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					Managing Interest Rate &
  Exchange Rate Risk
          Hedging and Speculation
• Part of operating a bank’s securities portfolio is to
  hedge the risks inherent in a bank’s balance
   – Hedge: Take a position in the securities markets to
     offset risk associated with portfolio or balance sheet
   – Many hedges are derivatives (a financial instrument
     whose value is determined by specific features of the
     underlying asset or investment).
      •   Forwards
      •   Futures
                            Speculators trade to take on
      •   Options
                            risk and make profits.
      •   Swaps
            Futures & Interest Rate Risk
    • Banks and other investors use these
      derivatives to insure against interest rate risk.

                                                          CME   10-year Swap Rate
Agricultural        Interest Rates
                                                          CME   13 Week US T-Bill
Corn                30 Year U.S. Treasury Bonds
                                                          CME   2-year Swap Rate
Ethanol             10 Year U.S. Treasury Notes
                                                          CME   5 Year Eurodollar Bundle
Oats                5 Year U.S. Treasury Notes
                                                          CME   5-year Swap Rate
Rough Rice          2 Year U.S. Treasury Notes            CME   Consumer Price Index
Wheat               10 Year Interest Rate Swap            CME   Eurodollar
Soybeans            5 Year Interest Rate Swap             CME   Euroyen
Soybean Meal        30 Day Federal Funds                  CME   Euroyen-LIBOR
Soybean Oil         10 Year Municipal Note Index          CME   Eurozone Harmonized Index of Consumer Price
Soybean Crush       mini-sized Eurodollar                 CME   Fed Fund Turn Rate
                    mini-sized Defered Month Eurodollar
South American Soybeans                                   CME   Japanese Government Bond
mini-sized Corn                                           CME   LIBOR
mini-sized Wheat                                          CME   Mexican 28 Day TIIE
mini-sized Soybeans                                       CME   Mexican 91 Day Cetes
                       Interest Rate Futures
• Each contract specifies:
    – A delivery date.
    – A type of asset (including maturity and, if
      appropriate, a coupon rate)
          • Maturity date means # of periods from delivery
            date to maturity date.
    – A fixed quantity (referring to face value).
    – A sale price for the future
    –Unit US T-Bill Futures
CME 13Additional Details
               3-month (13-week) U.S. Treasury Bills having a face value at maturity of $1,000,000
Contract Listing    Mar, Jun, Sep, Dec,
                   Futures Price
• For original interest rate derivatives, the future
  price is a contractual price for actual delivery of
  some security
• In efficient markets theory, the price of a future is
  the market’s forecast of the spot rate on the
  underlying security at the expiration date.
   – If buyer expects spot price to be lower, wait and buy in
     spot market.
   – If seller expects spot price to be higher, wait and sell in
     spot market.
    Instruments Less than 1 Year
• Deposit-like Money market instruments such as
  Negotiable CD’s, Eurodeposits, etc. are often
  quoted with a 360 day year with face value
  determined by initial deposit.
• Assume that the maturity is D days with a yield
  of d360 . At the beginning, the investor will pay
  Face. At the end of D days, the issuer will pay
  initial Face plus interest
                      Payoff  (1  d 360        )  Face
• To calculate true annualized yield, convert to a
  365 year                           365 
                                                         Days 

                       360 365             d365     
             d 365   d       ; i  1+                             1
                           360          365      
                                           Days  
  Instruments Less than 1 Year
• Yields for discount bonds sold at a price in
  money markets are usually reported on a
  discount basis: d 360   Par - Price  360 ;
                                      db                       
                                                  Par           D

• Calculate Bond equivalent rate &
  annualized yield
                                                          365      
                                                        
                                                              Days 

                   360 365 Par                d365     
        dbe     d db           ; i  1+      be
                                                                       1
                        360 Price          365      
                                              Days  
• You buy a 91 day Eurodeposit for $1
  million. Broker quotes you a rate of 10%.
  Par value is

