWER: True The number of contracts that need to be used to hedge a cash position is determined by the value of the cash flow to be hedged, the face value of the futures contract, the maturity of the anticipated cash flow, the maturity of the futures contract, and the ratio of the variability of the cash market to the variability of the futures market. ANSWER: True In a macro hedge, the bank is hedging the entire portfolio. ANSWER: True

6.2

6.3

6.4

6.5

6.6

6.7

6.8

6.9

6.10

6.11

6.12

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

99

6.13

In a micro hedge, the hedge is linked directly to a specific asset. ANSWER: True A bank may defer gains and losses for a macro hedge. ANSWER: False Options represent contracts that provide the holder both the right and obligation to buy a security. ANSWER: False A call option gives the buyer the right (but not the obligation) to buy an underlying instrument (such as a T-bill futures contract) at a specified price (called the exercise or strike price). ANSWER: True As with futures markets, options contracts are standardized contracts that trade on organized exchanges. ANSWER: True A bank with a positive dollar gap could buy call options in order to hedge its interest rate risk. ANSWER: True A bank with a positive duration gap could sell put options in order to hedge its interest rate risk. ANSWER: True An interest rate cap is a contract that reduces the exposure of a floating rate borrower (or a liability sensitive bank) to increases in interest rates. ANSWER: True In an interest rate swap, both the principal and interest are exchanged. ANSWER: False The principal purpose of an interest rate swap is to reduce the cost of borrowing. ANSWER: False A bank with a positive dollar gap could reduce its interest rate risk by receiving fixed and paying floating in an interest rate swap. ANSWER: True Differences in credit quality spreads between floating and fixed rate markets create the opportunity for both parties in an interest rate swap to lower their cost of funds. ANSWER: True

6.14

6.15

6.16

6.17

6.18

6.19

6.20

6.21

6.22

6.23

6.24

100

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

6.25

Futures are most commonly used for long-term adjustments in interest rate risk while swaps usually are used for short term adjustments. ANSWER: False

Multiple Choice 6.1 Which of the following is NOT true of a futures contract? a. standardized agreement b. set price to be bought or sold in the future c. option to exercise the contract d. specified quantity of a financial asset to be bought or sold in the future ANSWER: c The seller in a futures contract is said to have a: a. long position b. short position c. buying position d. selling position ANSWER: b Which of the following is unique to the cash market, as opposed to the futures market? a. organized exchanges are used in the cash market b. contracts are not standardized in the cash market c. pricing and delivery occur at the same time in the cash market d. buyers are not insured against losses in the cash market ANSWER: c What lowers the credit risk of the financial futures contracts? a. a clearinghouse b. insurance c. guarantees d. low risk securities e. none of the above ANSWER: a If the margin balance falls below the exchange mandated minimum when trading futures contracts, the trader will be required to add funds to the: a. surplus fund b. surplus margin c. margin contract d. margin account e. none of the above ANSWER: d

6.2

6.3

6.4

6.5

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

101

6.6

If a trader buys a financial futures contract and interest rates rise, the trader will: a. lose money b. make a gain c. break even ANSWER: a Assume the following information is given: $1 million (face value), thirteen-week T-bill futures contract, and the final index price is 95.00. The settlement price for this contract is: a. $987.361 b. $987,534 c. $1,012,465 d. $1,012,639 e. none of the above ANSWER: a If a bank has a positive dollar gap, it could hedge its interest rate risk by: a. buying a futures contract b. selling a futures contract c. buying and selling a futures contract d. none of the above e. ANSWER: a If a bank has a negative dollar gap and is short in T-bill futures, if interest rates fall, the _________ in the net interest margin of the bank will be ______ in the T-bill futures. a. losses/offset by gains b. losses/worsened by losses c. gains/offset by loses d. gains/increased by gains ANSWER: c Suppose that a bank has a negative duration gap and interest rates are expected to fall. In this case the bank: a. should hedge interest rate risk by going short in the futures market b. should hedge interest rate risk by going long in the futures market c. has no interest rate risk in the sense that the net interest margin will increase as rates fall. ANSWER: b Given the following definitions: Drsa = duration of cash assets Df = the duration of deliverable securities involved in the hypothetical futures contract from the delivery date Nf = the number of futures contracts FP = the futures price

