Banking Industry and Managing Funds - Research Paper Example

Banking Industry and Managing Funds Introduction The forecast about an increase in the Interest Rates within six (6) months brought about the need to plan for the bank in response to negative effects on profitability and the Net Worth. However, I am aware of a 2008 study concerning the interest rate hedging practices of banks and bank managers’ level of success in such a risk management in the banking industry, wherein 371 banks were evaluated. “The major finding is that on average managers are not good forecasters. This result suggests that the majority of banks should focus more on the core business (loans and deposits) instead of viewing the asset and liability management as profit center( Pinheiro V.L. & Ferreira, M.,2008,Abstract)”. Hedging Costs would include the funds needed for the Margin Requirement of the transaction. This involves tying up 10 % to 30 % of the total amount of the hedged position. There are commission costs of transaction execution on top of that. And the company that brokered or arranged the transaction will also be paid 1 % to 3 % of the hedging contract for one year. The bank will also incur cost of funds or lost income based on the interest rate factored on those other costs because the funds could be placed to earn interest instead of being paid for hedging. (The Benche, 2010, Web) Options Contracts, on the other hand, which is a right to exchange a fixed amount of one currency for a fixed amount of another within a predetermined period, will cost 3 % to 5 % of the contract value. Macro Hedging, on the other hand, was made very popular by Billionnaire George Soros who utilized the strategy of Global Macro hedging. “Soros assumed (correctly) that the Bank of England would not support the pound participation in the European Exchange Rate Mechanism (ERM) indefinitely by jacking up interest rates in an economy already in recession. Soros made $1 billion overnight when the Bank of England let the British currency devalue( Vardy,N 2010.Web).” Investing on a Hedge Fund, on the other hand, should consider that such an Investment fund is limited to high net worth investors. The bank has to pay a performance fee to its Investment Manager, 1 5 to 2 % management fee to be paid annually, plus 20 % of the returns made from the asset, according to Hedge Funds Studies in 2006. (TopQualityEssays.com, 2009, Web) Following all these information, the given facts of the Case Study were considered to arrive at a logical analysis about a bank that needs to hedge in preparation for a forecasted interest increase within the next 6 months. Assume the bank’s name is XYZ. Presentation of Given & Assumed Data XYZ Bank Balance Sheet Assets: (Only the given data) Treasury Bonds ( 5 yrs.; 6 % ) 7 million Stock 12 million Total Assets = 150 million Duration Gap = 2.2 years Current Base Lending Rate = 0.5 % Formula Application: I or i = interest rate ; Ic = change in the interest rate Dur = duration Pc = percentage change in market value of the Asset Pc = - Dur x Ic / [ 1 + i ] Treasury Bond Value will decline by Pc = -2.2 x 1 % / 1.06 = -0.02075 -0.02075 x 7,000,000 = - 145,283 Market Value of Treasury Bonds after increase in interest by 1 % = 7,000,000 – 145,283 = 6,865,716 -2.2 x 1 % / 1+ 0.5 % = - 2.189 % = Pc 150 – (2.189 % x 150) = 146.7165 million net value of Total Assets after a 1 % increase in the i Value of Total Assets will decline by 3.2835 million. Assumption: Base Lending Interest Rate is 0.5 % Assuming Given additional Info: Interest-Rate Sensistive Assets = 90 million Interest-Rates Sensitive Liabilities =120 million Futures Contract average change in the Interest Rate = 0.90 Economic Forecast = within the next 6 months, the average interest rate will increase Historical relationships between Treasury bond futures contracts and Treasury bonds indicate that the change in the value of the hedged asset relative to the futures contract would be about 1.3 To meet the SAS assignment to set up a Micro Hedge and a Macro hedge, the following analysis was done. Micro Hedge for the Treasury Bond ( Alternatives) A. Interest Rate Forward Contract XYZ Bank can set up a Forward Contract for the Treasury Bonds with the 6 %,with another Financial Institution that needs to cover for its Short Position, with the agreement of a buy back after 6 months at the same Principal amount. B. Financial Futures Contracts If the amount will be too big, XYZ can enter into a Futures Contracts which allows for 100,000 standardized face value of Treasury Bonds to be sold. One contract of Treasury Bond is 100,000. The market for Financial Futures Contracts is larger than the market for Forward Contracts. And the standard delivery dates are set to be the last business days of March, June, September, and December. After the Futures Contract has been sold, or bought, it can be traded again at any time until the delivery date. In contrast, forward contracts cannot be traded once there has been an agreement. The Stock Assets of the bank should likewise be hedged in order to increase the ability of the bank to raise its means to gain access to instruments that will earn higher interest when the rates go up. Since the hedged asset has a 1.3 value compared to one that is not hedged, the best recourse is to similarly enter into Futures Contracts for the duration of the projected rate increases which could be 6 months to a year. If the bank purchases an Option to hedge the Stocks, it buys the right but not the obligation to either buy or sell something in the future. It will be “based on the underlying futures market, which in turn is based on the cash market (Thomson Delmar Learning. Slide 2).” “Options are strong contracts and can be re-traded. The initial Buyer has three choices: exercise, let expire, or re-trade by selling. (Thomas Delmar Learning, Slide 4)” When the bank sells Stock Options through traders, there is a Model called the BSOPM or Black-Scholes Options Prising Model developed for European Options on stocks. There are many variables involved in the proper trading of Stocks in order that the owner will earn. One