Financial Futures Contract

2. CHAPTER SEVENUsing Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management The purpose of this chapter is to examine how financial futures, option, and swap contracts, as well as selected other asset-liability management techniques can be employed to help reduce a bank’s potential exposure to loss as market conditions change. We will also discover how swap contracts and other hedging tools can generate additional revenues for banks by providing risk-hedging services to their customers.

3. 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

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

5. Chicago Board of Trade (CBOT) Financial Exchange (FINEX) New York Futures Exchange (NYFE) Marche a Terme International De France (MATIF) Singapore Exchange LTD. (SGX) Chicago Mercantile Exchange (CME) London International Financial Futures Exchange (LIFFE) Sydney Futures Exchange Toronto Futures Exchange (TFE) The World’s Leading Futures and Option Exchanges

6. Most Common Financial Futures Contracts • U.S. Treasury Bond Futures Contracts • U.S. Treasury Bill Futures Contracts • Three-Month Eurodollar Time Deposit Futures Contract • 30-Day Federal Funds Futures Contracts • One Month LIBOR Futures Contracts

7. Hedging with Futures Contracts

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

9. 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

10. Number of Futures Contracts Needed

11. 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.

12. 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

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

14. Principal Uses of Option Contracts • Protection of the Bond Portfolio • Hedging Against Positive or Negative Gap Positions

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

16. 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

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

18. 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

19. 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.

20. 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

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

22. 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.