Use of derivative tools in alm
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1) Derivatives such as financial futures contracts, options, swaps, caps, floors and collars are used to manage interest rate risk. 2) Financial futures contracts work by establishing an agreement between a buyer and seller to deliver an underlying asset at a future date at a set price, allowing investors to hedge against interest rate fluctuations. 3) The basis risk of hedging with futures is the difference between the cash price of the underlying asset and the futures price, which can vary over time and impact hedging effectiveness. Managing the basis is important for successful hedging.
![Solution
Number of Future Contracts Needed:
574
25.531,11236.10
000,000,120]3
120
97
8[
](https://image.slidesharecdn.com/useofderivativetoolsinalm-140710234301-phpapp02/85/Use-of-derivative-tools-in-alm-52-320.jpg)
![Profit/Loss Computation
Before tax profit on put option
= [S0-(Ft X 100)] X 25-Option Premium
Where,
S0 = Option strike price
Ft = Future market price
Before tax profit on call option
= Security market price – Strike price – Opt. premium
Note: The option is allowed to be expired, If it is out of
money. Then, the loss or gain is only option premium.](https://image.slidesharecdn.com/useofderivativetoolsinalm-140710234301-phpapp02/85/Use-of-derivative-tools-in-alm-79-320.jpg)
Use of derivative tools in alm
- 1. Chapter Eight Risk Management: Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management 1
- 2. Key Topics • 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, Floors, and Collars 2
- 3. Derivatives A derivative is any instrument or contract that derives its value from another underlying asset, instrument, or contract, such as treasury bills and bonds and eurodollar deposits 3
- 4. Managing Interest Rate Risk • Derivatives used to manage interest rate risk – Financial futures contracts – Forward rate agreements – Interest rate swaps – Options on interest rates – Interest rate caps – Interest rate floors – Interest rate collars 4
- 5. Cash & Future Markets • Cash Markets: Financial assets are exchanged between buyers and sellers for cash at the time the price is set. • Future Markets: Buyers and sellers exchange a contract calling for delivery of the underlying asset at a specified date in the future. Futures markets is the organized exchanges where futures contracts are traded.
- 6. 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 6
- 7. Financial Futures Contracts 7 TA TL *D-DD LA IS Gap = IS Assets – IS Liabilities and Recall what happens when interest rates rise? Fall? One of the most popular methods for neutralizing these gap risks is to buy and sell financial futures contracts
- 8. Background on Financial Futures • Buyers – A buyer of a futures contract is said to be long futures – Agrees to pay the underlying futures price or take delivery of the underlying asset – Buyers gain when futures prices rise and lose when futures prices fall 8
- 9. Background on Financial Futures • Sellers – A seller of a futures contract is said to be short futures – Agrees to receive the underlying futures price or to deliver the underlying asset – Sellers gain when futures prices fall and lose when futures prices rise 9
- 10. The Purpose of Financial Futures To Shift the Risk of Interest Rate Fluctuations from Risk-Averse Investors to Speculators 10
- 11. The World’s Leading Futures and Option Exchanges • Chicago Board of Trade (CBT) • Chicago Board Options Exchange • Singapore Exchange LTD. (SGX) • Chicago Mercantile Exchange (CME) • Euronext.Liffe (Eurex) • Sydney Futures Exchange • Toronto Futures Exchange (TFE) • South African Futures Exchange (SAFEX) 11
- 12. Nepal’s Futures and Option Exchanges • Commodities & Metal exchange Nepal Ltd. (COMEN) • Nepal Derivative Exchange (NDEX) • Mercantile Exchange (MEX) 12
- 13. Futures vs. Forward Contracts – Futures Contracts • Traded on formal exchanges (CBOT, CME, etc.) • Involve standardized instruments • Positions require a daily marking to market – Forward Contracts • Terms are negotiated between parties • Do not necessarily involve standardized assets • Require no cash exchange until expiration • No marking to market 13
