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Ai Jun Hou
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Introduction to Forwards and Futures
Using forwards and furutres in the Asset Liability management
Outline
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
What is a “derivative”?
Definition (Derivative)
A derivative is a financial asset whose payoff depends on the value(s)
of one or several more basic underlying variables.
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
I asset allocation
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
Notation
T : delivery date
K : delivery price, paid at time T
St : price of underlying asset at time t
ftT : value/price at time t of long position in forward contract with
delivery date T and a given delivery price K
FtT : forward price at time t for delivery at time T , i.e. the value of K
that makes ftT = 0
r : risk-free interest rate over the relevant period, continuously
compounded
I does not have to be the same for all periods and at all points in
time, but that is not clear using Hull’s notation
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
Forwards
Definition (Forward)
A forward is an agreement to buy (or sell) an asset S at maturity T for
a fixed price K .
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
Payoff = ST − K
FtT = St er (T −t) .
FtT = St (1 + r )T −t .
Profit
K ST
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
Futures
• Like a forward
I a future is an agreement to buy (or sell) an asset at maturity for a
contract
I gains and losses are settled each trading day (daily settlements)
∗ T T )
settlement payment at time t for a short position: −(Ft − Ft−1
∗ the futures value immediately after settlement payment is zero
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
Margins
• A margin is cash or marketable securities deposited by an
investor with his or her broker
• The balance in the margin account is adjusted to reflect the
marking-to-market (=the daily settlement)
• Margins reduce the risk of default on a contract
• Initial margin: deposit when the contract is entered into
• Maintenance margin: Minimum balance on the margin account
• If the balance of the margin account falls below the maintenance
the investor gets a “margin call” and has to bring the balance
back to the initial margin
• The level of the initial and the maintenance margin may depend
on the type of trade
• Often some interest rate on the margin account
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
T-bills futures
• Call for delivery of a cash T-bill with $1 million in face values of
IMM index with 90 to 92-days maturity on CME
• Delivery occurs in March, June, September, December
• Treasury Bills and money market instruments are often quoted
using a discount rate: the interest earned as a percent of the final
value (principal) rather than of the initial price paid for the
instrument.
• The discount rate (d) is caculated as,,
F −p 360
)x( ) (
F t
where F is the face value, p is the quoted index price (points).
One basis point is 0.01%
• T-bill future calculations assume a 90 days maturity and a 360
days per year
• the Bond Equivalent Yield (BEY) is,
F −p 365
( )x( )
P t 15 / 50
Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
if d = 6%, t = 90
90
FT −bill = 1, 000, 000[1 − 0.06( )] = 985, 000
360
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
1, 000, 000x0.0001x90/360 = 25
90
FT −bill = 1, 000, 000[1 − 0.061( 360 )] = 984, 975, a loss in 25
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
• Call for delivery bonds that has a maturity of more than 15 years
(not callable) traded on the Chicago Board of Trade (CBOT)
• Contracts for four maturity dates per year: March, June,
September, December
• One contract involves the delivery of $100,000 of face value of
the bond.
• The quoted price for treasury bond is for a bond with a face value
of 100,
• Treasury bond futures are quoted in dollars and 32nd of a dollar,
I Example : a quote of 90-05 indicates that if the bond has a face
value of $100,000 its price will be (90+5/32)x1,000 = $90,156.25
(note that you might also see the quote expressed as: 151-20/32)
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
Eurodollar Futures
• The 3-month Eurodollar futures contract is the most popular
interest rate futures contract in the US.
• A Eurodollar is a dollar deposited in a bank outside the United
States (can be a US or foreign bank).
• A 3-month Eurodollar futures contract is a futures contract on the
interest that will be paid (by someone who borrows at the
Eurodollar interest, same as 3-month LIBOR rate) on $1 million
for a future period of 3 months.
• Maturities are in March, June, September, and December, for up
to 10 years in the future.
• One contract is on the rate earned on $1 million
• A change of one basis point or 0.01% in a Eurodollar futures
quote corresponds to a contract price change of $25
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
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Introduction to Forwards and Futures What are derivatives?
Using forwards and furutres in the Asset Liability management Introduction to the Forwards and futures
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
The basic rule for using short-term interest rates futures to hedge
interest rate risk:
• Using the long position to lock future investment yields (Long
Hedge).
