Chapter 23

Futures and
Forwards

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

 23-2
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Overview

 Derivative securities have become

increasingly important as FIs seek
methods to hedge risk exposures. The
growth of derivative usage is not without
controversy since misuse can increase
risk. This chapter explores the role of
futures and forwards in risk
management.
 23-3
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Derivatives
 Derivative securities generally involve an agreement
between two parties to exchange a standard quantity of
an asset or cash flow at a predetermined price and at a
specified date in the future.
 As the value of the underlying security to be exchanged
changes, the value of the derivative security changes.
 Derivatives involve the buying and selling, or
transference, of risk. As such they can involve profits
and losses if a position is unhedged.
 Beginning in 2000, the Financial Accounting Standards
Board (FASB) required all derivatives to be marked to
market and mandated that losses and gains be
immediately transparent on FIs’ and other firms’ financial
statements
 23-4
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Futures and Forwards
 Second largest group of interest rate
derivatives in terms of notional value and
largest group of FX derivatives.
 Swaps are the largest.
 23-5
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Spot and Forward Contracts
 Spot Contract
 Forward Contract
 Agreement to exchange an asset at a specified future

date for a price which is set at t=0.

 Commercial banks, investment banks, and broker–

dealers are the major forward market participants,

acting as both principals and agents.
 These financial institutions make a profit on the

spread between the prices at which they buy and sell

the asset underlying the forward contracts.
 Each forward contract is originally negotiated between

the financial institution and the customer, and

therefore the details of each (e.g., price, expiration,
size, delivery date) can be unique
 Counterparty risk
 23-6
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Forward & Futures Contract
 23-7
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Futures Contracts
 Futures Contract is normally arranged through an
organized exchange. It is an agreement between a
buyer and a seller at time 0 to exchange a
standardized, pre-specified asset for cash at a later
date.
 Similar to a forward contract except :
1) Marked to market
2) Exchange traded
1) Rapid growth of off market trading systems

3) Standardized contracts
1) Smaller denomination than forward

4) Lower default risk than forward contracts.

 23-8
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Hedging Interest Rate Risk
 Example: 20-year $1 million face value bond.
Current price = $970,000. Interest rates
expected to increase from 8% to 10% over
next 3 months. Duration is 9 years.

 From duration model, change in bond value:

P/P = -D  R/(1+R)
 23-9
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Hedging Interest Rate Risk
 Example: 20-year $1 million face value bond.
Current price = $970,000. Interest rates
expected to increase from 8% to 10% over
next 3 months. Duration is 9 years.

 From duration model, change in bond value:

P/P = -D  R/(1+R)
P/ $970,000 = -9  [.02/1.08]
P = -$161,666.67
 23-10
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Example continued: Naive hedge
 Hedged by selling 3 months forward at forward
price of $970,000.
 Suppose interest rate rises from 8%to 10%.

$970,000 - $808,333 = $161,667

(forward (spot price
price) at t=3 months)

 Exactly offsets the on-balance-sheet loss.

