10.

1 Introduction
In the final three modules of the course, we will be looking at various forms of derivative contract that banks use to hedge
risk. A derivative is an instrument that derives its value from another underlying asset.

Derivatives Used to Manage Interest Rate Risk

1. Financial Futures Contracts

2. Forward Rate Agreements
3. Interest Rate Swaps
4. Options on Interest Rates: Interest Rate Caps, Interest Rate Floors, Exchange traded options

10.1 Forward and futures contracts

Forward and futures contracts set terms today for transactions that take place in the future. They are used to manage the
risk arising from uncertainty relating to future conditions.

1. Forward contracts
A forward contract is a bilateral contract (between two parties) to buy or sell an asset. The price is set today, but delivery
is on an agreed date in the future.

 There is no upfront exchange of cash.

 If the contract is held to maturity, exchange will take place on the delivery date.
 Forward contracts are generally traded: over-the-counter (OTC).
 Individualised agreements (not standardised): amount, quality, time etc. are all customised to particular needs.

Difficulties:

 Trust between the buyer and seller is needed, due to settlement risk.
 It can be difficult to find a trading partner with complementary needs.
 Hedgers may prefer to take a temporary position but not make (or receive) delivery.

Example: A wheat farmer is concerned that prices might fall between the current time (March) and the time of harvest
(September). To protect himself, he forward sells his wheat harvest, specifying price, amount, grade, delivery date etc.

 Hence, he has locked in the price he will receive in September.

 If his harvest is below expectation, he may have to purchase wheat in order to fulfil his contract.
 If the wheat price has risen, the farmer will lose out on some profits.
 For this reason, there is a degree of settlement risk – the farmer may be tempted to renege on the contract.

2. Futures contracts

 Futures contracts are sold on centralised exchanges.

 They are standardised in terms of amount, quality, delivery date etc.
 Futures markets have high liquidity due to the larger numbers of buyers and sellers
 When the underlying asset is an interest-bearing security we call the derivative an interest rate future

In the futures market:

 Buyers/sellers seldom take/make delivery. They sell/buy offsetting contracts before the delivery date.
 Futures contracts do not have the settlement risk inherent in forwards.
 Traders must deposit a margin (called a performance bond) with the exchange. It can be cash, securities or
letters of credit.
 If price/rates have moved, the losing party must pay the exchange, and the exchange compensates the gaining
party. This is called marking to market.

Contracts are marked-to-market daily.

 If, due to marking to market, the margin falls below a certain level – called the maintenance margin, a margin call
is made on the trader. If the call is not met by close of business, the exchange closes out the position and
recompenses the disadvantaged party.
 The Clearing House of the exchange effectively acts as the counterparty to all trades. (not a bilateral contract)
 Hence, futures buyers and sellers transact with the clearing house, rather than with the person holding an
opposite position.
Financial institutions and Futures

 Financial institutions deal primarily in financial futures and forwards, rather than commodities.
 Forward rate agreements are a common form of OTC forward interest rate contract
 Commonly used interest rate futures include: 90 day BAB futures and 3 & 10 year Treasury bond futures.

Forward rate agreements (FRA)

An FRA is a forward contract on an interest rate. FRAs are traded OTC.

Example: A person plans to borrow in the future, eg. at the bank bill swap rate (BBSW). If she is afraid rates will rise, she
can buy an FRA. The buyer will pay the fixed FRA rate. The seller will pay the prevailing market rate which is the BBSW.

 Note that BBSW is the Australian equivalent of LIBOR.

 Major banks are active FRA market makers.
 They are written in most major currencies: USD, pounds, euros, yen, AUD etc.
 Rates quoted on FRAs are based on the yield curve.
 Most commonly, terms are 90 and 180 days.
 There are no deposits required, and no margin calls.

Example 3.2
In this example, a company plans to borrow in 1 month time. They are concerned that rates will rise before then (i.e., they
are exposed to a rate rise), so they buy an FRA from a bank. This way, they can effectively lock in the interest rate that they
will pay on their borrowing. Details:

 Company: Seasonal Ltd. (i.e. the need for funds is seasonal)

 Amount: $2 million
 Loan type: Bank accepted Bill
 Duration of loan: 90 days
 Starting in 1 month time.
 However, Seasonal Ltd is concerned that rates will rise. What can it do?

