Financial Derivatives
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1 Derivatives in ALM
2 Financial Derivatives Swaps Hedge Contracts Forward Rate Agreements Futures Options Caps, Floors and Collars
3 Swaps Agreement between two counterparties to exchange the cash flows. Cash flows determined on a specific notional principal for a maturity period and a specified interest rate. Swap Structures. Fixed for Floating swaps: Plain vanilla swaps are fixed for floating rate coupon payments Used by banks for managing interest rate gap strategies
4 Swaps Swap Structures Basis swaps: Exchange payments between two floating rate obligations by banks. Used by bank to hedge risky exposures through different floating interest rates. Cross-currency swaps: Interest payments between two currencies are exchanged between two counterparties. Used by banks to hedge interest risk exposure across currencies.
5 Swap Contracts An agreement between two parties to exchange interest payments for a specific maturity on a specified principle amount. Two parties facing different types of interest rate risk can exchange interest payments.
6 Swap Contracts Banks act as swap dealers linking two parties with different interest rate risk. Banks offer swap structures for both fixed and floating rate payers and earn a spread for their intermediary service.
7 Swap Contracts A firm with large financial liability will benefit if they agree on a fixed rate payment for their liability. A firm with a large financial asset position will benefit if they agree on a floating rate payment for their asset.
8 Plain Vanilla Interest Rate Swap
9 SWAP Contract: Example 1 Company A wishes to borrow Rs.10 million at a fixed rate for five years and has been offered 9% fixed rate or 6-month MIBOR+1%. Company B wishes to borrow Rs.10 million at a floating rate for five years and has been offered 6- month MIBOR + 0.4% or 8.50% fixed rate. A Bank swaps the contracts for both the companies
10 Swap Contract: Example 2 Company A wants to borrow at floating rate while company B wants to borrow at a fixed rate. Available rates: Company B - Floating rate - MIBOR+0.5%, Fixed -10.5% Company A - Floating rate - MIBOR+0.25%, Fixed - 10% A bank agrees to be a swap dealer for both the companies
11 Swap Contract: Example 3 Bank Details Fixed Assets Advances 1,000,000 3 year at 9% Deposits 3 month Deposit for 1,000,000 at MIBOR Bank is liability sensitive and would lose if MIBOR rates rise since the advances are funded by short term deposits Bank could agree to pay 8.60% fixed rate and receive MIBOR for 3-years
12 Effect of Swap as a Hedge: Example 3 Receive 9% from loan and receive MIBOR from swap deal Pay 8.60% fixed rate on swap deal and pay MIBOR for the deposit Net rate spread for the bank 0.40% ( ) Risk due to increase in MIBOR rate is eliminated for the bank in the swap structure
13 Risk Inherent in Swap deals Swap contracts may lock in higher interest rates while reducing the risk exposure. Bank may have to bear the credit risk (inability of either party of the swap contract not able to meet the swap claim).
14 Hedge Contracts Hedging results in entry of contracts that results in a consistent return for the bank. Hedge is entered into only when the bank has an open position that needs to be protected. Hedge results in a profit for the bank when hedged expectations are encountered. Hedge results in a notional loss for the bank when hedged expectations do not happen.
15 Bankers as Hedgers in the Derivative Market Banks are capable of reducing their risk exposure through their derivative positions. Risk reduction is achieved by the bank through the offsetting of expected loss in the bank holding position from derivative trading profits.
16 Hedge Position Interest rate increases Expected returns from pre committed loans / investment falls Negative gap position of the bank implies liability sensitive bank would incur loss in income. Desirable hedge position would be to sell futures contract now and buy later resulting in derivative profit.
17 Hedge Position Interest rate declines Bank s borrowing cost increases since committed deposit rates are higher than the current interest rates Positive gap position of the bank implies that the asset sensitive bank would incur loss in income. Desirable hedge position would be to buy futures contract now and sell later resulting in derivative profit.
18 Hedge Positions Hedge: Long Futures: loss when rates falls Hedge: Short Futures: loss when rates rise
19 Steps for Entering into Derivative Position Identify the balance sheet risk exposure position. Formulate expectations on the present risk exposure. Verify the regulatory norms and the bank s internal risk policies. Select the futures contract to be entered into by the bank. Determine the number of futures contract to deal (Hedge Ratio).
20 Determining the Number of Future contracts N F ( D A W D L ) A D P F F NF = Number of future contracts DA = Duration of Assets; W = Weight DL = Duration of Liabilities A = Total Asset Value DF = Duration of Futures; PF = Price of Futures contract
21 Steps for Entering into Derivative Position Transacting in the futures contract in the market. Identify when to withdraw from the futures position. Reverse the trade. Wait for the contract to expire. Accept or take delivery by closing out the trade.
22 Micro Hedge Applications for Banks Micro hedging refers to hedging of a specific asset, liability or a specific commitment by the bank. Micro hedging can be used to take futures position to reduce aggregate portfolio risk. Portfolio risk is measured through GAP analysis or duration gap analysis.
23 Micro Hedge Applications for Banks Banks as per regulatory framework are compelled to link hedged futures trade to a specific instrument or commitment of the bank. Example: A bank hedging interest rate commitments on one year certificate of deposits entered into a hedge in that year.