- 14. Marking in market • Future contract sell on August, 1 • Future contract for Treasury Bond having face value Rs. 100,000 at the opining price of 97-27 • The initial margin requirement is Rs. 2,500 • Maintenance margin is Rs. 2000 (additional funds deposited is called variation margin)
- 15. SellingCase
- 16. Date Settlement Price Settlement Price (Rs.) Marked to market Margin call Final equity Opening price 97-27 97,843.75 2,500 2500 1-Aug 97-13 97,406.25 437.50 2,937.50 4-Aug 97-25 97,781.25 (375.00) 2,562.50 5-Aug 96-18 96,562.50 1,218.75 3,781.25 6-Aug 96-07 96,218.75 343.75 4,125.00 7-Aug 97-05 97,156.25 (937.50) 3,187.50 8-Aug 99-03 99,093.75 (1,937.50) 1,250.00 11-Aug 101-01 101,031.25 (1,937.50) 1,250.00 562.50 12-Aug 99-25 99,781.25 1,250.00 1,937.50 3,750.00 13-Aug 101-01 101,031.25 (1,250.00) 2,500.00 14-Aug 100-25 100,781.25 250.00 2,750.00 15-Aug 100-25 100,781.25 - 2,750.00 18-Aug 100-16 100,500.00 281.25 (3,031.25) - Buy back the contract. Total deposited 5,687.50 Amount withdrawan (3,031.25) Net loss 2,656.25 Selling (Short Position)
- 17. Buying (Long Position) Date Settlement Price Settlement Price (Rs.) Marked to market Margin call Final equity Opening price 97-27 97,843.75 2,500 2500 1-Aug 97-13 97,406.25 (437.50) 2,062.50 4-Aug 97-25 97,781.25 375.00 2,437.50 5-Aug 96-18 96,562.50 (1,218.75) 1,218.75 6-Aug 96-07 96,218.75 (343.75) 1281.25 2,156.25 7-Aug 97-05 97,156.25 937.50 3,093.75 8-Aug 99-03 99,093.75 1,937.50 5,031.25 11-Aug 101-01 101,031.25 1,937.50 6,968.75 12-Aug 99-25 99,781.25 (1,250.00) 5,718.75 13-Aug 101-01 101,031.25 1,250.00 6,968.75 14-Aug 100-25 100,781.25 (250.00) 6,718.75 15-Aug 100-25 100,781.25 - 6,718.75 18-Aug 100-16 100,500.00 (281.25) (6,437.50) - Contract Sold back Total deposited 3,781.25 Amount withdrawan (6,437.50) Net Profit 2,656.25
- 18. 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 18
- 19. Notation F0 = Future price today S0 = Spot price today Ft = Future price at time t St = Spot price at time t FT = Future price at expiration ST = Spot Price at expiration T = Time to expiration t = Time period prior to expiration
- 21. F0=95 Ft=105 Ft=90 Short Position Or Sell (Market interest rate is expected to rise) Loss =10 Gain =5 F0=95 But, Interest rate fall and price rise Interest rise and price fall as expected
- 22. F0=105 Ft=115 Ft=90 Long Position Or Bye (When interest fall) Gain =10 Loss =15 F0=105 Interest rate fall and price rise as expected But, Interest rate rise and price fall
- 25. Solution: Price Index at 21 Nov, 2005 is 112-06 which equals to: (112+6/32)*100,000/100 = 112,187.50 Settlement price at 6 Jan, is 113-16 which equals to: (113+16/32)*100,000/100 = 113,500 Profit = 113,500 – 112,187.50 = 1312.50
- 26. Equity Account Balance = Initial margin + Profit =$1150 + $1312.50 = $2462.50
- 28. A. Annualized Discount Yield Based on the Low IMM index = 100 - 95.1300 = 4.87 B. (95.175 – 95.1400) × 100 × 25 × 15 = $1312.50 C. MTM Value of Equity account at settlement = $1312.50 + $700 = $2012.50
- 29. Hedging with Futures Contracts Avoiding Higher Borrowing Costs Use a Short Hedge: Sell Futures Contracts and then Purchase Similar Contracts Later Avoid Declining Asset Values Use a Short Hedge: Sell Futures Contracts and then Purchase Similar Contracts Later Avoiding Lower Than Expected Yields from Loans and Securities Use a long Hedge: Buy Futures Contracts and then Sell Similar Contracts Later 29
- 30. 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) • Profit will be made on futures trading, which will offset some or all of the loss in the value of any bonds still held. 30
- 31. 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) • The resulting profit from trading in financial futures will offset some or all the loss in revenue due to lower interest rates on loans. 31
- 32. Hedging Deposit Costs • Suppose market interest rate is rising at least one-half percent point from 10% p.a., over the next three months. • If a bank needs to raise $100 million from sale of deposits over the 90 days. • Then, the deposit cost at 10% rate is: =$100 million X 10% X 90 ÷ 360 = $2,500,000 • If the deposit interest climb to 10.5%, the deposit cost would be: =$100 million X 10.5% X 90 ÷ 360 = $2,625,000 • The amount of potential loss in profit : = $2,625,000 - $2,500,000 = $125,000