Answer: Buy a 1×4 FRA from a bank. 1month forward, 90 day rate: 6% This is a forward rate based on the yield curve
(expectations). What will be the relevant cash flows if in 1 month’s time the BBSW is 7%?

A bank bill is a discount security so to find the amount paid by the investor (and thus received by Seasonal Ltd), we can use
the discount security formula. We saw a version of this in module 7:
 
 Pf 
Po  
h 
1  i  
 365 

Since this example is taken from the Hogan text will we use the formula as stated in this text (which is in effect the same):
Face Value
Price received =
1  (r)(d/365) 2000000
 $1966065.18
Face value of BAB: $2 million, Seasonal Ltd will receive: 1  (.07)(90 / 365)

The FRA (6%) is settled against the BBSW (7%). Seasonal will receive a cash flow from the bank calculated as:

 Fixed: $2 M @ 6% for 90days: $1 970 842.33

 BBSW: $2 M @ 7% for 90 days: $1 966 065.18
 Settlement paid to Seasonal: $4,777.15
 Effectively, Seasonal Ltd will pay 6%.

What if rates declined rather than increased?

 Seasonal Ltd would pay a settlement to the bank. Again, it would effectively pay 6% on its loan.
 What if Seasonal Ltd believed that rates would fall rather than rise in 1 month?
 They could sell an FRA to bank. The bank would pay the fixed rate, and Seasonal would pay the BBSW.
Hedging with FRAs

 To hedge against future rate rise: buy FRA from bank

 If rates rise, bank pays a settlement to FRA holder.
 If rates fall, FRA holder pays settlement to bank.
 Either way, FRA holder effectively pays the fixed FRA rate on their loan.

FRAs are quoted as:

 1×4: 1 month forward, 90 day rate

 3×6: 3 month forward, 90 day rate
 1×7: 1 month forward, 180 day rate
 3×9: 3 month forward, 180 day rate
 Etc.

A liquid secondary market exists for up to 2 years out. Banks act as market makers. They take many positions, buying and
selling a range of FRAs. Note that a plain vanilla interest rate swap agreement is a series of FRAs. The swap buyer is the
fixed-rate payer.

Futures
In the U.S. and Europe, interest rate securities are quoted in the cash market on the basis of their price (contract value). In
Australia, they are quoted on the basis of their YTM. The Hogan text follows the convention used in Australia, while the
Koch and MacDonald text follows the U.S. Convention.
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 (i.e., interest rate falls) and lose when futures prices fall (interest rate rise).
 Note: price refers to the price of the underlying instrument, which varies inversely with the interest rate

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 (interest rate rise) and lose when futures prices rise (interest rate fall).
 Note: price refers to the price of the underlying instrument, which varies inversely with the interest rate

Interest rate futures traded on the Sydney Futures Exchange (SFE)

1. 90 Day Bank Accepted Bills Futures: These trade in contract units of $ 1,000,000. They can be settled in cash or Bank
Accepted Bills or Negotiable Certificates of Deposit. The instruments can have the value $100,000, in which case 10 would
be required, $500,000 (2 required) or $1,000,000. The instruments must mature 85-95 days from settlement day.

2. 3 Year Treasury Bond Futures: These are based on 3 year T bonds that trade in contract units of $ 100 000 and pay a 6%
coupon semi-annually. They are cash settled.

3. 10 Year Treasury Bond Futures: These are based on 10 year T bonds that trade in contract units of $ 100 000 and pay a
6% coupon semi-annually. They are cash settled.

4. Other futures: futures contracts are also available on:

 the 30 day interbank rate ($3 million contract);

 3 year Australian interest rate swaps ($100,000 contract);
 90 day New Zealand Bank Bills (NZ $1,000,000 contracts); and
 10 year New Zealand government bonds (NZ $100,000 contracts).

Contract prices

 Interest rate contracts on the SFE are quoted as 100 minus their YTM. Note that the SFE is now incorporated into
the Australian Securities Exchange (ASX).
 Example: see the top half of Figure 13.1 from Hogan
 The settlement price of 90-Day bank bills on March 03 is 95.28, which indicates a YTM of 4.72%.
  The last column lists ‘open interest’: a buy and sell contract combined create one contract of open interest. It is
cumulative – whereas the volume column is daily volume.
 Open interest is usually largest for the next contract due for delivery. The most distant contracts have least open
interest.
 Open interest goes to zero at the end of the contract’s life. Traders either enter a reverse trade, or take/make
delivery.

