Upload
sam-sinha
View
223
Download
0
Embed Size (px)
Citation preview
7/25/2019 Derivatives in ALM
1/53
Derivatives in ALM
7/25/2019 Derivatives in ALM
2/53
Financial Derivatives
Swaps
Hedge Contracts
Forward Rate Agreements
Futures
Options
Caps, Floors and Collars
7/25/2019 Derivatives in ALM
3/53
Swaps
Agreement between two counterparties to exchangethe cash flows.
Cash flows determined on a specific notional principal
for a maturity period and a specified interest rate.
Swap Structures.
Fixed for Floating swaps:
Plain vanilla swaps are fixed for floating rate coupon
payments
Used by banks for managing interest rate gap
strategies
7/25/2019 Derivatives in ALM
4/53
Swaps
Swap Structures
Basis swaps:
Exchange payments between two floating rate
obligations by banks.
Used by bank to hedge risky exposures
through different floating interest rates.
Cross-currency swaps:
Interest payments between two currencies areexchanged between two counterparties.
Used by banks to hedge interest risk exposure
across currencies.
7/25/2019 Derivatives in ALM
5/53
Swap Contracts
An agreement between two parties to exchange
interest payments for a specific maturity on a
specified principle amount.
Two parties facing different types of interest rate riskcan exchange interest payments.
7/25/2019 Derivatives in ALM
6/53
Swap Contracts
Banks act as swap dealers linking two parties with
different interest rate risk.
Banks offer swap structures for both fixed and floating
rate payers and earn a spread for their intermediaryservice.
7/25/2019 Derivatives in ALM
7/53
Swap Contracts
A firm with large financial liability will benefit if they
agree on a fixed rate payment for their liability.
A firm with a large financial asset position will benefit
if they agree on a floating rate payment for their asset.
7/25/2019 Derivatives in ALM
8/53
Plain Vanilla Interest Rate Swap
7/25/2019 Derivatives in ALM
9/53
SWAP Contract: Example 1
Company A wishes to borrow Rs.10 million at a fixed
rate for five years and has been offered 9% fixed rate
or 6-month MIBOR+1%.
Company B wishes to borrow Rs.10 million at a
floating rate for five years and has been offered 6-month MIBOR + 0.4% or 8.50% fixed rate.
A Bank swaps the contracts for both the companies
7/25/2019 Derivatives in ALM
10/53
Swap Contract: Example 2
Company A wants to borrow at floating rate while
company B wants to borrow at a fixed rate.
Available rates:
Company B - Floating rate - MIBOR+0.5%, Fixed -10.5%
Company A - Floating rate - MIBOR+0.25%, Fixed - 10%
A bank agrees to be a swap dealer for both the companies
7/25/2019 Derivatives in ALM
11/53
Swap Contract: Example 3
Bank Details
Bank is liability sensitive and would lose if MIBOR
rates rise since the advances are funded by short term
deposits
Bank could agree to pay 8.60% fixed rate and receive
MIBOR for 3-years
Fixed
Assets
Deposits
Advances1,000,000
3year
at9%3month
Deposit
for
1,000,000atMIBOR
7/25/2019 Derivatives in ALM
12/53
Effect of Swap as a Hedge: Example 3
Receive 9% from loan and receive MIBOR from swapdeal
Pay 8.60% fixed rate on swap deal and pay MIBORfor the deposit
Net rate spread for the bank 0.40% (9.00 8.60)
Risk due to increase in MIBOR rate is eliminated forthe bank in the swap structure
7/25/2019 Derivatives in ALM
13/53
Risk Inherent in Swap deals
Swap contracts may lock in higher interest rates while
reducing the risk exposure.
Bank may have to bear the credit risk (inability of
either party of the swap contract not able to meet the
swap claim).
7/25/2019 Derivatives in ALM
14/53
Hedge Contracts
Hedging results in entry of contracts that results in a
consistent return for the bank.
Hedge is entered into only when the bank has an
open position that needs to be protected.
Hedge results in a profit for the bank when hedged
expectations are encountered.
Hedge results in a notional loss for the bank when
hedged expectations do not happen.
7/25/2019 Derivatives in ALM
15/53
Bankers as Hedgers in the Derivative Market
Banks are capable of reducing their risk exposure
through their derivative positions.
Risk reduction is achieved by the bank through the
offsetting of expected loss in the bank holding position
from derivative trading profits.
7/25/2019 Derivatives in ALM
16/53
Hedge Position
Interest rate increases
Expected returns from pre committed loans /investment falls
Negative gap position of the bank implies liabilitysensitive bank would incur loss in income.
Desirable hedge position would be to sell futurescontract now and buy later resulting in derivativeprofit.
7/25/2019 Derivatives in ALM
17/53
Hedge Position
Interest rate declines
Banks borrowing cost increases since committed
deposit rates are higher than the current interest rates
Positive gap position of the bank implies that the asset
sensitive bank would incur loss in income.