- 33. To counteract the potential profit loss : • Today sell 100 90-day Eurodollar future contract trading at IMM index of 91.5 The price per $100 = 100-((100-IMM index) X90/360) = 100-((100-91.5) X90/360) = 97.875 Price for $100 m = $100 m X 97.875/100 = $97,875,000 • Within next 90 days, buy 100 90-day Eurodollar futures at an IMM Index of 91. The price per $100 = 100-((100-91.0) X90/360) =97.75 Price for $100 m = $100 m X 97.75/100 = $97,750,000 Profit on buy and sell of future = $97,875,000-$97,750,000 =$125,000
- 36. Basis Risk The basis is the cash price of an asset minus the corresponding futures price for the same asset at a point in time ▫ For financial futures, the basis can be calculated as the spot rate minus the futures rate ▫ It may be positive or negative, depending on whether futures rates are above or below spot rates ▫ May swing widely in value far in advance of contract expiration Basis=Cash-market price (or interest rate) – futures market price (or interest rate) Or Basis = C0 – F0 or Ct - Ft 36
- 37. Short Hedge C0 =97 F0 =96 Ct =90 Ft =89 Loss on Cash market =Ct – C0 = 90 – 97 = -7 Gain on Future market =F0 – Ft = 96 – 89 = 7 Net dollar return on trading = (Ct – C0)+(F0 – Ft )= -7+7 =0 Or Net dollar return on trading = (Ct – Ft) - (C0 - F0)
- 38. Realized Return from Combining Cash and Futures Market Trading =Closing Basis Between Cash and Futures Market -Opening Basis Between Cash and Futures Market Or Dollar Return = Basis at termination of hedge – Basis at initiation of hedge Or = Return Earned in the Cash Market +/- Profit or Loss from Futures Trading 38
- 39. Long Hedge C0 =101 F0 =103 Ct =106 Ft =108 Loss on Cash market =C0 –Ct = 101 – 106 = -5 Gain on Future market =Ft –F0 = 108 – 103 = 5 Net dollar return on trading = (C0 –Ct )+(Ft –F0 )= -5+5 =0 Or Net dollar return on trading = (C0 - F0) - (Ct – Ft)
- 40. Realized Return from Combining Cash and Futures Market Trading = Opening Basis Between Cash and Futures Market -Closing Basis Between Cash and Futures Market Or Dollar Return = Basis at initiation of hedge – Basis at termination of hedge Or = Return Earned in the Cash Market +/- Profit or Loss from Futures Trading 40
- 42. F0 = 109+5/32 = 109.1563×100,000/100 = 109156.25 Ft = 100+3/32 =100.0938 ×100,000/100 = 100093.75 F0 for 11 contracts = 109156.25 × 11 = 1200718.8 Ft for 11 contracts = 100093.75 × 11 = 1101031.3 Gain on Future Market = F0 - Ft =1200719 – 1101031 = 99687.5 Given, C0 = 1,100,000 and Ct = 1,000,000 Loss on Cash Market = Ct - C0 = 1,000,000 - 1,100,000 = 100,000
- 43. Gain or Loss from Combined Cash and Future Market = Gain from Future market - Loss from Cash Market = 99687.5 – 100000 = - 312.50 Basis at initiation = C0 – F0 = 1,100,000 – 1,200,718.8 = -100,718.75 Basis at termination = Ct – Ft = 1,000,000 – 1,101,031.3 = -101,031.3 Gain/Loss = (Ct – Ft)- (C0 – F0) = -101,031.3- (-100,718.75) = - 312.5
- 44. Change in the Market Value of the Futures Contract 44
- 46. Example Suppose a $100,000 par value TB futures contract is traded at a price of $99,700 initially but then interest rates on TB increase a full percentage point 7 to 8%, If the TB has a duration of nine years, then change in the value of TB is: = -9 yrs. X $99,700X0.01/(1+0.07) = -$8,385.98
- 47. Solution Value of Future Contract = (113+6/32)×$100,000/100 = $113,187.50 Change in value = -10.48 x $113,187.50 x.01/ (1+.05) = -$11,297.19
- 48. i)(1 i F-DFF 00t ………. (i) TL i)(1 i D--TA i)(1 i D-NW LA ………. (ii) If we set the change in net worth equal to the change in the N number of futures position value, then N i)(1 i FD- 0 TL i)(1 i D--TA i)(1 i D- LA (Ft – F0)×N = ΔNW Or
- 49. Or 0 LA FD TA) TA TL D-(D N Where Dis duration of Future and Nis Number of Future Contract Needed
- 50. Example Suppose, a bank has an average asset duration of four years, an average liability duration of two years, total assets of $500 million, and total Liabilities of $460 million. The bank plans to trade in T-Bond futures contracts. The T-Bond named in the future contracts have a duration of nine years and the T-bonds current price is $99,700 per $100,000 contract. Calculate number of contracts needed.
