1.1.1.1.1Chapter Twenty-Three
Managing Risk off the Balance Sheet with Derivative
Securities
1.1.1.2 I. Chapter Outline
1. Derivative Securities Used to Manage Risk: Chapter Overview
2. Forwards and Futures Contracts
a. Hedging with Forward Contracts
b. Hedging with Futures Contracts
3. Options
a. Basic Features of Options
b. Actual Interest Rate Options
c. Hedging with Options
d. Caps, Floors, and Collars
4. Risks Associated with Futures, Forwards, and Options
5. Swaps
a. Hedging with Interest Rate Swaps
b. Hedging with Currency Swaps
c. Credit Swaps
d. Credit Risk Concerns with Swaps
6. Comparison of Hedging Methods
a. Writing versus Buying Options
b. Futures versus Options Hedging
c. Swaps versus Forwards, Futures, and Options
Appendix 23A: Hedging with Futures Contracts (available on Connect or from your
McGraw-Hill representative)
Appendix 23B: Hedging with Options ((available on Connect or from your McGraw-Hill
representative)
Appendix 23C: Hedging with Caps, Floors and Collars ((available on Connect or from your
McGraw-Hill representative)
Instructor’s Manual Supplement: Hedging with Swaps (Not covered in the text)
d. Macrohedging with Swaps
e. Fixed Floating Currency Swaps
II. Learning Goals
1. Know how risk can be hedged with forward contracts.
2. Know how risk can be hedged with futures contracts.
3. Distinguish a microhedge from a macrohedge.
4. Recognize how risk can be hedged with option contracts.
5. Comprehend how risk can be hedged with swap contracts.
6. Understand how the different hedging methods compare.
1.1.1.3 III. Chapter in Perspective
FIs are increasingly managing their risks with derivative securities. These provide off balance
sheet methods to tailor or reduce the risk exposure that an FI faces. Derivatives usage remains
concentrated among the larger and more sophisticated FIs, but because derivatives can be used to
cheaply and effectively reduce risk, their usage will continue to grow as product familiarity
increases. Some of the largest FIs also act as dealers, creating derivative contracts that other
customers purchase. This chapter discusses the use of hedging with futures, forwards, options
and swaps. The main features of these securities and their valuation can be found in Chapter 10.
This chapter illustrates in conceptual terms how a FI may use derivatives to manage the risks
discussed in Chapters 19 through 22. The appendices and the supplement provide numerical
examples of hedging, including calculating the hedge ratio where appropriate. This chapter is
more difficult than prior chapters and the ancillary materials in particular are technical. By
relegating the more detailed applications to the appendices and the supplement the instructor can
choose to provide the students with the concept of hedging without requiring students to
understand the more difficult quantitative aspects. If the instructor prefers, one or more of the
example applications in the additional material can be used to illustrate the mechanics of
hedging.
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Spot contract Call option
Forward contract Put option
Futures contract Interest rate swap
Marked to market Swap buyer
Naïve hedge Swap seller
Immunized Plain vanilla swap
Microhedging Currency swap
Basis risk Naked options
Macrohedging Credit default swaps
Total return swaps Pure credit swaps
1.1.1.5 V. Teaching Notes
1. Derivative Securities Used to Manage Risk: Chapter Overview
Derivative securities can be used to create new payoff patterns for FIs. They can be used to
reduce a repricing or duration gap much more quickly than attempting to change balance sheet
accounts. For instance if a FI wished to increase its rate sensitive loan amounts relative to its
fixed rate loans in order to profit from a projected rate increase, it would probably need to alter
the loan pricing patterns on the two accounts to overcome customer resistance.1 Balance sheet
manipulations take time to effect, and the required changes in pricing needed to affect customer
behavior may more than offset any gain from the interest rate increase.2 Using derivatives to
hedge is best thought of as purchasing insurance to limit certain risks that arise from currency or
interest rate movements.
Banks generated fees and revenue from derivatives of $14.8 billion in 2013, down from $21
billion in 2010. Regulation of derivatives has slowly been increased over time as a result of
problems associated with their usage. Scandals from misusage in the 1990s and poor quality
controls along with the well known problems with OTC mortgage derivatives in the financial
crisis mean that increases in regulation on derivatives will occur. Indeed, derivatives can be
risky. Warren Buffet has called them ‘financial weapons of mass destruction.’ When used
properly however derivatives can be used to reduce an institution’s risk. The problem is that
most institutions have incentives to generate profitability rather than limit risk and managers
have a difficult time limiting profitable speculation even if it is risky. This chapter covers
hedging with forwards and futures, option contracts and swap contracts. Some of the features of
these contracts are reiterated in this chapter, but readers should be familiar with Chapter 10
before studying the hedging applications. The advantages and disadvantages of the types of
hedging instruments are also covered.
