Chapter Eight

Using Financial Futures, Options,

Swaps, and Other Hedging Tools in
Asset-Liability Management
©2008 The McGraw-Hill Companies,
McGraw-Hill/Irwin
All Rights Reserved
 Key Topics in this Chapter

• The Use of Derivatives

• Financial Futures Contracts: Purpose and
Mechanics
• Short and Long Hedges
• Interest-Rate Options:Types of Contracts
and Mechanics
• Interest-Rate Swaps
• Caps, Floor, and Collars
McGraw-Hill/Irwin 8-2
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 Financial Futures Contract

An Agreement Between a Buyer and

a Seller Which Calls for the Delivery
of a Particular Financial Asset at a Set
Price at Some Future Date

McGraw-Hill/Irwin 8-3
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 The Purpose of Financial
Futures

• To Shift the Risk of Interest Rate

Fluctuations from Risk-Averse
Investors to Speculators
• To hedge Interest rate risk

McGraw-Hill/Irwin 8-4
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 The World’s Leading Futures and
Option Exchanges
• Chicago Board of • Euronext.Liffe
Trade (CBT) (Eurex)
• Chicago Board • Sydney Futures
Options Exchange Exchange
• Toronto Futures
• Singapore Exchange
Exchange (TFE)
LTD. (SGX)
• South African
• Chicago Mercantile Futures Exchange
Exchange (CME) (SAFEX)
McGraw-Hill/Irwin 8-5
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 Most Common Financial
Futures Contracts
• U.S. Treasury Bond Futures Contracts
• Three-Month Eurodollar Time Deposit
Futures Contract
• 30-Day Federal Funds Futures Contracts
• One Month LIBOR Futures Contracts

McGraw-Hill/Irwin 8-6
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 What is a long hedge?
• A long hedge is taken to protect against a fall in
interest rates. A long hedge results when a futures
contract is purchased
• A long hedger offsets risk by buying financial futures
around the time a net inflow of funds is expected in
the form of maturing loans. If rates drop the inflow
of funds can only be invested at a lower rate
generating an opportunity loss. However if a long
hedge is in place the loss on the reinvestment of the
net cash inflow will be offset by a gain on the long
futures position. Later as the net cash flow is invested
a like amount of futures is sold.
McGraw-Hill/Irwin 8-7
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 What is a short hedge?
• A short hedge is taken to protect against a rise in
interest rates.
• If more deposits than loans are maturing or are
re-priced in a given future period the bank
would need to replace or re-price those deposits.
If rates move higher when the deposits are
replaced or re–priced at higher rates the bank
stands to lose money. The sale of a futures
contract would generate profits that would
offset such a loss.
McGraw-Hill/Irwin 8-8
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 Hedging with Futures Contracts


Avoiding Higher Use a Short Hedge:
Borrowing Costs Sell Futures
and Declining Contracts and then
Asset Values Purchase Similar
Contracts Later
Avoiding Lower Use a long Hedge:
Than Expected
Yields from Loans  Buy Futures
Contracts and then
and Securities Sell Similar
McGraw-Hill/Irwin
Contracts Later 8-9
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 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 Price Sold For (At the Beginning)
• If rates rise in the future, security prices will fall
resulting in a lower price when the offsetting contract is
purchased. The resulting profit offsets the loss on the
negative gap position being hedged.

McGraw-Hill/Irwin 8-10
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 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 Price Purchase For
(At the Beginning) and the Price Sold For (At the End)
• If interest rate do fall the offsetting sale of the futures
contract will occur at a higher price. The resulting profit
will offset the loss due to lower interest rates on an asset
sensitive position

McGraw-Hill/Irwin 8-11
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 Interpret futures quotes from the
wall street journal
• The first column gives the opening price.
The second and third the daily high and
low prices. The fourth column shows the
settlement price followed by the change in
the settlement price from the previous
day. The next two columns show the
historic high and low prices. The last
column shows the open interest in the
contract
McGraw-Hill/Irwin 8-12
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 Basis

• Cash-Market Price (or Interest Rate)

Less the Futures-Market Price (or
Interest Rate)

McGraw-Hill/Irwin 8-13
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 Basis
• A futures currently selling at an interest
yield of 4 % while yields in the cash
market are 4.6%. What is the basis for this
contract?
• The basis for this contract is currently 4.6 –
4 = 60 basis points

McGraw-Hill/Irwin 8-14
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 Hedging deposit costs with
financial futures
• Assume a rise in rates over the next three months from
10% to 10.5%
• Loss on 100 million = 100,000,000 x .5%x 90/360 =
$125,000
• To hedge against this loss sell 100 90 day Eurodollar
futures trading at 91.5 at the start of the three month
period . Price per $100 = 100 – (8.5 x 90/360) = 97.875 x
100,000,000/100 = 97,875,000
• Close to maturity Buy 100 90 day futures euro dollar
futures at index of 91. Price per 100 = 100-(9x90/360 =
97.75 x100,000,000/100 = 97,750,000
• Profit on futures = 97,875,000 – 97,750,000 = 125,000