 Immunized.
 23-11
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Naïve Hedge – Practice Q1
 An FI holds a 15-year, $10 million par value bond that
is priced at 104 with a yield to maturity of 7 percent.
The bond has a duration of eight years, and the FI
plans to sell it after two months. The FI’s market
analyst predicts that interest rates will be 8 percent at
the time of the desired sale. Because most other
analysts are predicting no change in rates, two-month
forward contracts for 15-year bonds are available at
104. The FI would like to hedge against the expected
change in interest rates with an appropriate position in
a forward contract. What will this position be? Show
that if rates rise 1 percent as forecast, the hedge will
protect the FI from loss.
 23-12
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Naïve Hedge – Practice Q1
The expected change in the spot position is
Change in Price = –8 x $10,400,000 x (1/1.07)
= -$777,570.
 This would mean a price change from 104 to 96.2243
per $100 face value of bonds.
 By entering into a two-month forward contract to sell
$10,000,000 of 15-year bonds at 104, the FI will have
hedged its spot position.
 If rates rise by 1 percent, and the bond value falls by
$777,570, the FI can close out its forward position by
receiving 104 for bonds that are now worth 96.2243
per $100 face value.
 The profit on the forward position will offset the loss
in the spot market.
 23-13
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Naïve Hedge – Practice Q1
 The actual transaction to close the forward
contract may involve buying the bonds in the
market at 96.2243 and selling the bonds to the
counterparty at 104 under the terms of the
forward contract.
 Note that if a futures contract were used,
closing the hedge position would involve
buying a futures contract through the
exchange with the same maturity date and
dollar amount as the initial opening hedge
contract.
 23-14
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Futures and Forwards- Practice Q2
 23-15
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Futures and Forwards- Practice Q2
a. You are obligated to take delivery of a
$100,000 face value 20-year Treasury
bond at a price of $95,000 at some
predetermined later date.
 23-16
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Futures and Forwards- Practice Q2
b. This is a long hedge undertaken to
protect the FI from falling interest rates.
 23-17
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Futures and Forwards- Practice Q2
c. The FI will lose $1,000 since the FI must
pay $95,000 for bonds that have a market
value of only $94,000.
 23-18
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Futures and Forwards- Practice Q2
d. In this case the FI gains $2,000 since the
FI pays only $95,000 for bonds that have
a market value of $97,000.
 23-19
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Hedging with futures
 Futures more commonly used than forwards.
 Microhedging

 Individual assets.

 Macrohedging

 Hedging entire duration gap

 Found more effective and generally lower cost.

 Basis risk

 Exact matching is uncommon

 Standardized delivery dates of futures reduces

likelihood of exact matching.
 23-20
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Routine versus Selective Hedging

 Routine hedging: reduces interest rate risk

to lowest possible level.
 Low risk - low return.

 Selective hedging: manager may selectively

hedge based on expectations of future
interest rates and risk preferences.
 Partially hedge duration gap or individual
assets or liabilities
 23-21
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Routine versus Selective Hedging
 23-22
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Macro hedging with futures
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Macro hedging with futures - Example
 23-24
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Macro hedging with futures - Example
 23-25
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Risk Minimizing futures position
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Risk Minimizing futures position
 23-27
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Futures – Practice Q3
 23-28
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Futures – Practice Q3
a. The modified duration is
10.292/1.04
= 9.896 years.
 23-29
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Futures – Practice Q3
b.
P = -MD(R)$100,000
= -9.896 x 0.005 x $100,000
= -$4,948.08.
 23-30
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Futures – Practice Q3
c.
P = - MD (R) P = - 9.896(0.005)$95,000 = - $4,700.67
 23-31
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Futures – Practice Q3
d.
Decrease in market value of the bond
purchase -$4,948.08

Gain in value from the sale of futures

contract $4,700.67

Net gain or loss from hedge -$247.41

 23-32
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Futures Price Quotes
 T-bond futures contract: $100,000 face value
 T-bill futures contract: $1,000,000 face value
 quote is price per $100 of face value

 Example: 112 23/32 for T-bond indicates

purchase price of $112,718.75 per contract

 Delivery options
 Conversion factors used to compute invoice

price if bond other than the benchmark bond

delivered
 23-33
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Risk Minimizing futures position
 23-34
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Risk Minimizing futures position
 23-35
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Short Macro Hedge - Example
 23-36
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Short Macro Hedge - Example
 23-37
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Short Macro Hedge - Example
 23-38
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Short Macro Hedge - Example
 23-39
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Short Macro Hedge - Example
 23-40
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Short Macro Hedge - Example
 23-41
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Futures and Forwards- Practice Q4
 23-42
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Futures and Forwards- Practice Q4

( DA  kDL ) A
NF 
DF x PF
(14  (0..875)4)$240m

9 x $102,656
 2728 contracts
 23-43
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Macro Hedging – Practice Q5
 23-44
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Macro Hedging – Practice Q5

a. DGAP = DA – k DL
= 6 – (0.9)(4)
= 6 – 3.6
= 2.4 years
 23-45
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Macro Hedging – Practice Q5
b.
Expected E

= -DGAP * [R/(1 + R)] * A

= -2.4 * (-0.01/1.10) * $150m

= $3.272 million
 23-46
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Macro Hedging – Practice Q5
c.
Expected E

= -DGAP * [R/(1 + R)] * A

= -2.4 * (0.011/1.10) * $150

= -$3.6.
 23-47
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Macro Hedging – Practice Q5
d. Solving for the impact on the change in equity under
this assumption involves finding the impact of the
change in interest rates on each side of the balance
sheet, and then determining the difference in these
values.

