Managing Risk off the Balance Sheet with Derivative Securities

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1 Managing Risk off the Balance Sheet Managing Risk off the Balance Sheet with Derivative Securities Managers are increasingly turning to off-balance-sheet (OBS) instruments such as forwards, futures, options, and swaps to hedge the risks their financial institutions (FIs) face interest rate risk foreign exchange risk credit risk FIs also generate fee income from derivative securities transactions 23-2 Managing Risk off the Balance Sheet A spot contract is an agreement to transact involving the immediate exchange of assets and funds A forward contract is a negotiated agreement to transact at a point in the future with the terms of the deal set today Any amount can be negotiated Not generally liquid, so each party must perform Counterparty default risk can be significant Managing Risk off the Balance Sheet A futures contract is an exchange-traded agreement to transact involving the future exchange of a set amount of assets for a price that is fixed today Futures are liquid, most traders close their position before the delivery date so the underlying transaction may never take place Futures contracts are marked to market daily i.e., the traders gains and losses on outstanding futures contracts are realized each day as futures prices change Exchange clearinghouse stands behind all contracts so there is no counterparty default risk and trading is anonymous

2 Hedging with Forwards Hedging with Futures A naïve hedge is a hedge of a cash asset on a direct dollar-for-dollar basis with a forward (or futures) contract Managers can predict capital loss (ΔP) using the duration formula: R P D P ( 1 R) where P = the initial value of an asset D = the duration of the asset R = the interest rate (and thus ΔR is the change in interest) FIs can immunize assets against risk by using hedging to fully protect against adverse movements in interest rates Microhedging is using futures (or forwards) contracts to hedge a specific asset or liability basis risk is a residual risk that occurs in a hedged position because the movement in an asset s spot price is not perfectly correlated with the movement in the price of the asset delivered under a futures (or forwards) contract firms use short positions in futures contracts to hedge an asset that declines in value as interest rates rise Macrohedging is hedging the entire (leverageadjusted) duration gap of an FI Futures Gain and Loss and Hedging with Futures Hedging Considerations Microhedging and macrohedging Risk-return considerations FIs hedge based on expectations of future interest rate movements FIs may microhedge, macrohedge, or even overhedge Accounting rules can influence hedging strategies in 1997 FASB required that all gains and losses from derivatives used to hedge must be recognized immediately U.S. companies must report derivative-related trading activity in annual reports futures contracts are not subject to risk-based capital requirements imposed by bank regulators (forward can be)

3 Hedging Considerations The Effects of Hedging Routine hedging: In a full hedge or routine hedge the bank eliminates all or most of its risk exposure such as interest rate risk Most managers engage in partial hedging or what the text terms selective hedging where some risks are reduced and others are borne by the institution Options Purchased and Written Call Option Positions Buying a call option on a bond As interest rates fall, bond prices rise, and the call option buyer has a large profit potential As interest rates rise, bond prices fall, but the call option losses are no larger than the call option premium Writing a call option on a bond As interest rates fall, bond prices rise, and the call option writer has a large potential loss As interest rates rise, bond prices fall, but the call option gains will be no larger than the call option premium

4 Options Purchased and Written Put Option Positions Buying a put option on a bond As interest rates rise, bond prices fall, and the put option buyer has a large profit potential As interest rates fall, bond prices rise, but the put option losses are bounded by the put option premium Writing a put option on a bond As interest rates rise, bond prices fall, and the put option writer has large potential losses As interest rates fall, bond prices rise, but the put option gains are bounded by the put option premium Options Hedging with Put Options Many types of options are used by FIs to hedge exchange-traded options over-the-counter (OTC) options options embedded in securities caps, collars, and floors Buying a put option on a bond can hedge interest rate risk exposure related to bonds that are held as assets the put option truncates the downside losses the put option scales down the upside profits, but still leaves upside profit potential Similarly, buying a call option on a bond can hedge interest rate risk exposure related to bonds held on the liability side of the balance sheet Payoff Gain Payoff for a bond held as an asset Net payoff function 0 Bond price X -P Payoff from buying a put Payoff on a bond Loss

