Module 6
Derivatives Securities, Foreign Exchange Markets, Banks
A. Financial Futures
A financial futures contract is a standardized agreement to deliver or receive a
specified amount of a specified financial instrument at a specified price and date. The
buyer of a financial futures contract buys the financial instrument, and the seller of a
financial futures contract delivers the instrument for the specified price. Many of the
popular financial futures contracts are on debt securities such as Treasury bills, Treasury
notes, Treasury bonds, and Eurodollar CDs. These contracts are referred to as interest rate
futures. For each type of contract, the settlement dates at which delivery would occur are
in March, June, September, and December.
There are also financial futures contracts on stock indexes, which are referred to
as stock index futures. A stock index futures contract allows for the buying and selling of
a stock index for a specified price at a specified date. Futures exchanges provide an
organized marketplace where standardized futures contracts can be traded. The
exchanges clear, settle, and guarantee all transactions. They can ensure that each party’s
position is sufficiently backed by collateral as the market value of the position changes
over time. In this way, any losses that occur are covered, so that counterparties are not
adversely affected. Consequently, participants are more willing to trade financial futures
contracts on an exchange.
Most financial futures contracts in the United States are traded through the CME
Group, which was formed in July 2007 by the merger of the Chicago Board of Trade
(CBOT) and the Chicago Mercantile Exchange (CME). The CBOT specialized in futures
contracts on Treasury bonds and agricultural products, and also traded stock options
(described in the next chapter). The CME specialized in futures contracts on money
market securities, stock indexes, and currencies. The CME went public in 2002, and the
CBOT went public in 2005. Their merger to form the CME Group created the world’s
largest and most diverse derivatives exchange, which serves international markets for
derivative products. As part of the restructuring to increase efficiency, the CME and
CBOT trading floors were consolidated into a single trading floor (at the CBOT) and
their products were consolidated on a single electronic platform, which has reduced
operating and maintenance expenses.
Financial futures are traded either to speculate on prices of securities or to hedge
existing exposure to security price movements. Speculators in financial futures markets
take positions to profit from expected changes in the price of futures contracts over time.
They can be classified according to their methods. Day traders attempt to capitalize on
price movements during a single day; normally, they close out their futures positions on
the same day the positions were initiated. Position traders maintain their futures positions
for longer periods of time (for weeks or months) and thus attempt to capitalize on
expected price movements over a more extended time horizon.
When the futures exchanges were created, they relied on commission brokers
(also called floor brokers) to execute orders for their customers, which generally were
brokerage firms. In addition, floor traders (also called locals) traded futures contracts for
their own account. The commission brokers and floor traders went to a specific location
on the trading floor where the futures contract was traded to execute the order.
Marketmakers can also execute futures contract transactions for customers. They may
facilitate a buy order for one customer and a sell order for a different customer. The
marketmaker earns the difference between the bid price and the ask price for such a trade,
although the spread has declined significantly in recent years. Market-makers also earn
profits when they use their own funds to take positions in futures contracts. Like any
investors, they are subject to the risk of losses on their positions.
Customers who desire to buy or sell futures contracts open accounts at brokerage
firms that execute futures transactions. Under exchange requirements, a customer must
establish a margin deposit with the broker before a transaction can be executed. This
initial margin is typically between 5 and 18 percent of a futures contract’s full value.
Brokers commonly require margin deposits above those required by the exchanges. As
the futures contract price changes on a daily basis, its value is “marked to market,” or
revised to reflect the prevailing conditions. A customer whose contract values moves in
an unfavorable direction may receive a margin call from the broker, requiring that
additional funds be deposited in the margin account. The margin requirements reduce the
risk that customers will later default on their obligations.
The futures exchange facilitates the trading process but does not itself take buy or
sell positions on the futures contract. Instead, the exchange acts as a clearinghouse. A
clearinghouse facilitates the trading process by recording all transactions and
guaranteeing timely payments. This precludes the need for a purchaser of a futures
contract to check the creditworthiness of the contract seller. In fact, purchasers of
contracts do not even know who the sellers are, and vice versa. The clearinghouse also
supervises the delivery specified by contracts as of the settlement date. Futures contracts
representing debt securities such as bonds result in the delivery of those securities at the
settlement date. Futures contracts that represent an index (such as a bond index or stock
index) are settled in cash.
B. Interest Rate Futures Contracts
Interest rate futures contracts specify a face value of the underlying securities
(such as $1,000,000 for T-bill futures and $100,000 for Treasury bond futures), a
maturity of the underlying securities, and the settlement date when delivery would occur.
There is a minimum price fluctuation for each contract, such as 1 =32 of a point ($1,000),
or $31.25 per contract. There are also futures contracts on bond indexes, which allow for
the buying and selling of a particular bond index for a specified price at a specified date.
For financial institutions that trade in municipal bonds, there are Municipal Bond Index
(MBI) futures. The index is based on the Bond Buyer Index of 40 actively traded general
obligation and revenue bonds.
The price of an interest rate futures contract generally reflects the expected price
of the underlying security on the settlement date. Thus any factors that influence that
expected price should influence the current prices of the interest futures contracts.
Participants in the Treasury bond futures market closely monitor the economic indicators
that affect Treasury bond prices, as shown in Exhibit 13.4. Some of the more closely
monitored indicators of economic growth include employment, gross domestic product,
retail sales, industrial production, and consumer confidence. When indicators signal an
increase in economic growth, participants anticipate an increase in interest rates, which
places downward pressure on bond prices and therefore also on Treasury bond futures
prices. Conversely, when indicators signal a decrease in economic growth, participants
anticipate lower interest rates, which places upward pressure on bond prices and therefore
also on Treasury bond futures.
Speculators who anticipate future movements in interest rates can likewise
anticipate the future direction of Treasury security values and therefore how valuations of
interest rate futures will change. Speculators take positions in interest rate futures that
will benefit them if their expectations prove to be correct. Because investors commonly
use a margin account to take futures positions, the return from speculating in interest rate
futures should reflect the degree of financial leverage involved. This return is magnified
substantially when considering the relatively small margin maintained by many investors.
Financial institutions can classify their assets and liabilities in terms of the
sensitivity of their market value to interest rate movements. The difference between a
financial institution’s volume of rate-sensitive assets and rate sensitive liabilities
represents its exposure to interest rate risk. Over the long run, an institution may attempt
to restructure its assets or liabilities in order to balance its degree of rate sensitivity.
However, restructuring the balance sheet takes time. In the short run, the institution may
consider using financial futures to hedge its exposure to interest rate movements. A
variety of financial institutions use financial futures to hedge their interest rate risk,
including mortgage companies, securities dealers, commercial banks, savings institutions,
pension funds, and insurance companies.
The preceding example presumes that the basis, or the difference between the
price of a security and the price of a futures contract, remains the same. In reality, the
price of the security may fluctuate more or less than the futures contract used to hedge it.
If so, a perfect offset will not result when a given face value amount of securities is
hedged with the same face value amount of futures contracts. The use of a futures
contract on one financial instrument to hedge a position in a different financial instrument
is known as cross-hedging. The effectiveness of a crosshedge depends on the degree of
correlation between the market values of the two financial instruments. If the price of the
underlying security of the futures contract moves nearly in tandem with the security
being hedged, the futures contract can provide an effective hedge.