The analysis is based on the equation:

Expected E = A - L

A = -DA * [RA/(1 + RA)] * A

L = -DL * [RL/(1 + RL)] * L

 23-48
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Macro Hedging – Practice Q5
d.
A = -DA * [RA/(1 + RA)] * A
= -6[0.01/1.10]$150m
= -$8.1818 million

L = -DL * [RL/(1 + RL)] * L

= -4[0.01/1.06]$135m
= -$5.0943 million
Therefore,
E = A - L
= -$8.1818m – (-$5.0943m)
= - $3.0875 million
 23-49
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Futures and Forwards- Practice Q6
 23-50
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Futures and Forwards- Practice Q6
a.
The bank should sell futures contracts
since an increase in interest rates would
cause the value of the equity and the
futures contracts to decrease.

But the bank could buy back the futures

contracts to realize a gain to offset the
decreased value of the equity.
 23-51
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Futures and Forwards- Practice Q6
b.
Nf = (DA – KDL) * A / (DF * PF)

= (6 – 0.9*4) * 150 / (0.25 *0.96)

= 1500
 23-52
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Futures and Forwards- Practice Q6
c. For an increase in rates of 100 basis points, the
change in the cash balance sheet position is:

Expected E = -DGAP[R/(1 + R)]A

= -2.4(0.01/1.10)$150m
= -$3.27million
The change in Futures:
= -0.25(0.01/1.04)($960,000*(-1500))
= 3.46 million
 23-53
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Part (c) continued..

For a decrease in rates of 50 basis points, the

change in the cash balance sheet position is:

Expected E = -DGAP[R/(1 + R)]A

= -2.4(-0.005/1.10)$150m
= $1.64 million
The change in each Futures contract
= -0.25(-0.005/1.04)$960,000*(-1500))
= $1.73 million
 23-54
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Futures and Forwards- Practice Q6
 23-55
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Basis Risk
 Spot and futures prices are not perfectly
correlated.
 We assumed in our example that
R/(1+R) = RF/(1+RF)

 Basis risk remains when this condition does

not hold. Adjusting for basis risk,

NF = (DA- kDL)A / (DF × PF × br)

where
br = [RF/(1+RF)] / [R/(1+R)]
 23-56
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Futures and Forwards- Practice Q7
 23-57
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Futures and Forwards- Practice Q7
Part (a)
( D A - k D L )A
Nf=
( D f P f br)
[6  (3 * 0.8)]$ 250,000,000

5.5 * $115,000 *1.10
$900,000,000

$695,750
 1,293.57 contracts
 23-58
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Futures and Forwards- Practice Q7
b. R/(1 + R) = (Rf/(1+Rf))/br

= 0.0990/1.10

= 0.09
 23-59
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Basis Risk - Reasons
 First, the balance sheet asset or liability being hedged is
not the same as the underlying security on the futures
contract. For instance, in our example we hedged interest
rate changes on the FI’s entire balance sheet with T-bond
futures contracts written on 20-year maturity bonds with a
duration of 9.5 years. The interest rates on the various
assets and liabilities on the FI’s balance sheet and the
interest rates on 20-year T-bonds do not move in a
perfectly correlated (or one-to-one) manner.
 The second source of basis risk comes from the
difference in movements in spot rates versus futures
rates. Because spot securities (e.g., government bonds)
and futures contracts (e.g., on the same bonds) are traded
in different markets, the shift in spot rates may differ from
the shift in futures rates (i.e., they are not perfectly
correlated
 23-60
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Basis Risk - Example
 23-61
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Futures and Forwards- Practice Q8
 23-62
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Futures and Forwards- Practice Q8
a. The mutual fund needs to enter into a
contract to buy Treasury bonds at 98-24
in four months.