5 Caps, Floors, and Collars Contingent Credit Risk Buying a cap means buying a call option, or a succession of call options, on interest rates rather than on bond prices like buying insurance against an (excessive) increase in interest rates Buying a floor is akin to buying a put option on interest rates seller compensates the buyer should interest rates fall below the floor rate like caps, floors can have one or a succession of exercise dates A collar amounts to a simultaneous position in a cap and a floor usually involves buying a cap and selling a floor to offset cost of cap Contingent credit risk is the risk that the counterparty defaults on payment obligations forward contracts and all OTC derivatives are exposed to counterparty default risk as they are nonstandard contracts entered into bilaterally Swaps Swaps Swap agreements are contracts where two parties agree to exchange a series of payments over time There are several types of swaps: Interest rate swaps Parties agree to swap interest payments on a stated notional principal amount for a set period of time (some are for more than 5 years) (No principal is usually exchanged) Currency swaps Parties agree to swap interest and principal payments in different currencies at a preset exchange rate Types of swaps (continued) Credit default swaps (aka credit swaps) Total return swap (TRS): o A TRS buyer agrees to make a fixed rate payment to the seller plus the capital gain or minus the capital loss on the underlying instrument o In exchange, the TRS seller may pay a variable or a fixed rate of interest to the buyer o Pure Credit Swap (PCS): o The swap buyer makes fixed payments to the seller and the seller pays the swap buyer only in the event of default. The payment is usually equal to par secondary market value of the underlying instrument

6 Swaps Swaps Credit Swaps and the crisis Lehman Brothers and AIG sold credit default swaps worth billions of dollars in payments insuring mortgagebacked securities (MBS) When mortgage security values collapsed, required outflows at these firms far exceeded capital Other institutions invested more heavily in MBS because they were insured; exposure to mortgage markets was more widespread than it would have been otherwise Credit swaps may cause lenders to make loans they would not otherwise make and earn fee income on other services offered to borrowers. There are also some less common types of swaps: commodity swaps equity swaps The market for swaps has grown enormously in recent years The notional value of swap contracts outstanding at U.S. commercial banks was more than $146.9 trillion in Swaps Swaps Hedging with interest rate swaps: An Example a money center bank (MCB) may have floating-rate loans and fixed-rate liabilities the MCB has a negative duration gap a savings bank (SB) may have fixed-rate mortgages funded by short-term liabilities such as retail deposits the SB has a positive duration gap accordingly, an interest swap can be entered into between the MCB and the SB either: directly between the two FIs OR indirectly through a broker or agent who charges a fee to accept the credit risk exposure and guarantee the cash flows A plain vanilla swap is: A standard agreement where one participant pays a fixed rate of interest and the other party pays a variable rate of interest on a stated notional principal; no principal is exchanged The SB sends fixed-rate interest payments to the MCB thus, the MCB s fixed-rate inflows are now matched to its fixed-rate payments the MCB sends variable-rate interest payments to the SB thus, the SB s variable-rate inflows are now matched to its variable-rate payments

7 Swap Hedging Example Illustrated Swaps Hedging with currency swaps: An Example Consider a U.S. FI with fixed-rate $ denominated assets and fixed-rate denominated liabilities Also, consider a U.K. FI with fixed-rate denominated assets and fixed-rate $ denominated liabilities The FIs can engage in a currency swap to hedge their foreign exchange exposure That is, the FIs agree on a fixed exchange rate at the inception of the swap agreement for the exchange of cash flows at some point in the future Both FIs have effectively hedged their foreign exchange exposure by matching the denominations of their cash flows Currency Swap Hedging Example Illustrated Hedging with Credit Swaps Pure Credit Swap

