Managing Risk off the Balance Sheet with Derivative Securities

8-1McGraw-Hill/IrwinChapter Twenty-ThreeManaging Risk off the Balance Sheet with Derivative Securities23-2McGraw-Hill/IrwinManaging Risk off the Balance SheetManagers are increasingly turning to off-balance-sheet (OBS) instruments such as forwards, futures, options, and swaps to hedge the risks their financial institutions (FIs) faceinterest rate riskforeign exchange riskcredit riskFIs also generate fee income from derivative securities transactions23-3McGraw-Hill/IrwinManaging Risk off the Balance SheetA spot contract is an agreement to transact involving the immediate exchange of assets and fundsA forward contract is an agreement to transact involving the future exchange of a set amount of assets at a set priceA futures contract is an agreement to transact involving the future exchange of a set amount of assets for a price that is settled dailyfutures contracts are marked to market daily—i.e., the prices on outstanding futures contracts are adjusted each day to reflect current futures market conditions23-4McGraw-Hill/IrwinHedging with ForwardsA naïve hedge is a hedge of a cash asset on a direct dollar-for-dollar basis with a forward (or futures) contractManagers can predict capital loss (ΔP) using the duration formula:where P = the initial value of an asset D = the duration of the asset R = the interest rate (and thus ΔR is the change in interest)FIs can immunize assets against risk by using hedging to fully protect against adverse movements in interest rates23-5McGraw-Hill/IrwinHedging with FuturesMicrohedging is using futures (or forwards) contracts to hedge a specific asset or liabilitybasis risk is a residual risk that occurs because the movement in a spot asset’s price is not perfectly correlated with the movement in the price of the asset delivered under a futures (or forwards) contractfirms use short positions in futures contracts to hedge an asset that declines in value as interest rates riseMacrohedging is hedging the entire (leverage-adjusted) duration gap of an FI23-6McGraw-Hill/IrwinHedging with FuturesMicrohedging and macrohedgingrisk-return considerationsFIs hedge based on expectations of future interest rate movementsFIs may microhedge, macrohedge, or even overhedgeaccounting rules can influence hedging strategiesin 1997 FASB required that all gains and losses from derivatives used to hedge must be recognized immediatelyU.S. companies must report derivative related trading activity in annual reportsfutures contracts are not subject to risk-based capital requirements impose by bank regulators (forward can be)23-7McGraw-Hill/IrwinOptionsMany types of options are used by FIs to hedgeexchange-traded optionsover-the-counter (OTC) optionsoptions embedded in securitiescaps, collars, and floorsBuying a put option on a bond can hedge interest rate risk exposure related to bonds that are held as assetsthe put option truncates the downside lossesthe put option scales down the upside profits, but still leaves upside profit potentialSimilarly, buying a call option on a bond can hedge interest rate risk exposure related to bonds held on the liability side of the balance sheetHedging with Put OptionsPayoff Payoff for a bondGain held as an asset Net payoff function 0 Bond price X -P Payoff from buying a putPayoff on a bondLossMcGraw-Hill/Irwin23-823-9McGraw-Hill/IrwinOptionsBuying a call option on a bondas interest rates fall, bond prices rise, and the call option buyer has a large profit potentialas interest rates rise, bond prices fall, but the call option losses are bounded by the call option premiumWriting a call option on a bondas interest rates fall, bond prices rise, and the call option writer has a large potential lossesas interest rates rise, bond prices fall, but the call option gains are bounded by the call option premium23-10McGraw-Hill/IrwinOptionsBuying a put option on a bondas interest rates rise, bond prices fall, and the put option buyer has a large profit potentialas interest rates fall, bond prices rise, but the put option losses are bounded by the put option premiumWriting a put option on a bondas interest rates rise, bond prices fall, and the put option writer has large potential lossesas interest rates fall, bond prices rise, but the put option gains are bounded by the put option premium23-11McGraw-Hill/IrwinCaps, Floors, and CollarsBuying a cap means buying a call option, or a succession of call options, on interest rateslike buying insurance against an (excessive) increase in interest ratesBuying a floor is akin to buying a put option on interest ratesseller compensates the buyer should interest rates fall below the floor ratelike caps, floors can have one or a succession of exercise datesA collar