HEDGING INTEREST

RATE RISK: FUTURES,

FORWARDS AND SWAPS

KIMEP
MANAGEMENT OF FINANCIAL INSTITUTIONS
What is a derivative?
A derivative is an instrument whose value
depends on the values of other more basic
underlying variable or asset.
Examples of variables/assets: corn, oats, soybeans, oil, wheat,
butter, eggs, gold, Treasury bonds, corporate stocks, S&P 500
stock index, currencies, interest rates etc.

Types of derivatives contracts:

Forwards;
Futures;
Options;
Swaps.
 SPOT and FORWARDS
 SPOT contract is an agreement between a buyer and
seller at time = 0 when the seller of the asset agrees to
deliver it immediately and the buyer of the asset agrees
to pay for it immediately.

0 1 2 3
Price set and bond delivered at time 0

 FORWARD contract is a contractual agreement

between a buyer and a seller to exchange or deliver an
asset for cash at an agreed date in future and on an
agreed quantity and price set at time 0.
0 1 2 3
Bond delivered at time 3
Price set at time 0 at price and quantity
agreed at time 0
 FUTURES and FORWARDS
 FUTURES contracts represent a commitment between
two parties on the price and quantity of a standardized
financial asset or index at an agreed date in future.

0 1 2 3
Future contract
Buyer pays the futures price
Between buyer and seller
Agreed at time 0;
at time 0 futures price
Seller delivers bond

Similar to a forward contract except

 Exchange traded;
 Standardized contracts;
 Daily Marked to market;
 Lower default risk than in forward contracts
Futures versus Forward Contracts
 Futures contracts are traded on formal exchanges
 http://www.cmegroup.com/trading/interest-rates/
 http://www.euronext.com/landing/liffeLanding-12601-EN.ht
ml

 http://www.rts.ru/ru/forts/
 http://www.ets.kz/
 Each party to a futures transaction effectively trades with
exchange members who, in turn, guarantee the
performance of all participants.
 Futures are standardized instruments, especially in
terms of amount and maturity dates
 Note: Forward contracts are negotiated between parties,
do not necessarily involve standardized assets, and
require no cash exchange until expiration.
Futures Positions and Margin
Requirements
 Future positions require a daily marking to market.
 Exchange members require traders to meet margin
requirements that specify the minimum deposit allowable at
the end of each day.
 Called “Initial Margin”
 The change in value of each trader’s account at the end of
every day, is credited to the margin accounts of those with
gains and debited the margin accounts of those with losses,
marking-to-market and the daily change in value variation
margin.
 If the Initial margin balance is below the maintenance margin
balance, an investor receives a margin call.
 Margin call means that an investor must put additional money
on his/her account in order to meet the initial margin at the end
of the day.
 Daily market to market on 30 year T-
bond futures contract
30 year T- 30 year T -
bonds Bond futures Daily Margin Margin call
Date rates (US/MO) gain/loss balance if < 1900
29-Mar-10 4.76% 115.53 0.00 2565 no
30-Mar-10 4.75% 115.66 130.00 2695 no
31-Mar-10 4.72% 116.13 470.00 3165 no
1-Apr-10 4.74% 115.85 -280.00 2885 no
2-Apr-10 4.81% 114.88 -970.00 1915 no
yes
5-Apr-10 4.85% 114.38 -500.00 1415 +1150
6-Apr-10 4.84% 114.41 30.00 2595 no
7-Apr-10 4.74% 115.69 1280.00 3875 no
8-Apr-10 4.75% 115.41 -280.00 3595 no
9-Apr-10 4.74% 115.66 250.00 3845 no
12-Apr-10 4.70% 116.25 590.00 4435 no
(115.66 – 115.53)x1000 Cumulative (1415 + 1150)+
gain/loss 720.00 30
T-bond futures price and T-bond yield
relationships
Hedging strategies:
1) Microhedging
2) Macrohedging
employs derivatives contracts
occurs to hedge the entire
to hedge a particular asset
balance sheet duration GAP.
or liability risk.