8 Credit Risk on Swaps Comparing Hedging Methods The growth of the over-the-counter swap market was a major factor underlying the imposition of the BIS riskbased capital requirements the fear was that out-of-the-money counterparties would have incentives to default BIS now requires capital to be held against interest rate, currency, and other swaps Credit risk on swaps differs from that on loans Netting: only the difference between the fixed and the floating payment is exchanged between swap parties Payment flows are often interest and not principal Standby letters of credit are required of poor-quality swap participants Writing vs. buying options writing options limits upside profits, but not downside losses buying options limits downside losses, but not upside profits CBs are prohibited from writing options in some areas Futures vs. options hedging futures produce symmetric gains and losses options protect against losses, but do not fully reduce gains Swaps vs. forwards, futures, and options swaps and forwards are OTC contracts, unlike options and futures futures are marked to market daily swaps can be written for longer-time horizons Regulation Regulation Regulators specify permissible activities that FIs may engage in Institutions engaging in permissible activities are subject to regulatory oversight Regulators judge the overall integrity of FIs engaging in derivatives activity based on capital adequacy regulation The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are the functional regulators of derivatives securities markets The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have implemented uniform guidelines that require banks to: establish internal guidelines regarding hedging activity establish trading limits disclose large contract positions that materially affect the risk to shareholders and outside investors As of 2000 the FASB requires all firms to reflect the marked-to-market value of their derivatives positions in their financial statements Prior to the Dodd-Frank Act, swap markets were governed by relatively little regulation except indirectly at FIs through bank regulatory agencies

9 Regulation The Dodd-Frank Act of 2010 requires most OTC derivatives to be exchange-traded to ensure performance by all parties The act also requires OTC derivatives be regulated by the SEC and/or the CFTC Managing Liquidity Risk on the Balance Sheet Liquidity Risk Management Liquidity Risk Management Unlike other risks, liquidity risk is a normal aspect of the everyday management of financial institutions (FIs) At the extreme, liquidity risk can lead to insolvency Some FIs are more exposed to liquidity risk than others Depository institutions (DIs) are highly exposed Mutual funds, pension funds, life insurers and propertycasualty insurers have relatively low liquidity risk One type of liquidity risk arises when an FI s liability holders seek to withdraw their financial claims FIs must meet the withdrawals with stored or borrowed funds Alternately, FIs may have to sell assets to generate cash, which can be costly if assets can only be sold at fire-sale prices A second type of liquidity risk arises from the exercise of off-balance-sheet commitments made by the FI Unexpected loan demand can occur when off-balance-sheet loan commitments are drawn down suddenly and in large volumes FIs are contractually obliged to supply funds through loan commitments immediately should they be drawn down

10 Liquidity Risk and Depository Institutions (DIs) DIs balance sheets typically have: Large amounts of short-term liabilities such as deposits and other transaction accounts that must be paid out immediately if demanded by depositors Large amounts of relatively illiquid long-term assets such as commercial loans and mortgages DIs know that normally only a small portion of demand deposits will be withdrawn on any given day Most demand deposits act as core deposits i.e., they are a stable and long-term funding source Deposit withdrawals are normally offset by the inflow of new deposits Liquidity Risk and Depository Institutions DI managers monitor net deposit drains i.e., the amount by which cash withdrawals exceed additions; a net cash outflow DIs manage liquidity needs by two methods: 1. Stored liquidity Maintaining liquid assets to meet cash needs Primary method for community banks Liquidity Risk and Depository Institutions DIs manage liquidity needs by two methods: (continued) 1. Purchased liquidity Rely on the ability to acquire funds from brokered deposits and borrowings Used primarily by the largest banks with access to the money market and other nondeposit sources of funds Most DIs utilize a combination of stored and purchased liquidity management Liquidity Risk and Depository Institutions Stored liquidity Liquidating cash stores and selling existing assets Banks hold cash reserves in their vaults and at the Federal Reserve in excess of minimum requirements When managers utilize stored liquidity to fund deposit drains, the size of the balance sheet is reduced and its composition changes