When considering the rising and the declining interest rate scenarios, the
advantages and disadvantages of interest rate futures are obvious. Interest rate futures can
hedge against both adverse and favorable events. Exhibit 13.6 compares two probability
distributions of returns generated by a financial institution whose liabilities are more rate-
sensitive than its assets. If the institution hedges its exposure to interest rate risk, its
probability distribution of returns is narrower than if it does not hedge. The return when
hedging would have been higher than the return without hedging if interest rates
increased (left side of the graph) but lower if interest rates decreased (right side).
Some financial institutions use a long hedge to reduce exposure to the possibility
of declining interest rates. Consider government securities dealers who plan to purchase
long-term bonds in a few months. If the dealers are concerned that prices of these
securities will rise before the time of their purchases, they may purchase Treasury bond
futures contracts. These contracts lock in the price at which Treasury bonds can be
purchased, regardless of what happens to market rates prior to actual purchase of the
bonds.
C. Stock Index Futures
A futures contract on a stock index is an agreement to purchase or sell an index at
a specified price and date. For example, the purchase of an S&P 500 (which represents a
composite of 500 large corporations) futures contract obligates the purchaser to purchase
the S&P 500 index at a specified settlement date for a specified amount. The S&P 500
index futures contract is valued as the index times $250 (see Exhibit 13.1), so if the index
is valued at 1600, the contract is valued at 1600 × $250 ¼ $400,000. Mini S&P 500 index
futures contracts are available for small investors. These contracts are valued at $50 times
the index, so if the index is valued at 1600, the contract is valued at 1600 × $50 ¼
$80,000.
The value of a stock index futures contract is highly correlated with the value of
the underlying stock index. However, the value of the stock index futures contract
commonly differs from the price of the underlying asset because of some unique features
of the stock index futures contract. Because stock index futures prices are primarily
driven by movements in the corresponding stock indexes, participants in stock index
futures monitor indicators that may signal movements in the stock indexes. The economic
indicators that signal changes in bond futures prices can also affect stock futures prices,
but not necessarily in the same manner. Whereas economic conditions that cause
expectations of higher interest rates adversely affect prices of Treasury bonds (and
therefore Treasury bond futures), the impact of such expectations on a stock index (and
therefore on stock index futures) is not as clear.
Stock index futures can be traded to capitalize on expectations about general stock
market movements. Speculators who expect the stock market to perform well before the
settlement date may consider purchasing S&P 500 index futures. Conversely, participants
who expect the stock market to perform poorly before the settlement date may consider
selling S&P 500 index futures. Stock index futures are also commonly used to hedge the
market risk of an existing stock portfolio.
The suitability of using stock index futures to hedge can be assessed by measuring
the sensitivity of the portfolio’s performance to market movements over a period prior to
taking a hedge position. The sensitivity of a hypothetical position in futures to those same
market movements in that period could also be assessed. A general test of suitability is to
determine whether the hypothetical derivative position would have offset adverse market
effects on the portfolio’s performance. Although it may be extremely difficult to perfectly
hedge all of a portfolio’s exposure to market risk, for a hedge to be suitable there should
be some evidence that such a hypothetical hedge would have been moderately effective
for that firm. That is, if the position in financial derivatives would not have provided an
effective hedge of market risk over a recent period, a firm should not expect that it will
provide an effective hedge in the future. This test of suitability uses only data that were
available at the time the hedge was to be enacted.
Portfolio managers do not necessarily hedge their entire stock portfolio, because
they may wish to be partially exposed in the event that stock prices rise. For instance, if
the portfolio in the preceding example were valued at $1.2 million, the portfolio manager
could have hedged one-third of the stock portfolio by selling one stock index futures
contract. The short position in one index futures contract would reflect one-third of the
stock portfolio’s value. Alternatively, the manager could have hedged two-thirds of the
stock portfolio by selling two stock index futures contracts. The higher the proportion of
the portfolio that is hedged, the more insulated the manager’s performance is from market
conditions, whether those conditions are favorable or unfavorable.
Institutional investors are increasingly using dynamic asset allocation, in which
they switch between risky and low-risk investment positions over time in response to
changing expectations. This strategy allows managers to increase the exposure of their
portfolios when they expect favorable market conditions and to reduce their exposure
when they expect unfavorable conditions. When they anticipate favorable market
movements, stock portfolio managers can purchase stock index futures, which intensify
the effects of market conditions. Conversely, when they anticipate unfavorable market
movements, they can sell stock index futures to reduce the effects that market conditions
will have on their stock portfolios. Because expectations change frequently, it is not
uncommon for portfolio managers to alter their degree of exposure. Stock index futures
allow portfolio managers to alter their risk–return position without restructuring their
existing stock portfolios. Using dynamic asset allocation in this way avoids the
substantial transaction costs that would be associated with restructuring the stock
portfolios.
The New York Stock Exchange narrowly defines program trading as the
simultaneous buying and selling of at least 15 different stocks that, in aggregate, are
valued at more than $1 million. Program trading is commonly used in conjunction with
the trading of stock index futures contracts in a strategy known as index arbitrage.
Securities firms act as arbitrageurs by capitalizing on discrepancies between prices of
index futures and stocks. Index arbitrage involves the buying or selling of stock index
futures with a simultaneous opposite position in the stocks that the index comprises. The
index arbitrage is instigated when prices of stock index futures differ significantly from
the stocks represented by the index. For example, if the index futures contract is priced
high relative to the stocks representing the index, an arbitrageur may consider purchasing
the stocks and simultaneously selling stock index futures. Conversely, if the index futures
are priced low relative to the stocks representing the index, an arbitrageur may purchase
index futures and simultaneously sell stocks. An arbitrage profit is attainable if the price
differential exceeds the costs incurred from trading in both markets.
D. Single Stock Futures
A single stock futures contract is an agreement to buy or sell a specified number
of shares of a specified stock on a specified future date. Such contracts have been traded
on futures exchanges in Australia and Europe since the 1990s. The Chicago Board
Options Exchange and the CME Group recently engaged in a joint venture called
OneChicago, where single stock futures contracts of U.S. stocks are traded. The size of a
contract is 100 shares. Investors can buy or sell singles stock futures contracts through
their broker, and they can be purchased on margin. The orders to buy and sell a specific
single stock futures contract are matched electronically. Single stock futures have become
increasingly popular, and today are available on more than 2,200 stocks. They are
regulated by the Commodity Futures Trading Commission and the Securities and
Exchange Commission.
Settlement dates are on the third Friday of the delivery month on a quarterly basis
(March, June, September, and December) for the next five quarters as well as for the
nearest two months. For example, on January 3, an investor could purchase a stock
futures contract for the third Friday in the next two months (January or February) or over
the next five quarters (March, June, September, December, and March of the following
year).
Market risk refers to fluctuations in the value of the instrument as a result of
market conditions. Firms that use futures contracts to speculate should be concerned
about market risk. If their expectations about future market conditions are wrong, they
may suffer losses on their futures contracts. Firms that use futures contracts to hedge are
less concerned about market risk because if market conditions cause a loss on their
derivative instruments, they should have a partial offsetting gain on the positions that
they were hedging.
