Chapter Twenty-Three

Managing Risk off the

Balance Sheet with
Derivative Securities
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Managing Risk off the Balance Sheet

Managers
Managers are
are increasingly
increasingly turning
turning to
to off-balanceoff-balancesheet
sheet (OBS)
(OBS) instruments
instruments such
such as
as forwards,
forwards,
futures,
futures, options,
options, and
and swaps
swaps to
to hedge
hedge the
the risks
risks
their
their financial
financial institutions
institutions (FIs)
(FIs) face
face
interest
interestrate
raterisk
risk
foreign
foreignexchange
exchangerisk
risk
credit
creditrisk
risk

FIs
FIs also
also generate
generate fee
fee income
income from
fromderivative
derivative
securities
securities transactions
transactions
McGraw-Hill/Irwin

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Managing Risk off the Balance Sheet

AAspot
spotcontract
contractisisan
anagreement
agreementto
totransact
transactinvolving
involvingthe
the
immediate
immediateexchange
exchangeof
ofassets
assetsand
andfunds
funds
AAforward
forwardcontract
contractisisan
anagreement
agreementto
totransact
transactinvolving
involving
the
thefuture
futureexchange
exchangeof
ofaaset
setamount
amountof
ofassets
assetsatataaset
setprice
price
AAfutures
futurescontract
contractisisan
anagreement
agreementto
totransact
transactinvolving
involving
the
thefuture
futureexchange
exchangeof
ofaaset
setamount
amountof
ofassets
assetsfor
foraaprice
price
that
thatisissettled
settleddaily
daily

futures
futurescontracts
contractsare
aremarked
markedto
tomarket
marketdailyi.e.,
dailyi.e.,the
theprices
priceson
on
outstanding
outstandingfutures
futurescontracts
contractsare
areadjusted
adjustedeach
eachday
daytotoreflect
reflect
current
currentfutures
futuresmarket
marketconditions
conditions

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2009, The McGraw-Hill Companies, All Rights

Hedging with Forwards

AAnave
navehedge
hedgeisisaahedge
hedgeof
ofaacash
cashasset
asseton
onaadirect
direct
dollar-for-dollar
dollar-for-dollarbasis
basiswith
withaaforward
forward(or
(orfutures)
futures)contract
contract
Managers
Managerscan
canpredict
predictcapital
capitalloss
loss(P)
(P)using
usingthe
theduration
duration
formula:
formula:
R
P D P
(1 R )
where
where

PP==the
theinitial
initialvalue
valueofofan
anasset
asset
DD==the
theduration
durationof
ofthe
theasset
asset
RR==the
theinterest
interestrate
rate(and
(andthus
thusR
Risisthe
thechange
changeinininterest)
interest)

FIs
FIscan
canimmunize
immunizeassets
assetsagainst
againstrisk
riskby
byusing
usinghedging
hedgingto
to
fully
fullyprotect
protectagainst
againstadverse
adversemovements
movementsin
ininterest
interestrates
rates
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2009, The McGraw-Hill Companies, All Rights

Hedging with Futures

Microhedging
Microhedging isis using
using futures
futures (or
(or forwards)
forwards)
contracts
contracts to
to hedge
hedge aa specific
specific asset
asset or
or liability
liability

basis
basisrisk
riskisisaaresidual
residualrisk
riskthat
thatoccurs
occursbecause
becausethe
the
movement
movementin
inaaspot
spotassets
assetsprice
priceisisnot
notperfectly
perfectly
correlated
correlatedwith
withthe
themovement
movementin
inthe
theprice
priceof
ofthe
theasset
asset
delivered
deliveredunder
underaafutures
futures(or
(orforwards)
forwards)contract
contract
firms
firmsuse
useshort
shortpositions
positionsin
infutures
futurescontracts
contractsto
tohedge
hedge
an
anasset
assetthat
thatdeclines
declinesin
invalue
valueas
asinterest
interestrates
ratesrise
rise

Macrohedging
Macrohedging isis hedging
hedging the
theentire
entire (leverage(leverageadjusted)
adjusted) duration
duration gap
gap of
of an
an FI
FI
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2009, The McGraw-Hill Companies, All Rights

Hedging with Futures

Microhedging
Microhedging and
and macrohedging
macrohedging
risk-return
risk-returnconsiderations
considerations

