Bank Management,

Management 6th edition.

Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning

Using Derivatives to Manage

Interest Rate Risk

Chapter 7

William Chittenden edited and updated the PowerPoint slides for this edition.
Derivatives

 A derivative is any instrument or

contract that derives its value from
another underlying asset, instrument,
or contract.
Managing Interest Rate Risk

 Derivatives Used to Manage Interest

Rate Risk
 Financial Futures Contracts
 Forward Rate Agreements
 Interest Rate Swaps
 Options on Interest Rates
 Interest Rate Caps
 Interest Rate Floors
Characteristics of Financial Futures

 Financial Futures Contracts

A commitment, between a buyer and a
seller, on the quantity of a
standardized financial asset or index
 Futures Markets
 The organized exchanges where
futures contracts are traded
 Interest Rate Futures
 When the underlying asset is an
interest-bearing security
Characteristics of Financial Futures

 Buyers
A buyer of a futures contract is said to
be long futures
 Agrees to pay the underlying futures
price or take delivery of the underlying
asset
 Buyers gain when futures prices rise
and lose when futures prices fall
Characteristics of Financial Futures

 Sellers
A seller of a futures contract is said to
be short futures
 Agrees to receive the underlying
futures price or to deliver the
underlying asset
 Sellers gain when futures prices fall
and lose when futures prices rise
Characteristics of Financial Futures

 Cash or Spot Market

 Market for any asset where the buyer
tenders payment and takes possession
of the asset when the price is set
 Forward Contract
 Contract for any asset where the buyer
and seller agree on the asset’s price
but defer the actual exchange until a
specified future date
Characteristics of Financial Futures

 Forward versus Futures Contracts

 Futures Contracts
 Traded on formal exchanges
 Examples: Chicago Board of Trade and the
Chicago Mercantile Exchange
 Involve standardized instruments
 Positions require a daily marking to

market
 Positions require a deposit equivalent

to a performance bond
Characteristics of Financial Futures

 Forward versus Futures Contracts

 Forward contracts
 Terms are negotiated between parties
 Do not necessarily involve

standardized assets
 Require no cash exchange until

expiration
 No marking to market
Types of Futures Traders

 Speculator
 Takes a position with the objective of
making a profit
 Tries to guess the direction that prices
will move and time trades to sell (buy)
at higher (lower) prices than the
purchase price.
Types of Futures Traders
 Hedger
 Has an existing or anticipated position in the
cash market and trades futures contracts to
reduce the risk associated with uncertain
changes in the value of the cash position
 Takes a position in the futures market whose
value varies in the opposite direction as the
value of the cash position when rates change
 Risk is reduced because gains or losses on
the futures position at least partially offset
gains or losses on the cash position.
Types of Futures Traders

 Hedger versus Speculator

 The essential difference between a
speculator and hedger is the objective
of the trader.
 A speculator wants to profit on trades
 A hedger wants to reduce risk

associated with a known or anticipated

cash position
Types of Futures Traders
 Commission Brokers
 Execute trades for other parties
 Locals
 Trade for their own account
 Locals are speculators
 Scalper
A speculator who tries to time price
movements over very short time
intervals and takes positions that
remain outstanding for only minutes
Types of Futures Traders
 Day Trader
 Similar to a scalper but tries to profit
from short-term price movements
during the trading day; normally
offsets the initial position before the
market closes such that no position
remains outstanding overnight
 Position Trader
A speculator who holds a position for a
longer period in anticipation of a more
significant, longer-term market move.
Types of Futures Traders
 Spreader versus Arbitrageur
 Both are speculators that take
relatively low-risk positions
 Futures Spreader
 May simultaneously buy a futures
contract and sell a related futures
contract trying to profit on anticipated
movements in the price difference
 The position is generally low risk
because the prices of both contracts
typically move in the same direction
Types of Futures Traders
 Arbitrageur
 Tries to profit by identifying the same asset
that is being traded at two different prices in
different markets at the same time
 Buys the asset at the lower price and
simultaneously sells it at the higher price
 Arbitrage transactions are thus low risk and
serve to bring prices back in line in the
sense that the same asset should trade at
the same price in all markets
Margin Requirements

 Initial Margin
A cash deposit (or U.S. government
securities) with the exchange simply
for initiating a transaction
 Initial margins are relatively low, often
involving less than 5% of the
underlying asset’s value
 Maintenance Margin
 The minimum deposit required at the
end of each day
Margin Requirements

 Unlike margin accounts for stocks,

futures margin deposits represent a
guarantee that a trader will be able to
make any mandatory payment
obligations
 Same effect as a performance bond
Margin Requirements