of the advantages is that the Option can be hedged to a certain price, considering that there are several Strike Prices to choose from. “Put Option hedgers can subtract the premium from the strike price and derive the price floor, known as the target price (Thomson Delmar Learning, 2007, Slide 25 ).” The 12 million worth of Stocks can then be made an underlying financial instrument of Futures Options to reap income instead of passively losing with the Stocks value in case the profitability of the business behind the Stocks goes down due to increase in the interest rate. The increase will mean higher cost of borrowing for businesses. Computation of the Number of Future Contracts for hedging: Treasury Bonds = 7,000,000 / 100,000 = 70 FCs Stocks = 12,000,000 Equity, 1 Contract = 200,000 Treasury Bond futures contracts 1 % increase of Interest on Treasury bond results in decline in value of the Treasury Bond. Potential Opportunity Loss on Treasury bond = 70,000 / year aside from the decline in the value of the Treasury Bond which should be computed as follows: Pc = - 2.2 x 1 % / 1 + 6 % = - 2.0755 % 2.0755 % x 7 million = -145, 283 decline in market value of the TB Opportunity Loss + Decline in Market Value = Total Loss as a result of increase in the interest rates by 1 % for both the Treasury Bonds and the Market Value of the Treasury Bonds. What is the opportunity loss ? If the bonds should carry 1 % higher interest, the bank should be making 1 % income more than the 6 %. Thus, 1 % of the Face Value is 70,000. 70,000 + 145,283 = 215,283 will be the total loss for every 1 % increase in the interest rate affecting the Treasury Bonds. But for the risk of loss from Total Assets, the loss due to decline in Net Worth was computed at 3,283,500 excluding the opportunity loss on Treasury Bonds with a fixed 6 % rate. One Contract of Treasury Bond is 100,000 One contract for Equity is 200,000 Hedged Asset Value Relative to the Futures Contract = 1.3 XYZ Bank had purchased Treasury Bonds amounting to 7 million. There is exposure to the risk of decline in the value of those bonds when the Interest Rate increases by 1 % for Treasury Bonds with 8 % interest . That means there will be a bigger decline in the value of XYZ Bank Treasury Bond since it carries an interest of only 6 %. Before that happens, the bank should be able to compensate for that loss of value by hedging the long position with a short position asset. “The first step in assessing interest-rate risk is for the bank manager to decide which assets and liabilities are rate sensitive, that is, which have interest rates that will be reset (re-priced) within the year ( Mishkin & Eakins, 2006 p.642).” In this scenario, the bank’s fixed rate assets include the Treasury Bonds worth 7 million. But given additional information about 90 million interest rate-sensitive assets, and 120 million rate-sensitive liabilities, another set of computations have to be shown. RSA-RSL = 90-120 = -30 million 30 million x 0.01 = 300,000 potential loss Questions & Answers: 1. If you expect interest rates to increase, what types of hedge should you set up, long or short ? And why ? Answer: Long “If a financial institution has more rate-sensitive liabilities than assets, a rise in interest rates will reduce the net interest margin and income, and a decline in interest rates will raise the net interest margin and income(Mishkin & Eakins, p.623).” Given the additional information concerning rate-sensitive assets and rate-sensitive liabilities, wherein XYZ Bank has 120 million liabilities and 90 million assets, the rise in the interest rates will reduce income if there will be a lack of Long Position Assets that earn higher income. By definition, hedging is engaging in a financial transaction to reduce risk by offsetting a long position with a short position or by offsetting a short position with a long position. If the Financial Institution (FI) bought a security and has therefore taken a long position, it can hedge by contracting to sell that security (which is a short position) at some future date. Alternatively, if it has taken a short position by selling a Security that it needs to deliver at a future date, then it conducts a hedge by contracting to buy that Security ( or take a long position) at a future date. (Mishkin & Eakins, 2006, p. 639) In this case, Treeasury Bonds that will mature after 5 years and bearing 6 % is a long position that needs to be balanced by a short position to protect its value from increases in the interest rates of Treasury Bonds. XYZ Bank can enter into a contract to sell the Treasury Bonds at a future date ( which should be before the interest rates increase ). The initial stage should be to sell the Treasury Bonds at par value on a future date. It is best to immunize the bank’s Total Assets with Futures Options for the purpose of a macro hedge. First of all, by having a macro hedge, the value of the assets will be 1.3 times the value of the same asset without any hedge. Another advantage of the Futures Options is the availability and low cost of trading per 1,000,000 Eurodollar for example. “The Eurodollar Futures Contract, developed and introduced by CME in 1981, represents an interest rate on a three-month deposit of $ 1 million. The Eurodollar futures contract is now the most actively traded futures contract in the world (Infinity Trading Corp., Web)” Option premiums are the amounts that have to be paid in order to acquire the option. They are also known as the option prices and should not be confused with the strike price which refers to the price of a financial instrument. Table 1 –Cost of Call Option Premiums (From the Options Guide : Options & Futures Trading Explained, TheOptionsGuide.com) In the above table, strike price (also known as exercise price) is the price at which the holder of an Option can buy. Intrinsic value is the Trading Value of a Stock less the Strike Price. Moneyness, which is also about the relationship of the Strike Price and the Trading Price, depends on whether it is a Call Option or a Put Option. In the above table pertaining to the Call Option, moneyness is said to be in the money when the strike price is below the current trading. If we speak of the Put Option, moneyness is said to be in the money when the strike price is above the trading price. Table 2 – Cost of Put Option Premiums illustrates a sample of that situation. There is a length of time to exercise the right to buy or sell at a certain strike price. And there is an expiration as well. “The option expiration date is the date on which an options contract becomes invalid and the right to exercise it no longer exists(TheOptionsGuide.com, Web).”