Techniques of asset/liability management:

Futures, options, and swaps

• Outline
– Financial futures
– Options
– Interest rate swaps
 – Futures contract:
• Standardized agreement to buy or sell a specified
quantity of an asset on a specified date at a set
price. Pricing and delivery occur at two points in
time.
• Buyer is in a long position, and seller is in a
short position. The buyer of the contract is to
receive delivery of the good and pay for it, while
the seller of the contract promises to deliver the
good and receive payment. The payment price
is determined at the initial time of the contract.
• Suppose you know that you will need 5,000 bushels of
corn in one year and want to lock in the price of corn
today.
You (long position trader) find a seller (short position
trader) who agrees to sell at $4/bushel (strike price) in
one year(settlement or expiration date) .
On expiration date, corn is selling for $5/bushel. You
would pay the previously agreed-upon $4/bushel for
5,000 bushels, $20,000, to the seller and the seller has to
deliver the 5,000 bushels of corn.
Your gain is $5,000, which is equal to the seller’s loss.
• Standardization tells traders exactly what is being
traded and the conditions of the transactions
Uniformity promotes market liquidity.
• Exchange clearinghouse is a counterparty to each
contract. Default risk on futures (but not forward)
contracts is minimized by the role of the exchange
clearinghouse in all futures contracts. The exchange
clearinghouse is, in effect, the counterparty in each
transaction.
• Marked-to-market at the end of each day. Futures
contracts are evaluated daily at their market values and
gains or losses are added to or subtracted from the
margin balance each day.
Margin Account (Stocks)
• Margin Account: A brokerage account in which,
subject to limits, securities can be bought and
sold on credit.
– Margin = Equity in account / Value of securities
the portion of the value of an investment that is not
borrowed.
– Initial Margin: the minimum margin that must be
supplied on a security purchase. Initial margin of
50% has been set by the Fed.
– Maintenance Margin: the minimum margin that
must be present at all times in a margin
account. Typically 30%.
– When the margin in account drops below the
maintenance margin, the broker issue a margin
call.
– Investors receiving this margin call should add
new cash or securities to the margin account.
Otherwise, your securities are sold and the
margin loan will be repaid.
• You have $10,000
• Initial margin is 50%; maintenance is 30%
• The maximum margin loan is $10,000.
• You buy 1,000 shares at $18
• Margin = $10,000/$18,000 = 55.56%
• Price falls to $10
• Total value of stock is $10,000; You borrowed
$8,000, so your equity is $2,000.
Margin = $2,000 / $10,000 = 20%
You have $5,000 and buy 400 WMT at $25 each.
Initial margin is 50%; maintenance is 30%
Your account balance sheet is as follows:
Assets Liabilities
400 WMT $10,000 Margin Loan $5,000
@ $25/share ______ Equity $5,000
Total $10,000 Total $10,000

Your margin is $5,000/$10,000 = 50%

• Margin call occurs at what price?
• Value of your stock
= Margin loan + Equity
• Value = 400 x P
• Equity = Value of stock – margin loan
= 400 x P - $5,000
• Maintenance margin
= Equity / Value of stock = .3
• (400 x P - $5,000) / (400 x P) = 0.3
• P = $17.86. At any price below $17.86, you will be
subject to a margin call.
Margin account (Futures)
• Bob buys one futures contract of corn at $2/bushel (1
contract =5,000 bushels). The initial margin was $1,000.
The next day the price of corn falls by 3 cent a bushel. So,
Bob has just lost $( ).
• At the end of the day, the daily settlement process marks
Bob’s margin account to market by taking $150 out of his
account leaving a balance of 850. Now, assume the
maintenance margin level is 75%. If Bob’s margin balance
falls to or below $750, he will get a ( ) and have to bring
his account back up to the initial $1,000.
• Suppose during the next day, corn again falls 3 cent per
bushel. Bob’s margin account balance now falls to $ ( ),
and he gets a margin call to deposit $300 in variation
margin. The deposit of $300 will bring his account back
up to the initial level of $1,000.
• Marking to market (Financial futures)
Suppose on day 1 the seller entered into a 90-day contract to
deliver 20-year T-Bonds at $97. The next day, because of a rise
in interest rates, the futures contract, which now has 89 days to
maturity, is trading at $96 when the market closes.
Marking to market requires the prices of all contracts to be
marked to market at each night’s closing price.
As a result, the price of the contract is lowered to $96 per $100 of
face value, but in turn for this lowering of the price from $97 to
$96, the buyer has to compensate the seller $1 per $100 of face
value.
Thus, given a $100,000 contract, there is a cash flow payment of
$1,000 on that day from the buyer to the seller.
Note that if the price had risen to $98, the seller would have had to
compensate the buyer $1,000.
• Q: What is meant by a short position in financial futures?
A long position? How is each affected by changes in
interest rates?
• A financial futures contract is a standardized agreement
to buy or sell a specified quantity of a financial
instrument at a set price.
• A short position represents the sale of a futures contract.
A long position represents the purchase of a futures
contract.
• Since interest rates and the prices of fixed income
instruments move inversely, a short position will benefit if
interest rates increase but will be harmed by falling
interest rates.
• Conversely, a long position will benefit from falling rates
and will be harmed by rising rates.
 Using interest rate futures to hedge a dollar gap position
• Q: How would a bank use interest rate futures to
hedge a positive dollar gap? A negative dollar gap?