 Marking-to-Market
 The daily settlement process where at
the end of every trading day, a trader’s
margin account is:
 Credited with any gains
 Debited with any losses

 Variation Margin
 Thedaily change in the value of margin
account due to marking-to-market
Expiration and Delivery

 Expiration Date
 Every futures contract has a formal
expiration date
 On the expiration date, trading stops
and participants settle their final
positions
 Less than 1% of financial futures
contracts experience physical delivery
at expiration because most traders
offset their futures positions in
advance
Example

 90-Day Eurodollar Time Deposit

Futures
 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.
Example

 90-Day Eurodollar Time Deposit

Futures
 Forty separate contracts are traded at
any point in time, as contracts expire in
March, June, September and December
each year
 Buyers make a profit when futures
rates fall (prices rise)
 Sellers make a profit when futures
rates rise (prices fall)
Example

 90-Day Eurodollar Time Deposit

Futures
 Contractstrade according to an index
that equals
 100% - the futures interest rate
 An index of 94.50 indicates a futures rate
of 5.5 percent
 Each basis point change in the futures
rate equals a $25 change in value of
the contract (0.001 x $1 million x
90/360)
 Eurodollar Futures
Eurodollar (CME)-$1,000,000; pts of 100%
 The first column indicates the OPEN
OPEN HIGH LOW SETTLE CHA YIELD CHA
settlement month and year Mar 96.98 96.99 96.98 96.99 — 3.91 —
INT
823,734
 Each row lists price and yield Apr 96.81 96.81 96.81 96.81 _.01 3.19 .01 19,460
June 96.53 96.55 96.52 96.54 — 3.46 — 1,409,983
data for a distinct futures Sept 96.14 96.17 96.13 96.15 _.01 3.05 .01 1,413,496
contract that expires Dec 95.92 95.94 95.88 95.91 _.01 4.09 .01 1,146,461
Mr06 95.78 95.80 95.74 95.77 _.01 4.23 .01 873,403
sequentially every three June 95.64 95.60 95.62 95.64 _.01 4.34 .01 567,637
months Sept 95.37 95.58 95.53 95.54 _.01 4.44 .01 434,034
Dec 95.47 95.50 95.44 95.47 — 4.53 — 300,746
 The next four columns report Mr07 95.42 95.44 95.37 95.42 — 4.58 — 250,271
the opening price, high and June 95.31 95.38 95.31
Sept 95.27 95.32 95.23
95.37
95.31
.01
.02
4.63 _.01
4.69 _.02
211,664
164,295
low price, and closing Dec 95.21 95.27 95.18 95.26 .03 4.74 _.03 154,123
settlement price. Mr08 95.16 95.23 95.11 95.21 .04 4.79 _.04 122,800
June 95.08 95.17 95.07 95.14 .05 4.84 _.05 113,790
 The next column, the change Sept 95.03 95.13 95.01 95.11 .06 4.89 _.06 107,792
in settlement price from the Dec 94.95 95.06 94.94
Mr09 94.91 95.02 94.89
95.05
95.01
.07
.08
4.95 _.07
4.99 _.07
96,046
81,015
previous day. June 94.05 94.97 94.84 94.97 .08 5.03 _.08 76,224
 The two columns under Yield Sept 94.81 94.93 94.79 94.92 .08 5.08 _.08 41,524
Dec 94.77 94.38 94.74 94.87 .08 5.15 _.08 40,594
convert the settlement price to Mr10 94.77 94.64 94.70 94.83 .09 5.27 _.09 17,481
a Eurodollar futures rate as: Sept 94.66 94.76 94.62
Sp11 94.58 94.60 94.47
94.75
94.60
.09
.09
5.25 _.09
5.40 _.09
9,309
2,583
100 - Settlement Price Dec 94.49 94.56 94.43
Mr12 94.48 94.54 94.41
94.56
94.53
.09
.09
5.44 _.09
5.47 _.09
2,358
1,392
= Futures Rate Est vol 2,082,746; vol Wed 1,519,709; open int 8,631,643, _160,422.
The Basis
 The basis is the cash price of an asset
minus the corresponding futures price
for the same asset at a point in time
 For financial futures, the basis can be
calculated as the futures rate minus
the spot rate
 It may be positive or negative,
depending on whether futures rates are
above or below spot rates
 May swing widely in value far in
advance of contract expiration
 The Relationship Between Futures Rates and
Cash Rates - One Possible Pattern on March 10

4.50
December 2005
Futures Rate
Rate (Percent)

4.09
3.00 Cash Rate

1.76

Basis Futures Rate- Cash Rate

1.09
0
March 10, 2005 August 23, 2005 Expiration
December 20, 2005
Speculation versus Hedging

