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Bank Mgt. 5th Ed, Chapter 13 - Financial Futures&...

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Unformatted text preview: Financial Futures & Forwards: Financial Hedging & Pricing Hedging Chapter 13 1 Overview of Derivatives Derivatives are so called because the values Derivatives of forwards, futures, options, & swaps each are derived from some other instrument. are 3 Other instrument is called the underlying, & Other they include items such as: they 3 – – – – Corporate shares Fixed-income securities Currency & Money market instruments Stock or bond indexes + Continued 2 Overview of Derivatives(Cont.) Derivatives are abstractions that depend on Derivatives reference to something else. reference 3 At end of 1997, banks held a notional At amount of derivatives equal to $26 trillion. 3 (This is 5 times the value of banks’ balance sheet assets.) (This – Notional amounts are the amounts of underlying Notional reference values such as those listed above. reference – They do not require commitment of principal They applied in underlying reference values. applied – Derivatives create payment obligations derived Derivatives from pseudo principal values. + from Continued 3 Overview of Derivatives(Cont.) Derivatives are heavily concentrated in Derivatives large banks, who use 90% for trading. large 3 Eight banks account for 95% of bank Eight derivatives. derivatives. 3 Smaller regional banks use for customer & Smaller own use. own 3 Derivatives used by banks to: 3 – – – Modify maturity/repricing of assets/liabilities. Price cash products. Trade for profit. + 4 Basics of Forward & Futures Basics Contracts Contracts 3 3 3 3 3 Forward & future contracts set the terms today for Forward transactions taking place in future. transactions Banks make loans by contracting forward for Banks positions in borrower income streams. positions Acquire long-term investment securities by Acquire contracting forward for positions in future shortcontracting term interest rates embedded in security yields. Sell deposits & investment products by contracting Sell short positions for future payments. short Forwards, futures & other derivative products can be Forwards, used to manage risk-return structure. + used Continued 5 Basics of Forward & Futures Basics Contracts (Continued) Contracts 3 3 3 Forwards & futures differ from cash transactions in Forwards that they call for future exchange of cash in return for delivery or receipt of currency, securities, or commodities at a price set today. commodities Cash transactions typically require an immediate Cash exchange of cash/credit & delivery of commodity. exchange At the time they are originated, positions in futures At & forwards have no monetary value. + forwards 6 Example of Why You Should Enter Into Example Forward Delivery of Securities, Cash, Etc. Forward 3 3 3 3 3 3 Farmer decides in March to sell corn crop forward for Farmer delivery in September @ $5 per bushel. delivery If price of corn falls to $4 by September, farmer is entitled to If sell corn for $5 & protects crop value. sell On the other hand, if corn prices rise to $6 in September, he On still must sell for $5. still By locking price to March planting, he missed chance to By make $6, but had comfort of locking in price to protect value at harvest. at He eliminated his price risk. Forward market enabled him to to take future position in Forward goods that didn’t exist at that time. + goods 7 Difference in Futures Contracts Difference & Forward Contracts Forward 3 3 3 Futures contracts are standardized as to size, Futures quality, & date of delivery of goods, & for many types of futures, liquidity is ensured by deep supply of contracts. of Futures buyers & sellers seldom take delivery of Futures underlying asset but sell/buy offsetting contracts before delivery date. before Forward contracts, as opposed to futures contracts, Forward are individualized agreements between buyer & seller requiring delivery of asset at specified time, 8 with payment on delivery. + with Disadvantages to Forwards 3 For several reasons, the lack of For standardization creates serious disadvantages. disadvantages. – First, it may be difficult to find a trading partner First, that has same time, quantity, & grade needs. that – Second, on forward contracts, delivery is often Second, called for even though one may not want it. called – Third, most important difference between Third, forwards & futures is settlement risk. settlement – Trust between buyer & seller is not a concern in Trust futures contracts because of daily mark-tofutures Continued 9 market which shows change in underlying asset. market Disadvantages to Forwards (Cont.) – At the outset, neither forward nor futures At contracts have monetary value. contracts – In forward market, time passes & market value In of underlying asset changes, creating a loss for one party & gain for the other party. one – This makes for for settlement-risk in forward This market where there is not daily settlement such as in the futures market. as – Once market changes, losing party doesn’t want Once to comply with contract. to – The buyer has everything to gain by not The 10 performing. + performing. Margin & Settlement Example 3 An example of margin requirements & settlements: – Futures contracts call for delivery of a cash T-bill Futures with $1 million face value, 90-92 day maturity. with – Delivery occurs on Thur., Fri., or Mon. after 3rd Delivery Monday of delivery month. Monday – Delivery month rotation for International Delivery Monetary Market is Mar., Jun., Sept. & Dec. Monetary – T-bill contract is priced on discount basis T-bill comparable with cash T-bills (spot T-bills). comparable – Quoted as index (100 - annual % discount). – Index of 94 implies 6% annual discount. + 11 Continued Margin & Settlement Example (Cont.) – As with bonds, index & discount (price & interest As rate) move in opposite directions. rate) – T-bill futures calculations assume 90-day maturity T-bill & 360-day year. 360-day – This results in price movement of $25 compared This to a single basis point change (this is called a tick or the value of 01.) or – Investors who buy (long) or sell (short) in futures Investors must deposit initial margin with broker for losses. must – Margin