MONASH

BUSINESS
SCHOOL

BFF3651 Week 9

Risk Management:
Futures and Forwards
 Unit Learning Outcomes
• On successful completion of this unit, you should be able to:
– explain the role of treasury operations in an international
or a local bank
– describe how risk management processes work
– demonstrate the application of hedging techniques used in
banks' treasury operations
– apply critical thinking, problem solving and presentation
skills to individual and/or group activities dealing with
treasury management and demonstrate in an individual
summative assessment task the acquisition of a
comprehensive understanding of the topics covered by
BFF3651.

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 Resources
• Lecture note
• Saunders and Cornett’s Financial Institution
Management Chapter 23-Futures and Forward

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 Learning Objectives
• Our discussion will focus on
– Forward and Futures contracts
– Forward contracts and hedging interest rate risk
– Future contracts and hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk

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 Why derivative contracts?

• When employed appropriately, derivatives can be used to hedge (or

reduce an FI’s risk).
• However, when misused, derivatives can increase the risk of an FI’s
insolvency.
– Bankers Trust, Barings Bank
• As of 2000, FASB requires that derivatives be marked to market
– Transparency of losses and gains on financial statements
• Late 2000s, major changes:
– Federal regulation and policing by SEC

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 Why derivative contracts?
• Role of a treasurer:
• Three levels of regulation:
– Permissible activities
– Supervisory oversight of permissible activities
– Overall integrity and compliance
• Exchange-traded futures not subject to capital requirements, while
OTC forwards potentially subject to capital requirements
• Establish internal guidelines regarding hedging activities
• Establish trading limits
• Disclose large contract positions that materially affect bank risk to
shareholders and outside investors
• Overall policy is to discourage speculation and encourage hedging

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BUSINESS
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 Learning Objectives
• Our discussion will focus on
– Forward and Futures contracts
– Forward contracts and hedging interest rate risk
– Future contracts and hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk

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BUSINESS
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 Forward and Futures contracts

• Spot contract
– Agreement at t = 0 for immediate delivery and immediate
payment
– Immediate and simultaneous exchange of cash for securities:
delivery versus payment
• Forward contract
– Agreement between buyer and seller to exchange an asset at a
specified future date for a price which is set at t = 0
• Trading in OTC markets
• Capital requirements
• Unique in features

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 Forward and Futures contracts

• Future contract: A futures contract is a commitment to buy or sell

a specific commodity of designated quality at a specified price and
date in the future (delivery date).

• Futures contract similar to a forward contract except:

– Exchange-traded
– Standardized contract specifications (face value, delivery date,
underlying instrument).
– Lower default risk than forward contracts
• The clearinghouse guarantees the performance of the
contract and assumes the responsibility for creditworthiness
of buyer.

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 Forward and Futures contracts
• Futures contract similar to a forward contract except:
– Price is marked to market daily
• A Single Stock Futures contract covering 500 shares of a
firm’s stock dropped by $1 per share. By the end of the
trading day, settlement price determined by the
clearinghouse. Since contracts are “marked to market” each
day, daily losses are charged to trader’s margin account.
The loss will be deducted from the long's margin account.
• Traders are required an initial margin (In the form of cash,
bank letter of credit, or short-term treasury securities) to
support position.
• The initial margin is usually no more than 5% of the face
value.
• The margin depends on: whether a trader is a hedger or a
speculator, price volatility of the underlying instrument.
• If the balance of margin account below a required minimum,
additional cash must be deposited (i.e. margin call).
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 Forward and Futures contracts
• Futures contract similar to a forward contract except:
– Limits on price change: The exchanges set a maximum amount
by which the price of a contract is allowed to change.
• When the limit is reached on a given day, the price cannot
move further.
• Subsequent trades will take place only if they are within the
limits.
– Delivery of underlying asset seldom occurs
• Because the contracts are standardized and default risk is
assumed by the clearinghouse, the original owner of a
futures contract can easily offset or cancel the contract
before its delivery date.

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 Forward and Futures contracts
• Futures contract similar to a forward contract except:
– Delivery of underlying asset seldom occurs
– A treasurer anticipates that her firm will need Australian
dollars (A$) in March to pay an Australian supplier.
Consequently, she purchases a futures contract specifying
A$100,000 and a March settlement date (which is March 19 for
this contract). On January 10, the futures contract is priced at
$.53 per A$. On February 15, she realizes a reduction in
production levels. Therefore, she has no need for A$ in March.
She sells a futures contract on A$ with the March settlement
date to offset the contract purchased in January. At this time,
the futures contract is priced at $.50 per A$. On March 19 (the
settlement date). However, the price when the futures contract
was purchased was higher than the price when an identical
contract was sold resulting in a loss from futures positions.