A second type of risk is basis risk, or the risk that the position being hedged by
the futures contracts is not affected in the same manner as the instrument underlying the
futures contract. This type of risk applies only to those firms or individuals who are using
futures contracts to hedge. The change in the value of the futures contract position may
not move in perfect tandem with the change in value of the portfolio that is being hedged,
so the hedge might not perfectly hedge the risk of the portfolio.
A third type of risk is liquidity risk, which refers to potential price distortions due
to a lack of liquidity. For example, a firm may purchase a particular bond futures contract
to speculate on expectations of rising bond prices. However, when it attempts to close out
its position by selling an identical futures contract, it may find that there are no willing
buyers for this type of futures contract at that time. In this case, the firm will have to sell
the futures contract at a lower price. Users of futures contracts may reduce liquidity risk
by using only those futures contracts that are widely traded.
A fourth type of risk is credit risk, which is the risk that a loss will occur because
a counterparty defaults on the contract. This type of risk exists for over-the-counter
transactions, in which a firm or individual relies on the creditworthiness of a
counterparty. The credit risk of counterparties is not a concern when trading futures and
other derivatives on exchanges, because the exchanges normally guarantee that the
provisions of the contract will be honored. The financial intermediaries that make the
arrangements in the over-the-counter market can also take some steps to reduce this type
of risk. First, the financial intermediary can require that each party provide some form of
collateral to back up its position. Second, the financial intermediary can serve (for a fee)
as a guarantor in the event that the counterparty does not fulfill its obligation.
Prepayment risk refers to the possibility that the assets to be hedged may be
prepaid earlier than their designated maturity. Suppose that a commercial bank sells
Treasury bond futures in order to hedge its holdings of corporate bonds and that, just after
the futures position is created, the bonds are called by the corporation that initially issued
them. If interest rates subsequently decline, the bank will incur a loss from its futures
position without a corresponding gain from its bond position (because the bonds were
called earlier).
A sixth type of risk is operational risk, which is the risk of losses as a result of
inadequate management or controls. For example, firms that use futures contracts to
hedge are exposed to the possibility that the employees responsible for their futures
positions do not fully understand how values of specific futures contracts will respond to
market conditions. Furthermore, those employees may take more speculative positions
than the firms desire if the firms do not have adequate controls to monitor them.
To the extent that traders of financial futures contracts or other derivative
securities are unable to cover their derivative contract obligations in over-the-counter
transactions, they could cause financial problems for their respective counterparties. This
could expose the futures market to systemic risk whereby the intertwined relationships
among firms may cause one trader’s financial problems to be passed on to other traders
(if there is not enough collateral backing the contracts).
E. Options Markets
Options are classified as calls or puts. A call option grants the owner the right to
purchase a specified financial instrument (such as a stock) for a specified price (called the
exercise price or strike price) within a specified period of time. A call option is said to be
in the money when the market price of the underlying security exceeds the exercise price,
at the money when the market price is equal to the exercise price, and out of the money
when it is below the exercise price. The second type of option is known as a put option. It
grants the owner the right to sell a specified financial instrument for a specified price
within a specified period of time. As with call options, owners pay a premium to obtain
put options. They can exercise the options at any time up to the expiration date but are
not obligated to do so. A put option is said to be “in the money” when the market price of
the underlying security is below the exercise price, “at the money” when the market price
is equal to the exercise price, and “out of the money” when it exceeds the exercise price.
Call and put options specify 100 shares for the stocks to which they are assigned.
Premiums paid for call and put options are determined by the participants engaged in
trading. The premium for a particular option changes over time as it becomes more or
less desirable to traders.
There are two major differences between purchasing an option and purchasing a
futures contract. First, to obtain an option, a premium must be paid in addition to the
price of the financial instrument. Second, the owner of an option can choose to let the
option expire on the expiration date without exercising it. Call options grant a right, but
not an obligation, to purchase a specified financial instrument. In contrast, buyers of
futures contracts are obligated to purchase the financial instrument at a specified date. If
the owner does exercise the call option, the seller (sometimes called the writer) of the
option is obligated to provide the specified financial instrument at the price specified by
the option contract if the owner exercises the option. Sellers of call options receive an
upfront fee (the premium) from the purchaser as compensation.
The Chicago Board Options Exchange (CBOE), which was created in 1973, is the
most important exchange for trading options. It serves as a market for options on more
than 2,000 different stocks. The options listed on the CBOE have a standardized format,
as will be explained shortly. The standardization of the contracts on the CBOE proved to
be a major advantage because it allowed for easy trading of existing contracts (a
secondary market). With standardization, the popularity of options increased and the
options became more liquid. Since there were numerous buyers and sellers of the
standardized contracts, buyers and sellers of a particular option contract could be
matched.
When options exchanges were created, floor brokers of exchanges were available
to execute orders for brokerage firms. They went to a specific location on the trading
floor where the option was traded to execute the order. Today, computer technology
allows investors to have trades executed electronically. Most small, standardized
transactions are executed electronically, whereas complex transactions are executed by
competitive open outcry among exchange members. Many electronic communication
networks (ECNs) are programmed to consider all possible trades and execute the order at
the best possible price.
As with stocks, an investor can use either a market order or a limit order for an
option transaction. A market order will result in the immediate purchase or sale of an
option at its prevailing market price. With a limit order, the transaction will occur only if
the market price is no higher or lower than a specified price limit. For example, an
investor may request the purchase of a specific option only if it can be purchased at or
below some specified price. Conversely, an investor may request to sell an option only if
it can be sold for some specified limit or more.
A comparison of the premiums among the four options illustrates how specific
factors affect option premiums. First, comparing Options 1 and 3 (to control for the same
expiration date) reveals that an option with a higher exercise price has a lower call option
premium and a higher put option premium. A comparison of Options 2 and 4 confirms
this relationship. Second, comparing Options 1 and 2 (to control for the same exercise
price) reveals that an option with a longer term to maturity has a higher call option
premium and a higher put option premium. A comparison of Options 3 and 4 confirms
this relationship.
F. Determinants of Stock Option Premiums
The higher the existing market price of the underlying financial instrument
relative to the exercise price, the higher the call option premium, other things being
equal. A stock’s value has a higher probability of increasing well above the exercise price
if it is already close to or above the exercise price. Thus a purchaser would be willing to
pay a higher premium for a call option on such a stock. The influence of the market price
of a stock (relative to the exercise price) on the call option premium can also be
understood by comparing stock options with different exercise prices on the same
instrument at a given time.
The higher the existing market price of the underlying stock relative to the
exercise price, the lower the put option premium, all other things being equal. A stock’s
value has a higher probability of decreasing well below the exercise price if it is already
close to or below the exercise price. Thus a purchaser would be willing to pay a higher
premium for a put option on that stock. This influence on the put option premium differs
from the influence on the call option premium because, from the perspective of put
option purchasers, a lower market price is preferable.
The greater the volatility of the underlying stock, the higher the put option
premium, all other things being equal. This relationship also held for call option
premiums. If a stock is volatile, there is a higher probability of its price deviating far from
the exercise price. Thus a purchaser would be willing to pay a higher premium for a put
option on that stock because its market price is more likely to decline well below the
option’s exercise price. The longer the time to maturity, the higher the put option
premium, all other things being equal. This relationship also held for call option
premiums. A longer time period until expiration allows the owner of the option more
time to exercise the option. Thus there is a higher probability that the stock’s price will
move well below the exercise price before the option expires.
