Posted: September 13th, 2017

Protecting the Bank's Income and the Value of Equity

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Use the following book as a reference for your answers:

Text: Koch, T. W. and S. S. MacDonald, Bank Management, Seventh
Edition, South-Western. 2010

Choose 5 of the following 7 questions.

1. How many 90-day Eurodollar futures contracts should a bank purchase
to hedge the roll-over of a 6-month, $20 million loan if loan rates
and Eurodollar rates have the same volatility?

2. Assume that two firms, one considered a high credit risk (HCR) and
the other a low credit risk (LCR), are considering an interest rate
swap. Each can borrow at the following rates:

Fixed Rate
Variable Rate

LCR
8%
LIBOR + 1%

HCR
12%
LIBOR + 3%
Parts (a), under what conditions would these two firms enter into a swap?

Part (b), how would you construct a swap for these two firms?

Use the following bank information for questions 3 – 5.

3. What is the weighted average duration of assets?

4. What is the bank’s duration gap?

5. What is the bank’s weighted average cost of liabilities?

6. What is the difference between a forward contract and a futures contract?

7. Suppose you are a jewelry manufacturer and you are planning to
purchase a large amount of gold in 5 months. How would protect your
cost of material? Will you always be able to hedge your position?

Class Notes

The concept of hedging
What is hedging?
Hedging is buying or selling a financial contract to protect the value
of a security or investment.

What makes a hedging instrument?
A hedging instrument is one who’s value move in the opposite direction
to the price of the security you are trying to protect. If the value
of the security decreases, the value of the hedging instrument
increases and the opposite is true. The net result is that the total
wealth is protected. An everyday life example of a hedging instrument
is the spare wheel in the trunk of your car. While driving, the four
wheels on the ground are valuable and the spare has very low value; it
just occupies trunk space. However, in the case of a blowout, the
damaged wheel drops in value and the spare become valuable. The net
result is the car is still usable.

In this section of the course, we will look at hedging financial
assets, the bank’s income, and the value of equity.

Introduction to hedging instruments

The section of the notes will introduce and explain the cash flows
from the financial instruments used for hedging purposes. The use of
these instruments for hedging will be covered below.

Have you heard of derivative securities, swaps, futures?
What are they?
How do they exist?

Derivatives or derivative securities refer to instruments that do not
exit on their own. These securities are derived from an existing
security. They are bets on the future value of the real securities.
Hence, they are named derivatives. Swaps are contracts where borrowers
exchange or swap, their debt service but not the loans themselves.
Futures contracts are agreements to sell an asset at a future date
with a predetermined price and delivery date regardless of future
market conditions.

If you analyze the above description of these securities, you will see
that they depend on the existence of some other asset or security.
They would not exist without it. Now we will look at them in more
detail.

Derivatives
The two derivative instruments we will look at are puts and calls;
they are also known as options. A put is defined as the option, but
not the obligation, to sell a security or an asset for a particular
price at a certain date. A put is created as a contract between two
parties who bet on the future value of an asset. The person buying the
put is betting that the value of the underlying asset will drop below
the exercise price within a certain period. The person writing the
put, the seller, is betting that the price will either not drop, or if
it does, it will not be that low.

A put has the following features:
The underlying security – a put is a bet that the market value of this
particular security will drop below a certain price within a certain
time period. Let us use XYZ stock as an example.

Exercise price – the exercise price is market value of the underlying
value when the put becomes worth exercising. Let us use $50.

Expiration date – the date the option expires; for European options it
is a date and for American ones it is any time leading to the
expiration date. Let us use 90 days.

Suppose that the current price of XYZ stock is $55. This means if the
price of the stock drops below $50 within the next 90 days, we can
exercise the put. If the price drops to $45 within the 90 days, the
put gives us the right to sell the stock to the option seller for $50.
In this case our minimum selling price is $50. The option seller loses
$5 and our wealth is protected down to $50. If the stock price drops
to only $52, then the option will expire unexercised. Our cost for
this protection is the purchase price of the put. Calculating the
value of the put is beyond the scope of this course.

When the market value of the underlying asset is below the exercise
price of the put, the option is said to be in-the-money. When the
market value of the underlying asset is above the exercise price of
the put, the option is said to be out-of-the-money. When a put is in
the money, its value will increase by $1 for every dollar drop in the
price of the underlying asset. The graph below illustrates the value
of a put.

The other option we need to look at is a call. A call is the option,
but not the obligation, to purchase a security at a particular price
and date. Therefore, the value of a call increases as the value of the
underlying asset increases. Calls can be used to protect the cost of a
security if you are planning to purchase it in the future. An example
of using a call option is a jeweler protecting his cost by buying a
call on gold. Therefore, if the price of gold increases, his materials
cost is protected.

When you look at the above graphs, you will notice that the value of
the option is below but parallel to the line representing the value of
the underlying assets. The reason is that the gap between the lines
represents the cost of buying the option.

The majority of options can be classified as either a call or a put.
If you look at warrants, the option to purchase equity that is
attached to some bonds, they can be classified a call options. The
notes below will demonstrate how many options a bank needs to buy to
protect its securities.

Swaps
To illustrate the point, consider the following example. I have a
$1,000 variable interest loan and you have a similar amount borrowed
with fixed interest. If I prefer to use fixed and you prefer variable
interest rates, we could swap the debt service or payments of our
loans. I will make the fixed payments on your loan and you will make
the variable ones on my debt. We will look at swaps in more details
below.

Futures
A futures contract is the standardized version of a forward contract.
We will first look at forward contract to explain the concept and,
afterwards, we will look at futures.

In a forward contract, the details of a sale of an asset, including
price and delivery date, are agreed upon now while delivery takes
place in the future. I first experienced a forward contract before I
knew what they were. When I was an international student in several
countries, I realized that when I am about to graduate and leave the
country I have to dispose of many of my belongings. The problem arose
when I realized that I still need these things. My friends and I would
make agreements with other people to sell them our cars, typewriters,
and radios. The agreements included the selling price and date of
delivery, but we kept these assets till our departure date. When I
sold my car as an international student, a friend of mine agreed to
buy it for a certain price with a delivery date a month later. Since
we agreed on all the details i
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