Chapter Six

Risk Management: Financial Futures, Options, Swaps, and Other Hedging Tools

VOCABULARY REVIEW

From Chapter 5 – Risk Management

Asset Management

Liability Management

Funds Management

Risks:

Default or credit risk Price risk

Liquidity risk Call risk

Inflation risk Maturity risk

Interest rate risk Reputation risk

VOCABULARY REVIEW

From Chapter 5 – Risk Management

Yield to Maturity

Net Interest margin

Spread or gap

From Chapter 10 – Pricing Services

Transaction deposit accounts

Non-transaction deposit accounts

Core deposits

VOCABULARY REVIEW

From Chapter 10 – Pricing Services

Cost plus pricing

Conditional pricing

Relationship pricing

Truth in Savings Act

Lifeline Banking

Key Topics

•The Use of Derivatives •Financial Futures Contracts •Options • Puts•Calls

• Interest-Rate Swaps •Regulations and Accounting Rules•Gail and Healthy Hen Farms Example

Key Vocabulary in Today’s Lesson

Premium or FeeOff-balance sheet itemsHedgingDerivatives•Futures•Swaps•Options• Puts • Calls

Introduction p. 167-168

•The asset-liability management tools in this chapter are used by banks sensitive to the risk of changes in market interest rates•Many of the risk management

tools in this chapter are used by banks to cover interest rate risk, but are also sold to customers who need risk protection and generate fee income for the banks

Introduction p. 167-168

•Most of the financial instruments in this chapter are derivatives

•WHAT IS A DERIVATIVE?▫A security that derives (gets) its

value from an underlying asset such as stocks, bonds, commodities like wheat, gold, oil or even a house.

▫It is a contract between 2 parties▫Derivatives can be:▫Futures▫Options ▫Swaps

Uses of Derivative Contracts Among FDIC-Insured Banks p. 168

•Derivatives help banks manage risk.•Derivatives are risk-hedging assets

that help a bank protect its balance sheet in case interest rates change. •Hedging: A means of protection or

defense, especially against financial loss. For example, protection against inflation (rising prices)

Uses of Derivative Contracts Among FDIC-Insured Banks p. 168

The very largest banks do the most trading in derivatives.

•Interest-rate risk is by far the most common reason for using derivatives.•The leading type of risk-hedging

contracts are swaps, followed by financial futures and options

EXHIBIT 8-1 Types of Derivative Contracts p. 169

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price p. 169

• In Chapter 5, we explored the nature of gaps between assets and liabilities that are exposed to interest rate risk

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) p. 169

•A futures contract is an agreement reached today between a buyer and a seller that calls for delivery of a security in exchange for cash at some future date•Derivatives are considered off-balance

sheet items• Sellers of financial assets remove the assets

from their balance sheet and account for the losses or gains on their income statements

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) p. 170

•When the contract is made, neither buyer nor seller is making a purchase or sale at that point in time, only an agreement for the future

•When an investor buys or sells futures contracts at a set price, it must deposit an initial amount (margin) of money▫The initial margin is the investor’s

equity in the position when he or she buys (or sells) the contract

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (continued) p. 170-171

•Buyers of futures contracts▫A buyer of a futures contract is said

to be long futures. Buyer = Long

▫Agrees to pay the asset’s futures price or take delivery of the asset

▫Buyers gain when futures prices rise and lose when futures prices fall

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (cont) p. 174-175

•Sellers of futures contracts▫A seller of a futures contract is said to

be short futures seller = short

▫Agrees to receive the asset’s futures price or to deliver the asset

▫Sellers gain when futures prices fall and lose when futures prices rise

Financial Futures Contracts: Promises of Future Security Trades at a Preset Price (cont) p. 170

•The financial futures markets shift the risk of interest-rate changes from investors who want to minimize risk, such as banks and insurance companies, to speculators/investors who are willing to accept and maybe profit from such risks.

OPTIONS P. 180-185

•OPTIONS grant the holder of securities the right to:1.Place (put) or sell those securities with

another investor (buyer) at an agreed upon price before the option expires or

2.Take delivery of securities (call) or buy from another investor at a an agreed upon price before the option’s expiration date

OPTIONS P. 180-185

Put option - An option contract giving the owner the right, but not the obligation, to sell a certain amount of an underlying security at a certain price within a certain time.

Jim & Dan both want to buy put options.

Jim owns 1000 shares of Alibaba. The current price is $25/share. Jim will retire in 1 year and want to make sure he can get that price.

OPTIONS P. 180-185

Jim finds an investor who will sign a contract to pay Jim $25 per share in 1 year. Jim pays him a fee.

$25-----------------------------------------

If the shares in 1 year’s time go below $25 Jim is protected. He gets his $25 per share.

If the price goes above $25 Jim does not have to use or exercise his option. He only loses the fee.

