Financial Futures, Forward Rate Agreements, and Interest Rate Swaps

1. Financial Futures, Forward Rate Agreements, and Interest Rate Swaps

2. Cash and Forward Markets Cash or spot market transactions represent the exchange of any asset between two parties who agree on the asset characteristics and price, where the buyer tenders payment and takes possession of the asset when the price is set. A forward contract involves two parties agreeing on asset characteristics, quantity, and price but deferring the actual exchange until a specified future date.

3. Futures versus Forward Contracts Futures contracts differ from forward contracts because they are traded on formal exchanges, involve standardized instruments, and positions require a daily marking to market. In Turkey, (Izmir) Vadeli Islem ve Opsiyon Borsasi is the only futures exchange in operation. (www.vob.org.tr) The most prominent in the United States are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) Forward contracts are negotiated between parties, do not necessarily involve standardized assets, and require no cash exchange until expiration.

4. The asset for which the futures contract is written is called the underlying asset. The underlying assets could be a short-term money market instrument a long-term bond units of a foreign currency precious metals common stock indexes If the underlying asset is an interest-bearing instrument, the contracts are labeled interest rate futures.

5. Characteristics of Financial Futures Financial futures contracts represent a commitment between two parties on the price and quantity of a standardized financial asset or index. They are traded on organized exchanges called futures markets. Buyers of futures contracts, referred to as long futures, agree to pay the underlying futures price and receive the underlying asset. Sellers of futures contracts, referred to as short futures, agree to receive the futures price and deliver the underlying asset.

6. Characteristics of Financial Futures Buyers and sellers can eliminate their commitments in two ways: 1. By taking the opposite position prior to contract expiration by selling or buying the futures contract, or 2. By making or taking delivery of the underlying asset.

7. Characteristics of Financial Futures When closing a position: The buyer of a futures contract will realize a profit if futures price increases since the buyer will close the position by selling the same futures contract at a higher price. The seller of a futures contract will realize a profit if futures price decreases since the seller will close the position by buying the same futures contract at a lower price.

8. The Mechanics of Futures Trading Each party to a futures transaction effectively trades with exchange members who, in turn, guarantee the performance of all participants. A buyer of a Treasury-bill futures contract with delivery in 60 days can offset the position by selling the same contract one week later when 53 days remain to delivery.

9. Expiration and Delivery Every futures contract has a formal expiration date. At expiration, trading stops and participants settle their final positions. Note that only the open positions settle.

10. Futures Positions and Margin Requirements At the beginning of the contract, the parties to the contract are required to open a margin account in which they deposit a certain amount of money (margin requirements). At the end of every day, the value of the futures contract in question is determined (taken from the market quotes). Exchange members require traders to meet margin requirements that specify the minimum deposit allowable at the end of each day.

11. Futures Positions and Margin Requirements The change in value of each trader�s account at the end of every day is credited to the margin accounts of those with gains and debited to the margin accounts of those with losses. This process is called marking-to-market and the daily change in value is called the variation margin. The purpose in setting up a margin account is to guarantee performance by the buyer and seller by acknowledging the gains and losses they have before the contract expires.

12. Futures Positions and Margin Requirements Example: Initial margin = $ 7 per contract Maintenance margin = $ 4 per contract Investor A buys 500 contracts at a price of $100. Investor B sells 500 contracts at a price of $100. Initial margin for A and B = 500 x $7 = $3,500 Maintenance margin for A and B = 500 x $4 = $2,000

13. Futures Positions and Margin Requirements Trading Day Settlement Price 1 $99 2 $97 3 $98 4 $95 Perform �marking-to-market� for the margin accounts.

14. Futures Positions and Margin Requirements Buyer�s Margin Account: bought, will now sell to close the position Day 1: ? = $99 � $100 = -$1 x 500 = -$500 Final Amount = $3500 � $500 = $3000 Day 2: ? = $97 � $99 = -$2 x 500 = -$1000 Final Amount = $3000 � $1000 = $2000 Day 3: ? = $98 � $97= +$1 x 500 = +$500 Final Amount = $2000 + $500 = $2500 Day 4: ? = $95 � $98 = -$3 x 500 = -$1500 Final Amount = $2500 - $1500 = $1000 Will receive a margin call and will deposit $2500 ($3500 - $1000) into the margin account to bring its balance up to the initial balance Final Amount after deposit = $3500