 A speculator takes on additional risk

to earn speculative profits
 Speculation is extremely risky
 A hedger already has a position in the
cash market and uses futures to adjust
the risk of being in the cash market
 The focus is on reducing or avoiding
risk
Speculation versus Hedging

 Example
 Speculating
 You believe interest rates will fall, so
you buy Eurodollar futures
 If rates fall, the price of the underlying
Eurodollar rises, and thus the futures
contract value rises earning you a profit
 If rates rise, the price of the Eurodollar
futures contract falls in value, resulting in
a loss
Speculation versus Hedging

 Example
 Hedging
 A bank anticipates needing to borrow
$1,000,000 in 60 days. The bank is
concerned that rates will rise in the
next 60 days
 A possible strategy would be to short
Eurodollar futures.
 If interest rates rise (fall), the short
futures position will increase (decrease)
in value. This will (partially) offset the
increase (decrease) in borrowing costs
Speculation versus Hedging

 With financial futures, risk often

cannot be eliminated, only reduced.
 Traders normally assume basis risk in
that the basis might change adversely
between the time the hedge is initiated
and closed
 Perfect Hedge
 The gains (losses) from the futures
position perfectly offset the losses
(gains) on the spot position at each
price
Profit Diagrams for the December 2005
Eurodollar Futures Contract: Mar 10, 2005
A. Speculation

Profit Profit

1 1

0 Futures 0 Futures
95.91 Price 95.91 Price

2 2

Loss Loss
1. Buy Dec. 2005 Eurodollar Futures at $95.91
2. Sell Dec. 2005 Eurodollar Futures at $95.91

B. Hedging

Profit Profit
Futures Cash
1 1
Hedge Result Hedge Result

0 Price Price
95.91 95.91
2

Loss Cash Loss Futures

Hedge: Long Futures--Cash Loss When Hedge: Short Futures--Cash Loss When
Rates Fall Rates Rise
Steps in Hedging
 Identify the cash market risk exposure to reduce
 Given the cash market risk, determine whether a
long or short futures position is needed
 Select the best futures contract
 Determine the appropriate number of futures
contracts to trade.
 Buy or sell the appropriate futures contracts
 Determine when to get out of the hedge position,
either by reversing the trades, letting contracts
expire, or making or taking delivery
 Verify that futures trading meets regulatory
requirements and the banks internal risk policies
A Long Hedge
 A long hedge (buy futures) is appropriate for
a participant who wants to reduce spot
market risk associated with a decline in
interest rates
 If spot rates decline, futures rates will
typically also decline so that the value of the
futures position will likely increase.
 Any loss in the cash market is at least
partially offset by a gain in futures
Long Hedge Example
 On March 10, 2005, your bank expects to
receive a $1 million payment on November
8, 2005, and anticipates investing the funds
in 3-month Eurodollar time deposits
 The cash market risk exposure is that the
bank will not have access to the funds for
eight months.
 In March 2005, the market expected
Eurodollar rates to increase sharply as
evidenced by rising futures rates.
Long Hedge Example
 In order to hedge, the bank should buy
futures contracts
 The best futures contract will generally
be the December 2005, 3-month
Eurodollar futures contract, which is
the first to expire after November 2005.
 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.
Long Hedge Example

 The time line of the bank’s hedging

activities would look something like
this:
March 10, 2005 November 8, 2005 December 20, 2005

Cash: Anticipated investment Invest $1 million Expiration of Dec. 2005

Futures: Buy a futures contract Sell the futures contract futures contract
Long Hedge Example
Date Cash Market Futures Market Basis
3/10/05 Bank anticipates investing $1 million Bank buys one December 2005 4.09% - 3.00% = 1.09%
(Initial futures in Eurodollars in 8 months; current Eurodollar futures contract at
position) cash rate = 3.00% 4.09%; price = 95.91
11/8/05 Bank invests $1 million in 3-month Bank sells one December 2005 4.03% - 3.93% = 0.10%
(Close futures Eurodollars at 3.93% Eurodollar futures contract at
position) 4.03%; price = 95.97%
Net effect Opportunity gain: Futures profit: Basis change: 0.10% - 1.09%
3.93% - 3.00% = 0.93%; 4.09% - 4.03% = 0.06%; = -0.99%
93 basis points worth 6 basis points worth
$25 each = $2,325 $25 each = $150

Cumulative
e investment income:
Interest at 3.93% = $1,000,000(.0393)(90/360) = $9,825
Profit from futures trades = $ 150
Total = $9,975