. Table 2 – Cost of Put Option Premiums (From the Options Guide : Options & Futures Trading Explained, TheOptionsGuide.com) Perhaps the major problem of hedging with Futures Options might be the need to find a conservative and reliable broker with a track record of usually gaining. To trade, there is a minimum deposit required to open a trading account. If the trading will be done in cash, only about $ 2000 will be needed to open a margin-enabled account. But if the trading will be done in stocks or any existing holdings, the brokerage will require a substantial margin requirement which can be in the millions of dollars, to allow a company to trade. There are so many variables involved in a typical Options trading. A trained professional broker will be necessary. It used to be dependent on the telephone communications with a broker. Nowadays, the online broker provides a more accurate and documented way of trading to avoid unnecessary miscommunications and costly mistakes. But it is possible for the bank to send its own qualified and trusted broker on the trading floor. 2. What is the hedge ratio for the micro hedge based on the information you have gathered in the scenario? By definition, the hedge ratio is the value of the asset protected by a hedge divided by the total asset. Considering only Part A of the instructions wherein no liability has been discovered although it was assumed for purposes of computations that the rate-sensitive liabilities amounted to 120 million and the rate-sensitive assets amounted to 90 million, the Treasury Bonds were recommended for hedging. And a macro hedge was also recommended. That brings the hedge ratio to 157 million / 150 million or 1.0467. 3. How many futures contracts are needed to set up a complete hedge based on the information you have gathered in the scenario ? For the Treasury Bonds, 70 contracts are needed for a micro hedge. For the macro hedge worth to protect the Bank’s Net Worth ( Total Assets minus Liabilities ), I have to make the assumption that there are no other liabilities other than the rate-sensitive liabilities. Thus, 150 million - 120.million = 30 million. Since each Equity Contract is worth 200,000 , the number of contracts needed would have to be 30 million / 200,000 = 150 contracts for the macro hedge. With this alternative, a total of 220 contracts will be needed. But if the decision is to hedge the Total Assets, 150 million / 200,000 = 750 contracts will be needed for the macro hedge alone. With this alternative, a total of 820 contracts will be needed. 4. If interest rates on the Treasury bonds rise by 1%, what would be the change in the value of the bank's a. Treasury Bonds ? b. Treasury Bond Futures Contracts ? Assuming a duration gap of 2.2 years, if there will be no hedge, the value of that Treasury Bond will go down to 6,846,770. -2.2 x 1 % / 1+ 0.6 % = - 2.0754 % = Pc ( 1 – 0.029754 ) x 7 million = 6,854,717 But because there will be Futures Contracts, the income as a result of the futures contracts will offset the decline in the value of the Treasury Bonds. When delivered to a buyer, it would have a price at the same old value because that will be the agreed upon price at the time the contract was signed by both parties. The Treasury Bond Futures Contracts will have a market value of its own if and when traded. To trade it, there is a need to provide the fixed amount plus a margin requirement to be placed in a Margin Account. 5. If the bank can set up £150 million in futures contracts whose underlying bonds have an average duration of 2.20 years, what would be the change in the value of the bank's a. Market value of net worth (without the futures contracts)? b. Macro hedge position? c. Market value of net worth (including the effects of the futures contracts)? (a) Without the Futures Contracts, the net worth will definitely decline when the interest rates increase and depending on how much is the interest change. Instead of realizing a 1.3 or 130 % Net Worth Value due to the hedged assets, opportunity loss will be incurred and the bank’s profitability will suffer, thereby resulting in a decrease in the Net Worth. For example, the value of the Treaury Bonds will definitely be lower if and when Treasury Bonds in the market bear a higher interest rate than the 6 % of the XYZ bank’s bond. Assuming Duration Gap is 2.2, there ia a need to compute for the Interest Rate Exposure. IRE = 30 million x 1 % = 300,000 ; NWc = Change in Net Worth; D = Duration Gap; K = L/A = 120/90 = 4/3 = 1.333 ; A is the size of the Asset ; L is liability. NWc = - 2.2 k x A x [ Ic / 1 + .06 ] = - [ 2.2 x 1.33 ] x 150 x [ 0.01 / 1.06 ] = -438.9 x .00943 = - 4.140566 NWc in millions = - 4,140,566 Net Worth = 30,000,000 – 4,140,566 = 25,859,434 (b) The Macro hedge position will definitely immunize the bank from volatile interest changes whether increase or decrease, Without a macro hedge, an unexpected increase in the interest rates instead of a decrease will result in losses. The Bank Manager will lose his job. (c) With a Macro Hedge and a 1.3 Net Worth value, the opportunities to earn much more than the costs of trading Futures Contracts will be available. But the bank must be careful with those derivatives specially in trading them because a mistake can also lead to a loss. If the bank wants to avoid losses, it should select Futures Options instead for purposes of giving the bank a chance to sell only when it will earn, unlike in a situation without the option to buy or sell, there is lower probability of earning at the right timing. 