15. Futures Positions and Margin Requirements Sellers Margin Account: sold, will now buy to close the position Day 1: ? = $100 � $99 = +$1 x 500 = +$500 Final Amount = $3500 + $500 = $4000 Will withdraw $500 ($4000 - $3500) Final amount after withdrawal = $3500 Day 2: ? = $99 � $97 = +$2 x 500 = +$1000 Final Amount = $3500 + $1000 = $4500 Will withdraw $1000 ($4500 - $3500) Final amount after withdrawal = $3500 Day 3: ? = $97 � $98= -$1 x 500 = -$500 Final Amount = $3500 - $500 = $3000 Day 4: ? = $98 � $95 = +$3 x 500 = +$1500 Final Amount = $3000 + $1500 = $4500 Will withdraw $1000 ($4500 - $3500) Final amount after withdrawal = $3500

16. An Example:90-Day Eurodollar Time Deposit Futures Eurodollar futures contracts are traded on the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange. The underlying asset is a Eurodollar time deposit with a 3-month maturity. Eurodollar rates are quoted on an interest-bearing basis, assuming a 360-day year. Each Eurodollar futures contract represents $1 million of initial face value of Eurodollar deposits maturing three months after contract expiration. Forty separate contracts are traded at any point in time, as contracts expire in March, June, September and December.

17. An Example (continued):90-Day Eurodollar Time Deposit Futures Eurodollar futures contracts trade according to an index that equals 100 percent minus the futures interest rate expressed in percentage terms. An index of 91.50 indicates a futures rate of 8.5 percent. Each basis point change in the futures rate equals a $25 change in value of the contract (0.0001 x $1 million x 90/360).

18. The first column indicates the settlement month and year. Each row lists price and yield data for a distinct futures contract that expires sequentially every three months. The next four columns report the opening price, high and low price, and closing settlement price. The next column, headed Chg, states the change in settlement price from the previous day. The two columns under Yield convert the settlement price to a Eurodollar futures rate as: 100 - settlement price = futures rate Eurodollar Futures

19. The Basis The term basis refers to the corresponding futures price minus the cash price of an asset at a point in time. For Eurodollar futures, the basis can be calculated as: basis = futures rate - cash rate It may be positive or negative, depending on whether futures rates are above or below cash rates.

20. The Relationship Between Futures Rates and Cash Rates -- One Possible Pattern

21. Speculation Versus Hedging Futures traders who take speculative positions purposefully increase their overall risk position with the hope of earning extraordinary profits. Futures traders who hedge take a position to reduce overall risk by: positioning the futures contract to increase in value when the cash position decreases in value, and vice versa With financial futures, risk cannot be eliminated, only reduced. Traders normally assume basis risk in that the basis (futures rate minus cash rate) might change adversely between the time the hedge is initiated and closed.

22. Hedging by Using Futures A trader who loses when cash market interest rates decrease will normally gain in the futures market with a long position since futures rates (prices) also decrease (increase) and the contract increases in value. A long position: Bought at the low price before the interest rates decrease Sells at the higher price after the interest rates decrease

23. Profit Diagrams for the September 1998 Eurodollar Futures Contract

24. Seven Basic Steps in Implementing Hedges for Commercial Banks: 1. Identify the cash market risk exposure to be reduced 2. Based on the cash market risk, determine whether a long or short futures position is needed 3. Select the best futures contract 4. Determine the appropriate number of futures contracts to trade (Hedge Ratio) 5. Buy or sell the appropriate futures contracts 6. Determine when to get out of the hedge position, either by reversing the trades in Step 5, or by letting contracts expire and making or taking delivery 7. Verify that futures trading meets regulatory requirements and the bank�s internal risk policies

25. A Long Hedge A long hedge is appropriate for a participant who wants to reduce cash market risk associated with a decline in interest rates. If cash rates decline, typically futures rates will decline also so that the value of the futures position will likely increase. The buyer makes a profit when s/he closes the position by selling the same contract at the higher price. Any loss in the cash market is at least partially offset by a gain in futures.

26. Key steps in hedging to a bank that implements a Eurodollar futures hedge: On April 2, 2002, your bank expects to receive a $1 million payment on November 8, 2002, and anticipates investing the funds in 3-month Eurodollar time deposits. If the bank had the funds in hand in April, it would immediately buy Eurodollar deposits. The cash market risk exposure is that the bank will not have access to the funds for seven months. In April 2002, the market expects Eurodollar rates to decrease sharply as evidenced by falling futures rates. In order to hedge, the bank should buy futures contracts, a long futures position The best futures contract will generally be the December 2002, 3-month Eurodollar futures contract, which is the first to expire after November 2002. The contract that expires immediately after the known cash transactions date is generally best because its futures price will show the highest correlation with the cash price.