McGraw-Hill/Irwin 8-15
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 Hedging with futures
problem
• March 10, 2005
Three month cash rate = 3%; Bank issues a $1million, 91
day euro dollar deposit to fund a 180 day loan at 3%. (six
month cash rate = 3.25%). Fearing a rise in interest rates
the bank sells one September 2005 Eurodollar futures
contract at 3.85%
• June 9,2005
Three month cash rate =3.88%; the bank issues a $1 million,
91day euro dollar time deposit at 3.88%. The bank also
buys back one September 2005 futures at 4.33%
What is the effective six month borrowing cost and how
does it compare with the option of having issued a six
month deposit to fund the six month loan. What would
have been the result if no hedging action was taken.
McGraw-Hill/Irwin 8-16
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 Solution
Cash market Futures
3/10/05 Issue 1 Mill 91 day Sell 1 Sept. futures
deposit at 3%; Interest = contract at 3.85%
$7,583
6/9/05 Issue 1 mill 91 day Buy 1 Sept. futures
deposit at 3.88%; contract at 4.33%.
interest = $9,808. Six Profit on
month interest = $17391 futures.48%;
48x25=$1200
6 month cost=(17931-
1200)/1,000,000 X [360/182]
= 3.20% VS 3.44 if left un-
McGraw-Hill/Irwin
hedged or 3.25 if matched 8-17
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Futures problem
• A bank wishes to sell $150 million in new
deposits next month. Interest rates today
are 8% but are expected to rise to 8.25%
next month. If management wishes to
hedge what type of futures contract would
you recommend? If the bank does not
hedge what would be the amount of the
loss?

McGraw-Hill/Irwin 8-18
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 Solution
• In this case the bank would use a short
hedge
• The loss would amount to 150,000 x .025 x
30/360 = 31,250

McGraw-Hill/Irwin 8-19
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 Question
• What kind of hedge would be appropriate in
the following circumstances:
1. Rising interest rates that could result in losses
on fixed rate loans as they are not matched
with fixed rate deposits
2. A financial firm is holding a large amount of
floating rate loans not matched with floating
rate deposits and rates are falling
3. A projected rise in rate threatens the value of a
bond portfolio

McGraw-Hill/Irwin 8-20
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 Answer

1. Use a short hedge in euro dollar futures

to offset the impact of rising rates
2. Use a long hedge in treasury bond
futures to offset the impact of falling
rates
3. Use a short hedge in treasury bonds

McGraw-Hill/Irwin 8-21
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Change in the Market Value of
the Futures Contract

i
Ft  F0  -D  F0 
(1  i)

McGraw-Hill/Irwin 8-22
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 problem
• By what amount will the market value of a
treasury bond futures contract change if
interest rates rise from 5% to 6%. The
underlying Treasury bond has a duration of
10.48 years and the treasury bond futures
contract is currently quoted at 113-06

McGraw-Hill/Irwin 8-23
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 solution
• Change in value = -10.48 x 113,187.50 x
(.01/1+.05) = -$11,297.19

McGraw-Hill/Irwin 8-24
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 Number of Futures Contracts
Needed

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

McGraw-Hill/Irwin 8-25
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 Problem
• A bank has assets with a duration of 8 years and
liabilities have a duration of 3 years. To hedge
this duration gap management plans to employ
treasury bond futures which are currently
quoted at 112-17 and have a duration of 10.36
years. The banks financial report shows total
assets of $120 million and total liabilities of $97
million. How many futures contracts are needed
to cover this exposure?

McGraw-Hill/Irwin 8-26
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 solution
• Number of futures contracts needed = 8 –
[3 x (97/120) ] x 120,000,000/(10.36 x
112,531.25) = 574 contracts

McGraw-Hill/Irwin 8-27
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 Interest Rate Option

It Grants the Holder of the Option the

Right but Not the Obligation to Buy
or Sell Specific Financial Instruments
at an Agreed Upon Price.