Some investors who are assessing a specific stock’s risk adapt the option-pricing
formula to derive an estimate of that stock’s anticipated volatility. By plugging in values
for the other factors that affect the particular stock option’s premium and for the
prevailing premium quoted in the market, it is possible to derive the stock’s anticipated
volatility, which is referred to as the implied standard deviation (or implied volatility).
The implied standard deviation is derived by determining what its value must be, given
the quoted option premium and the values of other factors that affect the stock option’s
premium. Various software packages and calculators are available that can estimate a
stock’s implied volatility. Such an estimate is of interest to investors because it indicates
the market’s view of the stock’s potential volatility. Some investors may use this estimate
as a measure of a stock’s risk when they consider what stocks to purchase.
Since the premiums paid on stock options are highly influenced by the price
movements of the underlying stocks, participants in the stock option market closely
monitor the same indicators that are monitored when trading the underlying stocks.
Traders of options tend to monitor economic indicators because economic conditions
affect cash flows of firms and thus can affect expected stock valuations and stock option
premiums. Economic conditions can also affect the premiums by influencing expected
stock volatility
G. Speculating and Hedging with Stock Options
Stock options are frequently traded by investors who are attempting to capitalize
on their expectations. When investors purchase an option that does not cover (hedge)
their existing investments, the option can be referred to as “naked” (uncovered). Since
speculators trade options to gamble on price movements rather than to hedge existing
investments, their positions in options are naked. Whether speculators purchase call
options or put options depends on their expectations.
If the price of Steelco stock had not risen above $115 before the option’s
expiration date, Pat would have let the option expire. Her net loss would have been the $4
per share she initially paid for the option, or $400 for one option contract. This example
reflects a 100 percent loss, since the entire amount of the investment is lost. Purchasers of
call options are normally most interested in returns (profit as a percentage of the initial
investment) under various scenarios. For this purpose, the contingency graph can be
revised to reflect returns for each possible price per share of the underlying stock. The
first step is to convert the profit per unit into a return for each possible price, as shown in
Exhibit 14.10. For example, for the stock price of $116, Call Option 1 generates a return
of 10 percent ($1 per share profit as a percentage of the $10 premium paid), Call Option 2
generates a loss of about 14 percent ($1 per share loss as a percentage of the $7 premium
paid), and Call Option 3 generates a loss of 75 percent ($3 per share loss as a percentage
of the $4 premium paid).
The potential gains or losses from the put option described here are shown in the
left portion of Exhibit 14.12, based on the assumptions that (1) the put option is exercised
on the expiration date, if at all, and (2) the shares would be purchased just before the put
option is exercised. The exhibit shows that the maximum loss when purchasing this
option is $2 per share. For stock prices between $108 and $110, the purchaser of a put
option incurs a net loss of less than $2 per share. The stock price of $108 is the break-
even point, because the gain from exercising the put option would exactly offset the $2
per share premium.
Speculating in options can be very risky. Financial institutions or other
corporations that speculate in options normally have methods to closely monitor their risk
and to measure their exposure to possible option market conditions. In several cases,
however, a financial institution or a corporation incurred a major loss on options
positions because of a lack of oversight over its options trading. Any firms that use
futures or other derivative instruments can draw a few obvious lessons from the Barings
collapse. First, firms should closely monitor the trading of derivative contracts by their
employees to ensure that derivatives are being used within the firm’s guidelines. Second,
firms should separate the reporting function from the trading function so that traders
cannot conceal trading losses. Third, when firms receive margin calls on derivative
positions, they should recognize that there may be potential losses on their derivative
instruments and should closely evaluate those positions. The Barings case was a wake-up
call to many firms, which recognized the need to establish guidelines for their employees
who take derivative positions and to monitor more closely the actions of these employees.
Portland Pension Fund owns a substantial amount of Steelco stock. It expects that
the stock will perform well in the long run, but it is concerned that the stock may perform
poorly over the next few months because of temporary problems Steelco is experiencing.
The sale of a call option on Steelco stock can hedge against such a potential loss. This is
known as a covered call because the option is covered, or backed, by stocks already
owned. If the market price of Steelco stock rises, the call option will likely be exercised
and Portland will fulfill its obligation by selling its Steelco stock to the purchaser of the
call option at the exercise price. But if the market price of Steelco stock declines, the
option will not be exercised. Hence Portland would not have to sell its Steelco stock, and
the premium received from selling the call option would represent a gain that could
partially offset the decline in the price of the stock. In this case, although the market
value of the institution’s stock portfolio is adversely affected, the decline is at least
partially offset by the premium received from selling the call option.
Long-term equity anticipations (LEAPs) are options that have longer terms to
expiration, usually between two and three years from the initial listing date. These
options are available for some large capitalization stocks, and they may be a more
effective hedge over a longer term period than using options with shorter terms to
expiration. The transaction costs for hedging over a long period are lower than the costs
of continually repurchasing short-term put options each time the options expire or are
exercised. Furthermore, the costs of continually repurchasing put options are uncertain,
whereas the costs of purchasing a put option on a long-term index option are known
immediately.
H. Options on ETFs, Stock Indexes, Futures Contracts, and Executive Compensation
Options are also traded on exchange-traded funds (ETFs) and stock indexes.
Exchangetraded funds are funds that are designed to mimic particular indexes and are
traded on an exchange. Thus, an ETF option provides the right to trade a specified ETF at
a specified price by a specified expiration date. Since ETFs are traded like stocks, options
on ETFs are traded like options on stocks. Investors who exercise a call option on an ETF
will receive delivery of the ETF in their account. Investors who exercise a put option on
an ETF will have the ETF transferred from their account to the counterparty on the put
option. A stock index option provides the right to trade a specified stock index at a
specified price by a specified expiration date. Call options on stock indexes allow the
right to purchase the index, and put options on stock indexes allow the right to sell the
index. If and when the index option is exercised, the cash payment is equal to a specified
dollar amount multiplied by the difference between the index level and the exercise price.
Financial institutions such as insurance companies and pension funds maintain
large stock portfolios whose values are driven by general market movements. If the stock
portfolio is broad enough, any changes in its value will likely be highly correlated with
market movements. For this reason, portfolio managers consider purchasing put options
on a stock index to protect against stock market declines. The put options should be
purchased on the stock index that most closely mirrors the portfolio to be hedged. If the
stock market experiences a severe downturn, the market value of the portfolio declines.
However, the put options on the stock index will generate a gain because the value of the
index will be less than the exercise price. The greater the market downturn, the greater
the decline in the market value of the portfolio but also the greater the gain from holding
put options on a stock index. Thus, this offsetting effect minimizes the overall impact on
the firm.
Dynamic asset allocation involves switching between risky and low-risk
investment positions over time in response to changing expectations. Some portfolio
managers use stock index options as a tool for dynamic asset allocation. For example,
when portfolio managers anticipate favorable market conditions, they purchase call
options on a stock index, which intensify the effects of the market conditions. Essentially,
the managers are using stock index options to increase their exposure to stock market
conditions. Conversely, when they anticipate unfavorable market movements, they can
purchase put options on a stock index in order to reduce the effects that market conditions
will have on their stock portfolios.