Desirable hedge position would be to buy futures
contract now and sell later resulting in derivative profit.
7/25/2019 Derivatives in ALM
18/53
Hedge: Long Futures: Hedge: Short Futures:loss when rates falls loss when rates rise
Hedge Positions
7/25/2019 Derivatives in ALM
19/53
Steps for Entering into Derivative Position
Identify the balance sheet risk exposure position.
Formulate expectations on the present risk exposure.
Verify the regulatory norms and the banks internalrisk policies.
Select the futures contract to be entered into by thebank.
Determine the number of futures contract to deal(Hedge Ratio).
7/25/2019 Derivatives in ALM
20/53
Determining the Number of Future contracts
( )A LFF F
D W D AN
D P
NF=Numberoffuturecontracts
DA=DurationofAssets;W=WeightDL=DurationofLiabilities
A=Total
Asset
Value
DF=DurationofFutures;PF=PriceofFuturescontract
7/25/2019 Derivatives in ALM
21/53
Steps for Entering into Derivative Position
Transacting in the futures contract in the market.
Identify when to withdraw from the futures position.
Reverse the trade.
Wait for the contract to expire.
Accept or take delivery by closing out the trade.
7/25/2019 Derivatives in ALM
22/53
Micro Hedge Applications for Banks
Micro hedging refers to hedging of a specific asset,
liability or a specific commitment by the bank.
Micro hedging can be used to take futures position to
reduce aggregate portfolio risk.
Portfolio risk is measured through GAP analysis or
duration gap analysis.
7/25/2019 Derivatives in ALM
23/53
Micro Hedge Applications for Banks
Banks as per regulatory framework are compelled to
link hedged futures trade to a specific instrument or
commitment of the bank.
Example: A bank hedging interest rate commitments
on one year certificate of deposits entered into a
hedge in that year.
7/25/2019 Derivatives in ALM
24/53
Hedge Implications: Example (Bank Cost)
First Deposit:
The 3-month deposit for 1000,000 at 2.00%
5,000
Next Deposit:
The 3-month deposit at 2.50%
6,250
1,250
Total expense for the Bank
11,250
7/25/2019 Derivatives in ALM
25/53
Hedge Implications: Example (Bank Profit)
Init ial Futures Position:
Sell six-month interest rate futures at 3.00%
Contract price (100-3.00 = 97.00)
Next Futures Trade:
Buy six-month interest rate futures at 3.50%
Contract price (100-3.50 = 96.50)
Net profit
(97.00-96.50) 50 Basis points
1,250
7/25/2019 Derivatives in ALM
26/53
Hedge Implications: Example (Net Cost to Bank)
Effective 6-month deposit cost
11,250 1,250 12 12x 1.00 % x
1,000,000 6 6
2.00 %
7/25/2019 Derivatives in ALM
27/53
Forward Rate Agreements
Forward Rate Agreements (FRAs)
Over The Counter (OTC) products that are futures
contract for financial products.
Customized contracts to meet needs of participants.
Marked to market requirements are not present,
hence has a risk of default.
7/25/2019 Derivatives in ALM
28/53
Forward Rate Agreements
Buyer of FRA agrees to pay a fixed rate coupon and
receive a floating rate coupon on a notional amount at
a specified future date.
Seller of FRA agrees to pay a floating rate coupon
and receive a fixed rate coupon on a notional amountat a specified future date.
7/25/2019 Derivatives in ALM
29/53
Forward Rate Agreements
Buyer of FRA will receive cash when the actual
interest rate at settlement date is higher than the
exercise rate.
Buyer of FRA will pay cash when the actual interest
rate at settlement date is lower than the exercise rate.
7/25/2019 Derivatives in ALM
30/53
Forward Rate Agreements
Seller of the FRA will receive cash when the actual
interest rate is less than the exercise rate.
Seller of the FRA will pay cash when the actual
interest rate is higher than the exercise rate.
7/25/2019 Derivatives in ALM
31/53
Forward Rate Agreement Example
Bank A buys a FRA of 3 Vs. 6 at 7% on a
Rs.1,000,000 notional amount from Bank B
Forward rate agreement entered into by Bank A is to
pay a fixed rate of 7% and receive a floating rate of 3-
month MIBOR with a maturity date of 6 months on thenotional amount of Rs.1,000,000.
Cash flow at the end of 6 months will be determinedby comparing the 3-month MIBOR rate with the fixed
rate of 7%.
7/25/2019 Derivatives in ALM
32/53
Forward Rate Agreement - Example
Equivalent 3-month MIBOR is 8% at the end of 6 months. Here Bank A will receive from Bank B the return from the deal
Actual interest amount from the deal is
Interest amount represents the payment that will be made three
months latter at the maturity of the instrument (present value)
will be identified as
30.08-0.07 x x 1,000,000= 2,50012
12,500 x =2,452
31+0.08
12
7/25/2019 Derivatives in ALM
33/53
Forward Rate Agreement - Example
Equivalent 3-month MIBOR is 6% at the end of 6 months.