McGraw-Hill/Irwin 8-28
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 Types of Options

• Put Option
– Gives the Holder of the Option the
Right to Sell the Financial Instrument at
a Set Price
• Call Option
– Gives the Holder of the Option the
Right to Purchase the Financial
Instrument at a Set Price
McGraw-Hill/Irwin 8-29
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Most Common Option Contracts
Used By Banks

• U.S. Treasury Bond Futures Options

• Eurodollar Futures Option
Note: Information contained in option
quotes consist of information on strike
prices and call and put premiums at each
different strike price for given months

McGraw-Hill/Irwin 8-30
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Principal Uses of Option
Contracts

• Protection of a Security Portfolio

• Hedging Against Positive or Negative
Gap Positions
Note: Put options are used to protect against
a rise in interest rates (Fall in security
prices). Call options are used to protect
against a fall in interest rates (rise in
liability security prices)

McGraw-Hill/Irwin 8-31
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Federal Funds Options and
Futures
• Represents the Consensus Opinion Of the
Likely Future Course of Market Interest
Rates
• Public Trading for Futures Contract Began
at the CBOT in 1988
• Public Trading on Options Contracts
Began in 2003

McGraw-Hill/Irwin 8-32
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 Regulations For Options and
Future Contracts

• OCC – Risk Management of Financial

Derivatives: Comptrollers Handbook
• FASB – Statement 133 – Accounting for
Derivatives Instruments and Hedging
Activities

McGraw-Hill/Irwin 8-33
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Regulations
• Each bank has to implement a proper risk
management system comprised of 1)policies and
procedures to control financial risk taking 2) risk
measurement and reporting systems and 3)
independent oversight and control processes
• In addition FASB introduced FASB 133 which
requires that all derivatives are recorded at their
fair market value. Furthermore, the change in
fair value of a derivative and a fair value of the
item hedged must be reported on the income
statement.
McGraw-Hill/Irwin 8-34
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Using euro dollar deposit options
• You hedged your bank’s exposure to declining interest
rates by buying one march call on euro dollar deposit
futures at the march premium (6.25) quoted on Dec 13th
2005 ( exhibit 8-4) for the strike price of 9525
• How much did you pay for the call in dollars if you
chose the strike price of 9525?
• Value of call = 6.25 x 25 = 156.25
• In march the futures move to 96 what is the profit or loss
• Payout from settlement = (9600-9525); 75x25=1875
• Net gain = 1875 – 156.25 = 1718.75

McGraw-Hill/Irwin 8-35
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Using US treasury Bond Futures
Options
• The premium quote for the march call is 3-24 for
a strike price of 109. This means that you would
pay 3 and 24/64ths percent of par value or 3,375
as a premium to have the right to a long position
in the T- bond futures contract at 109,000.
• If the futures price moves to 112 then this
contract will be exercised resulting in a long
position for one march contract.
• If this contract is offset then a profit of $3000 will
result. However this profit is not enough to
cover the premium paid of $3,375
McGraw-Hill/Irwin 8-36
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 Interest Rate Swap

A Contract Between Two Parties to

Exchange Interest Payments in an
Effort to Save Money and Hedge
Against Interest-Rate Risk

McGraw-Hill/Irwin 8-37
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 Quality Swap

• Borrower with Lower Credit Rating

Pays Fixed Payments of Borrower
with Higher Credit Rating
• Borrower with Higher Credit Rating
Pays Short-Term Floating Rate
Payments of Borrower with Lower
Credit Rating
McGraw-Hill/Irwin 8-38
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Risks of Interest Rate Swaps

• Substantial Brokerage Fees

• Credit Risk
• Basis Risk

McGraw-Hill/Irwin 8-39
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 Netting

The Swap Parties Only Swap the Net

Difference Between the Interest
Payments. This Reduces the Potential
Damage if One Party Defaults on its
Obligation

McGraw-Hill/Irwin 8-40
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 Example interest rate swap
• Consider the following illustration in which Party A
agrees to pay Party B periodic interest rate payments of
LIBOR + 50bps (bps = basis points = 0.01%) in exchange
for fixed interest rate payments of 3.00%. Note that there
is no exchange of the principal amounts. Also note that
the interest payments are settled in net (e.g. if LIBOR +
50bps is 1.25% then Party A receives 1.75% and pays B
nothing). The fixed rate (3.00% in this example) is
referred to as the swap rate.
• Party A ---------pays Libor + 50bps (1.25) ----- Party B
• Party B----- pays 3% fixed rate---------Party A
• In the net party B pays 1.75%

McGraw-Hill/Irwin 8-41
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Currency Swap
An Agreement Between Two Parties,
Each Owing Funds to Other
Contractors Denominated in
Different Currencies, to Exchange the
Needed Currencies with Each Other
and Honor Their Respective
Contracts.

McGraw-Hill/Irwin 8-42
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Interest Rate Cap

Protects the Holder from Rising

Interest Rates. For an Up Front Fee
Borrowers are Assured Their Loan
Rate Will Not Rise Above the Cap
Rate

McGraw-Hill/Irwin 8-43
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 Interest Rate Floor

A Contract Setting the Lowest

Interest Rate a Borrower is Allowed
to Pay on a Flexible-Rate Loan

McGraw-Hill/Irwin 8-44
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 Interest Rate Collar

A Contract Setting the Maximum and

Minimum Interest Rates That May Be
Assessed on a Flexible-Rate Loan. It
Combines an Interest Rate Cap and
Floor into One Contract.

McGraw-Hill/Irwin 8-45
Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.