11 Liquidity Risk and Depository Institutions Purchased liquidity includes: Using interbank markets for short-term loans fed funds repurchase agreements Acquiring fixed-maturity certificates of deposits Issuing notes and bonds Allows FIs to maintain the overall size of their balance when faced with liquidity demands Purchased liquidity may be expensive relative to stored liquidity and adds to volatility of interest expense Liquidity Risk and Depository Institutions Loan commitments and other credit lines can cause liquidity needs as with liability side liquidity risk, asset side liquidity risk can be managed with stored or purchased liquidity If stored liquidity is used to fund commitments, the composition of the asset side of the balance sheet changes, but not the size of the balance sheet If purchased liquidity is used to fund commitments, the composition of both the asset and liability sides of the balance sheet changes, and the size of the balance sheet increases Measuring Liquidity Risk The liquidity position of banks is measured by managers on a daily basis A net liquidity statement lists sources and uses of liquidity I. Net Liquidity Position (millions $) Sources 1. Total near cash assets $ 5, Excess cash reserves $ 2, Maximum new borrowings $ 9,000 Total $16,000 Uses 1. Funds already borrowed $ 8, Discount Window loans that must be repaid quickly $ 1,000 Total $ 9,000 Total Net Liquidity $ 7,000 Measuring Liquidity Risk Peer group ratio comparisons are used to compare a bank s liquidity position against its competitors March 2008 March 2011 Loans to deposits 81.33% 71.66% Loans to core deposits % 78.64% Short Term Non Core Funding to Assets 17.08% 5.76% Core deposits to total liabilities & equity 65.24% 77.75% Commitments to lend to loans 14.51% 13.44% Source: FFIEC; all banks in the nation, Peer Group Data Report, Report Dates March 2011 and March 2008 Ratios are often compared to those of banks of a similar size and in the same geographic location Ratios for peer groups of similar banks can be constructed at the FFIEC website

12 Measuring Liquidity Risk A liquidity index measures the potential losses a bank could suffer from a sudden or fire-sale disposal of assets versus the sale of the same assets at fair market value under normal market conditions where I [( w )( P / P * )] i i i N i 1 w i = the percent of each asset i in the FI s portfolio Pi = the price it gets if an FI liquidates asset i today P i * = the price it gets if an FI liquidates asset i under normal market conditions Measuring Liquidity Risk For simplicity, assume a bank has only two assets. Securities Value if liquidated immediately Fair market value if liquidated in 1 month % invested in each (at FMV) Treasury Bills $ 9,700,000 $ 9,850, % Bonds $15,000,000 $15,675, % I N i 1 * i i [(w i )(P /P )] $9.7m $15m I 38.58% 61.42% 96.76% $9.85m $15.675m Measuring Liquidity Risk The financing gap is the difference between a bank s average loans and average (core) deposits If the financing gap is positive, the bank must borrow to fund the gap Financing gap funding = - Liquid Assets + Borrowed funds Measuring Liquidity Risk The financing requirement is the financing gap plus a bank s liquid assets Financing gap funding = - Liquid Assets + Borrowed funds Thus, Financing Requirement (or Borrowed Funds) = Financing Gap + Liquid Assets A widening financing gap can be an indicator of future liquidity problems

13 Measuring Liquidity Risk The financing requirement is the financing gap plus a bank s liquid assets Financing Requirement (or Borrowed Funds) = Financing Gap + Liquid Assets = $5 + $5 = $10 Measuring Liquidity Risk The BIS Approach: Maturity Ladder/Scenario Analysis Liquidity management involves assessing all cash inflows against cash outflows The maturity ladder allows a comparison of cash inflows versus outflows on a day-to-day basis and over a series of specified time intervals Daily, maturity segment, and cumulative net funding requirements are determined from the maturity ladder The BIS also suggests that DIs prepare for abnormal conditions using various what if scenarios Measuring Liquidity Risk Liquidity Planning Liquidity planning allows managers to make important borrowing priority decisions before liquidity problems arise Lowers the costs of funds by determining an optimal funding mix Minimizes the amount of excess reserves that a bank needs to hold Liquidity plan components: Delineation of managerial responsibilities List of fund providers most likely to withdraw funds and a pattern of fund withdrawals Identification of the size of potential deposit and fund withdrawals over various time horizons Internal limits on separate subsidiaries and branches borrowings as well as acceptable risk premiums to pay in each market