6. If the bank cannot find a set of futures contracts with the same duration as the bank (2.20 years) but has found enough contracts with a duration of 4.40 years, a. How much of this contract would the bank sell? What I expect to gain is about 4.14 million after the macro hedge if the question refers to a macro hedge. I will then compute his corresponding Net Worth potential gain to reach that much. Assuming it means double, I can advise the bank to sell 15,000,000. But if that computation amounts to recovering the same potential decline in net worth, 30 million will still need to be hedged. Theoretically, however, the bank should sell Future Options equivalent to the amount needed to balance its short position with its long position. In this case, the bank needs to purchase interest rate sensitive assets that will earn more interest to cover for the effect of a rise in the interest rate wherein the company has more liabilities than assets. Rate sensitive liabilities – Rate sensitive assets = 120 Mln – 90 Mln = 30,000,000 ; if the proportion is 2.2 : 4.4, selling 30,000,000 / 2 = 15,000,000 worth of hedge will be needed. b. For a 1% increase in interest rates, what would be the percentage change in the price of the futures contract? The price of a Futures Contract will not be affected by any increase in interest rate because it has an agreed upon interest rate. When Interest Rates increase by 1 %, the Futures Contract which has a specified fixed rate will still have the same value, although its market value (if traded) will be lower since there is an opportunity loss as a result of its having a lower interest rate. To clarify further, “A Futures Contract is a legally binding agreement to deliver or receive a given quantity and quality of a commodity at an agreed price on a specific date or dates in the future… All Futures are traded on an exchange in a controlled, regulated environment where the underlying facts related to the trades, called the Contract Specifications, are set. The buyers and sellers of the commodities meet through the exchange to try and determine the price and location where the buying and selling of the product will take place. With the increase in popularity of online trading, more and more futures transactions take place through electronic trading environments, in addition to the more traditional trading floor arena (Xtentus, pp 1-4).” On the trading floor, the value of a Futures Contract can move only by “a Tick Value””. It should be recalled that Futures Contracts are considered liquid financial instruments, meaning easy to dispose of because of the large market of investors looking for alternative hedge to protect their investments. The value of the Futures Contracts will be the contract size and the current price when traded. c. What would be the decline in the market value of the bank's net worth without the futures contract in place? Without the Futures Contract and given that the Duration Gap is 2.2, assuming further that the Net Worth is 150 million minus 120 million = 30 million, the loss of - 4,140,566 computed considering the factors ( see answer to # 5 a) will be the decline in Net Worth. d. What would be the change in the market value of the bank's net worth with the futures contract in place? With a Macro Hedge, the case fact says there is a trend showing the value of hedged assets to be 1.3 or 130 % relative to the Futures Contract. Note that the case fact mentioned the value of the Hedged Asset relative to the Futures Contract is 1.3 which should be interpreted as 130 % of the actual value of the bank’s Net Worth if the bank decides to go for a macro hedge meaning protect the entire portfolio. 7. How could basis risk result in eliminating the forecasted success of the hedge positions described above? Basis Risk takes place when the change in the hedge price does not match the price of an asset. It can happen in situations when the price of a commodity rises and as a result caused the underlying asset price to be higher. E.g. Cash Settled Oil Futures affected by the price increase in oil ; a farmer who hedge his produce to ensure a definite income only to be ruined by an external cost factor (transportation cost) which increased and reduced his income. “Basis Risk - the risk that a change in prevailing interest rates will change the price of company's or investor's interest-bearing liabilities disproportionate to the price of interest-bearing assets. This would increase liabilities and decrease assets, resulting in a loss ( Farlex, Web).” When hedging against a bond by purchasing a Futures Contract, for example, there is always a risk that the fluctuation in the rates will not be identical. If the hedge realizes a lower price than expected, then the forecasted success will not be achieved. 8. Identify the generally accepted accounting principles that would influence your decision to use hedging strategies. The Principles of Accounting applicable would be the Full Disclosure Concept, the Revenue Recognition Principle, Cost Principle, and Matching Principle. Full disclosure will provide for details in the computation of effects of changes in the interest rate on the bank and the counterpart business with which the Futures Contracts will be set. Revenue Recognition will be difficult to forecast and needs to be done only when the actual income is realized. If there will be evidences of accurate information about the revenue recognition in previous years when similar attempts to hedge were done, perhaps that will serve as basis for saying a computation of revenue is correct. Cost Principle entails recording of the actual costs and expenses incurred in the hedging transactions. This will influence outcome when it comes to Cost-Benefit Analysis between Cost of Hedging and the Income derived from hedging. Matching Principle dictates that the bank should recognize revenue and the corresponding expenses incurred in order to arrive at the revenue. Hedging Income will have corresponding hedging expenses and costs. The objective is to maintain the Net Worth and increase its value by hedging. But if the costs and expenses turn out to be quite substantial, the findings that banks might as well focus on the core business of banking. Deposit and lend in order to earn more might indeed be a simpler way of arriving at a high Net Worth. 