27. Long Hedge Using Eurodollar Futures

28. A Short Hedge A short hedge applies to any participant who wants to reduce the risk of an increase in cash market interest rates (or a reduction in cash market prices). The appropriate strategy is to sell futures contracts on securities similar to those evidencing the cash market risk. If cash rates increase, futures rates will generally increase so that the value of the futures position will likely decrease. The seller will make a profit when s/he closes the position by buying the contract at the lower price. The loss in the cash position will be at least partially offset by a gain in futures value.

29. Short Hedge Using Eurodollar Futures

30. Short Hedge Using Eurodollar Futures

31. Change in the Basis Long and short hedges work well if the futures rate moves coincidentally with the cash rate. The actual risk assumed by a trader in both hedges is not that the level of interest rates moves against the cash position, but that the basis might change adversely between the time the hedge is initiated and closed. The effective return from a hedge equals total income from the combined cash and futures positions relative to the investment amount: Effective return = Initial cash rate - Change in basis

32. Basis Risk and Cross Hedging In a perfect hedge, the profit or loss in the cash position is exactly offset by the profit or loss from the futures position. This would occur if the basis change always equaled zero. A cross hedge is one in which a participant uses a futures contract based on one security that differs from the security being hedged in the cash market.

33. Microhedging Applications Microhedges refer to the hedging of a transaction associated with a specific asset, liability, or commitment. Macrohedges involve taking futures positions to reduce aggregate portfolio interest rate risk, typically measured by GAP or duration gap. Banks are generally restricted to using financial futures for hedging purposes. They must recognize futures on a micro basis by linking each futures transaction with a specific cash instrument or commitment in a contemporaneous log of hedge transactions.

34. Microhedging versus Macrohedging Many analysts feel that such micro linkages force microhedges that may potentially increase a firm�s total risk because these hedges ignore all other portfolio components. Accounting requirements may focus attention on inappropriate risk measures. Macrohedging is difficult to implement because of problems in accurately measuring a firm�s overall interest rate risk and in monitoring hedging effectiveness.

35. Creating a Synthetic Liability with a Short Hedge On June 29, 2005 a bank agrees to finance a $1 million 6-month working capital loan to a corporate customer. Management wants to match-fund the loan by issuing a $1 million, 6-month Eurodollar time deposit. At the time of the funding decision, 3-month Eurodollar time deposit rate is 5.70%. 6-month Eurodollar time deposit rate is 5.78%. Bank decides to issue a 3-month Eurodollar, then issue another one when the first one matures. In the meantime, a short futures position will reduce the risk of rising interest rates for the second cash Eurodollar borrowing.

36. Creating a Synthetic 6-Month Eurodollar Liability

37. Creating a Synthetic Liability with a Short Hedge

38. The Mechanics of Applying a Microhedge Determine the bank�s interest rate risk position The objective is to know in what interest rate environment the bank loses. Forecast the dollar flows expected in cash market transactions The objective is to determine how many futures contracts are necessary. Choose the appropriate futures contract The contract whose rates most highly correlate with those of the cash asset or liability being hedged.

39. The Mechanics of Applying a Microhedge Determine the correct number of futures contracts  NF = number of futures contracts A = dollar value of cash flow to be hedged F = face value of futures contract Mc = maturity or duration of anticipated cash asset or liability Mf = maturity or duration of futures contract  Determine the Appropriate Time Frame for the Hedge Generally, a bank matches the length of the hedge with the timing of cash flows for the underlying asset or liability. Monitor Hedge Performance

40. Forward Rate Agreements (FRA) While futures and forward contracts are similar, forward contracts differ because they are negotiated between counter-parties, there is no daily settlement or marking-to-market, no exchange guarantees performance FRAs are cash-settled at the settlement date with no interim cash flows.

41. Notional Principal Amounts The two counterparties to an FRA agree to a notional principal amount that serves as a reference figure in determining cash flows. notional refers to the condition that the principal does not change hands, but is only used to calculate the value of interest payments. The buyer of the FRA agrees to pay a fixed-rate coupon payment and receive a floating-rate payment against the notional principal at some specified future date. The seller of the FRA agrees to pay a floating-rate payment and receive the fixed-rate payment against the same notional principal.