Just as a stock’s implied volatility can be derived from information about options
on that stock, a stock index’s implied volatility can be derived from information about
options on that stock index. The same factors that affect the option premium on a stock
affect the option premium on an index. Thus, the premium on an index option is
positively related to the expected volatility of the underlying stock index. If investors
want to estimate the expected volatility of the stock index, they can use software
packages to insert values for the prevailing option premium and all the other factors
(except volatility) that affect an option premium.
In recent years, the concept of options has been applied to futures contracts to
create options on futures contracts (sometimes referred to as “futures options”). An
option on a particular futures contract gives its owner the right (but not an obligation) to
purchase or sell that futures contract for a specified price within a specified period of
time. Thus, options on futures grant the power to take the futures position if favorable
conditions occur but the flexibility to avoid the futures position (by letting the option
expire) if unfavorable conditions occur. As with other options, the purchaser of options
on futures pays a premium. Similarly, options are available on stock index futures. They
are used for speculating on expected stock market movements or hedging against adverse
market conditions. Individuals and financial institutions use them in a manner similar to
the way stock index options are used.
f speculators expect a decline in interest rates, they may consider purchasing a call
option on Treasury bond futures. If their expectations are correct, the market value of
Treasury bonds will rise and the price of a Treasury bond futures contract will rise as
well. The speculators can exercise their option to purchase futures at the exercise price,
which will be lower than the value of the futures contract.
Options on futures contracts are also used to hedge against risk. Financial
institutions commonly hedge their bond or mortgage portfolios with options on interest
rate futures contracts. The position they take on the options contract is designed to create
a gain that can offset a loss on their bond or mortgage portfolio while still allowing some
upside potential. Financial institutions and other investors commonly hedge their stock
portfolios with options on stock index futures contracts. The position they take on the
options contract is designed to create a gain that can offset a loss on their stock portfolio
while still allowing some upside potential.
When attempting to hedge larger portfolios than the one in the previous example,
additional put options would be purchased to hedge the entire portfolio against a possible
decline in the market. For example, if your stock portfolio were $1.2 million, you would
need to purchase three put options on S&P 500 index futures contracts. Since each index
futures contract would have a value of $400,000, you would need a short position in three
index futures contracts to hedge the entire stock portfolio (assuming that the index and
the stock portfolio move in tandem).
Many firms distribute stock options to executives and other managers as a reward
for good performance. For example, a manager may receive a salary along with call
options on 10,000 shares of stock that have an exercise price above the prevailing price
and an expiration date of five years from today. The purpose of awarding options as
compensation is to increase the executive’s incentive to make decisions that increase the
value of the firm’s stock, as their compensation from options is tied to the stock price.
Many option compensation programs do not account for general market
conditions. Thus executives who owned stock options when general stock market
conditions were more favorable may have earned high compensation because their firms’
stock prices increased substantially during that period, even for firms that performed
poorly relative to others in the same industry. Because compensation from holding
options is driven more by general stock market conditions than by the firm’s relative
performance, stock options are not always effective at aligning executives’ incentives
with actual firm performance.
I. Swap Markets
Many firms have inflow and outflow payments that are not equally sensitive to
interest rate patterns. Consequently, they are exposed to interest rate risk. Interest rate
swap contracts have been established to reduce these risks. In addition, credit default
swap contracts have been established to reduce credit risk.
Financial institutions such as savings institutions and commercial banks in the
United States traditionally had more interest rate–sensitive liabilities than assets and
therefore were adversely affected by increasing interest rates. Conversely, some financial
institutions in other countries (such as some commercial banks in Europe) had access to
long-term fixed-rate funding but used funds primarily for floating-rate loans. These
institutions were adversely affected by declining interest rates.
Interest rate swaps are sometimes used by financial institutions and other firms for
speculative purposes. For example, a firm may engage in a swap to benefit from its
expectations that interest rates will rise even if not all of its operations are exposed to
interest rate movements. When the swap is used for speculating rather than for hedging,
any loss on the swap positions will not be offset by gains from other operations.
Financial institutions such as commercial banks, savings institutions, insurance
companies, and pension funds that are exposed to interest rate movements commonly
engage in swaps to reduce interest rate risk. A second way to participate in the swap
market is by acting as an intermediary. Some commercial banks and securities firms
serve in this capacity by matching up firms and facilitating the swap arrangement.
Financial institutions that serve as intermediaries for swaps charge fees for their services.
They may even provide credit guarantees (for a fee) to each party in the event that the
counterparty does not fulfill its obligation. Under these circumstances, the parties
engaged in swap agreements assess the creditworthiness of the intermediary that is
backing the swap obligations. For this reason, participants in the swap market prefer
intermediaries that have a high credit rating.
The fixed rate negotiated on a forward swap will not necessarily be the same as
the fixed rate negotiated on a swap that begins immediately. The pricing conditions on
any swap are based on expected interest rates over the swap’s lifetime. Like any interest
rate swap, forward swaps involve two parties. Our example of a forward swap involves a
U.S. institution that expects interest rates to rise and wants to immediately lock in the
fixed rate that it will pay when the swap period begins. The party that takes the opposite
position in the forward swap will likely be a firm that will be adversely affected by
declining interest rates and expects interest rates to decline. This firm would prefer to
lock in the prevailing fixed rate because that rate is expected to be higher than the
applicable fixed rate when the swap period begins.
The interest rate of the index used for an interest rate swap will not necessarily
move perfectly in tandem with the floating-rate instruments of the parties involved in the
swap. For example, the index used on a swap may rise by 0.7 percent over a particular
period while the cost of deposits to a U.S. financial institution rises by 1.0 percent over
the same period. The net effect is that the higher interest rate payments received from the
swap agreement do not fully offset the increase in the cost of funds. This so-called basis
risk prevents the interest rate swap from completely eliminating the financial institution’s
exposure to interest rate risk.
There is risk that a firm involved in an interest rate swap will not meet its
payment obligations. This credit risk is not a deal breaker, however, for the following
reasons. As soon as the firm recognizes that it has not received the interest payments it is
owed, it will discontinue its payments to the other party. The potential loss is a set of net
payments that would have been received (based on the differential in swap rates) over
time. In some cases, the financial intermediary that matched up the two parties incurs the
credit risk by providing a guarantee (for a fee). If so, the parties engaged in the swap do
not need to be concerned with the credit risk, assuming that the financial intermediary
will be able to cover any guarantees promised.
J. Pricing Interest Rate Swaps
The fixed interest rate specified in a swap is influenced by supply and demand
conditions for funds having the appropriate maturity. For example, a plain vanilla
(fixedfor-floating) interest rate swap structured when interest rates are very high would
have a much higher fixed interest rate than one structured when interest rates were low.
In general, the interest rates specified in a swap agreement reflect the prevailing interest
rates at the time of the agreement.
Swap pricing is also determined by the availability of counterparties. When
numerous counterparties are available for a particular desired swap, a party may be able
to negotiate a more attractive deal. For example, consider a U.S. financial institution that
wants a fixed-for-floating swap. If several European institutions are willing to serve as
the counterparty, the U.S. institution may be able to negotiate a slightly lower fixed rate.