Total derivatives usage at commercial banks in March 2014 was $233,396,405.8 million
(notional principal). About eighty percent of the total was in interest rate contracts, the bulk of
which were swaps, another 14% were foreign exchange contracts and credit derivatives
comprised 4.8%. Derivative growth has slowed dramatically from before the crisis, usage of
credit derivatives continues to fall as a percent and foreign exchange contracts are growing.
Derivatives usage is heavily concentrated among the largest banks. As of 2013 about 1,400
banks actively used derivatives, about 93% of which were provided by only four large bank
dealers, J.P. Morgan Chase, Goldman Sachs, Bank of America and Citigroup.
Statistics of derivatives usage are provided in the table below:
1Sophisticated loan customers also have rate forecasts.
2Indeed in a perfect, efficient market the required change in pricing would exactly offset the profit change
from the expected rate change. Admittedly, derivative markets are probably highly efficient as
well.
Derivatives Usage at Commercial Banks (Millions $) % of Total % of Category
As of 3/2014
Notional Amount of Credit Derivatives 11,217,791 4.81%
Bank is the guarantor 5,575,059 49.70%
Bank is the beneficiary 5,642,732 50.30%
Interest Rate Contracts 185,772,115 79.60%
Notional value of interest rate swaps 128,172,264 68.99%
Futures and forward contracts 30,134,820 16.22%
Written option contracts 13,537,013 7.29%
Purchased option contracts 13,928018 7.50%
Foreign Exchange Contracts 32,992,854 14.14%
Notional value of exchange swaps 10,335,766 31.33%
Commitments to purchase FX 16,749,795 50.77%
Spot FX contracts 2,824,929
Written options contracts 2,946,325 8.93%
Purchased options contracts 2,960,969 8.97%
Other Contracts 3,413,646 1.46%
Notional value of other swaps 912,664 26.74%
Futures and forward contracts 347,312 10.17%
Written option contracts 1,136,301 33.29%
Purchased option contracts 1,017,368 29.80%
Total $233,396,406 100%
Source FDIC, SDI Report on Derivatives, All Institutions
Notes: FX = Foreign Exchange; Spot FX contracts are a part of Commitments to purchase FX
2. Forwards and Futures Contracts
A spot contract is a contract for immediate payment and delivery. Settlement is usually within
two to three business days. A forward contract is a contract for future payment and delivery
beyond two or three days, but the terms of the transaction are determined when the contract is
initiated. Futures contracts are standardized, exchange traded forward contracts except that
futures have daily marking to market, virtually no default risk and are typically highly liquid.
a. Hedging with Forward Contracts
Naïve hedge: A naïve hedge is one where the spot (or ‘cash’) instrument is fully hedged with a
forward or futures contract as opposed to a partial hedge. The “naivete” implied is the hedger’s
unwillingness to bear any risk by taking a position on a rate or price change.
Teaching Tip: When faced with a hedging situation a simple paradigm can help identify the
appropriate derivatives position:
1. Identify the rate or price change that hurts the existing or anticipated position.
2. Choose a derivatives position that makes money if the bad event (unfavorable rate or price
change) happens.
3. Calculate the number of contracts required if appropriate.
4. Secure sources of interim funding if needed (futures or written option positions).
Example 1:
A pension fund manager is anticipating buying 10 year duration, 9% yield corporate bonds in six
months. They are currently priced at par. She is afraid that rates may fall, raising the purchase
price of the bonds. How can she use a forward contract to fully hedge the position?
Answer:
Enter into a forward contract to buy the bonds in six months at a 9% yield.