The fund manager fears a fall in interest

rates (meaning the T-bond’s price will
increase) and by buying a futures contract,
the profit from a fall in rates will offset a
loss in the spot market from having to pay
more for the securities.
 23-63
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Futures and Forwards- Practice Q8
b.
D*P
NF 
DF * PF
12 * $481,250

8.5 * $98,750
 6.88 contracts
 23-64
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Futures and Forwards- Practice Q8
c. In this case the value of br = 1.12, and
the number of contracts is

6.88/1.12 = 6.14 contracts.

This may be adjusted downward to 6

contracts.
 23-65
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Futures and Forwards- Practice Q8
d.
One reason for the difference in price
sensitivity is that the futures contracts
and the cash assets are traded in
different markets.
 23-66
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Futures and Forwards- Practice Q9
 23-67
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Futures and Forwards- Practice Q9
a. The duration gap is
10 - (860/950)(2)
= 8.19 years.
 23-68
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Futures and Forwards- Practice Q9
b. The FI is exposed to interest rate
increases. The market value of equity will
decrease if interest rates increase.
 23-69
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Futures and Forwards- Practice Q9
c. FI can hedge its interest rate risk by
selling future or forward contracts
 23-70
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Futures and Forwards- Practice Q9
d. Change in E
= - 8.19(950,000)(.01)
= -$77,800
 23-71
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Futures and Forwards- Practice Q9
e. In cases where a large number of Treasury
bonds are necessary to hedge the balance
sheet with a macrohedge, the FI may need to
consider whether a sufficient number of
deliverable Treasury bonds are available.
Although the number of Treasury bill contracts
necessary to hedge the balance sheet is
greater than the number of Treasury bonds,
the bill market is much deeper and the
availability of sufficient deliverable securities
should be less of a problem.
 23-72
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Futures and Forwards- Practice Q9
e. Change in F
= - 9(96,000)(.01)
= -$8,640 per futures contract.

Since the macrohedge is a short hedge,

this will be a profit of $8,640 per contract.
 23-73
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Futures and Forwards- Practice Q9
f. To perfectly hedge, the Treasury bond futures
position should yield a profit equal to the loss
in equity value (for any given increase in
interest rates). Thus, the number of futures
contracts must be sufficient to offset the
$77,800 loss in equity value.

This will necessitate the sale of

$77,800/8,640 = 9.005 contracts.
Rounding down, to construct a perfect
macrohedge requires the FI to sell 9 Treasury
bond futures contracts.
 23-74
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Futures and Forwards- Practice Q10
 23-75
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Futures and Forwards- Practice Q10
 23-76
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Futures and Forwards- Practice Q10

 br = 0.90 means that the implied rate on the

deliverable bond in the futures market moves
by 0.9 percent for every 1 percent change in
discounted spot rates.
 23-77
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Futures and Forwards- Practice Q11
 23-78
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Futures and Forwards- Practice Q11

a. Profit
= (0.9860 - 0.9850) x 91/360 x 1,000,000
= $252.78
 23-79
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Futures and Forwards- Practice Q11

b. Loss
= (0.9840 - 0.9850) x 91/360 x 1,000,000
= -$252.78
 23-80
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Hedging FX Risk

 Hedging of FX exposure parallels hedging of

interest rate risk.
 If spot and futures prices are not perfectly
correlated, then basis risk remains.
 Tailing the hedge
 Interest income effects of marking to

market allows hedger to reduce number of

futures contracts that must be sold to
hedge
 23-81
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Hedging FX Risk
 23-82
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Hedging FX Risk - Example
 23-83
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Hedging FX Risk - Example
 23-84
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Hedging FX Risk - Example
 23-85
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Hedging FX Risk - Example
 23-86
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Hedging FX Risk – Basis Risk
 23-87
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Hedging FX Risk – Basis Risk
 23-88
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Hedging FX Risk – Basis Risk
 23-89
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Hedging FX Risk – Basis Risk
 23-90
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Hedging FX Risk – Basis Risk
 23-91
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Basis Risk
 In order to adjust for basis risk, we
require the hedge ratio,
h = St/ft