acts as performance bond. – Losing customer’s margin account is reduced. + 12 Table 13.1-Futures Settlement Procedure Example 90-day Treasury bill futures: Current margins are: Initial = $1,200 & Maintenance = $800 March 1: Cavarett Securities buys 100 contracts (long) Entry price 94.92 Closing price 94.79 Ticks moved -13 Initial margin $120,000 Settlement variation (-13) x $25 x 100 contracts -32,500 -32,500 Ending account balance $ 87,500 March 2: No trades March No Previous day’s close 94.79 Close on 3/2 94.73 Ticks moved -6 Opening margin $ 87,500 Settlement variation (-6) x $25 x 100 contracts -15,000 -15,000 Ending account balance $ 72,500 March 3: Cavaretta Securities liquidates positions Previous day’s close 94.73 Liquidation price 94.95 Ticks moved +22 Margin contribution $ 7,500 Opening margin 80,000 Settlement variation (+22) x $25 x 100 contracts +55,000 (+22) +55,000 Ending account balance $ 135,000 Profit computation: -$32,500 - $15,000 + $55,000 = + $7,500 13 Forward Prices 3 3 3 Two types of contracts used most by banks are those involving interest rates & foreign currency. Prices of forward contracts should have a logical connection to spot prices for the same assets--only difference between them is time. Forward-spot relationship depends on well-known principle of arbitrage-free markets. – Requires that two proposed deal with same payoffs be priced the same. – If not priced same, price difference is eliminated by the buying & selling action of arbitrageurs. 3 Pure arbitrage has no risk because no net investment 14 is put up--thus riskless arbitrage. + Arbitrage If forward price is greater that spot price, we sell the If overpriced one & but the underpriced one. overpriced EXAMPLE: March 20th Borrow $970,000 for 91 days @ 6.25% +$970,000 Buy six-month T-bill for $970,000 -970,000 Sell June T-bill futures for $986,000 0 March 20th net cash flow $0 June 19th June futures expires: Deliver 91-day T-bill +$986,000 Repay loan = $970,000(1.0625 x 91/360) -984,979 -984,979 June 19th net cash flow +$1,021 15 Microhedging 3 3 3 3 Most important aspect of the relationship between Most spot & forward prices is the light it sheds on why interest rate futures hedges largely succeed. interest Position of future hedger remains open, changes in Position futures’ price correspond to movement of market rates of interest. rates Hedging with interest rate futures protects against Hedging unfavorable effects of interest rate movements on market value or income. market Two classifications of interest rate futures hedges: – Cash – Anticipatory + 16 Financial Institution Hedges 3 3 3 Financial institutions conduct two kinds of cash Financial hedges: hedges: – Asset hedges – Liability hedges Hedgers who buy futures contracts profit from Hedgers current interest rates & rise in price. current An anticipatory hedge is a hedge against a financial An commitment made in the future. commitment Sell Futures (Short) Sell X 17 Table 13.3 Asset & Liability Future Hedges Buy Futures (Long) Lengthen asset or shorten liability X Shorten asset or lengthen liability Table 13.4 Anticipatory Hedge, First Place Financial Corporation’s Six-Month CD Rollover Corporation’s Date Cash Transaction Futures Transaction Futures 1/20/98 Bank anticipates rollover of Bank sells 20 Bank three-month $10,000,000 six-month CDs Eurodollar futures at 1MM $10,000,000 on 4/1/98. Expect rise in CD index = 94.00 rate. Current CD rate = 6.20% (Implied rate = 6%) $315,167 4/1/98 Bank completes rollover of Bank buys 20 three-month $10,000,000 six-month CDs. Eurodollar futures at 1MM CD market rate = 8.25% index = 92.00 (Implied rate = 8%) $419,375 Change in CD interest cost: Gain settlement variation $10,000,000 (0.0825 - 0.0620)183 200 bps x 20 contracts x 360 $25 per bp = $100,000 $25 = $104,208 Cash (loss) $104,208 Cash Futures (gain)$100,000 Net loss $4,208 Net 18 Strip Hedge to Price Fixed-Rate Loans Futures markets link short-term forward Futures rates with present long-term ones. rates 3 Some financiers believe they can accurately Some & safely link a series of short-term forward rates to price fixed-rate loans. rates 3 Lending institutions favor floating-rate over Lending fixed-rate loans for help in repricing assets. fixed-rate 3 Banks must be sensitive to their customers Banks who generally favor fixed rates. who 3 Sells strips to hedge floating rate. + 19 3 Macrohedging Microhedging is used on a deal-by-deal Microhedging basis to protect specific positions against unfavorable movements in interest rates. unfavorable 3 Regulators & auditors require clear specs of Regulators & accounting for derivative hedges. accounting 3 Microhedging is specific & relatively easy Microhedging to show how they reduce risk. to 3 Macrohedges are not so straightforward. + 3 Continued 20 Macrohedging (Continued) It is difficult to measure a balance sheet’s It interest rate exposure primarily because balance sheet assets/liabilities contain many different kinds of risk. different 3 In relation to banks’ balance sheets, basis In risk is a special problem. risk 3 Issue of embedded option risk comes up Issue when banks grant customers right to prepay loans when rates fall. loans 3 Difficulty aside, we must measure balance Difficulty sheet equity risk in order to hedge it. + 21 sheet 3 Basis Risk Futures hedges usually are distorted by Futures basis risk. basis 3 Basis is difference in cash price & price of Basis the futures used to hedge the cash price. the 3 Basis risk is the risk that this difference will Basis fluctuate. fluctuate. 3 Basis risk is minimized by choosing futures Basis contracts for the hedge that are highly correlated with the cash position. + correlated 3 22 Foreign Exchange Forwards & Futures 3 3 3 3 3 3 Banks use forwards & futures to manage interest Banks rate risk & foreign exchange risk. rate Major banks are active makers of markets. Forward market is worldwide & cannot be pinned Forward down to a geographic location. down Speculators in short-run are even larger users of Speculators forward markets. forward Counterparty is a bank & not an exchange as is Counterparty case of futures markets. case Institutions in both markets control exposure they Institutions take in currency by adopting limits. + take 23 ...
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