Question

Financial institutions use derivatives instruments to hedge their asset–liability risk exposures. The financial institutions` goal is to reduce the value of their net worth that is at risk due to adverse events.

• What are the reasons why a financial institution may choose to hedge its portfolio selectively?
• Substantiate your response with examples

Answer 1

Derivatives are used in Hedging. These are financial tools that derive their value from change in assets like foreign currency. There are three types of derivatives that are used in Hedging: forward contracts, future contracts, and options.

Forward and Futures Contracts

• Spot Contracts
• Forward Contracts
• Futures Contracts

Forward Contracts and Hedging Interest Rate Risk

Hedging Interest Rate Risk with Futures Contracts

• Microhedging
• Macrohedging
• Routine Hedging versus Selective Hedging
• Macrohedging with Futures
• The Problem of Basis Risk

Hedging Foreign Exchange Risk

• Forwards
• Futures
• Estimating the Hedge Ratio

Hedging Credit Risk with Futures and Forwards

• Credit Forward Contracts and Credit Risk Hedging
• Futures Contracts and Catastrophe Risk
• Futures and Forward Policies of Regulators

Derivatives are financial assets whose value is determined by the value of some underlying asset. As such, derivative contracts are instruments that provide the opportunity to take some action at a later date based on an agreement to do so at the current time. Although the contracts differ, the price, timing, and extent of the later actions usually are agreed upon at the time the contracts are arranged. Normally the contracts depend on the activity of some underlying asset.

The contracts have value to the managers of FIs because of their aid in managing the various types of risk prevalent in the institutions. As of September 2003 the largest category of derivatives in use by commercial banks was swaps, which was followed by options, and then by futures and forwards.

In many cases the accounting requirements for the use of derivative contracts have been tightened. Specifically, FASB now requires that all derivatives be marked to market and that all gains and losses immediately be identified on financial statements.

A spot contract is an exchange of cash, or immediate payment, for financial assets, or any other type of assets, at the time the agreement to transact business is made, i.e., at time 0. Futures and forward contracts both are agreements between a buyer and a seller at time 0 to exchange the asset for cash (or some other type of payment) at a later time in the future. The specific grade and quantity of asset is identified, as is the specific price and time of transaction.

One of the differences between futures and forward contracts is the uniqueness of forward contracts because they are negotiated between two parties. On the other hand, futures contracts are standardized because they are offered by and traded on an exchange. Futures contracts are marked to market daily by the exchange, and the exchange guarantees the performance of the contract to both parties. Thus the risk of default by the either party is minimized from the viewpoint of the other party. No such guarantee exists for a forward contract. Finally, delivery of the asset almost always occurs for forward contracts, but seldom occurs for futures contracts. Instead, an offsetting or reverse transaction occurs through the exchange prior to the maturity of the contract.

A hedge involves protecting the price of or return on an asset from adverse changes in price or return in the market. A naive hedge usually involves the use of a derivative instrument that has the same underlying asset as the asset being hedged. Thus if a change in the price of the cash asset results in a gain, the same change in market value will cause the derivative instrument to generate a loss that will offset the gain in the cash asset.

To be short in futures contracts means that you have agreed to sell the underlying asset at a future time, while being long means that you have agreed to buy the asset at a later time. In each case, the price and the time of the future transaction are agreed upon when the contracts are initially negotiated.

The purchase of an interest rate futures contract will add to the risk of the bank. If rates increase in the market, the value of the bank’s assets will decrease more than the value of the liabilities. In addition, the value of the futures contract also will decrease. Thus the bank will suffer decreases in value both on and off the balance sheet. If the bank had sold the futures contract, the increase in rates would have allowed the futures position to reflect a gain that would offset (at least partially) the losses in value on the balance sheet.

A commercial bank plans to issue CDs in three months.

The bank should sell a forward contract to protect against an increase in interest rates.

An insurance company plans to buy bonds in two months.

The insurance company should buy a forward contract to protect against a decrease in interest rates.

A thrift is going to sell Treasury securities next month.

The thrift should sell a forward contract to protect against an increase in interest rates.