Teaching Tip:
In an efficient market she should NOT be able to buy the bonds forward at a 9% yield when rates
are forecasted to fall. This is a serious drawback to a naïve or full hedge, and it is one of the
reasons why the German oil firm, MAG, did not fully hedge its risk and eventually went
bankrupt from derivatives. A FI does not hedge to earn a better rate of return, but rather to
reduce undesired risk. It is one thing to partially hedge to limit risk, it is quite another to attempt
to use a hedging program to bolster returns. Two reasons make the latter a risky practice; first,
because of the high amount of leverage involved mistakes can quickly generate larges losses, and
second, because hedging is supposed to reduce risk and these activities are very technical, the
internal control procedures on this activity may not accurately assess the risk exposure if hedgers
go beyond limiting risk.
b. Hedging with Futures Contracts
Microhedging
A microhedge is a hedge of a particular current or anticipated account or transaction. To limit
basis risk the hedger will normally select a futures contract on an underlying instrument that is as
similar as possible to the account to be hedged. Perfect matches are rare however. The risk that
remains in a hedged position is called basis risk. The basis is the difference between the spot and
futures price at a given point in time. The risk of a hedged position is the risk that spot and
futures prices will not move together over time, thus, the more similar the spot and futures
instruments, the less the basis risk.
Macrohedging
A macrohedge is a hedge of an entire balance sheet’s value. This is usually accomplished by
devising a hedge to change the effective duration of the hedged balance sheet to zero. Rather
than construct a macrohedge, the bank could construct a series of microhedges. The positions
and results of micro- and macrohedges can be quite different and macrohedges are probably a
more efficient means of hedging.3
Choosing between macro and microhedges
Risk and return: Macrohedges may be used to reduce the FI’s overall risk exposure to
interest rates. If interest rate risk is eliminated, the FI is said to be immunized. This
would also reduce the FI’s expected rate of return. If FIs perfectly hedged all risks,
including credit risks, over time their shareholders could expect to earn the T-bill rate (the
3 As applied to a hedge, the term ‘efficiency’ (an overused word) refers to the hedge’s
effectiveness at reducing variability of outcomes at the lowest possible cost.
risk free rate), and they would probably fire the board of directors. Managers may
instead choose to reduce some risks by applying selective microhedges to more price
volatile instruments. Partial macrohedges could achieve the same result.
Accounting rules and hedging strategies: FASB rulings favor microhedges. Under FASB
rules, gains and losses on futures used in microhedges and the instrument being hedged
are marked to market and thus go through the income statement. Since these should be
offsetting that is not a particular problem. Macrohedges may generate futures gains or
losses that are recognized in earnings but are not offset because many accounts are
carried at book value. This can be upsetting to management. In a full hedge the bank
eliminates all or a risk such as interest rate risk. If an institution hedges all risks
perfectly, its stockholders can expect to earn the risk free rate of return and will probably
be very unhappy since they can do that on their own by investing in T-bills. Most
managers engage in partial hedging where some risks are reduced and others are borne by
the institution.
Teaching Tip: The timing difference between realizing the spot and futures gains and
losses is one of the reasons that MAG failed. Senior management did not understand the
very complex hedging program in place. When the futures contracts required ongoing
extensive cash inflows management required the hedges and the spot contracts to be
terminated. However, the losses on the futures commitments would have eventually been
made up on the spot oil contracts and these gains should have prevented bankruptcy. It is
doubtful whether regulators and many bank board members understood the risks involved
in their institution’s mortgage derivatives before the financial crisis. It is certainly
problematic when managers choose strategies that their overseers do not fully understand.
Policies of bank regulators: Regulations generally encourage hedging instead of
speculating and require disclosure of significant risk positions. It may be that banks have
a more difficult time proving to regulators that macrohedges are valid hedges since they
are not tied to individual accounts. Forward contracts are subject to risk capital
requirements and futures contracts are not.
Microhedging with Futures
One needs to know a good deal about the contract terms including size, delivery dates, liquidity,
etc to establish a specific hedging strategy. In general terms however, if the FI’s risk is from
falling interest rates (or rising prices), a long hedge (buying futures) should be used.4 If the FI’s
risk is from rising interest rates (or falling prices) then a short hedge (selling futures) should be
used.
Teaching Tip: The number of contracts needed to hedge a position is calculated based on two
factors: 1) the size of the cash position relative to the futures contract size and 2) the price
volatility of the spot relative to the price volatility of the futures contract. The larger the cash
position relative to the quantity specified for delivery in the futures contract, the greater the
number of contracts required to hedge. The greater the price volatility of the spot relative to the
price volatility of the underlying futures commodity with respect to interest rates, the larger the
4 Futures hedges are normally named according to the position taken in the futures market.
number of contracts needed to hedge.