24 Hedge Implications: Example (Bank Cost) First Deposit: The 3-month deposit for 1000,000 at 2.00% 5,000 Next Deposit: The 3-month deposit at 2.50% 6,250 1,250 Total expense for the Bank 11,250
25 Hedge Implications: Example (Bank Profit) Initial Futures Position: Sell six-month interest rate futures at 3.00% Contract price ( = 97.00) Next Futures Trade: Buy six-month interest rate futures at 3.50% Contract price ( = 96.50) Net profit ( ) 50 Basis points 1,250
26 Hedge Implications: Example (Net Cost to Bank) Effective 6-month deposit cost 11,250 1, x 1.00 % x 1,000, %
27 Forward Rate Agreements Forward Rate Agreements (FRAs) Over The Counter (OTC) products that are futures contract for financial products. Customized contracts to meet needs of participants. Marked to market requirements are not present, hence has a risk of default.
28 Forward Rate Agreements Buyer of FRA agrees to pay a fixed rate coupon and receive a floating rate coupon on a notional amount at a specified future date. Seller of FRA agrees to pay a floating rate coupon and receive a fixed rate coupon on a notional amount at a specified future date.
29 Forward Rate Agreements Buyer of FRA will receive cash when the actual interest rate at settlement date is higher than the exercise rate. Buyer of FRA will pay cash when the actual interest rate at settlement date is lower than the exercise rate.
30 Forward Rate Agreements Seller of the FRA will receive cash when the actual interest rate is less than the exercise rate. Seller of the FRA will pay cash when the actual interest rate is higher than the exercise rate.
31 Forward Rate Agreement Example Bank A buys a FRA of 3 Vs. 6 at 7% on a Rs.1,000,000 notional amount from Bank B Forward rate agreement entered into by Bank A is to pay a fixed rate of 7% and receive a floating rate of 3- month MIBOR with a maturity date of 6 months on the notional amount of Rs.1,000,000. Cash flow at the end of 6 months will be determined by comparing the 3-month MIBOR rate with the fixed rate of 7%.
32 Forward Rate Agreement - Example Equivalent 3-month MIBOR is 8% at the end of 6 months. Here Bank A will receive from Bank B the return from the deal Actual interest amount from the deal is x x 1,000,000= 2, Interest amount represents the payment that will be made three months latter at the maturity of the instrument (present value) will be identified as 1 2,500 x =2,
33 Forward Rate Agreement - Example Equivalent 3-month MIBOR is 6% at the end of 6 months. Here Bank A will pay to Bank B the balance Actual interest amount from the computed as x x 1,000,000 = 2, Interest amount represents the payment that will be made three months latter at the maturity of the instrument (present value) will be identified as 1 2,500 x =2,
34 Example of a Bank Deal A quote of 9.50% % against 3 month MIBOR for 3 v/s 6 FRA The market maker: Agrees to pay (bid) 9.50% fixed and receive the 3 month MIBOR determined 3 months later. Agrees to receive (ask/offer) 10.00% fixed and pay the 3 month MIBOR determined 3 months later.
35 Futures Futures are standardized contracts. Traded at any point of time. Trading with longer maturities through contract extensions permitted. Delivery of a range of futures securities. Mark to market and margin requirements avoids default risk from the contract. Need not have compulsory physical deliver. Netting of long and short position of same trader.
36 Futures Commitment between two parties on the quantity and price of a standardized financial or commodity product. Buyers of futures (long futures) contracts agree to pay the futures price and take delivery of the product. Sellers of futures (short futures) contracts agree to receive the futures price and deliver the product.
37 Futures Profile A) Profit or loss for buyer of futures B) Profit or loss for seller of futures
38 Options Limits the loss to the buyer of the option contract. Options have several contract prices to enable liquidity of trades. Seller of the option takes the risk of the buyer of the option. Options provide the buyer with the advantage of exercising the contract only when it is favourable for the buyer.
39 Options Purchase a Put Option / Sell a Call Option Rising deposit cost and other borrowings. Falling value of assets or return. Offset loss from negative gaps. Purchase a Call Option / Sell a Put Option Falling yield on assets. Offset loss from positive gaps.
40 Options Profile A) Profit or loss for buyer of B) Profit or loss for buyer of put call option and buyer of futures option and seller of futures
41 Caps, Floors and Collars Caps can be entered into by banks to protect them from rising borrowing costs. Floors protect the banks at times of falling interest rates. Banks can purchase caps and sell floors to protect against fluctuation in interest rates within a rate expectation.
42 Caps Variable rate borrowers are the users of interest rate caps. Caps ensure that the banks can have a predetermined interest rate beyond which the borrowing rates will not increase. Cost of the cap is termed as the premium payment to be made on the instrument. Premium for an interest rate cap depends on the cap rate compared to current market interest rates.
43 Caps
44 Floors Variable rate investors are the users of interest rate floors. Floors set the minimum interest rate the investor will receive on their investments. Interest rate floor contracts ensure that the receipt is not less than a pre-determined level of the floor contract on investment. Cost of the floor is the premium payment on the contract. Premium for an interest rate floor depends on the floor rate compared to current market interest rates.
45 Floors
46 Collars Variable rate borrowers use interest rate collars. Collars give holders the benefit of borrowing by setting the minimum and maximum interest rate they will pay on their borrowings. An interest rate collar combines an interest rate cap and an interest rate floor contract. Interest rate collar ensures that payment is capped and at the same time no reduction below the minimum is set on the contract.
47 Collars Cost of the collar contract is the premium payment. Premium for an interest rate collar depends on the rate parameters when compared to current market interest rates and the frequency of payments agreed upon.
48 Collar
49 Derivative Position to Hedge Duration gap gives the sensitivity of the balance sheet. Hedging position could simulate a zero duration gap for the bank.
50 Liability Structure of a Bank
51 Asset Structure of a Bank
52 Derivative Structure of a Bank
53 Impact of Interest Rate Change on the Bank
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