copyright 2013 by diane s. docking1 risk management: hedging with futures
TRANSCRIPT
Copyright 2013 by Diane S. Docking 1
Risk Management:Hedging with Futures
Hedging with Financial Futures
contracts
Copyright 2013 by Diane S. Docking 2
Copyright 2013 by Diane S. Docking 3
Purpose of Trading Financial Futures
To Speculate_ – Take a position with the goal of profiting from
expected changes in the contract’s price– No position in underlying asset (naked
position)– Used by risk seekers
To Hedge_– Minimize or manage risks– Have position (or soon will have a position) in
spot market with the goal to offset risk– Used by the risk averse
Copyright 2013 by Diane S. Docking 4
Long vs. Short Hedges
Long Hedge (Anticipatory Hedge)• Involves purchasing futures contracts now as a
temporary substitute for the purchase of the cash market commodity at a later date
• Purpose is to lock in a buying price
Short Hedge• Initiate with a sale of a futures contract as a temporary
substitute for a later cash market sale of the underlying asset.
• Purpose is to lock in a selling price
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Long Hedge• Lock in buying price• Lock in inventory purchase
prices• Lay off (transfer) price risk• Avoid lower than expected
yields from loans and securities investments
• To protect against changing FX rates
Why Hedge?
Short Hedge:• Lock in selling price • Protect inventory value• Avoid higher borrowing costs• Avoid declining investment
portfolio values• To protect against changing
FX rates
Copyright 2013 by Diane S. Docking 6
Micro vs. Macro Hedge
Micro Hedge
A hedge strategy designed to reduce risk of a transaction associated with a specific asset, liability, or commitment or a portfolio of similar assets
Macro Hedge
A hedge strategy designed to reduce risk associated with a bank’s entire balance sheet position or portfolio of dissimilar assets.
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Steps in Executing a Hedge• Step 1: Identify cash market risk/exposure• Step 2: Determine long or short hedge• Step 3: Decide on futures contract to use• Step 4: Determine number of contracts• Step 5: Execute hedge• Step 6: Unwind hedge before expiration of
futures and compute net gain or loss on hedge
Copyright 2013 by Diane S. Docking
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Determining number of contracts for a Microhedge
brPD
PD
ff
cc
fN
Where:Dc = Duration in cash marketPc = Price in cash marketDf = Duration of futures contract
Pf = Price of futures contractbr = change in futures prices/change in spot prices
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Example: Micro-Hedging Bonds with T-bond Futures
• Julie wants to protect the value of $100,000,000 of bonds over the near term . How best does she do this?
• She knows the following:– The duration of these bonds is 8 years.– The duration of the underlying T-bond futures is 6.5 years– br = 1.111– The T-bond futures contract with 6-months to expiration is as
follows:Treasury Notes (CBT) - $100,000; pts. 32nds of 100%
Open High Low Settle Chg.
6-months 114’215 115’020 109’225 110’000 -0’165
Copyright 2013 by Diane S. Docking
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Solution to Example: Micro-Hedging Bonds with T-bond Futures
• Julie needs to ____________ the futures contracts.
• How many futures contracts does she need to sell?
Ksbr
09.007,1111.1000,110$5.6
000,000,100$8
PVD
PVD N
ff
ccf
Copyright 2013 by Diane S. Docking
Always round DOWN
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Example: Micro-Hedging Bonds with T-bond Futures (cont.)
• Julie decides to sell 1,007 near-term futures contracts.
• Over the next month, interest rates increase 1%.• The T-bond futures price falls to 102’27. (There are five
months left in the futures contract)
• How did this short hedge perform?
• That is, how much protection did selling futures contracts provide to her bonds?
Copyright 2013 by Diane S. Docking
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Solution to Example: Micro-Hedging Bonds with T-bond Futures (cont.)
Portfolio Futures market
(Cash Mkt) Price Quote
t0:
Current bonds value $100,000,000
Sell futures contracts at F0 110.00
t1-month:
Current bonds value
$100 mill. +[-8 x (+.01) x $100 mill.] $ 92,000,000
Unwind hedge:
Buy futures contracts at F1 (102 27/32) <102.84375>
Loss in portfolio value <$ 8,000,000>
Gain in futures market 7.15625Copyright 2013 by Diane S. Docking
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Solution to Example: Micro-Hedging Bonds with T-bond Futures (cont.)
Total Loss in bonds: = <$8,000,000>
Total Gain in Futures market:
7.15625 x $1,000 x 1,007Ks = $7,206,343.75
Net gain/<loss> on hedge < $793,656.25>
Value of bonds at t1-month, including hedge effects:
$92,000,000 + $7,206,344= $99,206,344
Or
$100,000,000 - $793,656 = $99,206,344
Copyright 2013 by Diane S. Docking
Copyright 2013 by Diane S. Docking 14
Determining number of contracts for a Macrohedge
where Nf = number of futures contractsDGAPK = Duration Gap of bank capital or portfolio duration*.TA = total assets of bank or portfolioDf = duration of futures contractPf = current price of futures contractbr = change in futures prices/change in spot prices
brff
P D
TA DGAPN K
f
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Example: Immunize Financial Institution Balance Sheet(Remember from DGAP Management)
Given the average duration items from First NationalBank’s Balance Sheet (see next slide), we calculated theDuration Gap of capital and saw what happens if interest rates decrease from 6% to 4.5%. (See next slides)
Example: Immunize Financial Institution Balance Sheet (cont.)