I Avoiding lower than expected yields from loans, buy futures and
then cancel with a subsequent sale of similiar contracts
• Using the short position to lock future borrowing costs (Short
Hedge)
I Avoiding higher borrowing cost (against interest rate increases),
sell futures and then cancel with a subsequent purchase of similiar
contracts
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
Basis
Not always possible to find a forward/futures contract that gives a
perfect hedge due to the basis risk
Basis risk: uncertainty about the basis when the hedge is closed out
• Mismatch in dates, types, and positions, etc.
I Example: you need to hedge a position in eight month CDs, but the
future contracts are only aviable in six or nine month maturity
• Need to calculate the hedging ratio
In relations to the balance sheet, the basis risk refers to the
dfifferences in the price sensitivity to interest rates in the two markets
• certain depositors are unresponsive to the spread between
interest rates on deposits and open market interest rates
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
Microhedge:
• Protects specific positions against unfavorable movements in
interest rates
• Reduces risk of individual assets and liabilities
h∗ VA
N∗ =
VF
where h∗ is the hedging ratio, VA is the value of the position being
hedged, VF is the value of one future contract
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
ρ∆E
N∗ =
∆F
• where ρ is the cash and future correlations, ∆E is the equity
values, ∆F is gain and loss per futures contract, N is the number
of future contracts:
I a negative N indicates a short position and
I a positive N is a long positions
I a perfect hedge implies ρ = 1
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
183
10, 000, 000[(0.062)( )] = 315, 167
360
183
10, 000, 000[(0.0825)( )] = 419, 375
360
• How does the First Place would like to lock in the Certificate
Deposit interest rate expense at 6.2 ? BlackBoard Demonstration
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
Table 13.4 First place financial corporation’s six month CD roll over
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
Still, lending institutions favor floating rate over fixed rate loans
• Floaters help to match up the repricing of asstes and liabilities
• Customers tend to favor fixed rate loans to avoid uncertainties
about the future interest rate expense
• Use the forward rate to hedge the fluctuations in future interest
rate in a floating rate loan
• Implies the links between short term financial market to the fixed
rate long term loan
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
BEY is Calculated as
90
Price = $1, 000, 000[1 − 0.0625( )] = $984, 375
360
Discount = $1, 000, 000 − 984, 375 = $15, 625
15, 625 365
BEY = × = 6.437%
984, 375 90
Day counts for quarters following December 17, March 1June 17 and September 16 are 90,92,92
and 91.
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
This rate implies an important link between the short term financial
market to the pricing of the fixed rate longer term loans.
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
ˆ
Dec ˆ
March ˆ
June ˆ
Sep
Borrow:
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
(Blackboard calculation)
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
• One percent increase in interest rates, the equity will decrease ∆E = −5.55m
• Firms with a positive duration gap (positive equity duration), Rising interest rate
produces a loss—liability sensitive (be aware of the typo on Hempel &Simonsson
(1999), P551, second paragraph, second line, the asset should be liabiity, the last
word “asset” of the thrid line should be asset)
• Firms with negative duration gap (negative equity duration), falling in interest rate
produces a loss—asset sensitive
• Future contracts can be used to macrohedge the loss when interest rate
rises/falls
• The most liquid and liquid futures are those for 20 years treasury bonds and 91
days Eurodollar CDs
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
∆E 5, 550, 000
N=− =− = −2220
∆F 2500
Why 2500 here?
One bps change in bond quote corresponds to a gain or loss of
25 per contract, 100 bps is 2500
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
4r
4F = −DF [ ]Fp
(1 + r )
where Fp = futures contract price, and Df = duration of futures
contract
• Substituting ∆E and ∆F into N = − ∆E∆F , we get,
∆F (N) = ∆E
∆r
= −DF ( )(FP )(N)
1+r
+0.01
= −7.49[ ](111, 281.25)(−732)
1.1
= 5, 546, 541
interest
I basis risk
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
∆E(ρ) = N ρ ∆F
∆E(ρ)
Nρ =
∆F
where ρ = the future and equity correlations, N ρ is the number of
futures modified by ρ
• In the previous example,
∆E(ρ)
Nρ = ∆r
−DF [ 1+r ]FP
5, 550, 000(0.8)
= 0.01
−7.49[ 1+0.1 ]111, 281.25
= −585.5
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The microhedging with forwrds and futures
Introduction to Forwards and Futures The basis risk and optimal hedging ratio
Using forwards and furutres in the Asset Liability management Microhedge
Macrohedge: Duration based hedge
Reading materials
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