Routine hedging Selective hedging

takes place when FI reduces occurs when FI’s managers

its interest rate risk to decide to hedge only

its lowest possible level. a proportion of its balance
However, reducing risk sheet position.
FI reduces the return as well
A Long Hedge
 A long hedge is appropriate for a participant who
wants to reduce cash market risk associated with a
decline in interest rates.
 If cash (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.
A Short Hedge
 A short hedge applies to any participant who wants
to reduce the risk of an increase in cash market
interest rates (or a reduction in cash market prices).
 The appropriate strategy is to sell futures contracts
on securities similar to those evidencing the cash
market risk.
 If cash rates increase, futures rates will generally
increase, so the loss in the cash position will be at
least partially offset by a gain in futures value.
 MICROHEDGING WITH FORWARDS

 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.
 From duration model, the change in bond value:
P/P = -D  R/(1+R)
P/ $970,000 = -9  [.02/1.08]
P = -$161,666.67
 P1 = 970 000 – 161 666.67 = 808 333.33
(-16.67%)
MICROHEDGING WITH FORWARDS

 Hedged by selling 3 months forward at

forward price of $970,000.
 Suppose interest rate rises from 8% to 10%.
$970,000 - $808,333 = $161,667
(forward (spot price
price) at t=3 months)
 Exactly offsets the on-balance-sheet loss.
 Position is immunized.
MACROHEDGING WITH FUTURES
 We have to calculate the interest rate exposure for the
whole balance sheet:

 E = -[DA - kDL] × A × [R/(1+R)], where k = L/A

 Suppose: DA = 5 years, DL = 3 years and interest rate

expected to rise from 10% to 11%. A = $100 million, L =
$90 mill. and E = $10 mill.

E = -(5 - (.9)(3)) $100 (.01/1.1) = -$2.09 million.

 Sensitivity of the futures contract:

F/F = -DF [R/(1+R)] or
F = -DF × [R/(1+R)] × F where F = NF × PF
MACROHEDGING WITH FUTURES

 Fully hedged requires

F = E
DF(NF × PF) = (DA - kDL) × A

 Number of futures to sell:

NF = (DA-DL* L/A) * A
(DF × PF)
MACROHEDGING WITH FUTURES

 Suppose, we use Treasury Bond futures contracts

with the current value 97$ per $100. The deliverable
bonds have 20 years maturity, 8% coupon and
duration of 9.5 years.

NF = (5 - 3 x 0.9) x 100 000 000 = 249.59 → we should sell

9.5 x 97 000 249 contracts

 ΔF = - 9.5 x (249 x 97 000) x 0.01/1.1 = - 2.086 mil $

 ΔE - ΔF = - 2.09 + 2.086 = - 0.004 mil $
 Hence, ΔE ≈ ΔF and ΔE - ΔF ≈ 0
 Perfect hedge may be impossible since number of
contracts must be rounded down.
The Basis
 The term basis refers to the cash price of an
asset minus the corresponding futures price
for the same asset at a point in time.
 For Eurodollar futures, the basis can be
calculated as the futures rate minus the cash
rate.
 It may be positive or negative, depending on
whether futures rates are above or below
cash rates.
 Basis Risk
 Spot and futures prices are not perfectly
correlated.
 We assumed in our example that
R/(1+R) = RF/(1+RF)
 Basis risk remains when this condition does
not hold. Adjusting for basis risk,
NF = (DA- kDL) * A
(DF × PF × br) where
br = [RF/(1+RF)]/ [R/(1+R)]
The Relationship Between Futures Rates and
Cash Rates -- One Possible Pattern
6 .0 0
D e ce m b e r 1 9 9 8
F u tu re s R a te
Rate (Percent)

5 .7 4
5 .7 0 C a sh R a te

0 .3 0

B a sis F u tu re s R a te- C a sh R a te

0 .0 4
0
Ju n e 2 9 , 1 9 9 8 August 27, 1998 E xp ira tio n
D e ce m b e r 1 5 , 1 9 9 8
Tim e
INTEREST RATE SWAP
 Interest rate swap is a contractual agreement
between two parties to exchange a series of interest
payments without exchanging the underlying debt
principle.
 Interest rate swap:
 Swap buyer agrees to pay fixed-rate
 Swap seller agrees to pay floating-rate.
 Purpose of swap
 Allows FIs to economically convert variable-
rate instruments into fixed-rate (or vice versa)
in order to better match the duration of assets
and liabilities.
 Off-balance-sheet transaction.