                              91 
           Par  $1 1  .1       1.025277778;
                             360 
           d  .1
                          0.101388889
                0.101388889          91

           i = 1+                          1  0.105313096
                   365      
                       91 
• You buy a 91 day
  Exchange fund bill
  with a face value of
  $1 million. Broker
  quotes you a rate on
                                      Par - Price  360  1 - Price  360
  a discount basis of    d db  .1  
                                                                      
                                          Par       D       1       91
  10%. Price is          Price=1-(.1
                                           )  0.974722222
                                    365         1
                         dbe  .1
                                                        0.104018239
                                    360 0.974722222
                                  0.104018239          91

                         i  i = 1+                          1  0.108150428
                                     365      
                                         91 
             Describing the Price
• ST-Bond Derivatives: Seller must deliver bonds
  with designated face value and maturity. Buyer
  must deliver some money. That money is the
  futures price. The framework that the buyers
  use to describe this price is the implied bankers
  discount yield d*.
  – Posted Price: 100∙(1-d*)
                                        d  Days
  – Actual Price: Contractual Volume∙(1- 360 )

  – Negative relationship between actual yield in the
    spot market and the ultimate profitability of the
    future to the buyer.
On February 6th, the listed price of a 90 day Tbill
  future was with delivery at end of Feb. was
• This implies d* = .044. Given Days = 90, the
  actual price was $1,000,000*(1-.011)=
• Assume that by end of February, discount yield
  on spot 3month Treasuries is d* = .048. Then
  the spot price would be US$988,000.
• Buyer of future having locked in a higher price,
  would then sell cheap Tbill in spot market losing
     Interest Rate Derivatives
• Interest Rate
  – Some interest futures are not based on actual
    bond, but are based on interest rates in
    interbank or time deposit markets.
  Problem: No bond to deliver.
  – At settlement, no actual financial instrument
    changes hands. Instead, an artificial security
    is created using the interest rate as d.
  – If the actual interest rate is different from d*,
    then buyer/seller exchange cash with
    clearinghouse on the difference.
• On February 6th, the price of a 3 month Euro
  deposit future with delivery at end of Feb. was
• This implies d* = .044. Given n = 90, the actual
  price was $1,000,000*(1-.011)= US$989,000.
• Assume that by end of February, Euro deposit
  rate is d = .048. Then the spot price would be
• Buyer of future must pay 1000 to clearinghouse.
• Two types of contracts
                                                    HK: HKEX: 3 Month HIBOR Futures: 3rd Month: Settlement Price
                                                                           Basis point


  on HK EX                      98

•1 Month HIBOR                  96

HKEX Website                    94


•3 Month HIBOR                  90

HKEX Website

                                     25-May-1998       24-Apr-2000               25-Mar-2002              23-Feb-2004         23-Jan-2006