The availability of counterparties can change in response to economic conditions. For
example, in a period when interest rates are expected to rise, many institutions will want
a fixed-for-floating swap but few institutions will be willing to serve as the counterparty.
The fixed rate specified on interest rate swaps will be higher under these conditions than
in a period when many financial institutions expect interest rates to decline.
Because the performance of a particular interest rate swap position is normally
influenced by future interest rate movements, participants in the interest rate swap market
closely monitor indicators that may affect these movements. Among the more closely
watched indicators are indicators of economic growth (employment, gross domestic
product), indicators of inflation (consumer price index, producer price index), and
indicators of government borrowing (budget deficit, expected volume of funds borrowed
at upcoming Treasury bond auctions).
K. Interest Rate Caps, Floors, and Collars
An interest rate cap offers payments in periods when a specified interest rate
index exceeds a specified ceiling (cap) interest rate. The payments are based on the
amount by which the interest rate exceeds the ceiling, multiplied as usual by the notional
principal specified in the agreement. A fee is paid upfront to purchase an interest rate cap,
and the lifetime of a cap commonly ranges between three and eight years. The typical
purchaser of an interest rate cap is a financial institution that is adversely affected by
rising interest rates. If interest rates rise, the payments received from the interest rate cap
agreement will help offset any adverse effects. The seller of an interest rate cap receives
the fee paid upfront and is obligated to provide periodic payments when the prevailing
interest rates exceed the ceiling rate specified in the agreement. The typical seller of an
interest rate cap is a financial institution that expects interest rates to remain stable or to
decline.
An interest rate floor offers payments in periods when a specified interest rate
index falls below a specified floor rate. The payments are based on the amount by which
the interest rate falls below the floor rate, which is multiplied by the notional principal
specified in the agreement. A fee is paid upfront to purchase an interest rate floor, and the
lifetime of the floor commonly ranges between three and eight years. The interest rate
floor can be used to hedge against lower interest rates in the same manner that the interest
rate cap hedges against higher interest rates. Any financial institution that purchases an
interest rate floor will receive payments if interest rates decline below the floor, and these
payments will help offset any adverse interest rate effects.
An interest rate collar involves the purchase of an interest rate cap and the
simultaneous sale of an interest rate floor. In its simplest form, the up-front fee received
from selling the interest rate floor to one party can be used to pay the fee for purchasing
the interest rate cap from another party. Any financial institution that desires to hedge
against the possibility of rising interest rates can purchase an interest rate collar. The
hedge results from the interest rate cap, which will generate payments to the institution if
interest rates rise above the interest rate ceiling.
L. Foreign Exchange Markets
In recent years, various derivative instruments have been created to manage or
capitalize on exchange rate movements. These so-called foreign exchange derivatives (or
“forex” derivatives) include forward contracts, currency futures contracts, currency
swaps, and currency options. Foreign exchange derivatives account for about half of the
daily foreign exchange transaction volume. The potential benefits from using foreign
exchange derivatives are dependent on the expected exchange rate movements. Thus, it is
necessary to understand why exchange rates change over time before exploring the use of
foreign exchange derivatives.
As international trade and investing have increased over time, so has the need to
exchange currencies. Foreign exchange markets consist of a global telecommunications
network among the large commercial banks that serve as financial intermediaries for such
exchange. These banks are located in New York, Tokyo, Hong Kong, Singapore,
Frankfurt, Zurich, and London. Foreign exchange transactions at these banks have been
increasing over time.
The direct exchange rate specifies the value of a currency in U.S. dollars. For
example, the Mexican peso may have a value such as $0.10 while the British pound is
valued at $2.00. The indirect exchange rate specifies the number of units of a currency
equal to a U.S. dollar. For the example values given here, the indirect exchange rates are
10 pesos per dollar and 0.50 pounds per dollar. The indirect exchange rate is the
reciprocal of the direct exchange rate.
By 1971, the U.S. dollar was clearly overvalued. That is, its value was maintained
only by central bank intervention. In 1971, an agreement among all major countries
(known as the Smithsonian Agreement) allowed for devaluation of the dollar. In addition,
the Smithsonian Agreement called for a widening of the boundaries from 1 percent to 2¼
percent around each currency’s set value. Governments intervened in the foreign
exchange markets whenever exchange rates threatened to wander outside the boundaries.
In 1973, the boundaries were eliminated. Since then, the exchange rates of major
currencies have been floating without any government-imposed boundaries. A
government may still intervene in the foreign exchange markets to influence the market
value of its currency, however. A system with no boundaries and in which exchange rates
are market determined but still subject to government intervention is called a dirty float.
This is to be distinguished from a freely floating system, in which the foreign exchange
market is totally free from government intervention. Most countries allow their local
currency to float but periodically intervene in the foreign exchange market to influence
the value of that currency, as will be explained shortly.
In January 1999, the euro replaced the national currencies of eleven European
countries; since then, five more countries have converted their home currency to the euro.
The countries that now use the euro as their home currency are Austria, Belgium, Cyprus,
Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta,
Netherlands, Portugal, Slovakia, Slovenia, and Spain. The countries that participate in the
euro make up a region that is referred to as the eurozone. Since all of these countries use
the same currency, transactions between them do not require any exchange of currencies.
Together, the participating countries produce more than 20 percent of the world’s gross
domestic product, which exceeds the total production of the United States. In Europe, the
countries of Denmark, Norway, Sweden, Switzerland, and the United Kingdom continue
to use their own home currency.
When a government in the eurozone is unable to obtain sufficient credit to cover
its budget deficit, it may need to rely on the European Central Bank (ECB) for funds.
However, when the ECB provides credit to a country, it imposes austerity conditions that
are intended to help the government resolve its budget deficit problems over time. These
conditions may include a reduction in government spending and higher tax rates on
citizens. Although these conditions may be necessary to correct the budget deficit, they
may weaken an economy.
M. Factors Affecting Exchange Rates
Begin with an equilibrium situation and consider what will happen to the U.S.
demand for euros, and to the supply of euros for sale, if U.S. inflation suddenly becomes
much higher than European inflation. The U.S. demand for European goods will increase,
reflecting an increased U.S. demand for euros. In addition, the supply of euros to be sold
for dollars will decline as the European desire for U.S. goods decreases. Both forces will
place upward pressure on the value of the euro. Under the reverse situation, where
European inflation suddenly becomes much higher than U.S. inflation, the U.S. demand
for euros will decrease while the supply of euros for sale increases, placing downward
pressure on the value of the euro. A well-known theory about the relationship between
inflation and exchange rates, purchasing power parity (PPP) suggests that the exchange
rate will, on average, change by a percentage that reflects the inflation differential
between the two countries of concern.
Central banks commonly consider adjusting a currency’s value to influence
economic conditions. For example, the U.S. central bank may wish to weaken the dollar
to increase demand for U.S. exports, which can stimulate the economy. However, a
weaker dollar can also cause U.S. inflation by reducing foreign competition (because it
raises the price of foreign goods to U.S. consumers). Alternatively, the U.S. central bank
may prefer to strengthen the dollar to intensify foreign competition, which can reduce
U.S. inflation.