9. If on September 5th you see February S&P 500 Index contracts selling for 800, how many contracts must the bank sell to immunize its portfolio against systematic (market) risk? A macro hedge would mean hedging its 150 million assets. Since one contract is 200,000, the maximum for macro would be 750. But since there are Treasury Bonds amounting to 70 contracts more, the bank can accept the offer to have S & P sell 800 Futures Options out of the 820 that can be made available. However, the bank should avoid showing signs of being bearish so that the Net Worth will have a higher value. Prices should be set in such a way that there would be Net Profits. Or it should not sell. The bank does not really need to focus on selling beyond what it needs to have a balanced short position against long position although it can be ready with the option to sell more to earn more, if there is an opportunity. Macro hedging usually takes place with the consent of Top Executives and owners. 10. If the S&P 500 falls by 10% between September 5th and February, what will be the change in a. The market value of the bank's stocks? Answer: Average Beta given was .9, which means the Stock Value will follow the change in market value of Stocks. 10 % decline x 0.9 = 0.9 % or a decline of 9 % in the value of Stocks if S & P 500 index falls by 10 %. b. The market value of the bank's index contracts described in Question 9? Futures Options have alternative prices that the buyer can select from. The market value will be the Strike Price at any given time. This depends on the agreements between the bank and a broker. The good thing about Options is that it is not an obligation but a right to buy or sell. Owners may decide not to buy or sell. c. The market value of the firm's net worth? As per case fact, a hedged asset has 1.3 value relative to the Options Futures (hedge). This is why it is said that the bank is immunized by a macro hedge. Thus, the market value of the bank’s Net Worth should be 1.3Assets-Liabilities . Applying this to the figures, instead of having a Net Worth before decline of 150 Mln-120 Mln = 30 Mln, the new Net Worth will be 1.3 (150) – 120 = 75 Mln for the duration of time that the Total Assets are hedged with Futures Options. 11. Explain how the bank would make use of forward contracts to hedge foreign exchange rate risk if they anticipate an increase in the value of the dollar relative to a foreign currency over the next six months. The bank can simply arrange the Forward Contract to commit itself to purchase dollars at the future time when needed and at the current exchange rate, so that when there might be a change in the exchange ratio with the dollar, there will be no increase in the value of the dollar because there is a contract pre-arranged. For the same amount of dollars to be purchased, there is a pre-arranged amount of foreign currency. 12. Explain how the bank would make use of futures contracts to hedge foreign exchange rate risk if they anticipate a decrease in the value of the dollar relative to a foreign currency over the next six months. The bank can buy Future Options that commit to purchase dollars over the next 6 months. It will incur costs to maintain such an Options to buy. But in the process, when the value of the dollar declines and it is time to buy, the bank will gain. “An option is the right, but not the obligation, to exchange a fixed amount of one currency for a fixed amount of another within, or at the end of, a predetermined period. In effect, it is a forward contract that can be walked away from, where you lose only the cost of the option, which could be 3–5% of the contract value. It therefore has the advantage of limiting the downside, as the maximum cost is known at the beginning, while leaving unlimited profit potential. These options are ideally suited to translations, where the size or existence of the exposure is uncertain, for example tender-to-contract or price list exposures ( Robinson 2010, Web).” Part B. What a Wonderful World A glossary of investment terminologies has been appended to this report, which will be utilized in analyzing alternative financial derivatives used by larger banks. Given the following bank information as follows: Total assets: £150 million Interest-rate-sensitive assets: £90 million Interest-rate-sensitive liabilities: £120 million Duration gap: 2.20 years Primary holdings of concern: £7 million in 6% Treasury bonds at par with 5 years to maturity; £12 million in stock, with an average beta of 0.90 The response to Treasury Bonds to a 1 % rise in the interest rate is 7 % of par, while the change in the price of the futures option contract is 6%. The interest rate on Treasury bonds on average changes by 1.10 percentage points when the interest rate on the Treasury notes futures contract changes by 1%. Value for 1 Contract for Treasury is 100,000. Value for 1 Contract for Equity is 200,000. 1. To protect against a rise in interest rates and a decline in the value of bonds held, how many Treasury bond futures put options (where the strike price is close to the current price) must the firm purchase? Answer: 7,000,000 / 100,000 = 70 contracts 2. If the forecasted rise in interest rates does not occur, can the bank still profit from its position in the Treasury bond futures options purchased in point 1? Yes. Future Options can be traded at a profit before they expire. 3. What is the most significant accounting principles difference between futures and options? The matching principle will be the most significant for recognitions of income and expenses. “This article emphasizes that possible financial risk in international business, like as price risk, credit risk, risk of liquidity, can be hedged using financial instruments, especially derivatives, like as forward, futures, options and swaps. The accounting treatment for these instruments is presented in accordance to the basic principles of hedge accounting imposed by IAS 39 ( Bunea-Bontas,2009, p.2).” Note that IAS stands for International Accounting Standards. “The aim of hedge accounting is to match the accounting effect of the hedged item and of the hedging instrument in profit or loss(Bunea-Bontas, 2009, p. 3).” 