$9,975 360
Effective return  3.99%
$1,000,000 90
A Short Hedge
 A short hedge (sell futures) is appropriate
for a participant who wants to reduce spot
market risk associated with an increase in
interest rates
 If spot rates increase, futures rates will
typically also increase so that the value of
the futures position will likely decrease.
 Any loss in the cash market is at least
partially offset by a gain in the futures
market
Short Hedge Example

 On March 10, 2005, your bank expects

to sell a six-month $1 million
Eurodollar deposit on August 15, 2005
 The cash market risk exposure is that
interest rates may rise and the value of
the Eurodollar deposit will fall by
August 2005
 In order to hedge, the bank should sell
futures contracts
Short Hedge Example

 The time line of the bank’s hedging

activities would look something like
this:
March 10, 2005 August 17, 2005 September 20, 2005

Cash: Anticipated sale of Sell $1 million Eurodollar Expiration of Sept. 2005

investment Deposit futures contract
Futures: Sell a futures contract Buy the futures contract
 Short Hedge Example

Date Cash Market Futures Market Basis

3/10/05 Bank anticipates selling Bank sells one Sept. 3.85% - 3.00% = 0.85%
$1 million Eurodollar 2005 Eurodollar futures
deposit in 127 days; contract at 3.85%;
current cash rate price = 96.15
= 3.00%
8/17/05 Bank sells $1 million Bank buys one Sept. 4.14% - 4.00% = 0.14%
Eurodollar deposit at 2005 Eurodollar futures
4.00% contract at 4.14%;
price = 95.86
Net result: Opportunity loss. Futures profit: Basis change: 0.14% - 0.85%
4.00% - 3.00% = 1.00%; 4.14% - 3.85% 3 0.29%; =-0.71%
100 basis points worth 29 basis points worth
$25 each = $2,500 $25 each = $725

Effective loss = $2,500 - $725 = $1,775

Effective rate at sale of deposit = 4.00% - 0.29% = 3.71%
or 3.00% - (0.71%) = 3.71%
Change in the Basis
 Long and short hedges work well if the
futures rate moves in line with the spot
rate
 The actual risk assumed by a trader in
both hedges is that the basis might
change between the time the hedge is
initiated and closed
 Inthe long hedge position above, the
spot rate increased by 0.93% while the
futures rate fell by 0.06%. This caused
the basis to fall by 0.99% (The basis fell
from 1.09% to 0.10%, or by 0.99%)
Change in the Basis

 Effective Return from a Hedge

 Totalincome from the combined cash
and futures positions relative to the
investment amount
 Effective return
 Initial Cash Rate - Change in Basis
 In the long hedge example:
 3.00% - (-0.99%) = 3.99%
Basis Risk and Cross Hedging
 Cross Hedge
 Where a trader uses a futures contract
based on one security that differs from
the security being hedged in the cash
market
 Example

 Using Eurodollar futures to hedge changes

in the commercial paper rate
 Basis risk increases with a cross
hedge because the futures and spot
interest rates may not move closely
together
Microhedging Applications

 Microhedge
 The hedging of a transaction
associated with a specific asset,
liability or commitment
 Macrohedge
 Taking
futures positions to reduce
aggregate portfolio interest rate risk
Microhedging Applications
 Banks are generally restricted in their
use of financial futures for hedging
purposes
 Banks must recognize futures on a
micro basis by linking each futures
transaction with a specific cash
instrument or commitment
 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
 Creating a Synthetic Liability with a Short Hedge

Time Line

3/10/05 7/3/05 9/30/05

Six-Month Deposit 3.25%
Synthetic
3.00% 3.88%
Six-Month Deposit
-0.48%
Profit = 3.40%
Three-Month Cash Eurodollar Three-Month Synthetic Eurodollar

All In Six-Month Cost = 3.20%

Creating a Synthetic Liability with a Short Hedge

Summary of Relevant Eurodollar Rates and Transactions

March 10, 2005
3-month cash rate = 3.00%; bank issues a $1 million, 91-day Eurodollar deposit
6-month cash rate = 3.25%
Bank sells one September 2005 Eurodollar futures; futures rate = 3.85%
July 3, 2005
3-month cash rate = 3.88%; bank issues a $1 million, 91-day Eurodollar deposit
Buy: One September 2005 Eurodollar futures; futures rate = 4.33%