42. A forward rate agreement (FRA) is a forward contract based on interest rates The buyer of an FRA agrees to pay a fixed-rate coupon payment (at the exercise/contract rate) and receive a floating-rate payment against a notional principal amount at a specified future date. The buyer of an FRA will receive (pay) cash when the actual interest rate at settlement is greater (less) than the exercise/contract rate (specified fixed-rate). The seller of an FRA agrees to make a floating-rate payment and receive a fixed-rate payment against a notional principal amount at a specified future date. The seller of an FRA will receive (pay) cash when the actual interest rate at settlement is less (greater) than the exercise rate.

44. On the dealing date, two parties to the FRA agree on all the terms. E.g. dealing date = Monday 12th April 1993 two parties agree to trade 1x4 FRA in $1M at 6.25% Meaning: contract currency = US dollar contract amount = $1 million contract rate = 6.25% 1x4 ? one-month period between the spot date and the settlement date four-month period between the spot date and the final maturity of the notional loan Spot date is normally two business days after the dealing date, so it is Wednesday 14th April 1993. Meaning: notional loan (or deposit) will start Friday 14th May 1993 (one month after spot) and will mature Monday 16th August 1993 (three months after spot)

45. Settlement date is 14th May, 1993. Maturity date is 16th August, 1993. Contract period is 94 days. The fixing date is when the reference rate is determined and it is two days before the settlement date. The reference rate is the rate on which the two parties agree to take as a basis for settlement.

46. Forward Rate Agreements: An Example Seller: Metro Bank will receive fixed rate payments at 7% and will make floating-rate payments at 3-month LIBOR. Buyer: County Bank will receive floating-rate payments at 3-month LIBOR and will make fixed rate payments at 7%. Notional principal = $1,000,000 Maturity = 6 months

47. Metro Bank would refer to this as a �3 vs. 6� or �3x6� FRA at 7 percent on a $1 million notional amount from County Bank. a 6-month maturity based on a $1 million notional principal amount floating rate is 3-month LIBOR and the fixed (exercise) rate is 7 percent The phrase �3 vs. 6� refers to a 3-month interest rate observed three months from the present, for a security with a maturity date six months from the present. So, the settlement is 3 months from today and the maturity is 6 months from today. The only cash flow will be determined in six months at contract maturity by comparing the prevailing 3-month LIBOR with 7 percent.

48. Assume that in three months, the 3-month LIBOR equals 8 percent. In this case, County Bank would receive from Metro Bank $2,451. The interest settlement amount is $2,500: interest = (0.08 - 0.07)(90/360)($1,000,000) = $2,500. Since this amount represents interest that would be paid three months later at the maturity of the instrument, the actual payment is discounted at the prevailing 3-month LIBOR: actual interest paid = $2,500/[1+(90/360)(0.08)]=$2,451 If instead, LIBOR equals 5 percent in three months, County Bank would pay Metro Bank: interest = (0.07 -0.05)(90/360)($1,000,000) = $5,000 $5,000 / [1 + (90/360)(0.05)] = $4,938

51. Metro and County Banks� positions are similar to a futures position In the previous example, County Bank would pay fixed-rate and receive floating-rate as a hedge if it was exposed to a loss in a rising rate environment. This is analogous to a short futures position since with short futures, rising rates means falling prices falling prices mean selling for higher at the beginning and buying for cheaper at the end

52. Metro Bank would pay floating-rate and receive fixed-rate as a hedge if it was exposed to a loss in a falling rate environment. This is analogous to a long futures position since with long futures, falling rates means rising prices rising prices means buying for cheaper at the beginning and selling for higher at the end

53. Interest Rate Swaps as a Risk Management Tool An interest rate swap is an agreement between two parties to exchange interest payments for a specific maturity on a specified principal amount.

54. Plain Vanilla Swaps With plain vanilla interest rate swaps, two parties facing different types of interest rate risk can exchange interest payments. One exchanges a fixed-rate payment for a floating rate payment. The other party exchanges a floating rate payment for a fixed-rate payment. When interest rates change, the party that benefits from a swap receives a net cash payment while the party that loses makes a net cash payment.