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 Forward and Futures contracts
• Futures contract similar to a forward contract except:
– Delivery of underlying asset seldom occurs

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BUSINESS
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Forward and Futures contracts

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BUSINESS
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 Learning Objectives
• Our discussion will focus on
– Forward and Futures contracts
– Forward contracts and hedging interest rate risk
– Future contracts and hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk

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BUSINESS
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 Forward contracts and hedging interest rate risk

• Naive hedge: When a cash asset is hedged on a direct dollar-for-

dollar basis with a forward or futures contract.
• Example: 20-year, $1 million face value bond. Current price =
$970,000. Interest rates expected to increase from 8% to 10% over
next 3 months. Duration= 9
• From duration model, change in bond value:
P/P = -D  R/(1+R)
P/ $970,000 = -9  [.02/1.08]
P = -$161,667 or P/P=-16.67% ; (97x(1-0.1667)) =80.83
• Suppose at time 0 the treasurer can find a buyer willing to pay $97
for every $100 of 20-year bonds delivered in three months’ time.
• After the rise in interest rates, the treasurer can buy $1 million
face value of 20-year bonds in the spot market at $80.833 per $100
of face value, a total cost of $808,333, and deliver these bonds to
the forward contract buyer.

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 Forward contracts and hedging interest rate risk

• After the rise in interest rates, the treasurer can buy $1 million
face value of 20-year bonds in the spot market at $80.833 per $100
of face value, a total cost of $808,333, and deliver these bonds to
the forward contract buyer.

• The on-balance-sheet loss of $161,667 is exactly offset by the off-

balance-sheet gain of $161,667 from selling the forward contract.
• The FI’s net interest rate exposure is zero; it has immunized its
assets against interest rate risk.

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BUSINESS
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 Learning Objectives
• Our discussion will focus on
– Forward and Futures contracts
– Forward contracts and hedging interest rate risk
– Future contracts and hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk

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BUSINESS
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 Future contracts and hedging interest rate risk

• Futures more commonly used than forwards for hedging interest rate
risk
• Microhedging: The hedging of a transaction associated with a specific
asset, liability or commitment.
• Macrohedging: Hedging entire duration gap (portfolio effects)
• Routine hedging: Seeking to hedge all interest rate risk exposure.
– Reduces interest rate (or other) risk exposure to lowest possible
level
– Low risk, low return
• Hedging selectively: Treasurer may selectively hedge a portion of
balance sheet position based on expectations of future interest rates
and risk preferences
– Not hedging, or overhedging, may be seen as speculative

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 Future contracts and hedging interest rate risk

• Macrohedging:
– The number of futures contracts: depends on the size
and direction of its interest rate risk exposure and the
return risk trade-off from fully or selectively hedging
that risk.
– Suppose: DA = 5 years, DL = 3 years and interest rate
expected to rise from 10% to 11%. A = $100 million, L
= $90 million, k=L/A=90/100 = 0.9
– = -[5-(0.9)X3] X $100 X
0.01/1.1
=-2.091million

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 Future contracts and hedging interest rate risk

• The Risk-Minimizing Futures Position:

• When interest rates rise, the price of a futures contract falls since its
price reflects the value of the underlying bond that is deliverable
against the contract.
• The amount by which a bond price falls when interest rates rise
depends on its duration.
• Thus, the sensitivity of the price of a futures contract depends on the
duration of the deliverable bond underlying the contract, or:

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 Future contracts and hedging interest rate risk

• The Risk-Minimizing Futures Position:

• F= NF X PF
• NF >0 if bought; NF <0 if sold
• Futures contracts are homogeneous in size.
• Thus, futures exchanges sell T-bond futures in minimum units of
$100,000 of face value; that is, one T-bond future (NF =1) equals
$100,000.

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 Future contracts and hedging interest rate risk

• The Risk-Minimizing Futures Position:

∆
• Loss on balance sheet:
∆
• Gain off balance sheet on futures = [
• Full hedging: +
∆ ∆
• [ =0
∆
• Cancelling and multiplying by -1:
• +
•

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 Future contracts and hedging interest rate risk

• The Risk-Minimizing Futures Position:

• On balance sheet loss= -2.091 million

∆
• Off balance sheet profit: [
.
.
• Is it perfect hedge?
• Marking to market: Future price falls by $2.086 million. Such a fall in value of
the futures contracts means a positive cash flow to the futures seller as the
buyer compensates the seller for a lower futures price through the marking-to-
market process. This requires a cash flow from the buyer’s margin account to
the seller’s margin account as the price of a futures contract falls.
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 Future contracts and hedging interest rate risk

• Basis Risk: A residual risk that arises because the movement in a spot
(cash) asset’s price (that requires hedging) is not perfectly correlated
with the movement in the price of the asset delivered under a futures
or forward contract.
• The interest rates on the various assets and liabilities on the FI’s
balance sheet and the interest rates on 20-year T-bonds do not move
in a perfectly correlated (or one-to-one) manner.
• The second source of basis risk comes from the difference in
movements in spot rates versus futures rates. Because spot securities
(e.g., government bonds) and futures contracts (e.g., on the same
bonds) are traded in different markets, the shift in spot rates may
differ from the shift in futures rates (i.e., they are not perfectly
correlated).
• In the previous section, we assumed a simple world of no basis risk in
which ΔR /(1 + R ) = R F /(1 + R F ).