Nf = (Long asset position × estimate

of h)/(size of one contract).
 23-92
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Estimating the Hedge Ratio
 The hedge ratio may be estimated using
ordinary least squares regression:

St = a + bft + ut

 The hedge ratio, h will be equal to the

coefficient b.
 The R2 from the regression reveals the
effectiveness of the hedge.
 23-93
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Futures and Forwards- Practice Q12
 23-94
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Futures and Forwards- Practice Q12

a. The net exposure is

$125 million - $100 million
= $25 million.
 23-95
-95
Futures and Forwards- Practice Q12

b. The FI is exposed to dollar appreciation,

or declines in the pound relative to the
dollar.
 23-96
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Futures and Forwards- Practice Q12

c. The FI can hedge its FX rate risk by

selling forward or futures contracts in
pound sterling, assuming the contracts
are quoted as $/£, that is, in direct quote
terms in the U.S.
 23-97
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Futures and Forwards- Practice Q12

d. Assuming that the contract size for

British pounds is £62,500, the FI must sell

Nf = [$25 million/1.55] / £62,500

= 258 pound sterling futures
contracts.
 23-98
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Futures and Forwards- Practice Q12

e. The cash position will experience a loss

if the pound sterling depreciates in terms
of the U.S. dollar.
The loss would be equal to
Pound value of exposure * (change in
exchange rate)
Pound value of exposure = 25/1.6
= 15.625 m
Loss = 15.625 * (1.5 – 1.6)
= -1.5625 million
 23-99
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Futures and Forwards- Practice Q12

f. The gain on the short futures hedge is:

= Nf x £62,500 x Change in Futurest

= -258(£62,500)($1.45 - $1.55)
= +$1.6125 million
 23-100
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Futures and Forwards- Practice Q12

g. In cases where basis risk occurs, a

perfect hedge is not possible.
 23-101
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Futures and Forwards- Practice Q13
 23-102
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Futures and Forwards- Practice Q13

a. The FI should be worried about the Sf

depreciation because it will provide
fewer dollars per Sf.
 23-103
-103
Futures and Forwards- Practice Q13

b. The FI should sell Sf futures contracts to

hedge this exposure.
 23-104
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Futures and Forwards- Practice Q13

c.
Nf
= (Long asset position x h)/(Futures
contract size)
= ($100m x 1.4) / Sf125,000
= 1,120 contracts

Nf is -1120 since it is a short hedge.

 23-105
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Futures and Forwards- Practice Q13

d. Loss on SF Loan
= 100 million SF * (0.55 – 0.6)
= - 5 million
The balance sheet has decreased in
value by $5,000,000.

The gain from hedge

= (Sf125,000 x (-1,120)) * ( 0.5443 – 0.58 )
= $4.998 million.
 23-106
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Futures and Forwards- Practice Q14
 23-107
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Futures and Forwards- Practice Q14

Nf = (Long asset position × estimate of h) / (size

of one contract)

= ( 75,500,000 * 1.5 ) / 62,500

= 1812
 23-108
-108
Futures and Forwards- Practice Q14

Hedging effectiveness = R – square

= ( r ) ^2

r = Cov / (Sdspot *Sdfuture)

= 0.06844 / (0.3234 * 0.2279)
= 0.93

R – Square = (0.93) ^ 2
= 0.86
 23-109
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Futures and Forwards- Practice Q15
 23-110
-110
Futures and Forwards- Practice Q15

a. The FI is exposed to the dollar

depreciating, or SF appreciating as in
such a case, it would require more
dollars to purchase the Sf10 million if the
loan is drawn down as expected.
 23-111
-111
Futures and Forwards- Practice Q15

b. The FI needs
$0.64 x SF10 million = $6.4 million
to make the Sf-denominated loan
 23-112
-112
Futures and Forwards- Practice Q15

c. The FI should buy Sf futures or take long

position in SF futures if it decides to
hedge against the appreciation of the
swiss franc. So, that it makes profits
when SF appreciates.
 23-113
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Futures and Forwards- Practice Q15

d.
The net payment will be:
$6.1 million ( = 10 * 0.61)

If it has hedged using futures, the FI will

gain:
($0.64-$0.61)* Sf10 million
= $300,000 on its futures position.