The Fed can affect the dollar’s value indirectly by influencing the factors that
determine its value. For example, the Fed can attempt to lower interest rates by increasing
the U.S. money supply (assuming that inflationary expectations are not affected). Lower
U.S. interest rates tend to discourage foreign investors from investing in U.S. securities,
thereby putting downward pressure on the value of the dollar. Or, to boost the dollar’s
value, the Fed can attempt to increase interest rates by reducing the U.S. money supply.
Indirect intervention can be an effective means of influencing a currency’s value.
In 1994, Mexico experienced a large balance of trade deficit, perhaps because the
peso was stronger than it should have been, which encouraged Mexican firms and
consumers to buy an excessive amount of imports. By December 1994, there was
substantial downward pressure on the peso. On December 20, 1994, Mexico’s central
bank devalued the peso by about 13 percent. Mexico’s stock prices plummeted, as many
foreign investors sold their shares and withdrew their funds from Mexico in anticipation
of further devaluation in the peso. On December 22, the central bank allowed the peso to
float freely; it declined by another 15 percent. This was the beginning of the so-called
Mexican peso crisis. The central bank increased interest rates as a form of indirect
intervention to discourage foreign investors from withdrawing their investments in
Mexico’s debt securities. The higher interest rates increased the cost of borrowing for
Mexican firms and consumers, thereby slowing economic growth.
A similar situation occurred in Russia in May 1998. Over the previous four
months, the Russian currency (the ruble) had consistently declined and stock market
prices had declined by more than 50 percent. Because the lack of confidence in Russia’s
currency and stocks could cause massive outflows of funds, the Russian central bank
attempted to minimize such outflows by tripling interest rates (from about 50 to 150
percent). The ruble was temporarily stabilized, but stock prices continued to decline
because investors were concerned that the high interest rates would reduce economic
growth.
N. Foreign Exchange Derivatives
Foreign exchange derivatives can be used to speculate on future exchange rate
movements or to hedge anticipated cash inflows or outflows in a given foreign currency.
As foreign securities markets have become more accessible, institutional investors have
increased their international investments, which in turn has increased their exposure to
exchange rate risk. Some institutional investors use foreign exchange derivatives to hedge
their exposure. The most popular foreign exchange derivatives are forward contracts,
currency futures contracts, currency swaps, and currency options contracts.
Forward contracts are contracts, typically negotiated with a commercial bank, that
allow the purchase or sale of a specified amount of a particular foreign currency at a
specified exchange rate (the forward rate) on a specified future date. A forward market
facilitates the trading of forward contracts. This market is not in one physical place; it is a
telecommunications network through which large commercial banks match participants
who wish to buy a currency forward with other participants who wish to sell a currency
forward. Many of the commercial banks that offer foreign exchange on a spot basis also
offer forward transactions for widely traded currencies. By enabling a firm to lock in the
price to be paid for a foreign currency, forward purchases or sales can hedge the firm’s
risk that the currency’s value may change over time.
A currency swap is an agreement that allows one currency to be periodically
swapped for another at specified exchange rates. It essentially represents a series of
forward contracts. Commercial banks facilitate currency swaps by serving as the
intermediary that links two parties with opposite needs. Alternatively, commercial banks
may be willing to take the position counter to that desired by a particular party. In such a
case, they expose themselves to exchange rate risk unless the position they have assumed
will offset existing exposure.
O. Commercial Banks
Up to this point, the text has focused on the role and functions of financial
markets. From this point forward, the emphasis is on the role and functions of financial
institutions. Recall from Chapter 1 that financial institutions commonly facilitate the flow
of funds between surplus units and deficit units. Commercial banks represent a key
financial intermediary because they serve all types of surplus and deficit units. They offer
deposit accounts with the size and maturity characteristics desired by surplus units. They
repackage the funds received from deposits to provide loans of the size and maturity
desired by deficit units. They have the ability to assess the creditworthiness of deficit
units that apply for loans, so they can limit their exposure to credit (default) risk on the
loans they provide.
In 1985, more than 14,000 banks were located in the United States. Since then,
the market structure has changed dramatically. Banks have been consolidating for several
reasons. One reason is that interstate banking regulations were changed in 1994 to allow
banks more freedom to acquire other banks across state lines. Consequently, banks in a
particular region are now subject to competition not only from other local banks but also
from any bank that may penetrate that market. This has prompted banks to become more
efficient in order to survive. They have pursued growth also as a means of capitalizing on
economies of scale (lower average costs for larger scales of operations) and enhanced
efficiency. Acquisitions have been a convenient way to grow quickly.
As a result of this trend, there are less than half as many banks today as there were
in 1985, and consolidation is still occurring. Exhibit 17.1 shows how the number of banks
has declined over time, thereby increasing concentration in the banking industry. The
largest 100 banks now account for about 75 percent of all bank assets versus about 50
percent in 1985. The largest five banks now account for more than 50 percent of bank
assets, versus 30 percent in 2001. JPMorgan Chase & Company is the largest bank in the
United States with about $2.3 trillion in assets, while Bank of America Corporation has
about $2.2 trillion in assets and Citigroup Inc. has about $1.9 trillion in assets. Large
banks have expanded over time by acquiring other banks. They also acquired many other
types of financial service firms in recent years.
P. Bank Sources of Funds
To understand how any financial institution (or subsidiary of that institution)
obtains funds and uses funds, its balance sheet can be reviewed. The institution’s reported
liabilities and equity indicate its sources of funds, and its reported assets indicate its uses
of funds. A demand deposit account, or checking account, is offered to customers who
desire to write checks against their account. A conventional demand deposit account
requires a small minimum balance and pays no interest. From the bank’s perspective,
demand deposit accounts are classified as transaction accounts that provide a source of
funds that can be used until withdrawn by customers (as checks are written). Another
type of transaction deposit is the negotiable order of withdrawal (NOW) account, which
pays interest as well as providing checking services. Because NOW accounts at most
financial institutions require a larger minimum balance than some consumers are willing
to maintain in a transaction account, traditional demand deposit accounts are still popular.
A common type of time deposit is a retail certificate of deposit (or retail CD),
which requires a specified minimum amount of funds to be deposited for a specified
period of time. Banks offer a wide variety of CDs to satisfy depositors’ needs.
Annualized interest rates offered on CDs vary among banks and even among maturity
types at a single bank. There is no secondary market for retail CDs. Depositors must
leave their funds in the bank until the specified maturity or forgo a portion of their
interest as a penalty.
Money market deposit accounts (MMDAs) differ from conventional time deposits
in that they do not specify a maturity. From the depositor’s point of view, MMDAs are
more liquid than retail CDs but offer a lower interest rate. They differ from NOW
accounts in that they provide limited check-writing ability (a limited number of
transactions is allowed per month), require a larger minimum balance, and offer a higher
yield. The remaining sources of funds to be described are of a nondepository nature. Such
sources are necessary when a bank temporarily needs more funds than are being
deposited. Some banks use nondepository funds as a permanent source of funds.
