Posted: July 23rd, 2015

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 banks duration gap?

5.What is the banks 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 whos 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 banks 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