ANSWER: A bank with a positive dollar gap would benefit

on-balance-sheet from rising interest rates but would lose
from falling interest rates. It would hedge this risk by
taking a long or buy position in the financial futures
market.
If, conversely, the bank has a negative dollar gap it would
take a short position in the futures market.
• Q: How would a bank use interest rate futures to hedge a
positive duration gap? A negative duration gap?

ANSWER: With a positive duration gap, a bank would

experience a decline in the market value of equity if
interest rates increased (because the market value of
assets would fall more than the market value of
liabilities). It could help this exposure by taking a short
position in financial futures. With such a position,
increases in interest rates would produce gains in the
futures market position that could be used to offset the
losses in the cash market position.
In contrast, a bank with a negative duration gap would
hedge with a long position in the futures market.
– Number of contracts to purchase in a hedge:
[(V/F) x (MC/ MF)] b
V = value of cash flow to be hedged
F = face value of futures contract
MC = maturity of cash assets
MF = maturity of futures contacts
b = variability of cash market to futures market.

Example: A bank wishes to use 3-month futures to hedge a

$48 million positive dollar gap over the next 6 months.
Assume the correlation coefficient of cash and futures
positions as interest rates change is 1.0.
N = [(48/1) x (6/3)] 1 = 96 contracts.
 Balance sheet hedging example
• Consider the problem of a bank with a negative
dollar gap facing an expected increase interest
rates in the near future.
• Assume that bank has assets comprised of only
one-year loans earning 10% and liabilities
comprised of only 90-day CDs paying 6%. If
interest rates do not change:
Day 0 90 180 270 360
Loans:
Inflows $1,000.00
Outflows $909.09

CDs:
Inflow $909.09 $922.43 $935.98 $949.71
Outflows $922.43 $935.98 $949.71 $963.65
Net cash flows 0 0 0 0 $ 36.35

Notice that for loans $1,000/(1.10) = $909.09. Also notice

that CDs are rolled over every 90 days at the constant
interest rate of 6% [e.g., $922.43 = $909.09(1.06)0.25,
where 0.25 = 90 days/360 days].
As a hedge against this possibility, the bank may
sell 90-day financial futures with a par of
$1,000. To simplify matters, we will assume
only one T-bill futures contract is needed. In
this situation the following entries on its
balance sheet would occur over time.
 Balance sheet hedging example
As a hedge against this possibility, the bank may sell 90-day financial
futures with a par of $1,000. To simplify matters, we will assume only
one T-bill futures contract is needed. In this situation the following
entries on its balance sheet would occur over time.

Day 0 90 180 270 360

T-bill futures (sold)
Receipts $985.54 $985.54 $985.54

T-bill (spot market

purchase)
Payments $985.54 $985.54 $985.54
Net cash flows 0 0 0
It is assumed here that the T-bills pay 6% and interest
rates will not change (i.e., $1,000/(1.06)0.25 = $985.54).
If interest rates increase by 2% in the next year
(after the initial issue of CDs), the bank’s net
cash flows will be affected as follows:
 Balance sheet hedging example
If interest rates increase by 2% in the next year (after the initial issue of
CDs), the bank’s net cash flows will be affected as follows:

Day 0 90 180 270 360

Loans:
Inflows $1,000.00
Outflows $909.09
CDs:
Inflow $909.09 $922.43 $940.35 $958.62
Outflows $922.43 $940.35 $958.62 $977.24
Net cash flows 0 0 0 0 $ 22.76

Thus, the net cash flows would decline by $13.59.