FIs
FIshedge
hedgebased
basedon
onexpectations
expectationsof
offuture
futureinterest
interestrate
rate
movements
movements
FIs
FIsmay
maymicrohedge,
microhedge,macrohedge,
macrohedge,or
oreven
evenoverhedge
overhedge

accounting
accountingrules
rulescan
caninfluence
influencehedging
hedgingstrategies
strategies

inin1997
1997FASB
FASBrequired
requiredthat
thatall
allgains
gainsand
andlosses
lossesfrom
from
derivatives
derivativesused
usedtotohedge
hedgemust
mustbe
berecognized
recognizedimmediately
immediately
U.S.
U.S.companies
companiesmust
mustreport
reportderivative
derivativerelated
relatedtrading
tradingactivity
activity
ininannual
annualreports
reports
futures
futurescontracts
contractsare
arenot
notsubject
subjecttotorisk-based
risk-basedcapital
capital
requirements
requirementsimpose
imposeby
bybank
bankregulators
regulators(forward
(forwardcan
canbe)
be)

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Options
Many
Manytypes
typesof
ofoptions
optionsare
areused
usedby
byFIs
FIsto
tohedge
hedge

exchange-traded
exchange-tradedoptions
options
over-the-counter
over-the-counter(OTC)
(OTC)options
options
options
optionsembedded
embeddedininsecurities
securities
caps,
caps,collars,
collars,and
andfloors
floors

the
theput
putoption
optiontruncates
truncatesthe
thedownside
downsidelosses
losses
the
theput
putoption
optionscales
scalesdown
downthe
theupside
upsideprofits,
profits,but
butstill
stillleaves
leavesupside
upside
profit
potential
profit potential

Buying
Buyingaaput
putoption
optionon
onaabond
bondcan
canhedge
hedgeinterest
interestrate
raterisk
risk
exposure
exposurerelated
relatedto
tobonds
bondsthat
thatare
areheld
heldas
asassets
assets

Similarly,
Similarly,buying
buyingaacall
calloption
optionon
onaabond
bondcan
canhedge
hedgeinterest
interest
rate
raterisk
riskexposure
exposurerelated
relatedto
tobonds
bondsheld
heldon
onthe
theliability
liabilityside
side
of
ofthe
thebalance
balancesheet
sheet
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Hedging with Put Options

Payoff
Payoff
Gain
Gain

Payoff
Payofffor
foraabond
bond
held
heldas
asan
anasset
asset
Net
Netpayoff
payofffunction
function

00

XX

-P
-P

Payoff
Payofffrom
from
buying
buyingaaput
put
on
onaabond
bond

Payoff
Payoff
Loss
Loss
McGraw-Hill/Irwin

Bond
Bondprice
price

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2009, The McGraw-Hill Companies, All Rights

Options
Buying
Buying aa call
call option
option on
on aa bond
bond

as
asinterest
interestrates
ratesfall,
fall,bond
bondprices
pricesrise,
rise,and
andthe
thecall
call
option
optionbuyer
buyerhas
hasaalarge
largeprofit
profitpotential
potential
as
asinterest
interestrates
ratesrise,
rise,bond
bondprices
pricesfall,
fall,but
butthe
thecall
call
option
optionlosses
lossesare
arebounded
boundedby
bythe
thecall
calloption
optionpremium
premium

Writing
Writing aa call
call option
option on
on aa bond
bond

as
asinterest
interestrates
ratesfall,
fall,bond
bondprices
pricesrise,
rise,and
andthe
thecall
call
option
optionwriter
writerhas
hasaalarge
largepotential
potentiallosses
losses
as
asinterest
interestrates
ratesrise,
rise,bond
bondprices
pricesfall,
fall,but
butthe
thecall
call
option
optiongains
gainsare
arebounded
boundedby
bythe
thecall
calloption
optionpremium
premium

McGraw-Hill/Irwin

23-9

2009, The McGraw-Hill Companies, All Rights

Options
Buying
Buying aa put
put option
option on
on aa bond
bond

as
asinterest
interestrates
ratesrise,
rise,bond
bondprices
pricesfall,
fall,and
andthe
theput
put
option
optionbuyer
buyerhas
hasaalarge
largeprofit
profitpotential
potential
as
asinterest
interestrates
ratesfall,
fall,bond
bondprices
pricesrise,
rise,but
butthe
theput
putoption
option
losses
lossesare
arebounded
boundedby
bythe
theput
putoption
optionpremium
premium