90 Day BAB futures contracts on SFE

 90 day BAB futures contracts are for delivery of $1M face value securities, with an 85-95 day maturity.
 Settlement months are March, June, Sept, and Dec. up to 20 quarters ahead.
 Delivery (either physical or cash settlement) occurs on the 2nd Friday of the month.
 Hence, the ‘June 05 90 day BAB futures’ settled on June 10.
 How was the contract priced? Consider June 2005.

Note: we will base our maths on a single instrument with a $1,000,000 face value. Settlement can be made with 1 BAB or
negotiable CD face value $1,000,000, or with 2 BABs or negotiable CDs face value $500,000 or with 10 BABs or negotiable
CDs face value $100,000. The instruments must have 85-95 day maturity. YTM = 100 – 94.76 = 5.24%
Face Value 1000000
P90 day = 1  (r)(d/365) = 1  .0524  90 / 365  $987244.26

The $ value of a .01% change is called a ‘tick’. For June ‘05, the value of a ‘tick’ could be calculated using a yield of 5.25%:

1000000
 $987220.23
1  .0525  90 / 365

Value of tick = 987244.26 – 987220.23 = $24.03, For simplicity, we will round this to $24

Margin requirements and settlement procedures

 One major difference between an FRA traded OTC and an exchange traded futures contract is that the futures
contract is margined.
 This provides protection against default.
 When traders enter a position in futures, they must deposit an initial margin with a broker. If there is a price
change, money will flow from one party to the other via the clearing house.
 Note: the seller is said to take a ‘short’ position; the buyer a ‘long’ position.
 The broker also maintains a margin deposit. The broker is either a clearing member firm or deals with one.
 The SFE marks to market open contracts each day & clearing member firms must settle gains & losses each day.
 Brokers set margins above the clearing house requirement, and make margin calls on their clients.

Direction of money flows:

 If a futures contract increases in value during the day (i.e. rates fall), money flows:
 From – the customer with a short position
 To – the customer with a long position
 And vice versa if the contract decreases (rates increase)

See example 13.3 of Hogan et al.

Cable Industries buys 90 day BABs on March 1 and plans to sell them on March 3. It is exposed to a rate rise, since, if rates
rise, the selling price will fall. What can it do? Sell BAB futures contracts. If rates rise, the futures contract value will fall,
and Cable Industries’ margin account will be credited. (The buyer’s account will be debited). This will offset the loss that
Cable incurs on the sale.
Note:

 There are 100 contracts, each valued at $1M. The value of a tick is $24 as calculated above!!!
 The initial margin is $600 per contract, and the Broker margin is $400 per contract.
 The total margin is (600+400) *100 = $100 000

Table 13.2 shows the flow of money to and from the margin account – a process called settlement variation (or margin
variation or marking to market). Contracts are sold on March 1:

 On March 1, rates rise by 14 basis points. Hence the price falls by 14 ticks.
 On March 2, rates rise by 5 basis points.
 The rate rises (price falls) lead to a flow of money into Cabal’s margin account.
 On March 3, rates fall 15 basis points. This leads to a flow out of the account.

At the close of March 3, Cabal buys 100 contracts – and closes out its position.

The net change is a rate increase of 4 basis points (a price fall of 4 ticks). The net flow into Cable’s account (from the
contract buyer’s account) is: -4 * 24 * -100 = $9600. i.e., price fall of 4 ticks, $24 per tick, 100 contracts.
Note: $24 per tick is an approximation. The minus sign against ‘100’ indicates that contracts are sold.

Main points:

1. Participants exposed to a rate rise will sell BAB futures contracts.

2. Money flows occur on a daily basis as the contracts are ‘marked to market’.
3. At the end of the period, Cabal goes long 100 contracts, and closes out its position.
4. Cabal withdraws: 100 000 + 9 600 = $109 600 from its margin account.