                                                   HK: HKEX: 3 Year Ex Fund Note Futures: 1st Mth: Settlement Price


 •3 Year Exchange Fund Bonds   111


 HKEX Website                  109







                                     25-Mar-2002   30-Dec-2002          6-Oct-2003         12-Jul-2004          18-Apr-2005   23-Jan-2006
         Positions: Short vs. Long
• A long position: When the bank (or other investor)
  buys a future contract (i.e. promise to pay a
  certain price for the contracted volume of
  securities upon delivery).
   – A long position in treasury bill futures hedges against
     the risk of an interest rate fall. If interest rates fall, bond
     prices rise. The owner of a long position will be able to
     buy securities at less than their market price.
• A short position: When the bank (or other
  investor) sells a future contract (i.e. promises to
  deliver the contracted volume of securities upon
  payment of a predetermined price).
   – A short position in treasury bill futures hedges against
     the risk of an interest rate rise. If interest rates rise,
     bond prices fall. The owner of a short position will be
     able to sell bonds above the market price making
           Example: Short Hedge
• Deposit rates/ExFundbill rates are 5%. A bank
  finances a 2-year 7% loan $1,000,000 with 1
  year time deposits. NIM = 2%, NII = $20,000
   – This creates interest rate risk: if interest rates rise,
     NIM will narrow. What if bank wants to insure against
     the possibility that interest rates will rise to 7% which
     would eliminate NII?
• Clearing House offers 1year HIBOR future with
  volume of $1,000,000 at rate of 95 (i.e. d* = .05).
   – Take a short position on 1 contract with a delivery
     date of 1 year. {Promise to deliver 1year CD’s w/face
     value of $10000000 in 1 year}. What happens if
     interest rates rise to 7%? What happens if interest
     rate fall to 3%?
               Futures Prices
• Closing Accounts: If investor wants to get rid of
  futures contract, they can settle it at the current
  price of the future rather than wait to settle at the
  spot price on delivery day.
• Margin: Most exchanges require futures markets
  participants to keep a small account at
• Marking to Market: When price changes at the
  end of one trading day to the next, changes in
  the value of open future positions are added to
  or subtracted from the account.
• Option - is an agreement giving its holder
  the right (but not the obligation) to buy or
  sell a specified asset, over a limited time
  period, at a specified price (exercise price
  or strike price) in exchange for a premium
   – Call Options
   – Put Options
• Call Option- an              • Put Option- an
  agreement in which the         agreement in which the
  option writer sells the        option writer sells the
  holder the right to buy a      holder the right to sell a
  specified asset on or          specified asset on or
  before a future date.          before a future date at the
• The buyer of the call          strike price.
  expects the price of the     • The buyer of the put
  asset to increase over the     expects the price of the
  life of the option,            asset to fall below the
  eventually exceeding the       strike price. (i.e. the buyer
  exercise price. (i.e. the      expects interest rates to
  buyer expects interest         rise).
  rates to fall)
                               • The value of the option
• The value of the option        rises as the price of the
  rises as the price of the      asset declines.
  asset rises.
          Floating Rate Loans
• Interest rate on mortgage loans in HK vary over
  time with some base short-term interest rate.
           ytFLOAT  ytBASE  % premium
• In terms of interest rate risk, (though not liquidity
  or credit risk) mortgage loans are short-term
• Banks typically use short-term government bill
  rate, interbank rate, or government discount rate
  as base rate. In HK, banks set their own base
Hedging Practices of HK Banks
              Outstanding Amounts Off Balance Sheet Interest Rate Derivatives



  Mill. HK$


                                                                            Hang Seng


                      Swaps       Futures         Options   Hedging

         Interest Rate Swaps
• One bank may have a comparative advantage in
  raising funds in short-term markets and lending
  in long-term markets. Another financial institution
  may have an advantage in raising funds in long-
  term markets and have short-term investment
• Solution 1: To reduce on-balance sheet interest
  rate risk, each institution may raise funds in
  ways not to their best advantage.
• Solution 2: To trade revenue streams on assets
  and/or cost stream on liabilities.
                    Interest Rate Swaps
 • “Plain Vanilla” Interest Swap
      – Two parties agree on a notional amount of principal
        (which does not change hands).
      – One party will pay the counterparty a fixed interest in
        every period.
      – The counterparty will pay the first a floating interest
        rate as a markup over LIBOR.
      – Only the net difference in interest is actually paid.
SWAP                Futures
OTC                 Exchange Traded
                                                  Exotic Swaps: New
Flexible Size       Standard Sized Contracts   types of swaps invented
and Settlement      Fixed Settlement Days            all the time
Available for       Most are Short-term
Longer Maturities
   Swaps Importance Growing
120000                                                                                                                                          Forward rate agreements
100000                                                                                                                                          Swaps
80000                                                                                                                                           OPTIONS

60000                                                                                                                                           FUTURES














