468-23-1 - Chapter 23 - MANAGING RISK WITH DERIVATIVES FIs...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Chapter 23 - MANAGING RISK WITH DERIVATIVES FIs can use derivatives to manage interest rate, credit and FX risk. Spot Market: Cash transactions for immediate delivery (1-3 days) of commodities, securities (bonds, stocks), FX. Forward Market : Agree on P and Q, for future delivery (1 week to 10 years), often customized, nonstandardized contracts for FX, commodities, securities. Actual exchange of commodity, FX, securities takes place, on expiration (settlement) date. Secondary markets for forward contracts are usually thin or nonexistent. Some possibility for default. Futures Markets : Exchange-traded standardized securities (size and settlement date), organized exchanges, active secondary market, daily settlement to eliminate default risk, cash settlement, daily price limits. $3T market for FIs. Hedging with Forward Contracts Naive Hedge - Full (100%) "perfect" hedge of a cash asset with a forward or futures contract. Example p. 631: Portfolio manager holds $1m face value 20-year T-Bonds, current price is 97%, or $970,000. Interest rates are 8%, but the FI forecasts that interest rates will rise to 10% over the next 3 months, causing a large capital loss for FI. D = 9 years. To calculate the possible capital loss: Δ% PV Bond = -D * [ΔR / (1 + R)] %P = -9 * ( .02 / 1.08) = -.16667 or -16.6667% OR %P = -9 * ( 2% / 1.08) = -16.6667% $970,000 - 16.6667% = $808,333 (or a loss $161,667) $97 - 16.6667% = $80.8333 Manager can make an off-balance-sheet hedge with a forward contract. Manager is worried about interest rates rising and bond prices falling, so would want to take a short position and sell T-Bonds forward 3 months, and find a buyer to go long at 97 for $1m face value of T-Bonds in 3 months. The buyer could be someone who is worried about interest rates going down in the next three months, i.e., a life insurance company planning to invest $1m in three months. Assume that the life insurance does not have the same forecast about interest rates rising. Payoff Diagram: Long Profit + + F Spot Price Expiration -- -- Loss Short BUS 468 / MGT 568: FINANCIAL MARKETS – CH 23 Professor Mark J. Perry 1
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Suppose that interest rates do rise and the FI has a capital loss of 16.67%, or $161,667, because the P went from 97 to 80.333. However, they can now buy $1m of face value 20-year bonds in spot market at $80.833 (80.333% of face), or $808,333, and can sell to the forward contract buyer at 97, or $970,000, for a gain of $161,667 (off-balance-sheet) to exactly offset the capital loss (on balance sheet). Any other change in interest rates would result in an off-balance-sheet gain (loss) to exactly offest the loss (gain) on-balance-sheet. Result:
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 01/24/2012 for the course MGT 568 taught by Professor Staff during the Spring '11 term at University of Michigan.

Page1 / 6

468-23-1 - Chapter 23 - MANAGING RISK WITH DERIVATIVES FIs...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online