Note also: we are not told what happened on the spot market i.e., how much rates on the BAB’s changed. However, if they
rose as the futures change suggests, then the gain on the futures trade would offset the loss Cable made on the spot trade.
It may not offset completely however – it depends how much the spot price changed.

10.2 Microhedging
Microhedging involves hedging the interest-rate risk of single assets and liabilities. As we have seen, hedging with interest
rate futures protects against the effects on asset price and net interest revenue of unfavourable movements in market
rates. Interest rate futures hedges are classified as either cash or anticipatory.
Cash Hedges
There are two kinds of cash hedges:

 Asset hedges: these transform the effective interest rate maturity of an asset. Buying futures lengthens the
maturity; Selling futures shortens the maturity.
 Liability hedges: these transform the effective interest rate maturity of a liability. Selling futures lengthens
maturity; Buying futures shortens maturity.
Hedgers who buy futures contracts profit from falling interest rates, and vice versa.

Anticipatory hedge:
This is a hedge against a financial commitment a hedger plans to make in the future.

 Example: An ADI could use this type of hedge when offering fixed rate loans; i.e., it hedges against a rise in rates.
Why would it do this? If rates rise, it will not benefit from increased loan income but may pay higher rates on the
liabilities that fund the loan. How would it do this? By selling futures contracts as in ex. 13.3 (Cable Securities)
 If rates decrease, losses will be made on the futures contracts, but these will be offset by gains made on the loan,
since income flows will not fall on the fixed rate loan (but could fall on the liabilities used to fund the loan).
 Alternatively, it could offer a large floating rate loan to a corporate and advise the corporate borrower to hedge
against a rate rise.

Example 13.7
First Place Financial Corp funds $10 M in new loans by rolling over 6-month CDs. Current CDs pay 6.2% and mature on April
4. Interest is paid at maturity. Once rolled over, new CDs will expire on October 4 (183 days maturity). At the current rate,
CD interest expense would be: $10 M × [0.062(183/365)] = $310 849.

 It is January 19, and the market news is that rates will rise. First Place is concerned the funding cost of CDs will
rise. What should First Place do to hedge against a rate rise? The should Sell interest rate futures.
 On January 19, First Place sells June 90-day BAB futures contracts, each with face value $1 M. The futures are
priced at 94.00 (6% YTM). Because interest rate impacts on 6-month CDs are about twice that of 90 day BAB
futures, First Place uses a hedge ratio of 2. 20 contracts are sold (worth $20M) to cover the $10 M worth of CDs.
 On April 4 when CDs are rolled over, rates have risen to 8.25%. Hence, the actual interest expense is:
$10M[0.0825(183/365)] = $413 630. Because of the rate rise, First Place is worse off (in the cash transaction) by:
$413 630 – $310 849 = $102 781
 To compensate, First Place closes out its short futures position by buying $20 M in June BAB contracts. Futures
price is now 92.00 (8% YTM). The gain on futures will be:

20M 20M
  $95312
90 90
1  0.06  1  0.08 
365 365

Net Result from Trading:

Cash (loss) $102 781
Futures (gain) $ 95 312
Net loss $ 7 469
Hence, the hedge wasn’t perfect, but it significantly reduced the cash loss. The results are summarised in Table 13.5

Perfect hedge:
When the net profit on both the futures and cash position equals zero, this is known as a perfect hedge.

One causal factor of an imperfect hedge is basis risk.

The basis on a futures contract is defined as the

cash price minus the futures price.

In our example, the price of CDs (moved 205 ticks

(rate rise of 205 basis points: 6.2% to 8.25%),
while the price of the futures contract moved 200 ticks
(rise of 200 basis points from 6.0% to 8.0%).
Mortgage illustration
While most home loans are floating rate, many ADIs offer mortgages with fixed rates for the first 12 months or so, and
hence for an ADI hedging is relevant in such cases. As we have seen, microhedging occurs on a deal-by-deal basis, to
protect specific positions against adverse interest rate movements. Example 13.8 is fairly complex, so we will skip this and
move on to macro hedging.

10.3 Macrohedging
Macrohedges are used to protect the overall net worth of the firm, or exposure on large portions of assets and liabilities.
Because asset and liability portfolios contain many types of risk, e.g., basis risk, it can be difficult to measure overall
interest rate exposure, and hence macrohedging is more complex and less exact than microhedging.