OPTIONS P. 180-185

Now, let’s look at a Put option for Dan:

Dan doesn’t own Alibaba stock but he pays a fee to an Investor to buy 1000 shares at $25 per share in 1 month from now

$25---------------------------------------------

If the price goes below 25 to say $15 He can buy the 1000 shares at $15,000 and sell them at $25,000, a profit of $10,000 minus the option fee or premium. If the price goes above $25 per share he doesn’t have to use his option, and just loses the fee.

OPTIONS P. 180-185

Call option, An agreement that gives an investor the right (but you don’t have to) to buy a stock, bond, commodity, or other asset at a certain price within a certain time period.It may help you to think that a call option gives you the right to “call in” or exercise (buy) an asset.This allows an investor to take a risk and buy a stock he doesn’t own

OPTIONS P. 180-185

Let’s look at an example: Ken thinks Alibaba stock will rise in price. He doesn’t own any shares but wants to buy some. Ken talks to Bob who has 100 shares of Alibaba at $20 per share but Bob thinks it could fall to $15 per share.Bob agrees to sell (sign a contract) his 100 shares at $22 in 1 month. Ken pays Bob a fee, called a premium - $22-20 =2 x 100 = $200

OPTIONS P. 180-185

$22-------------------------------------If the price goes up to $30 Ken buys 10 shares $22 from Bob and sells them at $30$3000 - $2200 = $800 gross profit$800 - $200 premium = $600 net profit.If the price is below, Ken does not have to buy (exercise the option) the shares but loses his $200 premium. But now he can buy shares at a lower cost.

Interest-Rate Options (continued)

•Banks use options today to minimize risks. Options are used mostly by money center (large) banks•They appear to be directed at two principal uses1. Protecting a security portfolio

through the use of put options to protect against falling security prices (rising interest rates)

Interest-Rate Options (continued)

2. Hedging (protection) against positive or negative gaps between interest-sensitive assets and interest-sensitive liabilities▫For example, put options can be

used to offset losses from a negative gap when interest rates rise, while call options can be used to offset a positive gap when interest rates fall

Regulations for Bank Futures and Options Trading p. 186-187

•Regulators expect banks to have a good risk-management system. They set limits based on the following risks:▫Some of these risks are:▫Reputation risk▫Price risk▫Interest rate risk▫Liquidity risk▫Credit risk

Interest-Rate Swaps p. 188-192

•An interest-rate swap is an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a certain amount.

•Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR) – London Interbank offered rate.

•This allows a bank to minimize interest-rate risk and have lower borrowing costs.

Interest-Rate Swaps (continued) p. 188-189

•The principal amount of the loans is not exchanged▫Only the net amount of interest due

flows to one or the other party to the swap

▫The swap itself normally will not show up on a swap participant’s balance sheet – an off balance sheet activity.

•Actual defaults are limited•Interest rate risk can be a problem if one

of the parties does not make the payments.

CHAPTER 6 SUMMARY

•This chapter focused on derivatives - financial futures contracts such as, options and swaps that help banks deal with losses due to changing market interest rates.

•Financial futures contracts are agreements to deliver bonds, treasury bills at a certain prices on a future date. These derivatives are more common because of their low cost.

CHAPTER 6 SUMMARY

Option contracts give owners the right to deliver (put) or take delivery of (call) of a stock at a certain price on or before a future date. Options provide risk protection should interest rates change.

Interest-rate swaps are agreements between 2 people or parties to exchange interest payments so that each party or person or bank can better match cash inflows & outflows.

Derivatives are used more by large banks and insurance companies.

Derivatives – Definition and Example

•The Definition in Review:Derivatives are financial products with value that come from an asset or set of assets. These can be stocks, bonds or almost anything. A derivative's value is based on an asset, but ownership of a derivative doesn't mean ownership of the asset. We will look at some examples.

Derivatives – Definition and Example

• The Barnyard Basics Of Derivatives – The Future of Healthy Hen Farms and it’s owner Gail. A Futures Contract P. 170

•Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market, with all the reports of bird flu coming. Gail wants a way to protect her business from bad news. Gail meets with an investor who enters into a futures contract with her.

Derivatives Example – Gail & Happy Hen Farms

Investor Joe agrees to pay $30 per bird in six months' time, no matter what the price. They sign a contract.Gail pays Joe a fee for this service.If, at that time, the price is above $30, Joe will benefit as he will be able to buy the birds for less than market cost and sell them on the market at a higher price for a gain. If the price goes below $30, then Gail will benefit because she will be able to sell her birds for more than the current market price, or more than what she would get for the birds in the open market.

Healthy Hen Farms

Owner Gail

Investor Joe

Example – Healthy Hen Farms

• By entering into a futures contract, Gail is protected from price changes in the market, as she has locked in a price of $30 per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but she will be protected if the price falls to $10 on news of a bird flu outbreak.

By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations.

Example – Healthy Hen Farms

•Now we will learn about an INTEREST RATE SWAP•Gail has decided that it's time to

take Healthy Hen Farms to the next level. She has already acquired all the smaller farms near her and is looking at opening her own processing plant. She tries to get more financing, but the lender, Lenny, rejects her.

