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Chapter Eight

Chapter Eight. Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management. 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.

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Chapter Eight

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  1. Chapter Eight Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management

  2. 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

  3. The Purpose of Financial Futures To Shift the Risk of Interest Rate Fluctuations from Risk-Averse Investors to Speculators

  4. 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) The World’s Leading Futures and Option Exchanges

  5. 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

  6. Hedging with Futures Contracts

  7. 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)

  8. 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)

  9. Basis Cash-Market Price (or Interest Rate) Less the Futures-Market Price (or Interest Rate)

  10. Realized Return from Combining Cash and Futures Market Trading = Return Earned in the Cash Market +/- Profit or Loss from Futures Trading • Closing Basis Between Cash and Futures Market • Opening Basis Between Cash and Futures Market

  11. Change in the Market Value of the Futures Contract

  12. Number of Futures Contracts Needed

  13. 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.

  14. 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

  15. Most Common Option Contracts Used By Banks • U.S. Treasury Bond Futures Options • Eurodollar Futures Option

  16. Principal Uses of Option Contracts • Protection of a Security Portfolio • Hedging Against Positive or Negative Gap Positions

  17. 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

  18. Regulations For Options and Future Contracts • OCC – Risk Management of Financial Derivatives: Comptrollers Handbook • FASB – Statement 133 – Accounting for Derivatives Instruments and Hedging Activities

  19. Interest Rate Swap A Contract Between Two Parties to Exchange Interest Payments in an Effort to Save Money and Hedge Against Interest-Rate Risk

  20. 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

  21. Risks of Interest Rate Swaps • Substantial Brokerage Fees • Credit Risk • Basis Risk • Interest Rate Risk

  22. 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

  23. 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.

  24. 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

  25. Interest Rate Floor A Contract Setting the Lowest Interest Rate a Borrower is Allowed to Pay on a Flexible-Rate Loan

  26. 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.

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