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 Future contracts and hedging interest rate risk

• Basis Risk:
∆
• Loss on balance sheet:
∆
• Gain off balance sheet on futures = [
• Full hedging: +
∆ ∆
• [ =0
∆ ∆
• Using Basis risk (br) = / and rearrangement, we get

. $ , ,
• If br=1.1, the number of contracts = =-226.9
. , .

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BUSINESS
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 Learning Objectives
• Our discussion will focus on
– Forward and Futures contracts
– Forward contracts and hedging interest rate risk
– Future contracts and hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk

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BUSINESS
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 Hedging foreign exchange risk
• All assets and liabilities are of a one-year maturity and duration.
• Because the FI is net long in pound assets, it faces the risk that over
the period of the loan, the pound will depreciate against the dollar.
• For simplicity, we have ignored the equity of the FI. Generally, FI’s
equity will absorb losses. In the extreme cases, insolvency risk will
increase.

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 Hedging foreign exchange risk
• Using Future contracts: NO basis risk
• On September 2, 2015: St = $1.5345 per £1; Ft = $1.5074 per £1 for
contract expiring on September 16 (after 1 year)
• Loan: £100 million with 15% interest rate
• Forecasted rate in one year: St+1 = $1.4845 per £1; Ft+1 = $1.4574 per
£1
• Thus, Δ St =-5cents and Δ Ft =-5cents
• Size of British pounds future contracts = £62,500
• Number of Future contracts = NF
Size of long position £ , ,
= = =1,840
£ ,
• On balance sheet loss = (£Principal + interest)x ΔSt =
£ x5cents= 5,750,000=$5.75 million (longposition)
• Off balance sheet gain: NF x size of contracts x Δ Ft = 1,840 x
£ x 5 cents = $5.75 million(short position)

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 Hedging foreign exchange risk
• Using Future contracts: with basis risk
• On September 2, 2015: St = $1.5345 per £1; Ft = $1.5074 per £1 for
contract expiring on September 16 (after 1 year)
• Loan: £100 million with 15% interest rate
• Forecasted rate in one year: St+1 = $1.4845 per £1; Ft+1 = $1.4774 per
£1
• Thus, Δ St =-5cents and Δ Ft =-3cents
• Size of British pounds future contracts = £62,500
• Number of Future contracts = NF
Size of long position £ , ,
= = =1,840
£ ,
• On balance sheet loss = (£Principal + interest)x ΔSt =
£ x5cents= 5,750,000=5.75 million
• Off balance sheet gain: NF x size of contracts x Δ Ft = 1,840 x
£ x 3 cents = $3.45 million
• Net loss= 2.3 million
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 Hedging foreign exchange risk
• Using Future contracts: with basis risk
• To see how many more contracts are required, we need to know how
much more sensitive spot exchange rates are relative to futures prices.
• Hedge ratio: (h)= ΔSt/ ΔFt = 0.05/0.03=1.66.
• Spot rates are 66 percent more sensitive than futures prices, or, for
every 1 percent change in futures prices, spot rates change by 1.66
percent.
• Thus, for every £1 in the long asset position, £1.66 futures contracts
should be sold (offsetting).
• Number of Future contracts = NF
Size of long position £ , , .
= = =3,054.4
£ ,
• Off balance sheet gain: NF x size of contracts x Δ Ft = 3,054 x
£ x 3 cents = $5.73 million

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 Hedging foreign exchange risk
• Estimating the Hedge: Depends on the correlation between the change
in the dollar–pound spot rate and the change in its futures price
• Unfortunately, without perfect foresight, we cannot know exactly how
exchange rates and futures prices will change over some future time
period.
• A common method to calculate h is to look at the behavior of these
two rates over the recent past and use this past behavior as a
prediction of the appropriate value of h in the future.
• .
(∆ ∆ )
•
∆
• For perfect correlation: = and =1
• If spot rate changes are greater than futures price changes,
> and 1

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 Hedging foreign exchange risk
• Estimating the Hedge:
•
• Number of Future contracts = NF
Size of long position £ , , .
= = =2,208
£ ,

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 Learning Objectives
• Our discussion will focus on
– Forward and Futures contracts
– Forward contracts and hedging interest rate risk
– Future contracts and hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk

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 Hedging credit risk
• Credit forward contract
• A credit forward is a forward agreement that hedges against an
increase in default risk on a loan (a decline in the credit quality of a
borrower) after the loan rate is determined and the loan is issued.
• Common buyers are insurance companies
• Common sellers are banks
• Specifies a credit spread on a benchmark bond (generally government
bonds –Treasury bonds)

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 Hedging credit risk
• Credit forward contract
• Borrower Bond rating: BBB
• CFF=Credit forward spread at the time of issue
• CST=Credit spread at the maturity; Minimum value = 0
• MD= Modified duration
• A = Value of loan

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Hedging credit risk

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 Conclusion

– Forward and Futures contracts

– Forward contracts and hedging interest rate risk
– Future contracts and hedging interest rate risk
– Hedging foreign exchange risk
– Hedging credit risk

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