Date Cash Market Futures Market Basis

3/10/05 Bank issues $1 million, 91-day Eurodollar time deposit Bank sells one September 2005 0.85%
at 3.00%; 3-mo. interest expense = $7,583. Eurodollar futures contract at 3.85%
7/3/05 Bank issues $1 million, 91-day Eurodollar time deposit Bank buys one September 2005 0.45%
at 3.88%; 3-mo. interest expense = $9,808 (increase Eurodollar futures contract at 4.33%;
in interest expense over previous period = $2,225).
Net effect: 6-mo. interest expense = $17,391 Profit on futures = $1,200
$17,391 - $1,200 360
Effective borrowing cost  3.20%
$1,000,000 182
Interest on 6-month Eurodollar deposit issued March 10 = $13,144 at 3.25%; vs. 3.20% from synthetic liability
The Mechanics of Applying a Microhedge

1. Determine the bank’s interest rate

position
2. Forecast the dollar flows or value
expected in cash market transactions
3. Choose the appropriate futures
contract
The Mechanics of Applying a Microhedge

4. Determine the correct number of futures

contracts
A Mc
NF  b
 Where
F Mf
 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

b Expected rate movement on cash instrument
Expected rate movement on futures contract
The Mechanics of Applying a Microhedge

5. Determine the Appropriate Time

Frame for the Hedge
6. Monitor Hedge Performance
Macrohedging

 Macrohedging
 Focuses on reducing interest rate risk
associated with a bank’s entire
portfolio rather than with individual
transactions
Macrohedging

 Hedging: GAP or Earnings Sensitivity

 If GAP is positive (negative), the bank
is asset (liability) sensitive and its net
interest income rises (falls) when
interest rates rise (falls) and falls
(rises) when interest rates fall (rise)
 Positive GAP
 Use a long hedge
 Negative GAP
 Use a short hedge
Hedging: GAP or Earnings Sensitivity

 Positive GAP
 Use a long hedge
 If rates rise, the bank’s higher net
interest income will be offset by losses
on the futures position
 If rates fall, the bank’s lower net

interest income will be offset by gains

on the futures position
Hedging: GAP or Earnings Sensitivity

 Negative GAP
 Use a short hedge
 If rates rise, the bank’s lower net
interest income will be offset by gains
on the futures position
 If rates fall, the bank’s higher net

interest income will be offset by losses

on the futures position
Hedging: Duration GAP and EVE Sensitivity

 To eliminate interest rate risk, a bank

could structure its portfolio so that its
duration gap equals zero
y
ΔEVE - DGAP[ ]MVA
(1  y)
Hedging: Duration GAP and EVE Sensitivity

 Futures can be used to adjust the

bank’s duration gap
 The appropriate size of a futures
position can be determined by solving
the following equation for the market
value of futures contracts (MVF), where
DF is the duration of the futures
contract
DA(MVRSA) DL(MVRSL) DF(MVF)
  0
1  ia 1  il 1  if
Hedging: Duration GAP and EVE Sensitivity

 Example:
A bank has a positive duration gap of
1.4 years, therefore, the market value
of equity will decline if interest rates
rise. The bank needs to sell interest
rate futures contracts in order to hedge
its risk position
 The short position indicates that

the bank will make a profit if futures

rates increase
Hedging: Duration GAP and EVE Sensitivity

 Example:
 Assume the bank uses a Eurodollar
futures contract currently trading at
4.9% with a duration of 0.25 years, the
target market value of futures
contracts (MVF) is:
2.88($900) 1.61($920) 0.25(MVF)
  0
(1.10) (1.06) (1.049)
 MVF = $4,024.36, so the bank should
sell four Eurodollar futures contracts
Hedging: Duration GAP and EVE Sensitivity

 Example:
 Ifall interest rates increased by 1%, the
profit on the four futures contracts
would total 4 x 100 x $25 = $10,000,
which partially offset the $12,000
decrease in the economic value of
equity associated with the increase in
cash rates
 Recall from Exhibit 6.2, the unhedged
bank had a reduction in EVE of $12,000
Accounting Requirements and Tax Implications

 Regulators generally limit a bank’s use of

futures for hedging purposes
 If a bank has a dealer operation, it can use
futures as part of its trading activities
 In such accounts, gains and losses on these
futures must be marked-to-market, thereby
affecting current income
 Microhedging
 To qualify as a hedge, a bank must show that
a cash transaction exposes it to interest rate
risk, a futures contract must lower the bank’s
risk exposure, and the bank must designate
the contract as a hedge
Using Forward Rate Agreements to Manage
Interest Rate Risk
 Forward Rate Agreements
 A forward contract based on interest rates based on a
notional principal amount at a specified future date
 Buyer
 Agrees to pay a fixed-rate coupon payment (at the
exercise rate) and receive a floating-rate payment
 Seller
 Agrees to make a floating-rate payment and receive a
fixed-rate payment
 The buyer and seller will receive or pay cash when
the actual interest rate at settlement is different
than the exercise rate
Forward Rate Agreements (FRA)