In terms of present value, this loss equals
$13.59/1.10 = $12.35.
Balance sheet hedging example
We next show the effect of this interest rate increase on
net cash flows from the short T-bill futures position:

Day 0 90 180 270 360

T-bill futures (sold)
Receipts $985.54 $985.54 $985.54

T-bill (spot market

Purchase)
Payments $980.94 $980.94 $980.94
Net cash flows $4.60 $4.60 $4.60

The total gain in net cash flows is $13.80. In present value

terms, this equals 4.60/(1.10).25 + 4.60/(1.10).50 +
4.60/(1.10).75 = $13.16. Thus, the gain on T-bill futures
exceeds the loss on spot bank loans and CDs.
 Options
• Definition: Right but not obligation to buy or sell
at a specified price (“striking price”) on or before a
specified date (“expiration date”).
• Call option: Right to buy -- pay “premium”
to seller for this right.

A July call option on Motorola stock with exercise

price of $50 gives the owner of the call option to
buy this stock for a price of $50 before expiration in
July.
The holder of the call is not required to exercise the
option. Only when the stock price exceeds the
exercise price of $50, the holder will exercise the
call option.
• Put Option: Right to sell -- pay “premium” to
seller for this right.

• An October put option on Motorola stock with

exercise price of $50 gives the owner of the put
option to sell this stock for a price of $50 at
any time before expiration in October.
A put option will be exercised only if the stock
price is less than the exercise price of $50.
– Note: Seller of option must sell or buy as
arranged in the option, so the seller gets a
premium for this risk. The premium is the
price of the option.
 Option Payoffs to Buyers
Payoff Gross payoff

Call Option
Net payoff
Buy for $4 with
exercise price $100
“In the money”
$100 $104
-4 Price of security

Premium =
$4
NOTE: Sellers earn premium if option not
exercised by buyers.
Payoff
Option Payoffs to Buyers
Net payoff Put Option

Gross profit Buy put for $5 with

exercise price of $40.

“In the money”

0
$40 Price of security
-4 $35

Premium = $5
NOTE: Sellers earn premium if option not
exercised by buyers.
• Options on futures contracts (futures options)
Give the holder the right, but not the obligation to enter into
a futures contract on an underlying security or commodity
at a later date and at a predetermined price.
Purchasing a call on a futures allows for the acquisition of a
long position in the futures market, while exercising a put
would create a short futures position.
The writer of the call would be obligated to enter into the
short side of the futures contract if the option holder
decided to exercise the contract, while the seller of the put
might be forced into a long futures contract.
• When the bank hedges by buying put options on
futures, if interest rates rise and bond prices fall,
the exercise of the put results in the bank
delivering a futures contract to the writer at an
exercise price higher than the cost of the bond
future currently trading on the futures exchange.
• If interest rates fall while bond and futures prices
rise, the buyer of the futures put option will not
exercise the put, and the losses on the futures put
option are limited to the put premium.
• Q) What is a futures options contract? Compare
and contrast a futures options contract with a
futures contract.
•
ANSWER: A futures options contract is an option
contract in which the deliverable is a futures
contract, such as the Treasury bill futures
contract. As with all options contracts, the holder
has the right but not the obligation to take
delivery (call option) or make delivery (put
option).
• Q) Suppose that your bank has a commitment to make a
fixed rate loan in three months at the existing rate. In
order to hedge against the prospect of rising interest rates,
the bank takes a position in the futures options markets.
What position should it take? The relevant information is
as follows:
•
• T-bill futures prices 89
• Put option 90
• Premium $2500
•
• What will be the net gain to the bank if T-bill futures
prices fall to 85? Increase to 93?
• If T-bill futures prices fall to 85, the put
option could be exercised at 90 for a gain of
5, or $50,000. After paying the premium,
the net gain would be $47,500.
• If T-bill futures prices rise to 93, the put
option would not be exercised. The loss
would equal the premium paid for the
option, or $2,500.
• Q) Explain how futures options contracts
can be used to hedge interest rate risk.
•
ANSWER: A bank that would be harmed if
interest rates increased could hedge this risk
by selling call options on futures or buying
put option on futures.