First National BankAmount Duration Weight Wtd.Duration($ millions) (years) (%) (years)
AssetsReserve and cash items 5 0.0 5% 0.000Securities Less than 1 year 5 0.4 5% 0.020 1 to 2 years 5 1.6 5% 0.080 Greater than 2 years 5 5.5 5% 0.275Residential mortgages Variable-rate 10 0.5 10% 0.050 Fixed-rate (30-year) 10 6.0 10% 0.600Commercial loans Less than 1 year 25 0.7 25% 0.175 1 to 2 years 20 1.4 20% 0.280 Greater than 2 years 5 2.3 5% 0.115Physical capital 10 0.0 10% 0.000 Total Assets 100 100% DA 1.595
LiabilitiesCheckable deposits 5 0.1 5% 0.005MMDAs 6 0.5 6% 0.032Savings deposits 8 1.0 8% 0.084CDs Variable-rate 3 0.5 3% 0.016 Less than 1 year 5 0.2 5% 0.011 1 to 2 years 15 1.9 16% 0.300 Greater than 2 years 23 5.6 24% 1.356Fed funds 5 0.0 5% 0.000Borrow ings Less than 1 year 2 0.3 2% 0.006 1 to 2 years 8 1.5 8% 0.126 Greater than 2 years 15 5.3 16% 0.837 Total Liabilities 95 100% DL 2.773 DGAPK -1.039
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Example: Immunize Financial Institution Balance Sheet (cont.)
• $ D in K if rates decrease:
TE_current $5,000,000
K <$1,470,283>
TE_new $3,529,717
Ai1
ΔiDGAPΔK
0K
$1,470,283 million 100$1.06
.0151.039-ΔK
Regulatory capital requirements could be in trouble and bank in danger of being declared insolvent!
Copyright 2013 by Diane S. Docking 18
Example: Immunize Financial Institution Balance Sheet (cont.)
You want to protect the capital of the bank over the next 3 months.
How best can you do this using T-bond futures contracts expiringin 6 months, with a duration on 6.5 years?
Treasury Notes (CBT) - $100,000; pts. 32nds of 100%
Open High Low Settle Chg.
6-months 114’215 115’020 109’225 110’000 -0’165
Copyright 2013 by Diane S. Docking
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Solution to Example: Immunize Financial Institution Balance Sheet
1. How can the Bank hedge this risk?– If interest rates decrease, prices increase; therefore a futures
contract.
2. How many futures contracts does the bank need to buy?
contracts
315.145
$110,000 x .56
000000100x 1.039-
P x D
TAx DGAP N
ff
Kf
,,
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Example: Immunize Financial Institution Balance Sheet (cont.)
• Assume that over the next three months, interest rates decrease 1.60% to 4.4%.
• The T-bond futures price rises to 120’24. (There are three months left in the futures contract)
• How did this long hedge perform?
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Solution to Example: Immunize Financial Institution Balance Sheet (cont.)
3. How did this long hedge perform? Capital Futures
market
(Cash Mkt) Price Quote
t0:
Current capital balance $5,000,000
Buy futures contracts at F0 < 110.00>
t3-month:
Current capital balance
$5 mill. – 1,568,302** = $3,431,698
Unwind hedge:
Sell futures contracts at F1 120.75
**Change in Capital if rates decrease 1.6%:
- (-1.039) x (-.016/1.06) x $100 mill. = <$1,568,302>
Gain in futures market 10.75Copyright 2013 by Diane S. Docking
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Solution to Example: Immunize Financial Institution Balance Sheet (cont.)
3. How did this long hedge perform? (cont.)
Total Loss in capital = <$1,568,302>
Total Gain in Futures market:
10.75 x $1,000 = $10,750/K
$10,750/K x 145Ks = $1,558,750
Net gain/<loss> on hedge <$ 9,552>
4. Capital value with macro hedge =
$5 mill – 9,552 = $4,990,448
Copyright 2013 by Diane S. Docking
Copyright 2013 by Diane S. Docking 23
Complications in using financial futures
• Accounting and regulatory guidelines.• Macrohedge of the bank’s entire portfolio -- cannot defer gains and
losses on futures, so earnings are less stable with this hedge strategy.• Microhedge linked to a specific asset -- can defer gains and losses
on futures until contracts mature.• Basis risk is the difference between the cash and futures prices.
These two prices are not normally perfectly correlated (e.g., corporate bond rates in a cash position versus T-bill futures rates).
• Bank gaps are dynamic and change over time.• Futures options allow the execution of the futures position only to
hedge losses in the cash position. Gains in the cash position are not offset by losses in the futures position.
Copyright 2013 by Diane S. Docking 24
Basis Risk
Basis in a futures contract is (in prices):
Basist = Spott - Futurest
Basis in a futures contract is (in interest rates):
Basist = Futurest - Spott