Writing
Writing aa put
put option
option on
on aa bond
bond

as
asinterest
interestrates
ratesrise,
rise,bond
bondprices
pricesfall,
fall,and
andthe
theput
put
option
optionwriter
writerhas
haslarge
largepotential
potentiallosses
losses
as
asinterest
interestrates
ratesfall,
fall,bond
bondprices
pricesrise,
rise,but
butthe
theput
putoption
option
gains
gainsare
arebounded
boundedby
bythe
theput
putoption
optionpremium
premium

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23-10

2009, The McGraw-Hill Companies, All Rights

Caps, Floors, and Collars

Buying
Buyingaacap
capmeans
meansbuying
buyingaacall
calloption,
option,or
oraasuccession
succession
of
ofcall
calloptions,
options,on
oninterest
interestrates
rates
like
likebuying
buyinginsurance
insuranceagainst
againstan
an(excessive)
(excessive)increase
increaseinininterest
interest
rates
rates

Buying
Buyingaafloor
floorisisakin
akinto
tobuying
buyingaaput
putoption
optionon
oninterest
interest
rates
rates

seller
sellercompensates
compensatesthe
thebuyer
buyershould
shouldinterest
interestrates
ratesfall
fallbelow
belowthe
the
floor
rate
floor rate
like
likecaps,
caps,floors
floorscan
canhave
haveone
oneor
oraasuccession
successionof
ofexercise
exercisedates
dates

AAcollar
collaramounts
amountsto
toaasimultaneous
simultaneousposition
positionin
inaacap
capand
andaa
floor
floor
usually
usuallyinvolves
involvesbuying
buyingaacap
capand
andselling
sellingaafloor
floor

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23-11

2009, The McGraw-Hill Companies, All Rights

Contingent Credit Risk

Contingent
Contingent credit
credit risk
risk isis the
the risk
risk that
that the
the
counterparty
counterparty defaults
defaults on
on payment
payment obligations
obligations

forward
forwardcontracts
contractsare
areexposed
exposedto
tocounterparty
counterpartydefault
default
risk
riskas
asthey
theyare
arenonstandard
nonstandardcontracts
contractsentered
enteredinto
into
bilaterally
bilaterally
options
optionstraded
tradedOTC
OTCare
areexposed
exposedto
tocounterparty
counterpartyrisk
risk
futures
futuresand
andoptions
optionstraded
tradedon
onorganized
organizedexchanges
exchangesare
are
exposed
exposedto
torelatively
relativelyless
lesscontingent
contingentcredit
creditrisk
risk

the
theexchanges
exchangesact
actas
asguarantors
guarantorsininthe
thetransactions
transactions
the
thecontracts
contractsare
aremarked-to-market
marked-to-marketdaily
dailyso
solosses
losses(and
(andgains)
gains)
are
arerealized
realizeddaily
daily

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23-12

2009, The McGraw-Hill Companies, All Rights

Swaps
Swap
Swapagreements
agreementsinvolve
involverestructuring
restructuringasset
assetor
orliability
liability
cash
cashflows
flowsin
inaapreferred
preferreddirection
direction
The
Themarket
marketfor
forswaps
swapshas
hasgrown
grownenormously
enormouslyin
inrecent
recent
years
years
the
thenotional
notionalvalue
valueof
ofswap
swapcontracts
contractsoutstanding
outstandingatatU.S.
U.S.
commercial
banks
was
more
than
$111
trillion
in
2008
commercial banks was more than $111 trillion in 2008

There
Thereare
areseveral
severaltypes
typesof
ofswaps
swaps

interest
interestrate
rateswaps
swaps
currency
currencyswaps
swaps
credit
creditrisk
riskswaps
swaps
commodity
commodityswaps
swaps
equity
equityswaps
swaps