                     (In billions of US dollars)
                Pricing Swaps
• Swaps are subject to counter-party risk.
• Plain vanilla swaps are usually
  intermediated by swaps dealers with good
  – Floating rates are typically 3 month LIBOR.
  – Fixed interest rate payments are the rate of
    Treasury bonds (in HK, exchange fund bills)
    plus some spread.
     • Typically, 3 month Tbills & LIBOR are very close.
• Dealers quote bid & offer
Example from Bank Management
by Koch & McDonald
                                                     Swap Rates
        Term       US Treasuries (%)   Swap Spread   Bid       Offer
        2 years         3.53                42.5          3.95       3.96
        3 years         3.81                64.5          4.45       4.46
        4 years         4.29                66.5          4.95       4.96
        5 years         4.66                57.5          5.23       5.24
        7 years         4.91                69.5           5.6       5.61
        10 years        5.28                  64         5.915      5.925
        20 years         5.5                76.5          6.26       6.27
        30 years        5.73                56.5          6.29        6.3

• If you will agree to pay dealer 3 month LIBOR for 5
  years, he will agree to pay you a fixed rate of 5.23.
• If you will agree to pay dealer a fixed interest rate of
  5.23, he will agree to pay you 3 month LIBOR.
            Bid/Offer Rates on US
                    EURO                 USD                 YEN
    YEARS     BID          ASK    BID          ASK    BID          ASK
      2      4.12          4.15   5.01         5.04   0.91         0.94
      5      4.08          4.11   4.95         4.98   1.3          1.33
      10     4.16          4.19   5.08         5.11   1.74         1.77
      20     4.3           4.33   5.23         5.26   2.22         2.25
      30     4.3           4.33   5.24         5.27   2.41         2.44

• If you will agree to pay dealer 3 month LIBOR for 5
  years, he will agree to pay you a fixed rate of 4.95.
• If you will agree to pay dealer a fixed interest rate of
  4.98, he will agree to pay you 3 month LIBOR.
         Swap Applications
• Microhedge: Hedge a specific Asset or
• Macrohedge: Hedge aggregate rate
  sensitivity. If bank has a positive
  aggregate duration gap, bank can
  synthetically immunize by engaging in Pay
  Fixed/Received Floating Swaps.
              Final Exam
• Thursday, March 27th 9-12pm. Room
• Style: Approximately 25% multiple choice
  problems, 25% short answer problems,
  50% longer problems similar to the
  homework problems.
           Group Project
• Wednesday, March 19thth 9-12am
• 7 projects: 10-20 minutes each
• Powerpoints/slides?
1.   Fan li, Qian Zhiyi, Liu Jielan, Wei Zhenhui, Wei Qian,
     Cui Lu
2.   Wang hongxia, Chan Wanyu, Yang Linfang, Zhang
     Hui, Lam Kit Yung, Chen Qian
3.   Wang Siye, Pao Wing Kin, Xie Xuhong, Deng Qiyan,
     Zhang Jing, Xie Jun
4.   Hu Lin, Hu Xiaoyan, Jin ye, Zhang yan, Chen Shuo
5.   Ye He, Chen Rui, Chan Chi Yeung, Wang Xuan, Lin
6.   Li Ka Man, Zhu Xiaolei, Deng Haibo, Jiang Kun, Pang
     Ming, Leung Wai Yan
1.   Xue, Yuhan; Zhou, Yi; He Miao; Yang Liuqing; Zhou
2.   Debin Xu; Jing Zhang; Xiaoxing Wang; Mao Ye;
     Jingying Yu.
3.   Yang Linyan; Liu Yu; Peng Jia; Xia Yingying; Li Juan;
     Liang Feng
4.   Mu Chen; Fu Binbin; Jing Jing; Penghang Ren; Yichao
5.   Zhao Xin Ho; Danwei Liu; Jing Zhao; Xiao Yin Liu
6.   Yang Zhiming; Zheng Canhao, Lin YuanYuan; Li Yan;
     Yang Guanlin; Liu Shasha
7.   Hao Jie, Li Yu; Jing Sun; Yan Li, Xiang Hong Tang;
     Song Huo Dong