Chapter 9
Using Derivafives to Manage Interest Rate Risk
Chapter Objecfives
1. Describe the characteristics of financial futures contracts, how they are priced, and
basic trading activity.
2. Demonstrate differences between speculation and hedging activity.
3. Explain how banks can use financial futures to manage interest rate risk associated
with specific transactions (microhedging).
4. Explain how banks can use financial futures to manage interest rate risk associated
with the entire por&olio (macrohedging).
5. Describe the characteristics of forward rate agreements.
6. Explain how banks can use forward rate agreements to manage interest rate risk
with specific transactions.
7. Describe the mechanics of basic interest rate swaps and demonstrate their use in
managing interest rate risk.
8. Introduce the characteristics of interest rate caps, ,oors and collars.
9. Demonstrate how interest rate caps, ,oors, and collars can be used to convert loans from
fixed to ,oating rates, convert fixed deposit rates to ,oating deposit rates, and to generally
manage interest rate risk.
10. Provide an overall comparison of the hedging effectiveness of interest rate swaps versus
caps, ,oors and collars.
Key Concepts
1. Futures contracts differ from forward contracts because they are traded on formal
exchanges, involve standardized instruments, and positions require a daily marking
to market. Forward contracts are negotiated between parties, do not necessarily
involve standardized assets, and require no cash exchange until expiration.
2. Futures traders who take speculative positions purposefully increase their overall
risk position with the hope of earning extraordinary profits.
3. Futures traders who hedge take a position to reduce overall risk. This is
accomplished by positioning the futures contract to increase in value when the
cash position decreases in value, and vice versa. With financial futures, risk cannot
be eliminated, only reduced. Traders normally assume basis risk in that the basis
(futures rate minus the cash rate) might change adversely between the time the
hedge is initiated and closed.
4. Microhedges with futures involve taking a futures position to reduce interest rate
risk associated with a specific asset, liability, or commitment. Macrohedges involve
taking a futures position to reduce interest rate risk associated with a bank’s total
por&olio.
5. A hedger will sell financial futures contracts based on fixed-income securities to
reduce risk of loss if cash rates were to rise. A hedger will buy the same financial
futures contracts to reduce risk of loss if cash rates were to fall.
6. The size of a futures position depends on the value of the cash market exposure to
changing interest rates, the time over which the exposure exists, the face value of
the futures contract, and the relative sensitivity of expected rate movements on
the cash position compared to the futures instrument. It also re,ects the extent to
which the trader wants to hedge the cash market exposure or speculate.
7. A forward rate agreement (FRA) is a forward contract based on interest rates. The
buyer of a FRA agrees to pay a fixed-rate coupon payment (at the exercise rate) and
receive a ,oating-rate payment against a notional principal amount at a specified
future date. The seller of a FRA agrees to make a ,oating-rate payment and receive
a fixed-rate payment against a notional principal amount at a specified future date.
Both parties will either make a cash payment or receive a cash payment if the
actual ,oating rate at the specified future date (se;lement date) differs from that
originally expected.
8. The buyer of a FRA will receive (pay) cash when the actual interest rate at
se;lement is greater than the exercise rate (specified fixed-rate). The seller of a
FRA will receive (pay) cash when the actual interest rate at se;lement is less than
the exercise rate.
9. With basic (plain vanilla) interest rate swaps, two parties facing different types of
interest rate risk can exchange interest payments. One exchanges a fixed-rate
payment for a ,oating rate payment, while the other exchanges a ,oating rate
payment for a fixed-rate payment. When interest rates change, the party that
benefits from a swap receives a net cash payment while the party that loses makes
a net cash payment.
10. Most swap transactions are handled by dealers who make a market in swap
contracts. Swap dealers offer terms for both fixed-rate and ,oating rate payers and
earn a spread for their services. Swap agreements o>en require that each party
post collateral to cover potential decreases in value of the position. This mitigates
credit risk.
11. If they use swaps to hedge, banks that lose in the cash market when interest rates
increase (decrease) will normally benefit from a basic swap if they agree to make
(receive) a fixed-rate payment and receive (make) a ,oating rate payment.
12. Banks may use swaps to manage interest rate risk by exchanging payments, or they
may act as swap dealers (intermediaries) by arranging swap transactions for other
participants.
13. The buyer of a call option or a put option pays a premium for the option. The premium
represents the entire cost of the position as there is no margin requirement and the buyer
can lose no more than the initial premium. One a;raction to the purchase of either a call or
put option is that the buyer knows the maximum potential loss, or cash ou&low. Buying
these options when used to offset interest rate risk elsewhere is like buying insurance. In
contrast, the sale of an option has unlimited loss potential.