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23-13

2009, The McGraw-Hill Companies, All Rights

Swaps
Hedging
Hedging with
with interest
interest rate
rate swaps:
swaps: an
an example
example

aamoney
moneycenter
centerbank
bank(MCB)
(MCB)may
mayhave
havefloating-rate
floating-rate
loans
loansand
andfixed-rate
fixed-rateliabilities
liabilities
the
theMCB
MCBhas
hasaanegative
negativeduration
durationgap
gap

aasavings
savingsbank
bank(SB)
(SB)may
mayhave
havefixed-rate
fixed-ratemortgages
mortgages
funded
fundedby
byshort-term
short-termliabilities
liabilitiessuch
suchas
asretail
retaildeposits
deposits
the
theSB
SBhas
hasaapositive
positiveduration
durationgap
gap

accordingly,
accordingly,an
aninterest
interestswap
swapcan
canbe
beentered
enteredinto
into
between
betweenthe
theMCB
MCBand
andthe
theSB
SBeither:
either:

directly
directlybetween
betweenthe
thetwo
twoFIs
FIs
indirectly
indirectlythrough
throughaabroker
brokeror
oragent
agentwho
whocharges
chargesaafee
feetoto
accept
acceptthe
thecredit
creditrisk
riskexposure
exposureand
andguarantee
guaranteethe
thecash
cashflows
flows

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23-14

2009, The McGraw-Hill Companies, All Rights

Swaps
(example
(example cont.)
cont.)
aaplain
plainvanilla
vanillaswap
swapisisusedi.e.,
usedi.e.,aastandard
standard
agreement
agreementwithout
withoutany
anyspecial
specialfeatures
features
the
theSB
SBsends
sendsfixed-rate
fixed-rateinterest
interestpayments
paymentsto
tothe
theMCB
MCB
thus,
thus,the
theMCBs
MCBsfixed-rate
fixed-rateinflows
inflowsare
arenow
nowmatched
matchedtotoits
its
fixed-rate
fixed-ratepayments
payments

the
theMCB
MCBsends
sendsvariable-rate
variable-rateinterest
interestpayments
paymentsto
tothe
the
SB
SB
thus,
thus,the
theSBs
SBsvariable-rate
variable-rateinflows
inflowsare
arenow
nowmatched
matchedtotoits
its
variable-rate
variable-ratepayments
payments

McGraw-Hill/Irwin

23-15

2009, The McGraw-Hill Companies, All Rights

Swaps

McGraw-Hill/Irwin

23-16

2009, The McGraw-Hill Companies, All Rights

Swaps
Hedging
Hedging with
with currency
currency swaps:
swaps: an
an example
example

consider
consideraaU.S.
U.S.FI
FIwith
withfixed-rate
fixed-rate$$denominated
denominatedassets
assets
and
andfixed-rate
fixed-ratedenominated
denominatedliabilities
liabilities
also
alsoconsider
consideraaU.K.
U.K.FI
FIwith
withfixed-rate
fixed-ratedenominated
denominated
assets
assetsand
andfixed-rate
fixed-rate$$denominated
denominatedliabilities
liabilities
the
theFIs
FIscan
canengage
engagein
inaacurrency
currencyswap
swapto
tohedge
hedgetheir
their
foreign
foreignexchange
exchangeexposure
exposure
that
thatis,
is,the
theFIs
FIsagree
agreeon
onaafixed
fixedexchange
exchangerate
rateatatthe
theinception
inception
of
the
swap
agreement
for
the
exchange
of
cash
flows
of the swap agreement for the exchange of cash flowsatatsome
some
point
pointininthe
thefuture
future
both
bothFIs
FIshave
haveeffectively
effectivelyhedged
hedgedtheir
theirforeign
foreignexchange
exchange
exposure
exposureby
bymatching
matchingthe
thedenominations
denominationsof
oftheir
theircash
cashflows
flows

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23-17

2009, The McGraw-Hill Companies, All Rights

Credit Risk and Swaps

The
Thegrowth
growthof
ofthe
theover-the-counter
over-the-counterswap
swapmarket
marketwas
wasaa
major
majorfactor
factorunderlying
underlyingthe
theimposition
impositionof
ofthe
theBIS
BISriskriskbased
basedcapital
capitalrequirements
requirements

the
thefear
fearwas
wasthat
thatout-of-the-money
out-of-the-moneycounterparties
counterpartieswould
wouldhave
have
incentives
to
default
incentives to default
BIS
BISnow
nowrequires
requirescapital
capitaltotobe
beheld
heldagainst
againstinterest
interestrate,
rate,currency,
currency,
and
other
swaps
and other swaps