 For ex, pricing relationships/sensitivity in wholesale financial markets and retail customer markets are different.
 Another issue is imbedded option risk. One example of this is when banks give customers the option to repay
their fixed rate loans early (although the customer must pay a fee to do this).
 Despite the difficulties, interest risk on the balance sheet must be estimated in order to hedge it.
 When the exposure is measured, and the type of futures to be used is chosen, a hedge ratio must be determined.
 The effectiveness of the hedge depends ultimately on how well the firm’s net worth is insulated from the effects
of interest rate changes.
 In order to examine balance sheet hedging, we will look at an example from Hogan chapter 4.

Example 4.10 on page 147.

Snowbank’s asset and liability durations were: DA = 1.225 years; DL = 0.572 years and duration gap was:
L   900 
Dgap  DA   DL   1.125    0.572   0.610 years
 A   1000 

We can also calculate the change in equity caused by a change in rates. In the example given on page 148, the initial rate
was 10% , the increase in rates was 2% and assets were $1000M.
 Δr   0.02 
ΔE  - D gap   A  -0.610    $1000M  $11 090 909
1  r  1  0.10 
As you can see, this could have serious consequences for the bank. Given that duration gaps for ADIs are typically positive,
macrohedging is an important aspect of interest rate management.

As noted, the bank must choose a hedging instrument and a hedge ratio. In Australia, available instruments include: 3- and
10-year T bond futures; 3- and 10-year interest rate swaps, and 90 day BAB futures. How many contracts will be needed?

See the following equation. The equality represents a perfect macro hedge, where a loss in net worth is exactly offset by a
gain in futures trading.
E
∆E = - (N  F) or N = 
F
Where N = number of futures contract, ∆F = gain or loss per futures contract, ∆E = change in equity

Futures are based on the underlying asset. For example, 10 year Treasury bond futures are based on the 10 year Treasury
Bond. Based on this we can derive the following relationships:

 r 
F  - D F  FP
1  r 
Where FP = futures contract price, DF = duration of futures contract
 Dgap  A  r 
By substitution, we get the following relationship: N AND  F(N)  E  - D F  FP (N)
DF  FP 1  r 
 A positive inflow from futures trading will offset a negative change in equity resulting from an adverse movement
in interest rates.
 Recall that in general, an ADI will have a positive duration gap, and hence the balance sheet is exposed to interest
rate rises.
 Hedging won’t work perfectly because futures contracts can only be traded in whole contracts (eg. $1,000,000
per contract) and because duration calculations are approximations – they work best for very small changes in
interest rate.
 Once N is calculated it will need to be rounded to the nearest whole number.
10.4 Foreign exchange derivative markets
As well as interest rate risk, ADIs use forwards and futures to manage foreign exchange risk. This section compares interest
rate forwards and futures with foreign exchange forwards and futures.

 For interest rates, exchange traded futures dominate OTC forwards in terms of market size in Australia.
 The reverse is true for foreign exchange: the forward market dominates the exchange traded market.
 An active, liquid forward market is available for a range of foreign currency pairs. It is a worldwide market.
 Banks and other FIs are active market makers for forward foreign exchange. Trading is 24 × 7.
 Users of forward markets include importers, exporters and speculators. The counterparty to these transactions
is most commonly an FI.
 Durations range from overnight to several years.

Example
Consider the case of an Australian importer who purchases goods from a US manufacturer.
The contract specifies that payment must be made in USD in 100 days.

Exposure?
If the importer is afraid the AUD will depreciate against the USD, he can enter a forward contract with his bank to buy USD
forward 100 days, and hence lock in the AUD-USD exchange rate.

Regulation in Australia
The SFE and the Australian Stock Exchange are now amalgamated as the Australian Securities Exchange (ASX).
The SFE is partly self-regulated and also regulates in cooperation with the Australian Securities and Investments
Commission (ASIC) under the Corporations Act 2001.

In addition, SFE Clearing, ASIC and the RBA are co-regulators of the clearing and settlement systems operated by SFE and
Austraclear (used for fixed interest securities).

All activities are also subject to review by the Australian Competition and Consumer Commission (ACCC) with regards
competition issues under the Competition and Consumer Act 2010.