Risk Management in Financial Institutions II: Hedging with Financial Derivatives

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Risk Management in Financial Institutions
(II)Hedging with Financial Derivatives

• Forwards
• Futures
• Options
• Swaps

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In April 2006, Bank of America holds 10 million
face value treasury bonds. The coupon rate of
the bond is 10, and the bond is sold at par.
The bond matures on April 2016. Bank of America
worries about its interest rate risk faced in the
next year. Illustrate Fleets interest rate
risk?
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Forward Contracts

• Agreements by two parties to engage in a
  financial transaction at a future point of time

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Interest-Rate Forward Markets

• Long contract buy securities at future date
• Locks in future interest rate
• Short contract sell securities at future date
• Locks in future price, so reduces price risk from
  change in interest rates

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Pros and Cons

• Pros of forward
• 1. Flexible
• Cons of forward
• 1. Lack of liquidity hard to find counter party
• 2. Subject to default risk Requires info to
  screen good from bad risk

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Financial Futures Markets
Traded on Exchanges Global competition Regulated
by CFTC Financial Futures Contract 1. Specifies
delivery of type of security at future date
2. Arbitrage ? At expiration date, price of
contract price of the underlying asset
delivered 3. i ?, long contract has loss, short
contract has profit Differences in Futures from
Forwards 1. Futures more liquid standardized,
can be traded again, delivery of range of
securities 2. Delivery of range prevents
corner 3. Mark to market avoids default risk
4. Don't have to deliver net long and short
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• Bank of America could take a short position in an
  interest rate forward. Specifically, it
  shorts/sells the treasury bond to a counterpart
  in April 2007 (that is 1 year later)) at a price
  of 10 million (which is todays bond price).
• 2007/4 is called the settlement date.
• The counterparty could take a long position on
  this US treasury bonds

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Alternatively, to hedge its interest rate risk,
Bank of America could take a short position of
10 million 10 2006 T- bond futures contract
with the settlement date of April/2007 and at a
price of 10 million. The face value for each
treasury bond futures contract is 100,000. What
is the number of contracts (NC) should be used
here?
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Options

• Options Contract
• Right to buy (call option) or sell (put option)
  instrument at exercise (strike) price up until
  expiration date (American) or on expiration date
  (European)

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Payoffs of Call option
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Payoff of a put option
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Hedge BOA Risk with Option

• What type of option should be applied?
• How?
• Face value of T-bond option is 100,000. BOA
  needs to buy 100 contracts of T-bond ____ option
  here.

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Covered Call A trading Strategy

• Buy Stock and sell a call on the stock.

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Example

• Current price of the IBM stock is
• Lets look at the call option of IBM in ____,
• Strike price is ____.
• If in ______, the stock price is ____, then the
  profit from the covered call option is ____ if
  the stock price is _____, then the profit is
  _____

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SWAP

• SWAPs are financial contracts that obligate each
  party to the contract to exchange (swap) a set of
  payments it owns for another set of payments
  owned by another party.
• Is a set of forward contracts
• Purpose
• Risk management
• Get lower cost of capital

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Components of a Swap

• The interest rate on the payments that are being
  exchanged
• The type of interest payment (variable or fixed)
• The amount of notional principal
• The time period over which the exchanges continue
  to be made

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Interest Rate Swap
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Why Engage in SWAP?

• Company A can borrow cheaper with floating rate,
  while its investment income is mainly fixed rated
• Having an income gap, trying to immunize interest
  rate risk

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Dangers of Using Derivatives

• Allow financial institutions to increase leverage
• Money placed in margin accounts is only a small
  portion of the price of futures contracts
• Expose banks to large credit risk since holding
  of financial derivatives could exceed the amount
  of bank capital
• Too complicated for most managers
• Notional amount versus credit risks