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CHAPTER SEVEN Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management. - PowerPoint PPT Presentation
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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.
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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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The Purpose of Financial Futures
To Shift the Risk of Interest Rate Fluctuations from Risk-Averse Investors to Speculators
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The World’s Leading Futures and Option Exchanges
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)
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Most Common Financial Futures Contracts
U.S. Treasury Bond Futures ContractsU.S. Treasury Bill Futures ContractsThree-Month Eurodollar Time Deposit Futures Contract30-Day Federal Funds Futures ContractsOne Month LIBOR Futures Contracts
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Hedging with Futures Contracts
Avoiding Higher Borrowing Costs and
Declining Asset Values
Use a Short Hedge: Sell Futures
Contracts and then Purchase Similar Contracts Later
Avoiding Lower Than Expected
Yields from Loans and Securities
Use a long Hedge: Buy Futures
Contracts and then Sell Similar
Contracts Later
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Basis Risk
Cash-Market Price (or Interest Rate) Less the Futures-Market Price (or Interest Rate)
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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
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Number of Futures Contracts Needed
Contract Futures theof Price * D
TA *) TATL
* D - (D
F
LA
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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.
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Types of Options
Put OptionGives the Holder of the Option the Right to Sell the Financial Instrument at a Set Price
Call OptionGives the Holder of the Option the Right to Purchase the Financial Instrument at a Set Price
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Most Common Option Contracts Used By Banks
U.S. Treasury Bill Futures Options
Eurodollar Futures Option
U.S. Treasury Bond Option
LIBOR Futures Option
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Principal Uses of Option Contracts
Protection of the Bond Portfolio
Hedging Against Positive or Negative Gap Positions
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Interest Rate Swap
A Contract Between Two Parties to Exchange Interest Payments in an Effort to Save Money and Hedge Against Interest-Rate Risk
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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
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Risks of Interest Rate Swaps
Substantial Brokerage Fees
Credit Risk
Basis Risk
Interest Rate Risk
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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
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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.
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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
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Interest Rate Floor
A Contract Setting the Lowest Interest Rate a Borrower is Allowed to Pay on a Flexible-Rate Loan
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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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