 Similar to futures but differ in that

they:
 Are negotiated between parties
 Do not necessarily involve
standardized assets
 Require no cash exchange until
expiration
 There is no marking-to-market
 No exchange guarantees performance
Notional Principal

 The two counterparties to a forward

rate agreement 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.
Notional Principal

 Buyer
 Agrees to pay a fixed-rate coupon
payment and receive a floating-rate
payment against the notional principal
at some specified future date.
 Seller
 Agrees to pay a floating-rate payment
and receive the fixed-rate payment
against the same notional principal.
Example: Forward Rate Agreements

 Suppose that Metro Bank (as the

seller) enters into a receive
fixed-rate/pay floating-rating forward
rate agreement with County Bank (as
the buyer) with a six-month maturity
based on a $1 million notional
principal amount
 The floating rate is the 3-month LIBOR
and the fixed (exercise) rate is 7%
Example: Forward Rate Agreements
 Metro Bank would refer to this as a “3 vs. 6”
FRA at 7 percent on a $1 million notional
amount from County Bank
 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
 The only cash flow will be determined in six
months at contract maturity by comparing
the prevailing 3-month LIBOR with 7%
Example: Forward Rate Agreements
 Assume that in three months 3-month
LIBOR equals 8%
 In this case, Metro Bank would receive from
County Bank $2,451.
 The interest settlement amount is $2,500:
 Interest = (.08 - .07)(90/360) $1,000,000 = $2,500.
 Because this represents interest that would
be paid three months later at maturity of the
instrument, the actual payment is discounted
at the prevailing 3-month LIBOR:
 Actual interest = $2,500/[1+(90/360).08]=$2,451
Example: Forward Rate Agreements

 If instead, LIBOR equals 5% in three

months, Metro Bank would pay County
Bank:
 The interest settlement amount is $5,000
 Interest = (.07 -.05)(90/360) $1,000,000 = $5,000
 Actual interest = $5,000 /[1 + (90/360).05] = $4,938
Example: Forward Rate Agreements

 The FRA position is similar to a

futures position
 County Bank would pay
fixed-rate/receive floating-rate as a
hedge if it was exposed to loss in a
rising rate environment.
 This is analogous to a short futures
position
Example: Forward Rate Agreements

 The FRA position is similar to a

futures position
 Metro Bank would take its position as a
hedge if it was exposed to loss in a
falling (relative to forward rate) rate
environment.
 This is analogous to a long futures
position
Basic Interest Rate Swaps

 Basic or Plain Vanilla Interest Rate

Swap
 An agreement between two parties to
exchange a series of cash flows based
on a specified notional principal
amount
 Two parties facing different types of
interest rate risk can exchange interest
payments
Basic Interest Rate Swaps
 Basic or Plain Vanilla Interest Rate
Swap
 One party makes payments based on a
fixed interest rate and receives floating
rate payments
 The other party exchanges floating rate
payments for fixed-rate payments
 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
Basic Interest Rate Swaps

 Conceptually, a basic interest rate

swap is a package of FRAs
 Aswith FRAs, swap payments are
netted and the notional principal never
changes hands
Basic Interest Rate Swaps

 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
Basic Interest Rate Swaps
Basic Interest Rate Swaps
 Firms with a negative GAP can reduce
risk by making a fixed-rate interest
payment in exchange for a floating-rate
interest receipt
 Firms with a positive GAP take the
opposite position, by making floating-
interest payments in exchange for a
fixed-rate receipt
Basic Interest Rate Swaps
 Basic interest rate swaps are used to:
 Adjust the rate sensitivity of an asset
or liability
 For example, effectively converting a

fixed-rate loan into a floating-rate loan

 Create a synthetic security
 For example, enter into a swap instead

of investing in a security
 Macrohedge
 Use swaps to hedge the bank’s

aggregate interest rate risk

Basic Interest Rate Swaps
 Swap Dealers
 Handle most swap transactions
 Make a market in swap contracts
 Offer terms for both fixed-rate and
floating rate payers and earn a spread for
their services
Basic Interest Rate Swaps
 Comparing Financial Futures, FRAs,
and Basic Swaps
Position
Objective Financial Futures FRAs & Basic Swaps
Profit If Rates Rise Sell Futures Pay Fixed, Receive Floating
Profit If Rates Fall Buy Futures Pay Floating, Receive Fixed

 There is some credit risk with swaps in

that the counterparty may default on
the exchange of the interest payments
 Only the interest payment exchange is
at risk, not the principal
Interest Rate Caps and Floors