4. Given the gap of the bank, how large an interest-rate swap does the bank need to arrange to hedge interest-rate risk and prevent a decline in profits when interest rates increase? Interest-Rate Risk = Pc = Change in the Market Value of the Security Pc = - Dur x Ic / (1 + i ) ; where Dur is the Duration Gap of the bank ; Ic is the Incremental Change of interest rate ; and I = interest NWc = A ( - Dur x Ic / [1 + i] ) = 150 ( - 2.2 x 0.01/ 1.06) = -3,113,207 The financial instrument to swap with should have a potential interest income totalling 3,113,207. Since the bank has more liabilities than assets, it needs to balance with a long position. To cover the potential decline in the Net Worth, worth 3,113,207, the bank can swap some of its fixed rate assets in favour of a counterpart bank that has an excess of rate-sensitive assets, so that there will be a balance in the rate-sensitive assets and the rate sensitive liabilities. This will prevent a decrease in the Net Worth. The difference of 30 million worth of fixed rate assets have to be swapped for rate sensitive assets of another financial institution. Rate-Sensitive Liabilities less Rate-Sensitive Assets = 120 Mln – 90 Mln = 30 Mln. To balance, swap fixed rate assets for rate-sensitive assets. Value should be a total of 30,000,000. 5. You are offered an interest-rate swap in which you would receive interest payments of 1% over the one-year Treasury bill rate for the next five years in exchange for a 7% fixed-rate payment. a. What is the notional principal of the swap? Answer : 30,000,000 worth of fixed rate instruments to swap with rate-sensitive instruments in order to prevent a decline in the Net Worth value using the option to Swap b. What will be the change in net worth as a percentage of assets if interest rates rise 1%? No change. There will be a balance in the short position and the long position. c. What will be the percentage change in the value of the swap if interest rates rise 1%? When there is an increase in the interest rate, the income from rate sensitive assets which will now include the swapped instruments from the counterpart bank, should match the costs of rate-sensitive liabilities, thereby having no effect on profitability. The Swap Contracts will be earning 1 % higher than the income when it was swapped. d. What will be the net change in the value of the firm as a result of a 1% increase in interest rates? No change. The Net Worth will remain the same as a result of the swap. 6. Explain the difference between hedging foreign exchange risk with currency options and currency swaps and doing so using futures contracts. The purpose of hedging foreign exchange risk is to protect the value of assets and liabilities in domestic currency in times when the exchange rates of currencies keep changing. In case there is a decrease in value of a currency, such a decrease will not be actually realized. This is a process. ( Gandhi, Gurvinder S., 2006, p. 260) Currency Options is not a process but instruments that give the owner the right to buy or sell currency at a stated price. The bank has to incur a cost to have such Currency Options. This is one of the derivatives to hedge against foreign exchange risk. Currency Swaps are also derivatives to protect against foreign exchange risks. These are agreements to exchange certain amounts of two different currencies, whereby recurring payments take place. It is different from a currency exchange because Currency Swaps are used for hedging in order to avoid losses when the exchange values change. Futures Contracts are financial derivatives used for hedging that “lock” the value in terms of currency and other terms so that the expected outcome of a transaction will be according to the exact amount of desired currency. There are many types of Futures Contracts: Oil Futures Contracts, Commodity Futures Contracts, Currency Futures Contracts, Interest Rate Futures Contract, Trading Futures Contract, Gold Futures Contracts. The difference between hedging foreign exchange risk with Currency Options and hedging fx risk with Futures Contracts is that the former is hedged with a right to buy or sell the underlying financial instrument within the predetermined period, while the latter is hedged with an obligation, a legal binding agreement to deliver or receive a given quantity and quality of a commodity at an agreed price on a specific date or dates in the future. With the Currency Option as hedge, the Options owner may decide to sell, later buy then sell in order to earn, or just let it expire if not much can be earned from trading it. There is an additional cost to have Options. The maximum loss for Options will be the premium. Hedging with Currency Swaps involve an agreement to exchange currencies with recurring payments while hedging with Futures Contracts involves a specific date. To compute for the income from Currency Swaps, a stream of Cash Flow with a currency needs to be computed at present value and compared with the present value of the other currency’s stream of cash flow. In Futures Contracts, there is only one figure to convert to its present value. Banking Industry and Managing Funds Conclusions Banking Industry is known for conservative practices when it comes to managing funds. While it may be true that forecasted increases in the interest rates within the coming 6 months can be wrong, there would still have to be risk management to balance the long position with the short position. In the given case study, hedging will be necessary. But the alternatives will consist of Interest Rate Forward Contracts for the Treasury Bond, Futures Options for the macro hedge, and/or Swaps. Since the bank will have to tie up Margin Requirements aside from pay for Cost of Options in the event of a Macro Hedge, the bank may decide to simply hedge the Net Worth instead of the Total Assets. A Macro Hedge will require higher up approval. The