Derivatives in ALM

7/25/2019 Derivatives in ALM

1/53

Derivatives in ALM


2/53

Financial Derivatives

Swaps

Hedge Contracts

Forward Rate Agreements

Futures

Options

Caps, Floors and Collars


3/53

Swaps

Agreement between two counterparties to exchangethe 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


4/53

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 areexchanged between two counterparties.

Used by banks to hedge interest risk exposure

across currencies.


5/53

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 riskcan exchange interest payments.


6/53

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 intermediaryservice.


7/53

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.


8/53

Plain Vanilla Interest Rate Swap


9/53

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


10/53

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


11/53

Swap Contract: Example 3

Bank Details

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

Fixed

Assets

Deposits

Advances1,000,000

3year

at9%3month

Deposit

for

1,000,000atMIBOR


12/53

Effect of Swap as a Hedge: Example 3

Receive 9% from loan and receive MIBOR from swapdeal

Pay 8.60% fixed rate on swap deal and pay MIBORfor the deposit

Net rate spread for the bank 0.40% (9.00 8.60)

Risk due to increase in MIBOR rate is eliminated forthe bank in the swap structure


13/53

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).


14/53

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.


15/53

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.


16/53

Hedge Position

Interest rate increases

Expected returns from pre committed loans /investment falls

Negative gap position of the bank implies liabilitysensitive bank would incur loss in income.

Desirable hedge position would be to sell futurescontract now and buy later resulting in derivativeprofit.


17/53

Hedge Position

Interest rate declines

Banks 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.


18/53

Hedge: Long Futures: Hedge: Short Futures:loss when rates falls loss when rates rise

Hedge Positions


19/53

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 banks internalrisk policies.

Select the futures contract to be entered into by thebank.

Determine the number of futures contract to deal(Hedge Ratio).


20/53

Determining the Number of Future contracts

( )A LFF F

D W D AN

D P

NF=Numberoffuturecontracts

DA=DurationofAssets;W=WeightDL=DurationofLiabilities

A=Total

Asset

Value

DF=DurationofFutures;PF=PriceofFuturescontract


21/53

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.


22/53

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.


23/53

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.


24/53

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


25/53

Hedge Implications: Example (Bank Profit)

Init ial Futures Position:

Sell six-month interest rate futures at 3.00%

Contract price (100-3.00 = 97.00)

Next Futures Trade:

Buy six-month interest rate futures at 3.50%

Contract price (100-3.50 = 96.50)

Net profit

(97.00-96.50) 50 Basis points

1,250


26/53

Hedge Implications: Example (Net Cost to Bank)

Effective 6-month deposit cost

11,250 1,250 12 12x 1.00 % x

1,000,000 6 6

2.00 %


27/53


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.


28/53


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 amountat a specified future date.


29/53


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.


30/53


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.


31/53

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 thenotional amount of Rs.1,000,000.

Cash flow at the end of 6 months will be determinedby comparing the 3-month MIBOR rate with the fixed

rate of 7%.


32/53

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

Interest amount represents the payment that will be made three

months latter at the maturity of the instrument (present value)

will be identified as

30.08-0.07 x x 1,000,000= 2,50012

12,500 x =2,452

31+0.08

12


33/53

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

Interest amount represents the payment that will be made

three months latter at the maturity of the instrument

(present value) will be identified as

3

0.07-0.06 x x 1,000,000= 2,50012

12,500 x =2,463

31+0.06

12


34/53

Example of a Bank Deal

A quote of 9.50% - 10.00% against 3 month MIBOR for 3

v/s 6 FRA

The market maker:

Agrees to pay (bid) 9.50% fixed and receive the 3 monthMIBOR determined 3 months later.

Agrees to receive (ask/offer) 10.00% fixed and pay the 3month MIBOR determined 3 months later.


35/53

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.


36/53

Futures

Commitment between two parties on the quantity andprice of a standardized financial or commodity

product.

Buyers of futures (long futures) contracts agree to paythe futures price and take delivery of the product.

Sellers of futures (short futures) contracts agree toreceive the futures price and deliver the product.


37/53

A) Profit or loss for buyer of futures B) Profit or loss for seller of futures

Futures Profile


38/53

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.


39/53

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.

O ti P fil


40/53

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

Options Profile


41/53

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.


42/53

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.


43/53

Caps


44/53

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 oninvestment.

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.

Fl


45/53

Floors

C ll


46/53

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 cappedand at the same time no reduction below the

minimum is set on the contract.

Collars


47/53

Collars

Cost of the collar contract is the premium payment.

Premium for an interest rate collar depends on therate parameters when compared to current market

interest rates and the frequency of payments agreed

upon.

C ll


48/53

Collar


49/53

Derivative Position to Hedge

Duration gap gives the sensitivity of the balance

sheet.

Hedging position could simulate a zero duration gap

for the bank.

Liabili ty Structure of a Bank


50/53

Asset Structure of a Bank


51/53

Derivative Structure of a Bank


52/53

Impact of Interest Rate Change on the Bank


53/53

Impact of Interest Rate Change on the Bank

Documents

Derivatives in ALM