- 51. Number of Futures Contracts Needed $99,7009yrs $500m) $500m m$460 yrs2-(4yrs N 51 ≈ 1,200 contracts
- 52. Solution Number of Future Contracts Needed: 574 25.531,11236.10 000,000,120]3 120 97 8[
- 53. Questions for Discussion • What are financial futures contracts? Which financial institutions use futures and other derivatives for risk management? • How can financial futures help financial service firms deal with interest rate risk? • What futures transactions would most likely be used in a period of rising interest rates? Falling interest rates? 53
- 54. What types of Future you use When: • Yield on assets decline? • Borrowing costs increase? • Value of interest earning assets decline?
- 55. Option • Option means ‘The freedom to choose’ • Definition: A contract that gives its buyer the right but not obligation to buy or sell an asset at a fixed price on or before a given date. • Buyer of Option is also called HOLDER or OWNER of option. • Seller is also called WRITER of option.
- 56. Option contd.. • The seller of the option grants the buyer of the option the Right, but not the OBLIGATION, to purchase from or sell to the seller something. • The Writer grants this right to the buyer in exchange for a certain sum of money, which is called Option Price or Option Premium.
- 57. Types of Options Call Option: Call option if contract that gives its owner the right but not obligation to buy the specified asset at a pre-specified price before or given date. Put Option: Put option is a contract that gives its owner the right but not obligation to sell the specified asset at a pre-specified price.
- 58. Types of Options contd.. Naked Option: Naked option is an option in which an investor writes the option on the stock not already owned. Covered Option: Covered option is a option in which an investor writes the option on the stock already owned.
- 59. Option Terminologies Option Price: The initial entry fee of the option is the option price or option premium. Exercise/Strike Price: The fixed price specified at which the option buyer has right to buy or sell an asset specified in an option contract is called the option’s Exercise Price or Strike Price.
- 60. Option Terminologies contd… Expiration Date: The date after which an option no longer be exercised. Underlying Asset: An underlying asset is the asset to be exchanged on or before expiration date in the option contract. Exercising the Option: Exercising the option is the act of actually buying or selling the underlying asset as per option contract.
- 61. Option Terminologies contd… In-the-Money Option: Option is said to be in-the- money option if it is worth exercising. • If the price of an underlying asset is higher than the exercise price, call option is in-the-money. If asset price is substantially higher than exercise price, call option is said to be deep-in-the-money. • If the price of an underlying asset is lower than the exercise price, put option is in-the-money. Put option is the deep-in-the-money if stock price is substantially lower then exercise price.
- 62. Option Terminologies contd… Out-of-the-Money Option: Option is said to be out- of-the-money option if it is not worth exercising. • If the price of an underlying asset is lower than the exercise price, call option is out-of-the- money. If asset price is substantially lower than exercise price, call option is said to be deep-out- of-in-the-money. • If the price of an underlying asset is higher than the exercise price, put option is in-the-money. Put option is the deep-in-the-money if stock price is substantially higher then exercise price.
- 63. Asset Price Option Exercise Price Call Option Put Option In-the- money Out-of- the- money
- 64. Asset Price Option Exercise Price Put Option Call Option In-the- money Out-of- the- money
- 65. Option Terminologies contd… At-the-Money Option: Option is at the money option when the market price of an underlying asset is equal to exercise price. Option Position: The buyer of the asset is called long position and seller of asset is called short position.