core business of a bank is with deposits and loans. Naturally, the bank will want to depend more on its profitability from the core business of banking rather than in trading Futures Options. The purpose of hedging is simply to balance the long position with the short position so that the Net Worth value of the company will improve. In this case, with the Rate Sensitive Liabilities of 120 million way above the 90 million Rate Sensitive Assets, the bank needs more Rate Sensitive Assets to be ready for an increase in the interest rate within 6 months. The final recommendation then is to hedge the Treasury Bonds and the Net Worth to save on costs of trading, to maximize profitability, to manage the risk when interest rates change, to maintain and improve the value of the bank’s net worth. Lastly, the bank should continue to focus on its core business of accepting deposits and lending to credit worthy clients while it hedges Treasury Bonds and Net Worth in order to achieve a balance in the long position and the short position of its resources. References: AllBusiness.com (2010). Stock Swap. Business Glossary. AllBusiness.com 1999-2010. http://www.allbusiness.com/glossaries/stock-swap/4956130-1.html Basis Swap Valuation (2010). Derivatives One, 2010. http://www.derivativesone.com/basis-swap-valuation/ . Retrieved 15 Dec. 2010. Bunea-Bontas, Cristina (2009). Basic Principles of Hedge Accounting. MPRA Paper No. 17072, 03 Sept. 2009. George Bacovia University. http://mpra.ub.uni-muenchen.de/17072/1/MPRA_paper_17072.pdf . Retrieved 15 Dec. 2010. Farlex (2004). Put Option. The Free Dictionary. Campbell R. Harvey 2004. http://financial-dictionary.thefreedictionary.com/Put+Option . Retrieved 15 Dec. 2010. Farlex (2004). Basis Risk. The Free Dictionary. Campbell R. Harvey 2004. http://financial-dictionary.thefreedictionary.com/basis+risk . Retrieved 15 Dec. 2010. FinWeb.com (2010).American Options vs. European Options. Internet Brands Company 2010. http://www.finweb.com/investing/american-options-vs-european-options.html . Retrieved 15 Dec. 2010. Gandhi, Gurvinder S. (2006). Hedging Foreign Exchange Risk: Isn’t It Also A Risk ? The Chartered Accountant. Banking & Finance. 2006. http://www.icai.org/resource_file/9968260-264.pdf . Retrieved 15 Dec. 2010. Gatev, Evan & Schuermann, Til, & Strahan, Philip E. (2006). Hedging Bank Liquidity Risk. Proceedings. Federal Reserve Bank of Chicago, pp. 189-203. Gatev, Evan & Strahan Philip E. (2003). Bank’s Advantage in Hedging Liquidity Risk: Theory and Evidence from the Commercial Paper Market. Center for Financial Institutions Working Papaers. Wharton, University of Pennsylvania. Infinity Trading Corp. (2010). Eurodollar Futures and Options. Infinity Trading corp. 2010. http://www.infinitytrading.com/futures/financial-futures/eurodollar-futures . Retrieved 13 Dec. 2010. Investopedia (2010) Stock Option. Investopedia ULC. 2010. http://www.investopedia.com/terms/s/stockoption.asp . Retrieved 15 Dec. 2010. Kolb, Robert W., Timme, Stephen G., & Gay, Gerald D. (1984). Macro Versus Micro Futures Hedges at Commercial Banks. Journal of Futures Markets. Wiley Periodicals Inc. Wiley Co. 4 (1): 47-54. doi: 10.1002/fut.3990040106 Kambhu, John & Schuermann, Til, & Stroh, Kevin J. (2007). Hedge Funds Financial Intermediation and Systematic Risk. Staff Reports. " 291, Federal Reserve Bank of New York. Investor Glossary (2010). Option Premium. Investor Glossary 2004-2010. http://www.investorglossary.com/option-premium.htm . Retrieved 15 Dec. 2010. Mishkin, Frederic S. and Eakins, Stanley G. (2006 ). Financial Markets & Instituions 5th Edition. Pearson International Edition. Print. Moneyterms.co.uk (2010). Basis Risk. Graeme Pietersz 2005-2010. http://moneyterms.co.uk/basis-risk/ . Retrieved 14 Dec. 2010. NYSE Liffe (2010). Trading Days in 2010 – London Derivatives Market. Euronext Derivatives Markets, London Market. http://www.euronext.com/fic/000/053/950/539509.pdf . Retrieved 13 Dec. 2010. Options Trading Tips (2005). Options 101. Options Trading Tips. http://www.optiontradingtips.com/options101/index.html . Retrieved 14 Dec. 2010. Options Trading Tips (2005). Option Trading Tutorials. Option Trading Tips. http://www.optiontradingtips.com/trading/index.html . Retrieved 15 Dec. 2010. Pinheiro, Luis Vasco & Ferreira, Miguel A. (2008). How Do Banks Manage Interest Rate Risk: Hedge or Bet ? Social Science Research Network (SSRN). 21st Australasian Finance and Banking Conference 2008 Paper. Available at SSRN: http://ssrn.com/abstract=1157672 Social Science Electronic Publishing. 30 June 2008. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1157672 . Retrieved 14 Dec. 2010. Riskglossary.com (2010) . Currency Swap. Glyn A. Holton, 2005. http://www.riskglossary.com/link/currency_swap.htm . Retrieved 15 Dec. 2010. Robinson, Steve (2010). To Hedge or Not to Hedge. Financial Risk Management Best Practice. QFinance: The Ultimate Financial Resource. 2010 http://www.qfinance.com/financial-risk-management-best-practice/to-hedge-or-not-to-hedge?page=4 . Retrieved 14 Dec. 2010. Strahan, Philip E. & Gatev, Evan, & Shuermann, Til (2004). How Do Banks Manage Liquidity Risks ? Evidence from Equity and Deposit Markets in the Fall of 1998. NBER Working Papers 10982, National Buureau of Economic Research Inc. Stocks 500 (2010). What is an Options Contract. 2010 Morning Star Inc. http://news.morningstar.com/classroom2/course.asp?docId=145386&page=3&CN=COM . Retrieved 15 Dec. 2010. Sunshine, John & Foster, Nikki ed. (2010). What is a Call Option. WiseGeek. 8 Sept. 2010. Conjecture Corporation. http://www.wisegeek.com/what-is-a-call-option.htm . Retrieved 15 Dec. 2010. The Benche I Your Financial Community. Hedging Practice.4 Oct. 2010 http://www.thebenche.com/315-hedging-practice.html . Retrieved 14 Dec,. 2010. The Options Guide (2010). Options Premium. TheOptionsGuide.com 2010. http://www.theoptionsguide.com/options-premium.aspx#intrinsic-value . Retrieved 13 Dec. 2010 Thomson Delmar Learning (2007). Chapter 6: Options Hedging. A Powerpoint Presentation. Thomson Corporation. 