.
 23-114
-114
Futures and Forwards- Practice Q16
 23-115
-115
Futures and Forwards- Practice Q16

a. The net exposure is –Sf50 million.

 23-116
-116
Futures and Forwards- Practice Q16

b. The FI is exposed to depreciation of the

dollar or appreciation of SF. If the dollar
weakens, the FI will need to pay more
dollars to cover its Sf liabilities than it
will receive for its assets.
 23-117
-117
Futures and Forwards- Practice Q16

c. The loss would be

= Sf50,000,000($0.6667-$0.6897)
= -$1,150,000.
 23-118
-118
Futures and Forwards- Practice Q16

d. The number of contracts

= Sf50,000,000/Sf125,000
= 400 contracts.
 23-119
-119
Futures and Forwards- Practice Q16

e. The loss on the futures position would

be
= 400*Sf125,000*($0.6349 - $0.6579)
= -$1,150,000.
 23-120
-120
Hedging Credit Risk
 More FIs fail due to credit-risk exposures
than to either interest-rate or FX
exposures.
 In recent years, development of
derivatives for hedging credit risk has
accelerated.
 Credit forwards, credit options and credit
swaps.
 23-121
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Credit Forwards
 Credit forwards hedge against decline in credit quality
of borrower.
 Common buyers are insurance companies who bear

the risk of default & make money when default risk or

credit spread decreases.
 Common sellers are banks who hedge against risk of

default & make money when risk of default or credit

spread increases.
 Specifies a credit spread on a benchmark bond

issued by a borrower.
 Example: BBB bond at time of origination may
have 2% spread over U.S. Treasury of same
maturity.
 23-122
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Credit Forwards
 CSF defines agreed forward credit spread at
time contract written
 CST = actual credit spread at maturity of
forward
Credit Spread Credit Spread Credit Spread
at End Seller Buyer
CST> CSF Receives Pays
(CST - CSF)MD(A) (CST -C SF)MD(A)

CSF>CST Pays Receives

(CSF - CST)MD(A) (CSF - CST)MD(A)
 23-123
-123
Credit Forwards
 23-124
-124
Credit Forwards - Example
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Credit Forwards - Example
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Credit Forwards – Practice Q17
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Credit Forwards – Practice Q17
The gain would be
= - (CST - CSF) * MD * $20 million
= - (-0.005) * 7 * $20 million
= $700,000.
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Futures and Catastrophe Risk
 CBOT introduced futures and options for
catastrophe insurance.
 Contract volume is rising.
 Catastrophe futures to allow PC insurers to
hedge against extreme losses such as
hurricanes.
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Regulatory Policy
 Three levels of regulation:
 Permissible activities

 Supervisory oversight of permissible activities

 Overall integrity and compliance

 Functional regulators
 SEC and CFTC

 As of 2000, derivative positions must be marked-to-

market.
 Exchange traded futures not subject to capital
requirements: OTC forwards potentially subject to
capital requirements
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Regulatory Policy for Banks
 Federal Reserve, FDIC and OCC require banks
 Establish internal guidelines regarding hedging.

 Establish trading limits.

 Disclose large contract positions that materially

affect bank risk to shareholders and outside

investors.
 Discourage speculation and encourage hedging

 Allfirst/Allied Irish: Existing (and apparently

inadequate) policies were circumvented via fraud and
deceit.
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Pertinent websites

Federal Reserve www.federalreserve.gov

Chicago Board of Trade www.cbot.org
Chicago Mercantile Exchange www.cme.com
CFTC www.cftc.gov
FDIC www.fdic.gov
FASB www.fasb.org
OCC www.ustreas.gov
SEC www.sec.gov
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Futures & Forwards – Practice Q18
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Futures & Forwards – Practice Q18
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Futures & Forwards – Practice Q18