 Interest Rate Cap

 An agreement between two
counterparties that limits the buyer’s
interest rate exposure to a maximum
limit
 Buying a interest rate cap is the same
as purchasing a call option on an
interest rate
Buying a Cap on 3-Month LIBOR at 4 percent A. Cap5 Long Call Option on Three-Month LIBOR

Dollar Payout
(Three-month LIBOR 1C
- 4%)3 Notional
Principal Amount

Three-Month
LIBOR
4 Percent

B. Cap Payoff: Strike Rate

5 4 Percent*

Floating
Rate

Value Value Value Value Value

Date Date Date Date Date
Time
Interest Rate Caps and Floors

 Interest Rate Floor

 An agreement between two
counterparties that limits the buyer’s
interest rate exposure to a minimum
rate
 Buying an interest rate floor is the
same as purchasing a put option on an
interest rate
Buying a Floor on 3-Month LIBOR at 4 percent A. Floor= Long Put Option on Three-Month LIBOR

Dollar Payout
(4%- Three-month 1P
LIBOR)X Notional
Principal Amount

Three-Month
LIBOR
4 Percent

B. Floor Payoff: Strike Rate

= 4 Percent*

Floating
Rate

Value Value Value Value Value

Date Date Date Date Date
Time
Interest Rate Caps and Floors
 Interest Rate Collar
 The simultaneous purchase of an
interest rate cap and sale of an interest
rate floor on the same index for the
same maturity and notional principal
amount
 A collar creates a band within which
the buyer’s effective interest rate
fluctuates
 It protects a bank from rising interest
rates
Interest Rate Caps and Floors
 Zero Cost Collar
 A collar where the buyer pays no net
premium
 The premium paid for the cap equals
the premium received for the floor
 Reverse Collar
 Buying an interest rate floor and
simultaneously selling an interest rate
cap
 It protects a bank from falling interest
rates
Pricing Interest Rate Caps and Floors
 The size of the premiums for caps and
floors is determined by:
 The relationship between the strike
rate an the current index
 This indicates how much the index
must move before the cap or floor is in-
the-money
 Theshape of yield curve and the
volatility of interest rates
 With an upward sloping yield curve,
caps will be more expensive than floors
Pricing Interest Rate Caps and Floors
A. Caps/Floors
Term Bid Offer Bid Offer Bid Offer
Caps 4.00% 5.00% 6.00%
1 year 24 30 3 7 1 2
2 years 51 57 36 43 10 15
3 years 105 115 74 84 22 29
5 years 222 240 135 150 76 5
7 years 413 433 201 324 101 116
10 years 549 573 278 308 157 197

Floors 1.50% 2.00% 2.50%

1 year 1 2 15 19 57 55
2 years 1 6 31 37 84 91
3 years 7 16 40 49 128 137
5 years 24 39 75 88 190 205
7 years 38 60 92 106 228 250
10 years 85 115 162 192 257 287
 Floating Rate
Loans
Bank Swap Terms: Pay LIBOR, Receive 4.18 Percent
Prime + 1%
Basic Swap to Hedge Aggregate Balance

Three-Month LIBOR
Swap
Sheet Risk of Loss from Falling Rates

Bank
Counterparty
4.18% Fixed
Fixed 3.75%

Deposits

Current Rates Rates Fall Rates Rise

Constant 100 Basis Points 100 Basis Points

PRIME 5.50% PRIME 4.50% PRIME 6.50%

LIBOR 3.00% LIBOR 2.00% LIBOR 4.00%
Balance Sheet
Flows:
Loan 6.50% 5.50% 7.50%
Deposit (3.75%) (3.75%) (3.75%)
Spread 2.75% 1.75% 3.75%

Interest Rate
Swap Flows:
Fixed 4.18% 4.18% 4.18%
Floating (3.00%) (2.00%) (4.00%)
Spread 1.18% 2.18% 0.18%

Margin 3.93% 3.93% 3.93%

 Floating Rate
Loans
Floor Terms: Buy a 2.50 Percent Floor on 3-Month LIBOR
Buying a Floor on 3-Month LIBOR to Hedge Aggregate

Prime + 1%

Receive when
Bank Counterparty
Three-Month LIBOR < 2.50%
Balance Sheet Risk of Loss From Falling Rates

Fee: (0.30%) per year

Fixed 3.75%

Deposits

Current Rates Rates Fall Rates Rise

Constant 100 Basis Points 100 Basis Points

PRIME 5.50% PRIME 4.50% PRIME 6.50%

LIBOR 3.00% LIBOR 2.00% LIBOR 4.00%
Balance Sheet
Flows:

Loan 6.50% 5.50% 7.50%

Deposit (3.75%) (3.75%) (3.75%)

Spread 2.75% 1.75% 3.75%

Floor
Flows:

Payout 0.00% 0.50% 0.00%

Fee Amort. (0.30%) (0.30%) (0.30%)

Spread (0.30%) 0.20% (0.30%)

Margin 2.45% 1.95% 3.45%

 Floating Rate
Loans
Balance Sheet Risk of Loss from Falling Rates Strategy: Buy a Floor on 3-Month LIBOR at 2.00 Percent,
Buying a Reverse Collar to Hedge Aggregate
Prime + 1% and Sell a Cap on 3-Month LIBOR at 3.50 Percent
Pay when

Three-Month LIBOR > 3.50%

Bank Counterparty
Receive when

Three-Month LIBOR < 2.00%

Premium: 0.38% per year
Fixed 3.75%

Deposits Rates Fall Rates Rise

100 Basis Points 100 Basis Points

PRIME 5.50% PRIME 4.50% PRIME 6.50%

LIBOR 3.00% LIBOR 2.00% LIBOR 4.00%
Balance Sheet
Flows:

Loan 6.50% 5.50% 7.50%

Deposit (3.75%) (3.75%) (3.75%)

Spread 2.75% 1.75% 3.75%

Reverse Collar
Flows:

Payout 0.00% 0.50% (0.50%)

Fee Amort. 0.38% 0.38% 0.38%

Spread 0.38% 0.88% (0.12%)

Margin 3.13% 2.63% 3.63%

Using a Basic Swap to Hedge Aggregate Balance Fixed Rate
Loans Strategy: Pay 4.19 Percent, Receive 3-Month LIBOR
Fixed 7.00%

4.19% Fixed
Swap
Bank
Counterparty
Sheet Risk of Loss From Rising Rates

Three-Month LIBOR
3-Month LIBOR -0.25%

Deposits
Current Rates Rates Fall Rates Rise
Constant 100 Basis Points 100 Basis Points

LIBOR 3.00% LIBOR 2.00% LIBOR 4.00%

Balance Sheet
Flows:

Loan 7.00% 7.00% 7.00%

Deposit (2.75%) (1.75%) (3.75%)

Spread 4.25% 5.25% 3.25%

Interest Rate
Swap Flows:

Fixed (4.19%) (4.19%) (4.19%)

Floating 3.00% 2.00% 4.00%

Spread (1.19%) (2.19%) (0.19%)

Margin 3.06% 3.06% 3.06%

Buy a Cap on 3-Month LIBOR to Hedge Balance Fixed Rate
Loans
Strategy: Buy a Cap on 3-Month LIBOR at 4.00 Percent
Fixed 7.00%
Sheet Rate Risk of Loss from Rising Rates

Receive when
Bank Counterparty
Three-Month LIBOR > 4.00%

Fee: (0.50%) per year

Three-Month LIBOR -0.25%

Deposits

Current Rates Rates Fall Rates Rise

Constant 100 Basis Points 100 Basis Points

LIBOR 3.00% LIBOR 2.00% LIBOR 4.00%

Balance Sheet
Flows:

Loan 7.00% 7.00% 7.00%

Deposit (2.75%) (1.75%) (3.75%)

Spread 4.25% 5.25% 3.25%

Cap
Flows:

Payout 0.00% 0.00% 0.50%

Fee Amort. (0.50%) (0.50%) (0.50%)

Spread (0.50%) (0.50%) 0.00%

Margin 3.75% 4.75% 3.25%

 Fixed Rate
Balance Sheet Risk of Loss from Rising Rates Loans Strategy: Buy a Cap at 3.00 Percent, and Sell a Floor
at 2.00 Percent
Using a Collar on 3-Month LIBOR to Hedge

Fixed 7.00%

Receive when

Three-Month LIBOR > 3.00%

Bank Counterparty
Pay when

Three-Month LIBOR < 2.00%

Fee: (0.75%) per year
3-Month LIBOR -0.25%

Deposits
Current Rates Rates Fall Rates Rise
Constant 100 Basis Points 100 Basis Points

LIBOR 3.00% LIBOR 2.00% LIBOR 4.00%

Balance Sheet
Flows:

Loan 7.00% 7.00% 7.00%

Deposit (2.75%) (1.75%) (3.75%)

Spread 4.25% 5.25% 3.25%

Collar
Flows:

Payout 0.00% (0.00%) 1.00%

Fee Amort. (0.75%) (0.75%) (0.75%)

Spread (0.75%) (0.75%) 0.25%

Margin 3.50% 4.50% 3.50%

 Bank Management,
Management 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning

Using Derivatives to Manage

Interest Rate Risk

Chapter 7

William Chittenden edited and updated the PowerPoint slides for this edition.