FIN 683 Financial Institutions Management Hedging with Derivatives

Transcription

1 FIN 683 Financial Institutions Management Hedging with Derivatives Professor Robert B.H. Hauswald Kogod School of Business, AU Futures and Forwards Third largest group of interest rate derivatives in terms of notional contract volumes Swaps are the largest Options second largest Contracts are held not only for hedging FIs also serve as counterparty for other firms wishing to hedge on balance sheet risks 2

2 Derivatives Rapid growth of derivatives use has been controversial Bankers Trust, Allfirst Bank (Allied Irish) 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 3 Spot and Forward Contracts Spot contract Agreement at t = 0 for immediate delivery and immediate payment Forward contract Agreement between two parties to exchange an asset at a specified future date for a price which is set at t = 0 Counterparty risk OTC, but secondary markets have developed for forward contracts 22-4

3 Futures Contracts Futures similar to a forward contract except: Marked to market Standardized contracts: smaller denomination than forward Exchange traded : rapid growth of off market trading systems Lower default risk than forward contracts Delivery of underlying asset seldom occurs 5 Hedging Interest Rate Risk 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, change in bond value: P/P = -D R/(1+R) P/ $970,000 = -9 [.02/1.08] P = -$161,

4 Naive Hedge 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 price) (spot price at t=3 months) Exactly offsets the on-balance-sheet loss Immunized 7 Hedging with Futures Futures more commonly used than forwards Microhedging: individual assets Macrohedging: hedging entire duration gap more effective (portfolio effects) and generally lower cost Basis risk Exact matching is uncommon Standardized delivery dates of futures reduces likelihood of exact matching 8

5 Routine versus Selective Hedging Routine hedging: Reduces interest rate risk to lowest possible level Low risk - low return: who likes this strategy? Selective hedging: selectively hedge based on expectations of future interest rates and risk preferences Partially hedge duration gap or individual A&L unhedged or overhedged may be seen as speculative 9 Macrohedging with Futures Number of futures contracts depends on interest rate exposure and risk-return tradeoff: E = -[D A - kd L ] A [ R/(1+R)] Suppose: D A = 5 years, D L = 3 years and interest rate expected to rise from 10% to 11%. A = $100 million: E = -(5 - (.9)(3)) $100 (.01/1.1) = -$2.091 million 10

6 Risk-Minimizing Futures Position Sensitivity of the futures contract: F/F = -D F [ R/(1+R)] or, F = -D F [ R/(1+R)] F and F = N F P F 11 Payoff Profiles Short Position Long Position Futures Price Futures Price 22-12

7 Risk-Minimizing Futures Position Fully hedged requires: F = E D F (N F P F ) = (D A - kd L ) A Number of futures to sell: N F = (D A - kd L )A/(D F P F ) Perfect hedge may be impossible since number of contracts must be rounded down 3/2/ Hedging with Derivatives Robert B.H. Hauswald Interest Rate Swaps Interest rate swap as succession of forwards Swap buyer agrees to pay fixed-rate Swap seller agrees to pay floating-rate Purpose of interest rate 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 14

8 Macrohedging with Swaps Assume a thrift has positive gap such that: E = -(D A - kd L )A [ R/(1+R)] > 0, if rates rise Suppose it chooses to hedge with 10-year swaps. Fixed-rate payments are equivalent to payments on a 10-year T-bond. Floating-rate payments repriced to LIBOR annually Changes in swap value DS depend on duration difference (D 10 - D 1 ). S = -(D Fixed - D Float ) N S [ R/(1+R)] 15 Macrohedging Optimal notional value requires S + E = 0 -(D Fixed - D Float ) N S [ R/(1+R)] = -(D A - kd L ) A [ R/(1+R)] N S = [(D A - kd L ) A]/(D Fixed - D Float ) Implied objective? what should/will management do 16