6.7

6.8

6.9

6.10

6.11

102

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

Vrsa 6.12

= the market value of the assets

The correct formula for the duration of a portfolio containing both spot market assets and futures contracts is: a. Drsa(DfNfFP/Vrsa) b. Vrsa(DfNfFP/Drsa) c. Drsa + (DfNfFP/Vrsa) d. Vrsa + (DfNfFP/Drsa) ANSWER: c Which of the following is NOT one of the steps involved in hedging the interest rate sensitivity position of the bank. a. determine the length of the hedge b. determine the depth of the hedge c. place the hedge d. monitor the hedge e. lift the hedge ANSWER: b Which of the following hedges is for the entire portfolio of the bank? a. macro hedge b. micro hedge c. short hedge d. long hedge e. none of the above ANSWER: a The difference between the cash and futures price of the financial instrument that is used for a hedge is known as: a. spread risk b. dollar gap risk c. duration gap risk d. basis risk e. none of the above ANSWER: d Current accounting procedures for futures contracts are set by: a. the Federal Reserve Board b. Federal Deposit Insurance Corporation c. Comptroller of the Currency d. All of the above ANSWER: d

6.13

6.14

6.15

6.16

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

103

6.17

Mark-to-market is a term in the futures market that means that: a. gains and losses are taken immediately on delivery of the contracts b. gains and losses are taken at the end of the day on contracts c. gains and losses are taken every hour on contracts d. gains and losses are taken on the delivery date on contracts ANSWER: b Options contracts ____________ holders to buy or sell a particular financial instrument at a specified price on or before a specified date. a. require b. do not require c. require under certain circumstances d. require under state laws e. require under federal laws ANSWER: b From the perspective of the buyer, a call option is concerned with the ________ of a financial asset. a. purchase b. sale c. purchase and sale d. liquidation ANSWER: a Unlike futures contracts, options contracts: a. are traded in unorganized exchanges b. are not standardized contracts c. are not based on cash market contracts d. do not require that a margin be put forward e. none of the above, they are all true of both futures and options contracts ANSWER: d The maximum amount that the buyer of an unhedged option can lose is: a. the call premium plus the value of the option b. the call premium c. dependent on the price movement of the underlying asset d. dependent on the insurance backing the option ANSWER: b If a trader buys a put option, he(she) will make a profit if the price of the underlying asset: a. increases b. decreases c. increases and then decreases d. decreases and then increases ANSWER: b

6.18

6.19

6.20

6.21

6.22

104

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

6.23

Suppose the bank has a positive dollar gap and interest rates are expected to fall in the near future. The bank could hedge this interest rate risk by: a. buying a call option b. selling a call option c. buying a put option d. none of the above; the bank has no interest rate risk because its net interest margin will increase as rates fall ANSWER: a Suppose the bank has a positive duration gap and interest rates are expected to rise in the near future. The bank could hedge this interest rate risk by: a. buying a call option b. selling a call option c. selling a put option d. none of the above; the bank has no interest rate risk because its interest rate margin will increase as rates rise ANSWER: b In an interest rate swap two firms exchange: a. their interest and principal obligations b. their interest obligations only c. their options contracts d. their futures contracts e. none of the above ANSWER: b Interest rate swaps are intended to: a. decrease the interest rate risk of the firms involved b. decrease the credit risk of the firms involved c. decrease the market risk of the firms involved d. decrease the liquidity risk of the firms involved ANSWER: a Which of the following is(are) an advantage(s) of swaps? a. low search costs b. customized to meet the exact needs of the parties involved c. can be established for a long time d. b and c e. a, b, and c ANSWER: d

6.24

6.25

6.26

6.27

Chapter 6 Techniques of Asset/Liability Management: Futures, Options, and Swaps

105

6.28

Another name for a swap in which a dollar fixed-rate loan is swapped for a dollar floating-rate loan is a ______ swap. a. straight b. plain vanilla c. rate risk d. mixed e. none of the above ANSWER: b The ______ is really a performance bond that guarantees that the buyer or seller of a futures contract will fulfill the commitment. a. clearinghouse b. margin c. futures price d. spot price ANSWER: b Banks can use futures contracts to both speculate and hedge against future interest rate movements: a. as they desire b. according to restrictions placed on them by the clearinghouse c. according to the restrictions placed on them by bank regulatory authorities d. according to the restrictions placed on them by the Securities Exchange Commission ANSWER: c

6.29

6.30