14 Example: Liquidity Plan Potential Deposit From most likely to withdraw to least likely Withdrawals Mutual Funds $ 70 Pension Funds $ 40 Correspondent banks $ 50 Large corporations $ 45 Small businesses $ 25 Consumers $ 75 Total $305 Expected total withdrawals period per Average Maximum Likely One week $ 60 $100 One month $ 70 $150 Three months $130 $220 Total $260 $470 Sequence of funding options as needed One Week One month Three month New deposits $ 15 $ 35 $ 75 Sale liquid assets $ 15 $ 25 $ 55 Sale investment portfolio $ 30 $ 40 $ 50 Borrowings from other FIs $ 30 $ 40 $ 35 Borrowings from Fed $ 10 $ 10 $ 5 Total $100 $150 $220 Liquidity Risk Major liquidity problems arise if deposit drains are abnormally large and unexpected Abnormal deposit drains can occur because: Concerns about a bank s solvency Failure of another bank (i.e., the contagion effect) Sudden changes in investors preferences regarding holding nonbank financial assets relative to bank deposits A bank run is a sudden and unexpected increase in deposit withdrawals from a bank Liquidity Risk Deposit Insurance Demand deposits are first-come, first-served contracts The incentives for depositors to withdraw their funds at the first sign of trouble creates a fundamental instability in the banking system a bank panic is a systemic or contagious run on the deposits of the banking industry as a whole Regulatory mechanisms are in place to ease banks liquidity problems and to deter bank runs and panics deposit insurance ($250,000 per account since the financial crisis of ) the discount window Deposit insurance was first introduced in the U.S. in 1933 with coverage up to $2,500 Coverage was increased to $100,000 in 1980 Beginning in 2011 the Federal Deposit Insurance Corporation (FDIC) will increase coverage every year based on the Consumer Price Index (CPI) The Federal Deposit Insurance Reform Act of 2005 increased deposit insurance for retirement accounts from $100,000 to $250,

15 Deposit Insurance The Discount Window Individuals can achieve many times the $250,000 coverage cap on deposits by creatively structuring their deposits and by using multiple banks The FDIC now uses a risk-based deposit insurance program to evaluate and assign deposit insurance premiums Some states operate state guarantee funds to insure investments made with insurance firms, but they are not federally backed The Federal Reserve also provides a discount window lending facility Historically, the borrowing rate was below market rates and borrowing was restricted In response to the liquidity problems caused by the credit crunch in 2007 and 2008, the Fed announced in March 2008 that it would lend up to $200 billion to both commercial and investment banks through its new Primary Dealer Credit Facility (PDCF) The Discount Window New federal borrowing programs emerged over the succeeding months providing funding to money market mutual funds, commercial paper, insurance companies, and others The Fed also lowered interest rates to near zero and reduced the spread between the discount rate and the Fed funds rate Liquidity Risk and Insurance Companies Life insurance companies hold cash reserves and other liquid assets Meet policy payments Meet cancellation (surrender) payments The surrender value of a life insurance policy is the amount that an insurance policyholder receives when cashing in a policy early Fund working capital needs which can be unpredictable Property-casualty (P&C) insurance companies Claims against P&C insurers are hard to predict Thus, P&C insurance companies have a greater need for liquidity than life insurance companies

16 Liquidity Risk and Mutual Funds Mutual funds (MFs) can be subject to dramatic liquidity needs if investors become nervous about the true value of the funds assets However, the way MFs are valued reduces the incentive of fund shareholders to engage in banklike runs on any given day assets are distributed on a pro rate basis (i.e., rather than a first-come, first-served basis) losses are incurred to shareholders on a proportional basis