A U.S. bank lends to a French company; the loan is payable in francs.

The bank should sell francs forward to protect against a decrease in the value of the franc, or an increase in the value of the dollar.

A finance company has assets with a duration of six years and liabilities with a duration of 13 years.

The finance company should buy a forward contract to protect against decreasing interest rates that would cause the value of liabilities to increase more than the value of assets, thus causing a decrease in equity value.

A microhedge uses a derivative contract such as a forward or futures contract to hedge the risk exposure of a specific transaction, while a macrohedge is an attempt to hedge the duration gap of the entire balance sheet. FIs that attempt to manage their risk exposure by hedging each balance sheet position will find that hedging is excessively costly, because the use of a series of microhedges ignores the FI’s internal hedges that are already on the balance sheet. That is, if a long-term fixed-rate asset position is exposed to interest rate increases, there may be a matching long-term fixed-rate liability position that also is exposed to interest rate decreases. Putting on two microhedges to reduce the risk exposures of each of these positions fails to recognize that the FI has already hedged much of its risk by taking matched balance sheet positions. The efficiency of the macrohedge is that it focuses only on those mismatched positions that are candidates for off-balance-sheet hedging activities.

Selective hedging involves an explicit attempt to not minimize the risk on the balance sheet. An FI may choose to hedge selectively in an attempt to improve profit performance by accepting some risk on the balance sheet, or to arbitrage profits between a spot asset’s price movements and the price movements of the futures price. This latter situation often occurs because of changes in basis caused in part by cross-hedging.

Fully hedging the balance sheet involves using a sufficient number of futures contracts so that any gain (or loss) of net worth on the balance sheet is just offset by the loss (or gain) from off-balance-sheet use of futures for given changes in interest rates.

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.

the bank faces different average interest rates on both sides of the balance sheet, and further, the yield on the bonds underlying the futures contracts is a third interest rate. Thus the hedge also has the effects of basis risk. Determining the number of futures contracts necessary to hedge this balance sheet must consider separately the effect of a change in rates on each side of the balance sheet, and then consider the combined effect on equity. Estimating the number of contracts can be determined with the modified general equation shown on the next page.

Basis risk is the lack of perfect correlation between changes in the yields of the on-balance-sheet assets and the changes in interest rates on the futures contracts. The reason for this difference is that the cash assets and the futures contracts are traded in different markets.

The fund manager fears a fall in interest rates 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.

A sufficient number of futures contracts should be purchased so that a loss (profit) on the futures position will just offset a profit (loss) on the cash loan portfolio. If there is perfect correlation between the spot and futures prices, the number of futures contracts can be determined by dividing the value of the foreign currency asset portfolio by the foreign currency size of each contract. If the spot and futures prices are not perfectly correlated, the value of the long asset position at maturity must be adjusted by the hedge ratio before dividing by the size of the futures contract.

Gains from futures contract positions typically are received throughout the life of the hedge from the process of marking-to-market the futures position. These gains can be reinvested to generate interest income cash flows that reduce the number of futures contracts needed to hedge an original cash position. Higher short-term interest rates and less uncertainty in the pattern of expected cash flows from marking-to-market the futures position will increase the effectiveness of this process.

The hedge ratio measures the relative sensitivity of futures prices to changes in the spot exchange rates. This ratio is particularly helpful when the changes in futures prices are not perfectly correlated with the changes in the spot exchange rates. The hedge ratio is a measure of the basis risk between the futures and spot exchange rates.

A common method to estimate the hedge ratio is to regress recent changes in spot prices on recent changes in futures prices. The degree of confidence is measured by the value of R² for the regression. A value of R² equal to one implies perfect correlation between the two price variables. The estimated slope coefficient (b) from the regression equation is the estimated hedge ratio or measure of sensitivity between spot prices and futures prices. A value of b greater than one means that changes in spot prices are greater than changes in futures prices, and the number of futures contracts must be increased accordingly. A value of b less than one means that changes in spot prices are less than changes in futures prices, and the number of futures contracts can be decreased accordingly.