- 66. Most Common Option Contracts Used By Banks • U.S. Treasury Bond Futures Options • Eurodollar Futures Option 66
- 67. The option buyer can: 1. Exercise the option, 2. Sell the options to another buyer, 3. Simply allow the option to expire.
- 68. Principal Uses of Option Contracts 1. Protecting a security portfolio through the use of put options to insulate against falling security prices (rising interest rates); however, there is no delivery obligation under an option contract so the user can benefit from keeping his or her securities if interest rates fall and security prices rise 2. Hedging against positive or negative gaps between interest- sensitive assets and interest- sensitive liabilities; for example, a. put options can be used to offset losses from a negative gap when interest rates rise, b. call options can be used to offset a positive gap when interest rates fall. 68
- 69. Fall Interest Rate when Gap is Positive • When interest rate fall, the price of security rises, • Buy call option at low price and sell or exercise before expiration at high price, • The gain on option will offset the loss in NIM ISA 10 million ISL 7 million IS Gap 3 million Suppose, Interest rate fall by 1% point (9 to 8%) Then, Loss of potential profit =3 million X 1% = 30,000
- 70. Rise Interest Rate when Gap is -ve • When interest rate rise, the price of security decline, • Buy put option in current price and buy back the option future before expiration at low price, • The gain on option will offset the loss in NIM ISA 10 million ISL 12 million IS Gap -2 million Suppose, Interest rate rise by 1% point (9 to 10%) Then, Loss of potential profit =2 million X 1% = 20,000
- 72. Explanation • When interest rate falls, yields on assets also fall. Falling on yields is LOSS. • On the other hand, price of assets increase. • Loss due to falling in yield on asset can be offset through buying call option.
- 74. Explanation • When interest rate rise, deposit and borrowing costs also rise. Increase in deposit cost is LOSS. • On the other hand, price of assets decline. • Loss due to rising in deposit cost can be offset through buying put option.
- 79. Profit/Loss Computation Before tax profit on put option = [S0-(Ft X 100)] X 25-Option Premium Where, S0 = Option strike price Ft = Future market price Before tax profit on call option = Security market price – Strike price – Opt. premium Note: The option is allowed to be expired, If it is out of money. Then, the loss or gain is only option premium.
- 83. Interest Rate Swap A contract between two parties to exchange interest payments in an effort to save money and hedge against interest-rate risk Swaps are often employed to deal with asset-liability maturity mismatches. 83
- 84. Interest Rate Swap Firm US Dollar Rate (in US) British Pound Rate (in UK) US Firm 10.0% 9.0% British Firm 11.0% 8.0%
- 85. U.S.A. U.K. Lender Lender $10,000 m £6,250 m US Firm US Firm British Firm British Firm
- 86. U.S.A. U.K. Lender Lender $10,000 m £6,250 m US Firm US Firm British Firm British Firm @10% @11% @8% @9% @10% @8%
- 88. 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 88
- 90. Parties to the SWAP Fixed interest rates parties must pay if they issue long-term bonds Floating interest rates parties must pa if they receive a short-term loan Potential interest rate savings of each borrower A lower credit- rated borrower 11.50% Prime+1.75% 0.50% A higher credit- rated borrower 9.00% Prime interest rate 0.25% Difference in interest rates due to differences in borrowers’ credit ratings (quality spread) 2.50% 1.75% 0.75%
- 91. Swaps can reduce risk by matching asset-liability maturity mismatch. Bank A Short- term asset with flexible yields Long-term liability with Carrying fixed interest rate Bank B Short-term liabilities with flexible interest Long-term asset with fixed interest rate Risk in decreasing interest rate Risk in rising interest rate
- 92. Risks of Interest Rate Swaps • Substantial Brokerage Fees • Credit Risk ▫ The counterparty may default on the exchange of the interest payments ▫ Only the interest payment exchange is at risk, not the principal • Basis Risk ▫ A swap’s reference interest rates are not the same as those attached to all the assets and liabilities (LIBOR, bond rates, etc.), so rates do not change exactly the same -> some risk remains 92
- 93. 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 93
- 94. 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 94
- 95. Interest Rate Floor A contract setting the lowest interest rate a borrower is allowed to pay on a flexible-rate loan 95
- 96. 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. 96
- 97. Quick Quiz • What is a call option? • Suppose market interest rates were expected to rise. What type of option would normally be used? • If rates were expected to fall, what type of option would a financial institution’s manager be likely to employ? 97