amounts to a simultaneous position in a cap and a floorusually involves buying a cap and selling a floor23-12McGraw-Hill/IrwinContingent Credit RiskContingent credit risk is the risk that the counterparty defaults on payment obligationsforward contracts are exposed to counterparty default risk as they are nonstandard contracts entered into bilaterallyoptions traded OTC are exposed to counterparty riskfutures and options traded on organized exchanges are exposed to relatively less contingent credit riskthe exchanges act as guarantors in the transactionsthe contracts are marked-to-market daily so losses (and gains) are realized daily23-13McGraw-Hill/IrwinSwapsSwap agreements involve restructuring asset or liability cash flows in a preferred directionThe market for swaps has grown enormously in recent yearsthe notional value of swap contracts outstanding at U.S. commercial banks was more than $111 trillion in 2008There are several types of swapsinterest rate swapscurrency swapscredit risk swapscommodity swapsequity swaps23-14McGraw-Hill/IrwinSwapsHedging with interest rate swaps: an examplea money center bank (MCB) may have floating-rate loans and fixed-rate liabilitiesthe MCB has a negative duration gapa savings bank (SB) may have fixed-rate mortgages funded by short-term liabilities such as retail depositsthe SB has a positive duration gapaccordingly, an interest swap can be entered into between the MCB and the SB either:directly between the two FIsindirectly through a broker or agent who charges a fee to accept the credit risk exposure and guarantee the cash flows23-15McGraw-Hill/IrwinSwaps(example cont.)a plain vanilla swap is used—i.e., a standard agreement without any special featuresthe SB sends fixed-rate interest payments to the MCBthus, the MCB’s fixed-rate inflows are now matched to its fixed-rate paymentsthe MCB sends variable-rate interest payments to the SBthus, the SB’s variable-rate inflows are now matched to its variable-rate payments23-16McGraw-Hill/Irwin Swaps23-17McGraw-Hill/IrwinSwapsHedging with currency swaps: an exampleconsider a U.S. FI with fixed-rate $ denominated assets and fixed-rate £ denominated liabilitiesalso consider a U.K. FI with fixed-rate £ denominated assets and fixed-rate $ denominated liabilitiesthe FIs can engage in a currency swap to hedge their foreign exchange exposurethat is, the FIs agree on a fixed exchange rate at the inception of the swap agreement for the exchange of cash flows at some point in the futureboth FIs have effectively hedged their foreign exchange exposure by matching the denominations of their cash flows23-18McGraw-Hill/IrwinCredit Risk and SwapsThe growth of the over-the-counter swap market was a major factor underlying the imposition of the BIS risk-based capital requirementsthe fear was that out-of-the-money counterparties would have incentives to defaultBIS now requires capital to be held against interest rate, currency, and other swapsCredit risk on swaps differs from that on loansnetting: only the difference between the fixed and the floating payment is exchanged between swap partiespayment flows are interest and not principalstandby letters of credit are required of poor-quality swap participants23-19McGraw-Hill/IrwinComparing Hedging MethodsWriting vs. buying optionswriting options limits upside profits but not downside lossesbuying options limits downside losses but not upside profitsCBs are prohibited from writing options in some areasFutures vs. options hedgingfutures produces symmetric gains and lossesoptions protect against losses but do not fully reduce gainsSwaps vs. forwards, futures, and optionsswaps and forwards are OTC contracts, unlike options and futuresfutures are marked to market dailyswaps can be written for longer time horizons23-20McGraw-Hill/IrwinRegulationRegulators specify “permissible activities” that FIs may engage inInstitutions engaging in permissible activities are subject to regulatory oversightRegulators judge the overall integrity of FIs engaging in derivatives activity based on capital adequacy regulationThe Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are the functional regulators of derivatives securities markets23-21McGraw-Hill/IrwinRegulationThe Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have implemented uniform guidelines that require banks to:establish internal guidelines regarding hedging activityestablish trading limitsdisclose large contract positions that materially affect the risk to shareholders and outside investorsAs of 2000 the FASB requires all firms to reflect the marked-to-market value of their derivatives positions in their financial statementsSwap markets are governed by relatively little regulation—except indirectly at FIs through bank regulatory agencies