Interest Rate Swap – Introducing Lenny p. 188

The reason Lenny rejects Gail is that to take over other farms she financed her takeovers with a large variable-rate loan, and Larry the lender is worried that, if interestrates rise, Gail won't be able to pay her debts. Lenny tells Gail that he will only lend to her if she can convert the loan to a fixed-rate. Unfortunately, her other lenders refuse to change her current loan terms because they are hoping interest rates will increase too. ENTER SAM Sam has a fixed-rate loan about the same size as Gail’s and he wants to change it to a variable-rate loan because he hopes interest rates will go down in the future.

Gail and a larger

Healthy Hen Farm

Business

Lenny the Lender

GAIL & HEALTHY

H EN FARMS

SAM THE RESTAURANT

OWNER

GAIL AND SAM SWAP LOANS• Gail and Sam decide to swap loans. They

work out a deal in which Gail's payments go toward Sam's loan and his payments go toward Gail's loan. Although the names on the loans haven't changed, their contract allows them both to get the type of loan they want. • Each person still pays their same loan

amount and must still pay off their debt. And they pay a fee to a bank or financial provider to do the swap. What they are swapping is the interest rate only.

GAIL AND SAM SWAP LOANS• On each payment due date Gail and Sam

exchange only the Net difference between the interest payments each owes the other person.• This is a bit risky for both of them because

if one of them defaults or goes bankrupt, it may require a payment for which either Gail or Sam may be unprepared. However, it allows them to change their loans to meet their individual needs.

BUYING DEBT – DERIVATIVES AND HOW IT WORKS

• With Gail now having a fixed rate loan, Lenny the Lender is now willing to make a larger loan to Gail so she can expand or grow her Healthy Hen Farms business. Lenny

is also happy to be getting a return on his money.

ENTER Dale is Lenny’s friend and he asks Dale for a loanbecause he wants to start a film company.

LENNY THE

LENDER

DALE THE MOVIE MAKER

BUYING DEBT – DERIVATIVES AND HOW IT WORKS

Lenny knows Dale has a lot of collateral and that the loan would be at a higher interest rate because of the more volatile nature of the movie industry, so he's kicking himself for loaning all of his money to Gail. Lenny turns Gail's loan into a credit derivative and sells it to a speculator at a discount to the true value. Although Lenny doesn't see the full return on the loan, he gets his money back and can now loan it out again to his friend Dale.

LENNY THE

LENDERDALE THE MOVIE

MAKER

Derivatives and the Fee Benefit

•Lenny, likes this system so much that he continues to spin out (make) his loans as credit derivatives, taking modest returns in exchange for less risk of default and more liquidity.

Derivatives and the Fee BenefitHow this works: Lenny sells his fixed rate loan he made to Gail at a much lower interest rate than he could make to his friend Dale. Because, Dale’s loan is more risky the interest rate is much higher and since Dale has good collateral Lenny knows he can collect if Dale defaults (cannot make his payment) on his loan. Lenny also makes a fee for selling Gail’s fixed rate loan.

OPTIONS

• Years later, Healthy Hen Farms Corporation and CEO Gail, is a publicly traded corporation (HEN) and is

America’s largest poultry (chicken) producer.

Gail and Sam, remember him? They both are looking forward to a good retirement.Sam bought quite a few shares of HEN. In fact, he has more than $100,000 invested in the company.

HEN

OPTIONS

Sam is getting nervous because he is worried that another shock, perhaps another case of bird flu, might decrease his retirement money. Sam starts looking for someone to take on his risk. Lenny, who now makes lots of money on these deals agrees to help him out.

HEN

OPTIONS – CALLS AND PUTS P. 180 - 186• Lenny makes a deal in which Sam pays Lenny

a fee to for the right (but not the obligation) to sell Lenny the HEN shares in a year's time at their current price of $25 per share. If the share prices go down in price, Lenny protects Sam from the loss of his retirement savings.

Lenny is OK because he has been collecting the fees and can handle the risk. This is called a put option, but it can be done in reverse by someone agreeing to buy a stock in the future at a fixed price (called a call option).

OPTIONS – CALLS AND PUTS P. 180 - 186

•The Bottom LineHealthy Hen Farms remains stable until Sam and Gail have both pulled their money out for retirement. Lenny profits from the fees and his booming trade as a financier.

Thus ends the story of Gail, Sam and Lenny and I hope you have learned how derivatives, swaps, futures and options work.

CONCLUSION OF THE TALE OF GAIL AND HEALTHY HEN FARMS• In this tale, you can see how derivatives can move risk (and

the accompanying rewards) from the risk averse (avoiders) to the risk seekers. Although Warren Buffett once called derivatives, "financial weapons of mass destruction," derivatives can be very useful tools, provided they are used properly.• Like all other financial instruments, derivatives can be risky,

but they also hold potential to help the function of the financial system.