In contrast, if the bank was in a position in its

portfolio where it would lose if interest rates
fell it could hedge by buying a call option
on futures or selling a put option.
Caps
Buying a cap means buying a call option on interest
rates.
If interest rates rise above the cap rate, the seller of the
cap compensates the buyer in return of an up-front
premium. The seller of the cap is obliged to pay the
difference between LIBOR and the exercise or cap
rate (times the fraction of the year, times the
notional principal).

As a result, buying an interest cap is like buying

insurance against an increase in interest rates.
Suppose a bank buys a 9 % cap at t=0 with exercise
dates at the end of the first year and end of the
second year. Face value is $100M. If the actual
interest rate at the end of year 1 is 10%, the cap
holder is entitled to receive the difference between
the current market interest rate and the strike price
multiplied by the principal value of the contract.
(10%-9%)(100M)= $1M

If the interest rate is below the cap, the cap seller

makes no payments to the buyer.
• Floors
a put option on interest rates. An interest rate floor
is a contract that limits the exposure of the buyer
to downward movements in interest rates.
The seller of a floor makes settlement payments
only when LIBOR is below the floor rate
Your bank is liability sensitive. To protect itself against
rising interest rates, management purchased 10 caps
from a large investment bank firm. Each contract
had a notional value of $1,000,000, a strike price
(based on three-month Treasury bill rates) of 7%
(rate was currently 6%), and a one-year maturity.
Over the next year interest rates in Treasury bills
fell, reaching 3% at the end of the year, the cap
expired without benefit, and the bank lost the full
premium of $46,000. Did management error in its
decision to purchase the cap?
• ANSWER: No, the bank bought insurance against a
negative event. The negative event did not occur.
• Interest rate swaps
An exchange of fixed interest payments for
floating interest payments by two counterparties.
The swap buyer agrees to make a number of fixed
interest rate payments on periodic settlement
dates to the swap seller.
The seller agrees to make floating rate payments to
the buyer on the same settlement dates.
Advantages of swap markets:
• swap markets are very private since only the
counterparties know that the swap is taking place
• swap markets have virtually no government
regulation
• swap markets allow for custom designed
contracts (size and maturity)
Limitations of swap markets:
• it is difficult to find counterparites wanting
to take the opposite side of a specific
transaction
• swap agreements are difficult to alter and
hard to terminate once they are initiated
• the counterparties are both exposed to
default risk.
 Consider two banks.
• Bank A has raised $100 million of its funds by
issuing four-year medium-term notes with 10%
annual fixed coupons. On the asset side of its
portfolio, the bank makes C&I loans whose rates
are indexed to LIBOR.
• Bank B has short-term CD with an average of
duration of one year, and it has $100 million worth
of fixed rate residential mortgages of long duration.

• Bank A has a positive dollar gap, while Bank B has

a negative dollar gap.
• Bank A sells an IRS (makes floating-rate payments)
and Bank B buys an IRS (makes fixed-rate
payments)
• Bank A sends annual payments indexed to one-
year LIBOR+2% (assuming one-year LIBOR is
8%) to help the Bank B cover the cost of
refinancing its one year CDs
• Bank B sends fixed annual payments of 10% for
the notional principal of $100 M to the Bank A
to allow the bank to cover fully the coupon
interest payments on its note issue.
• Bank A and Bank B have the following opportunities for
borrowing in the short-term (floating rate) and long-
term (fixed rate) markets.
•
• Bank A Bank B
• Floating Rate T-Bill + 1.0% T Bill + 2.0%
• Fixed Rate 8% 10.5%
• Bank A has a positive gap and Bank B has a negative
gap. Show that both banks can benefit from a swap in
the sense of lowering their interest rate risk. Can they
also lower their cost of funds?
• Bank A wants to receive fixed and pay floating. Bank B
wants to receive floating and pay fixed. If Bank A and
Bank B exchange flows in this manner it will reduce
the interest rate risk of both parties.
• Since the relative credit quality spreads are different in
the two markets (Bank A has a 1% advantage in the
floating rate market and a 2.5% advantage in the fixed
rate market), both parties can lower their cost of funds
through the swap as well as reduce their interest rate
risk. Pick swap terms and show this to be true.
• One such is the following (but there are others). Bank
A pays T-Bill and receives 8%, and B receives T-Bill
and pays 8%. In this case, the cost of funds to A is T-
Bill with the swap (versus T Bill + 1.0% without the
swap) and for B it is 10% with the swap (versus 10.5%
without the swap).