9 Hedging FX Risk Hedging of FX exposure parallels hedging of interest rate risk if spot and futures or forward prices are not perfectly correlated, then basis risk remains Tailing the hedge: interest income effects marking to market allows hedger to reduce number of futures contracts that must be sold to hedge To adjust for basis risk: the hedge ratio is h = S t / f t N f = (Long asset position estimate of h)/(size of one contract) 17 Currency Swaps Fixed-rate: set up hedge over asset s lifetime U.S. bank fixed-rate assets denominated in dollars, partly financed with 50 million in 4-year 10 percent (fixed) notes U.K. bank has assets partly funded by $100 million 4-year 10 percent notes Solution: Enter into currency swap 18

10 Cash Flows from Swap U.S. FI U.K. FI Outflows (B/S) -10% 50-10% $100 Inflows (Swap) 10% 50 10% $100 Outflows -10% $100-10% 50 (Swap) Net 10% $100-10% 50 Rates on notes 10.5% 10.5% 19 Hedging Credit Risk More FIs fail due to credit-risk exposures than to either interest-rate or FX exposures surprise, surprise what typically is the problem? In recent years, development of derivatives for hedging credit risk has accelerated Credit forwards, credit options, and credit swaps 22-20

11 Credit Derivatives Credit risk can be offloaded via credit derivatives Moral hazard: originate to distribute Reduction of incentive to properly manage the underlying credit risk at origination Incentives for fraud for both parties at loan origination This was important in the crisis 3/2/ Hedging with Derivatives Robert B.H. Hauswald Credit Forwards Credit forwards hedge against decline in credit quality of borrower Common buyers are insurance companies Common sellers are banks Specifies a credit spread on a benchmark bond issued by a borrower BBB bond or loan at time of origination may have 2% spread over same-maturity UST 22

12 Credit Swaps Credit swaps to hedge credit risk Involvement of other FIs in the credit risk shift Greenspan recognized that these swaps were prone to induce speculative excesses Total return swap Swap interest payments for total return to a bond or loan, hedging possible change in credit risk exposure Pure credit swap Interest-rate sensitive element stripped out, leaving only the credit risk 23 Swaps and Credit Risk Concerns Credit risk concerns partly mitigated by netting of swap payments, but financial crisis elevated concerns Scale of individual firm exposures is large Lehman Brothers $700 billion in general and large exposure to AIG in particular one or the other had to fail! Due to the role of swaps in the crisis, greater regulation resulted Over-the-Counter Derivatives Market Act 24

13 Regulatory Policy Three levels of regulation: Permissible activities Supervisory oversight of permissible activities Overall integrity and compliance Functional regulators: SEC and CFTC Bank regulator guidelines for banks Wall Street Reform and Consumer Protection Act of 2010 As of 2000, derivative positions must be marked-tomarket Exchange-traded futures not subject to capital requirements, OTC forwards potentially subject to capital requirements 25 Regulatory Policy for Banks Federal Reserve, FDIC, and OCC require banks Establish internal guidelines regarding hedging Establish trading limits Disclose large contract positions that materially affect bank risk to shareholders and outside investors Discourage speculation and encourage hedging 26

14 Basis Risk Spot and futures prices not perfectly correlated We assumed in our example that R/(1+R) = R F /(1+R F ) Basis risk remains since asset to hedged and underlying asset unlikely to be the same Adjusting for basis risk: N F = (D A - kd L )A/(D F P F br) where br = [ R F /(1+R F )]/ [ R/(1+R)] 27 Monthly Changes in Spot & Futures 28

15 Estimating the Hedge Ratio The hedge ratio may be estimated using ordinary least squares regression: S t = α + β f t + u t The hedge ratio, h, will be equal to the coefficient β. The R 2 from the regression reveals the effectiveness of the hedge 29 Credit Forwards CS F defines agreed forward credit spread at time contract written CS T = actual credit spread at maturity of forward Credit Spread Credit Spread Credit Spread at End Seller Buyer CS T > CS F Receives Pays (CS T - CS F )MD(A) (CS T -C S F )MD(A) CS F >CS T Pays Receives (CS F - CS T )MD(A) (CS F - CS T )MD(A) 30

16 Impact of Hedging With a Credit Forward 31 Summary Market-related systematic exposures natural hedge derivatives Unsystematic exposures: credit risk operating policies Problem: no risk, no what? take good risks: what is the problem? steering a middle course takes a lot of discipline 32