Credit
Creditrisk
riskon
onswaps
swapsdiffers
differsfrom
fromthat
thaton
onloans
loans

netting:
netting:only
onlythe
thedifference
differencebetween
betweenthe
thefixed
fixedand
andthe
thefloating
floating
payment
is
exchanged
between
swap
parties
payment is exchanged between swap parties
payment
paymentflows
flowsare
areinterest
interestand
andnot
notprincipal
principal
standby
standbyletters
lettersof
ofcredit
creditare
arerequired
requiredof
ofpoor-quality
poor-qualityswap
swap
participants
participants

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23-18

2009, The McGraw-Hill Companies, All Rights

Comparing Hedging Methods

Writing
Writingvs.
vs.buying
buyingoptions
options

writing
writingoptions
optionslimits
limitsupside
upsideprofits
profitsbut
butnot
notdownside
downsidelosses
losses
buying
buyingoptions
optionslimits
limitsdownside
downsidelosses
lossesbut
butnot
notupside
upsideprofits
profits
CBs
CBsare
areprohibited
prohibitedfrom
fromwriting
writingoptions
optionsininsome
someareas
areas

futures
futuresproduces
producessymmetric
symmetricgains
gainsand
andlosses
losses
options
optionsprotect
protectagainst
againstlosses
lossesbut
butdo
donot
notfully
fullyreduce
reducegains
gains

swaps
swapsand
andforwards
forwardsare
areOTC
OTCcontracts,
contracts,unlike
unlikeoptions
optionsand
andfutures
futures
futures
futuresare
aremarked
markedtotomarket
marketdaily
daily
swaps
swapscan
canbe
bewritten
writtenfor
forlonger
longertime
timehorizons
horizons

Futures
Futuresvs.
vs.options
optionshedging
hedging

Swaps
Swapsvs.
vs.forwards,
forwards,futures,
futures,and
andoptions
options

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2009, The McGraw-Hill Companies, All Rights

Regulation
Regulators
Regulatorsspecify
specifypermissible
permissibleactivities
activitiesthat
thatFIs
FIsmay
may
engage
engagein
in
Institutions
Institutionsengaging
engagingin
inpermissible
permissibleactivities
activitiesare
aresubject
subject
to
toregulatory
regulatoryoversight
oversight
Regulators
Regulatorsjudge
judgethe
theoverall
overallintegrity
integrityof
ofFIs
FIsengaging
engagingin
in
derivatives
derivativesactivity
activitybased
basedon
oncapital
capitaladequacy
adequacyregulation
regulation
The
TheSecurities
Securitiesand
andExchange
ExchangeCommission
Commission(SEC)
(SEC)and
and
the
theCommodity
CommodityFutures
FuturesTrading
TradingCommission
Commission(CFTC)
(CFTC)
are
arethe
thefunctional
functionalregulators
regulatorsof
ofderivatives
derivativessecurities
securities
markets
markets
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2009, The McGraw-Hill Companies, All Rights

Regulation
The
TheFederal
FederalReserve,
Reserve,the
theFederal
FederalDeposit
DepositInsurance
InsuranceCorporation
Corporation
(FDIC)
(FDIC)and
andthe
theOffice
Officeof
ofthe
theComptroller
Comptrollerof
ofthe
theCurrency
Currency(OCC)
(OCC)
have
haveimplemented
implementeduniform
uniformguidelines
guidelinesthat
thatrequire
requirebanks
banksto:
to:

establish
establishinternal
internalguidelines
guidelinesregarding
regardinghedging
hedgingactivity
activity
establish
establishtrading
tradinglimits
limits
disclose
discloselarge
largecontract
contractpositions
positionsthat
thatmaterially
materiallyaffect
affectthe
therisk
risktoto
shareholders
shareholdersand
andoutside
outsideinvestors
investors

As
Asof
of2000
2000the
theFASB
FASBrequires
requiresall
allfirms
firmstotoreflect
reflectthe
themarked-tomarked-tomarket
marketvalue
valueof
oftheir
theirderivatives
derivativespositions
positionsinintheir
theirfinancial
financial
statements
statements
Swap
Swapmarkets
marketsare
aregoverned
governedby
byrelatively
relativelylittle
littleregulationexcept
regulationexcept
indirectly
indirectlyatatFIs
FIsthrough
throughbank
bankregulatory
regulatoryagencies
agencies
McGraw-Hill/Irwin

23-21

2009, The McGraw-Hill Companies, All Rights