Here Bank A will pay to Bank B the balance
Actual interest amount from the computed as
Interest amount represents the payment that will be made
three months latter at the maturity of the instrument
(present value) will be identified as
3
0.07-0.06 x x 1,000,000= 2,50012
12,500 x =2,463
31+0.06
12
7/25/2019 Derivatives in ALM
34/53
Example of a Bank Deal
A quote of 9.50% - 10.00% against 3 month MIBOR for 3
v/s 6 FRA
The market maker:
Agrees to pay (bid) 9.50% fixed and receive the 3 monthMIBOR determined 3 months later.
Agrees to receive (ask/offer) 10.00% fixed and pay the 3month MIBOR determined 3 months later.
7/25/2019 Derivatives in ALM
35/53
Futures
Futures are standardized contracts.
Traded at any point of time.
Trading with longer maturities through contract
extensions permitted.
Delivery of a range of futures securities. Mark to market and margin requirements avoids
default risk from the contract.
Need not have compulsory physical deliver.
Netting of long and short position of same trader.
7/25/2019 Derivatives in ALM
36/53
Futures
Commitment between two parties on the quantity andprice of a standardized financial or commodity
product.
Buyers of futures (long futures) contracts agree to paythe futures price and take delivery of the product.
Sellers of futures (short futures) contracts agree toreceive the futures price and deliver the product.
7/25/2019 Derivatives in ALM
37/53
A) Profit or loss for buyer of futures B) Profit or loss for seller of futures
Futures Profile
7/25/2019 Derivatives in ALM
38/53
Options
Limits the loss to the buyer of the option contract.
Options have several contract prices to enable
liquidity of trades.
Seller of the option takes the risk of the buyer of the
option.
Options provide the buyer with the advantage of
exercising the contract only when it is favourable for
the buyer.
7/25/2019 Derivatives in ALM
39/53
Options
Purchase a Put Option / Sell a Call Option
Rising deposit cost and other borrowings.
Falling value of assets or return.
Offset loss from negative gaps.
Purchase a Call Option / Sell a Put Option
Falling yield on assets.
Offset loss from positive gaps.
O ti P fil
7/25/2019 Derivatives in ALM
40/53
A) Profit or loss for buyer of B) Profit or loss for buyer of put
call option and buyer of futures option and seller of futures
Options Profile
7/25/2019 Derivatives in ALM
41/53
Caps, Floors and Collars
Caps can be entered into by banks to protect them
from rising borrowing costs.
Floors protect the banks at times of falling interest
rates.
Banks can purchase caps and sell floors to protect
against fluctuation in interest rates within a rate
expectation.
7/25/2019 Derivatives in ALM
42/53
Caps
Variable rate borrowers are the users of interest rate caps.
Caps ensure that the banks can have a predetermined
interest rate beyond which the borrowing rates will not
increase.
Cost of the cap is termed as the premium payment to be
made on the instrument.
Premium for an interest rate cap depends on the cap rate
compared to current market interest rates.
7/25/2019 Derivatives in ALM
43/53
Caps
7/25/2019 Derivatives in ALM
44/53
Floors
Variable rate investors are the users of interest rate floors.
Floors set the minimum interest rate the investor will
receive on their investments.
Interest rate floor contracts ensure that the receipt is not
less than a pre-determined level of the floor contract oninvestment.
Cost of the floor is the premium payment on the contract.
Premium for an interest rate floor depends on the floor rate
compared to current market interest rates.
Fl
7/25/2019 Derivatives in ALM
45/53
Floors
C ll
7/25/2019 Derivatives in ALM
46/53
Collars
Variable rate borrowers use interest rate collars.
Collars give holders the benefit of borrowing by
setting the minimum and maximum interest rate they
will pay on their borrowings.
An interest rate collar combines an interest rate cap
and an interest rate floor contract.
Interest rate collar ensures that payment is cappedand at the same time no reduction below the
minimum is set on the contract.
Collars
7/25/2019 Derivatives in ALM
47/53
Collars
Cost of the collar contract is the premium payment.
Premium for an interest rate collar depends on therate parameters when compared to current market
interest rates and the frequency of payments agreed
upon.
C ll
7/25/2019 Derivatives in ALM
48/53
Collar
7/25/2019 Derivatives in ALM
49/53
Derivative Position to Hedge
Duration gap gives the sensitivity of the balance
sheet.
Hedging position could simulate a zero duration gap
for the bank.
Liabili ty Structure of a Bank
7/25/2019 Derivatives in ALM
50/53
Asset Structure of a Bank
7/25/2019 Derivatives in ALM
51/53
Derivative Structure of a Bank
7/25/2019 Derivatives in ALM
52/53
Impact of Interest Rate Change on the Bank
7/25/2019 Derivatives in ALM
53/53
Impact of Interest Rate Change on the Bank