55. Swap Transactions Most swap transactions are handled by swap dealers who make a market in swap contracts. They offer terms for both fixed-rate and floating rate payers and earn a spread for their services. With an interest rate swap transaction, the two firms essentially trade interest rate payments on a portion of their portfolios. Risk can be reduced if the firm with a negative GAP (lose if rates rise) makes a fixed-rate interest payment in exchange for a floating-rate interest receipt. The firm with a positive GAP (lose if rates fall) takes the opposite position, by making floating-interest payments in exchange for a fixed-rate receipt.

56. Interest Rate Swap Dealer Quotes for Basic Swaps: Fixed-Rate Versus 3-Month LIBOR, March 18, 1998 The first column indicates the term or maturity of the basic swap contract. The second column lists the prevailing U.S. Treasury spot rate with the same maturity as that for the swap. The third block of data represents the dealer�s bid-offer spread relative to the prevailing Treasury rate. The final block of data provides the fixed rates for the different maturity swaps. Bid rates indicate the fixed rate that a swap party will receive if it pays 3-month LIBOR. Offer rates indicate the fixed rate that a swap party will pay if it receives 3-month LIBOR. The difference represents the dealer�s spread or profit potential.

57. Conceptually, a basic interest rate swap is a package of FRAs As with FRAs, swap payments are netted and the notional principal never changes hands Using data for a 2-year swap based on 3-month LIBOR as the floating rate: This swap involves eight quarterly payments. Party FIX agrees to pay a fixed rate Party FLT agrees to receive a fixed rate with cash flows calculated against a $10 million notional principal amount The following rates apply: Party FIX: Pay: 5.83% Receive: 3-month LIBOR Party FLT: Pay: 3-month LIBOR Receive: 5.79%

58. Cash Flows Associated With Basic Interest Rate Swap Position

59. Adjust the Rate Sensitivity of an Asset or Liability The most common use of basic swaps is to adjust the rate sensitivity of a specific asset or liability: making a fixed-rate loan a floating rate loan, converting a floating rate liability to a fixed-rate liability Consider a bank that makes a $1 million, 4-year fixed-rate loan at 9 percent it finances the loan by issuing a 3-month Eurodollar deposit priced at 3-month LIBOR. The following T-account demonstrates the transaction Asset Liability Loan: $1 million 3-month Eurodollar 4-year maturity deposit: $1 million Rate: 9% fixed Rate: 3-month LIBOR floating

60. This Transaction Exhibits Considerable Interest Rate Risk The bank will see its net interest income shrink if it continues to roll-over the 3-month deposit at each maturity date and LIBOR increases. The bank is liability sensitive and loses (gains) if LIBOR rises (falls). The bank could agree to pay 5.91%and receive 3-month LIBOR against $1 million for the four years, matching this with its continuous issuance of 3-month Eurodollar Net Effect of Balance Sheet Transaction + Swap Receive : 9% from loan + 3-month LIBOR from swap Pay : 3-month LIBOR to Eurodollar deposit  + 5.91% to swap Net spread = 3.09% The use of the swap enables the bank to reduce risk and lock-in a spread of 3.09% (9% - 5.91%)

61. Commercial customer who demands a fixed-rate loan The bank wants to price the loan on prime. Suppose that the bank makes the $1 million, 3-year fixed-rate loan. Enter a 3-year basic swap involving prime as the floating-rate and a fixed-rate based on prevailing Treasuries. $1 million notional principal amount, agreeing to pay a 4.56 percent fixed rate and receive (prime minus 2.82 percent) with quarterly payments. The effective interest rate received is now a floating rate equal to prime plus 162 basis points: Loan Basic Swap Receive: 9.00% Prime - 2.82% Pay: 4.56% Net receipt: Prime + (9.00% - 2.82% - 4.56%)  or Prime +1.62% This swap effectively converts a fixed-rate loan into a loan with a rate that floats with the prime rate.

62. Comparing Financial Futures, FRAs, and Basic Swaps Financial futures are standardized contracts based on fixed principal amounts. Parties negotiate the notional principal amount with FRAs and interest rate swaps. Financial futures require daily marking-to-market, which is not required with FRAs and swaps. The market for FRAs is not that liquid and most contracts are short-term. Swap activity has recently grown to where participants can readily buy and sell swaps in a secondary market and thus exit a position when needed. Finally, swap documentation is quite standardized and participating firms can negotiate master agreements with partners that enhance the development of long-term business relationships.

63. The Risk with Swaps They lock in much higher fixed interest expense for the benefit of risk reduction There is some credit risk with swaps as well, but this is not as great as it originally seems Swap parties exchange only net interest payments, so no principal is at risk