14. Banks can buy interest rate caps, ,oors, collars, and reverse collars to hedge or speculate.
The purchase of an interest rate cap is effectively the purchase of a call option on an
interest rate. It protects against rising interest rates. The purchase of an interest rate ,oor is
effectively the purchase of a put option on an interest rate. It protects against falling
interest rates. The purchase of a cap is the simultaneous purchase of an interest rate cap
and sale of an interest rate ,oor, which establishes bounds (or a collar) within which the
underlying rate ,uctuates. It protects against rising rates, but has a lower cost than a cap
because the sale of the ,oor reduces the initial cash outlay. The purchase of a reverse collar
is the simultaneous purchase of an interest rate ,oor and sale of an interest rate cap. It
protects against falling interest rates, but at a lower cost than the outright purchase of a
,oor.
15. Interest rate caps and ,oors can be used to convert fixed rate loans and deposits to ,oating rate
instruments. They can also be used to hedge against general interest rate movements. As options,
they protect against the adverse event, but retain potential benefits from favorable rate moves.
Teaching Suggesfions
The concept and application of financial futures contracts are o>en confusing to
students when first introduced. Begin discussion with a basic contract, such as the
90-day Eurodollar futures contract. Describe the futures contract characteristics related
to the same cash market instrument. Use a time line to demonstrate timing differences
with the underlying cash ,ows and to emphasize the nature of trading today with
current price quotes, with expiration of the futures contract at some point in the future.
This is helpful in clarifying what happens at delivery (offset, cash se;lement, or physical
delivery) and what the underlying asset is. Use current data from The Wall Street Journal
or similar source from the internet (www.cme.com) where appropriate.
Explain that futures rates differ from cash rates. Use T-bill or Eurodollar futures contracts
to explain why futures rates might exceed or fall below cash rates as related to expected
interest rates suggested by forward rates calculated from the yield curve. Ask students to
determine when they would initiate a specific long or short position as a speculator, and
explain when they would profit. Use examples to demonstrate margin requirements and
the impact of marking to market.
Once students understand how gains and losses arise from futures positions, they can
more readily appreciate hedging strategies and techniques. The examples in the text and
questions and problems at the end of the chapter provide numerous applications. Have
students work through both microhedges and macrohedges based on GAP data.
Introduce students to forward rate agreements (FRAs) by comparing them to futures
contracts. Start with the differences between a futures contract and forward contract.
Two key features are marking-to-market and the credit risk with each. Show that FRAs
are conceptually the same as futures contracts (and basic interest rate swaps) in terms
of expected cash ,ows when rates change. Again, work through basic examples using
the text example and end-of-chapter examples.
Interest rate swaps are best introduced via the example in the text. Start with the
characteristics of a basic swap. Focus on the data in Exhibit 9.8 and discuss how swaps
are priced off of the Treasury curve. The same ,oating rate applies at all maturities and
only the fixed-rate changes. One way that a dealer makes a profit is by balancing the
volume of business on both the pay fixed and pay ,oating sides, such that the dealer
makes the spread. Discuss credit risk to each counterparty and the use of bilateral
collateral agreements whereby both counterparties post collateral to support their
positions.
Treat the basic (plain vanilla) swap as a package of FRAs. Work through the data in the
time line of Exhibit 9.9 so students can see the nature of the cash ,ows. Note that the
fixed rate quoted in Exhibit 9.8 is actually the rate that makes the net present value of
expected cash ,ows from the data in Exhibit 9.9 equal to zero. (Actually the mid-point
of the bid and offer fixed swap rates produces the zero net present value.) Discuss swap
applications using the examples in the text. Students generally find this type of financial
engineering fascinating. Discuss the credit risk with swaps and their usefulness both in
hedging and creating synthetic securities.
Emphasize the analogy of long option positions with the purchase of insurance. Demonstrate via
microhedging examples provided in the text how options on Eurodollar futures work. Contrast
the cash ,ows, both initial ou&lows and net payoffs, with financial futures and interest rate
swaps. Emphasize that the primary advantage of long options positions is that they limit
downside losses when the cash market changes favorably in value, but provide unlimited gains
when losses arise in the cash market.
Introduce interest rate caps, ,oors, collars, and reverse collars as options on interest rates. Again,
the buyer of the option is effectively buying insurance against unfavorable interest rate moves.
The buyer pays an upfront premium, which represents the cost of the position and the most the
buyer can lose. If rates move favorably, the buyer retains the potential to benefit from the rate
move. Use the examples in the text to demonstrate how the buyer of an interest rate cap can
convert a fixed-rate loan to a loan that ,oats with prime. Do the same with the buyer of an
interest rate ,oor that converts a fixed-rate deposit to a ,oating rate deposit. Make a special
note of collars and reverse collars. Banks o>en resist buying caps and ,oors because they are
expensive. Brokers then try to sell banks on using collars and reverse collars as a way to provide
protection at a reduced upfront cost. Be sure that students understand that the way the upfront
premium is lowered with a collar or reverse collar is by selling an option. With the option sale, a
bank gives up potential upside price moves.
To introduce interest rate swaps with options, work through the example provided in the text for
a firm that wants to obtain long-term fixed-rate financing. The purpose is to identify the
characteristics of swaps with options and explain the many alternatives a firm has when it faces
interest rate risk.