2007. www.delmarlearning.com/companions/​content/1401814417 . Retrieved 14 Dec. 2010. TopQualityEssays.com(2009). The role of Hedge funds in Financial Markets. Financial Markets. TopQualityEssays.com, 2009. http://www.topqualityessays.com/FinancialMarkets.aspx . Retrieved 14 Dec. 2010. Travis (2010). Understanding the Strike Price. LSOT – Learn-Stock-Option-Trading.com . 2009-2010. http://www.learn-stock-options-trading.com/strike-price.html . Retrieved 15 Dec. 2010. Vardy, Nicholas (2010). The Hedge fund Strategy That Made George Soros a Billionnaire. The Global Guru: Uncovering the World’s Secret Bull Markets. 14 Dec. 2010 . http://www.theglobalguru.com/article.php?id=74&offer=GURU . Retrieve 14 Dec. 2010. Xtentus ( 2010). Futures. Swiss Quality Investments. http://www.xtentus.com/dokumente//Futures.pdf . Retrieved 13 Dec. 2010 . Glossary American Options Contract – a right to buy or sell on the Options trading floor that can be exercised anytime before the expiration date. (Finweb.com, 2010, Web) Basis Risk – “The risk that a change in prevailing interest rates will change the price of a company's or investor's interest-bearing liabilities disproportionate to the price of interest-bearing assets. This would increase liabilities and decrease assets, resulting in a loss ( Farlex, Web).” Basis Swap – an exchange of contracts each having their corresponding floating interest rate and the instruments themselves are insensitive to changes in market interest rates Call Option – “A call option is a type of financial instrument known as a derivative. It is basically an agreement between two parties to exchange ownership of a stock at an agreed upon price within a certain time period. The exchange of the stock is optional and the owner of the call option decides whether it takes place (Wise Geek , 2010, Web).” “Cross Currency Basis Swaps - involve exchanging floating rate streams of different currencies These types of basis swaps are far more common as there is an intrinsic value to the swaps. The swaps can either have an exchange of notional on maturity or no exchange of notional, exchanging the notional on the maturity of the swap is the most common form as the swap is used to hedge an offsetting loan/investment which will be repaid on the maturity of the swap (Basis Swap Valuation, 2010, Web). Currency Swaps – involves two different currencies for exchange at a given time; It is utilized to “exploit inefficiencies in the debt market (Riskglossary.com, 2010, Web).” European Option Contract – a right to buy or sell on the Options trading floor that can be exercised only when the expiration date is reached. (Finweb.com, 2010, Web) Exercise or Strike Price – “The strike price (or exercise price) of an option is the "price" at which the stock will be bought or sold when the option is exercised (Travis, 2010, Web).” Interest-rate Swaps – a contract or commitment between two parties to exchange cash flow streams with the same currency but which have income obligations wherein one may contain fixed rate of interest on the commercial loan while the other contains a floating rate. (Riskglossary.com, 2010, Web) Option Contract – is a financial instrument with underlying cash value that is the basis for trading the right to buy or sell ( otherwise known as the Option). (Stocks 500, 2010, Web). Option Premium – “refers to the per-share amount that a buyer pays for an option - for the right to buy/"call" or sell/"put" a security at a specified price in the future. An option premium is a nonrefundable, full payment (not a down payment) for the rights specified in the stock option contract. One pays an option premium regardless of whether or not the option is actually exercised. The option premium often changes, due to fluctuating market conditions and economic variables. An option premium is therefore determined by several factors. The main thing affecting the option premium is the difference between the stock price and the strike price, which is the specified future price. Additional primary factors affecting the option premium include the time remaining for the option to be exercised and the volatility of the underlying stock (Investor Glossary, 2010, Web).” Put Option – is a security that gives investors “ the right to sell a fixed number of shares at a fixed price within a given period…by a certain time in order to protect or hedge an existing investment (Farlex 2004, Web).” Stock Options – “A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date. In the U.K., it is known as a "share option ( Investopedia, 2010, Web)". Stock Swaps –“ trading of stock to enhance portfolio performance and reduce taxes. This practice is followed when the investor has accumulated losses on stocks and sells these stocks in order to use the losses to offset capital gains on other investments, thereby reducing taxable income. Losses incurred in this manner can be used to offset capital gains dollar-for-dollar. For any additional losses, they can be used to offset ordinary income of up to $3000. All excess losses can be carried forward to future years (AllBusiness.com 2010, Web).” Swaps – Just like Future Contracts, these are set for a future eventual exchange. “They involve the exchange of a liability now, with the exchange back at a predetermined future time, and the compensation of the other party for costs in the intervening period. Swaps are used primarily to protect an investment or portfolio of borrowings. They involve a back-to-back loan between companies with a matching but opposite need. What is “swapped” is essentially a series of cash flows (Robinson 2010, Web). Trading Options & Swaps – involves a very liquid market with many buyers and sellers and the Arbitrage that makes sure both parties will fulfil responsibilities and commitments. There are many strategies involved. Traders have enormous amounts of underlying leverage, and are familiar with the many variables and strategies. For a neophyte, Options Trading is very risky .(Options Trading Tips 2005, Web) “By trading options, you can specify your maximum loss upfront and even define specifically where you think the underlying will be trading at by the expiration date (Options Trading Tips,2005,Web).” Read More