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Risk Management

Chapter 23 Futures and Forward

Farida Ariyani Nurti Wijayanti, SE, MM, CWM

Radityo Heru Prabowo

No. Reg. 19R0712
Kelas Eksekutif 19b


I. Overview

In this chapter, we look at the role futures and forward contracts play in managing
an FI’s interest rate, FX and credit risk exposures as well as their role in hedging natural
catastrophes. We start with a comparison of forward and futures contract to spot
contract. We then examine how forwards and futures can be used to hedge interest rate,
FX risk, credit risk, and catastrophe risk.

II. Forward and Futures Contracts

ƒ Spot contract : an agreement beetwen a buyer and a seller at time 0, when

the seller of the asset agrees to deliver it immediately and the buyer of the
asset agrees to pay for the asset immediately.

0 1 2 3 Month

Price agreed / paid + Bonds delivered by seller to buyer

beetwen buyer and seller

ƒ Forward contarct : an agreement involving the exchange of an asset for a

cash at a fixed price in the future.

0 1 2 3 Month

Price agreed Buyer pays forward

beetwen buyer and seller price. Seller delivered bonds

ƒ Futures contract : an agreement involving the future exchange of an asset

for cash at a price that is determined daily.

0 1 2 3 Month

Buyer and seller enter futures Buyer pays the futures price quoted at
contract at time 0 future contract the end of month 3. Seller delivers bond
III. Forward Contract and Hedging Interest Rate Risk

ƒ Naïve hedge : When a cash asset is hedge on a direct dollar-for-dollar basis

with a forward or futures contract.

= −D ×
P 1+ R

Where :

ΔP = Capital loss on bonds

P = Initial value of bond position = $970,000
D = Duration of the bonds = 9 years
ΔR = Change in forecast yield = .02
1+R = 1 plus the current yield on 20-year bonds = 1.08

ƒ Immunized : Describe an FI that is fully hedged or protected against adverse

movements in interest rate (or other asset prices)

IV. Hedging Interest Rate With Future Contract

ƒ Microhedging : Using a futures (forward) contract to hedge a specific asset

or liabilities.
ƒ Basis risk : A residual risk that arises because the movement in a spot (cash)
asset’s price is not perfectly correlated with the movement in the price of the
asset delivered under a futures or forward contract.

ƒ Macrohedging : Hedging the entire duration gap of an FI

¾ Routine Hedging : Seeking to hedge all interest rate risk exposure.
(low risk-low return).
¾ Selective Hedging : Only partially hedging the gap or individual assets
and liabilities. (selectively hedge based on expectations of future interest
rates and risk preferences).
The effect of hedging on risk and expected return

¾ Macrohedging with Futures.

ΔE = [Da − kDl ]× A ×
1+ R

where :
ΔE = Change in an FI’s net worth
DA = Duration of its asset portfolio
DL = Duration of its liability portfolio
k = Ratio of an FI’s liabilities to asset (L/A)
A = Size of an FI’s asset portfolio
= Shock to interest rates
1+ R

™ The Risk-Minimizing Futures Option

Δ = − Dr
F 1+ R
where :
ΔF = Change in dollar value of futures contracts
F = Dollar value of the initial futures contracts
Dr = Duration of the bond to be delivered against the futures contracts such as a
20-year, 8 percent coupon T-bond
ΔR = Expected shock to interest rates
1+R = 1 plus the current level of interest rates
V. Hedging Credit Risk with Futures and Forward

ƒ Credit Forward Contract and Credit Risk Hedging : An agreement that

hedges against an increase in default risk on a loan after the loan terms have
been determined and the loan has been issued.
o Credit forwards hedge against decline in credit quality of borrower.
o Common buyers are insurance companies.
o Common sellers are banks.
o Specifies a credit spread on a benchmark bond issued by a borrower.
Example: BBB bond at time of origination may have 2% spread over
U.S. Treasury of same maturity.

ƒ Futures Contracts and Catastrophe Risk

o CBOT introduced futures and options for catastrophe insurance.
o Contract volume is rising.
o Catastrophe futures to allow PC insurers to hedge against extreme losses
such as hurricanes.
o Payoff linked to loss ratio

ƒ Futures and Forward Policies of Regulators.

• Three levels of regulation:
o Permissible activities
o Supervisory oversight of permissible activities
o Overall integrity and compliance
• Functional regulators
o SEC and CFTC
• Beginning in 2000, derivative positions must be marked-to-market.
• Federal Reserve, FDIC and OCC require banks
o Establish internal guidelines regarding hedging.
o Establish trading limits.
o Disclose large contract positions that materially affect bank risk to
shareholders and outside investors.