Banks purchase various types of securities. One advantage of investing funds in
securities rather than loans is that the securities tend to be more liquid. In addition, banks
can easily invest in securities whereas more resources are required to assess loan
applicants and service loans. However, they normally expect to generate higher rates of
return on funds used to provide loans. Banks purchase Treasury securities as well as
securities issued by agencies of the federal government. Government agency securities
can be sold in the secondary market, but the market is not as active as it is for Treasury
securities. Federal agency securities are commonly issued by federal agencies, such as the
Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan
Mortgage Corporation (Freddie Mac). Funds received by the agencies issuing these
securities are used to purchase mortgages from various financial institutions. Such
securities have maturities that can range from one month to 25 years.
Q. Regulation of Bank Operations
Because banks rely on funds from depositors, they have been subject to
regulations that are intended to ensure the safety of the financial system. Many of the
regulations are intended to prevent banks from taking excessive risk that could cause
them to fail. In particular, regulations are imposed on the types of assets in which banks
can invest, and the minimum amount of capital that banks must maintain. However, there
are trade-offs due to bank regulation. Some critics suggest that the regulation is
excessive, and it restricts banks from serving their owners. Banks might be more efficient
if they were not subject to regulations. Given these trade-offs, regulations are commonly
revised over time in response to bank conditions, as regulators seek the optimal level of
regulation that ensures the safety of the banking system, but also allows banks to be
efficient.
Federal deposit insurance has existed since the creation in 1933 of the FDIC in
response to the bank runs that occurred in the late 1920s and early 1930s. During the
1930–1932 period of the Great Depression more than 5,000 banks failed, or more than 20
percent of the existing banks. The initial wave of failures caused depositors to withdraw
their deposits from other banks, fearing that the failures would spread. These actions
actually caused more banks to fail. If deposit insurance had been available, depositors
might not have removed their deposits and some bank failures might have been avoided.
In 1980, the Depository Institutions Deregulation and Monetary Control Act
(DIDMCA) was enacted to (1) deregulate the banking (and other depository institutions)
industry and (2) improve monetary policy. Because this chapter focuses on regulation and
deregulation, only the first goal is discussed here. The DIDMCA was a major force in
deregulating the banking industry and increasing competition among banks. It removed
interest rate ceilings on deposits, allowing banks and other depository institutions to
make their own decisions on what interest rates to offer for time and savings deposits. In
addition, it allowed banks to offer NOW accounts. The DIDMCA has had a significant
impact on the banking industry, most importantly by increasing competition among
depository institutions.
Banks are not allowed to use borrowed or deposited funds to purchase common
stock, although they can manage stock portfolios through trust accounts that are owned
by individuals. Banks can invest only in bonds that are investment-grade quality. This
was measured by a Baa rating or higher by Moody’s or a BBB rating or higher by
Standard & Poor’s. The regulations on bonds are intended to prevent banks from taking
excessive risks.
The Banking Act of 1933 (better known as the Glass-Steagall Act) separated
banking and securities activities. The act was prompted by problems during 1929 when
some banks sold some of their poor-quality securities to their trust accounts established
for individuals. Some banks also engaged in insider trading: buying or selling corporate
securities based on confidential information provided by firms that had requested loans.
The Glass-Steagall Act prevented any firm that accepted deposits from underwriting
stocks and bonds of corporations. The separation of securities activities from banking
activities was intended to prevent potential conflicts of interest. For example, the concern
was that if a bank were allowed to underwrite securities, it might advise its corporate
customers to purchase these securities and could threaten to cut off future loans if the
customers did not oblige.
Banks offer a variety of off–balance sheet commitments. For example, banks
provide letters of credit to back commercial paper issued by corporations. They also act
as the intermediary on interest rate swaps and usually guarantee payments over the
specified period in the event that one of the parties defaults on its payments. Various off–
balance sheet transactions have become popular because they provide fee income. That
is, banks charge a fee for guaranteeing against the default of another party and for
facilitating transactions between parties. Off–balance sheet transactions do expose a bank
to risk, however. If a severe economic downturn causes many corporations to default on
their commercial paper or on payments specified by interest rate swap agreements, the
banks that provided guarantees would incur large losses.
R. Regulation of Capital
Banks are subject to capital requirements, which force them to maintain a
minimum amount of capital (or equity) as a percentage of total assets. They rely on their
capital as a cushion against possible losses. If a bank has insufficient capital to cover
losses, it will not be able to cover its expenses and will fail. Therefore, regulators closely
monitor bank capital levels. Some bank managers and shareholders would prefer that
banks hold a lower level of capital, because a given dollar level of profits would represent
a higher return on equity if the bank holds less capital. This might allow for larger
bonuses to managers and higher stock prices for shareholders during strong economic
conditions. However, regulators are more interested in the safety of the banking system
than managerial bonuses, and have increased bank capital requirements in recent years as
a means of stabilizing the banking system.
As a bank generates new earnings, and retains them rather than distributing them
as dividends to shareholders, it boosts its capital. However, it cannot retain earnings if it
does not generate earnings. If it incurs losses, it needs to use some of its existing capital
to cover some of its expenses, because its revenue was not sufficient to cover its
expenses. Thus losses (negative earnings) result in a lower level of capital. Poorly
performing banks cannot rely on retained earnings to boost capital levels because they
may not have any new earnings to retain.
When bank regulators of various countries develop their set of guidelines for
capital requirements, they are commonly guided by the recommendations in the Basel
guidelines. These guidelines are intended to guide the banks in setting their own capital
requirements. In the first Basel Accord (1988, often called Basel I), the central banks of
12 major countries agreed to establish a framework for determining uniform capital
requirements. A key provision in the Basel Accord bases the capital requirements on a
bank’s risk level. Banks with greater risk are required to maintain a higher level of
capital, which discourages banks from excessive exposure to credit risk. Assets are
weighted according to risk.
To comply with the Basel Accord, banks commonly apply a value-at-risk (VaR)
model to assess the risk of their assets, and determine how much capital they should hold.
The VaR model can be applied in various ways to determine capital requirements. In
general, a bank defines the VaR as the estimated potential loss from its trading businesses
that could result from adverse movements in market prices. Banks typically use a 99
percent confidence level, meaning that there is a 99 percent chance that the loss on a
given day will be more favorable than the VaR estimate. When applied to a daily time
horizon, the actual loss from a bank’s trading businesses should not exceed the estimated
loss by VaR on more than 1 out of every 100 days. Banks estimate the VaR by assessing
the probability of specific adverse market events (such as an abrupt change in interest
rates) and the sensitivity of responses to those events. Banks with a higher maximum loss
(based on a 99 percent confidence interval) are subject to higher capital requirements.
S. Financial Reform Act of 2010
The Financial Reform Act requires that banks and other financial institutions
granting mortgages verify the income, job status, and credit history of mortgage
applicants before approving mortgage applications. This provision is intended to prevent
applicants from receiving mortgages unless they are creditworthy, which should
minimize the possibility of a future credit crisis. It may seem that this provision would
naturally be followed even if there was no law. Yet there were many blatant violations
shortly before and during the credit crisis in which mortgages were approved for
applicants who were clearly not creditworthy.
The Financial Reform Act created the Financial Stability Oversight Council,
which is responsible for identifying risks to financial stability in the United States and
makes recommendations that regulators can follow to reduce risks to the financial
system. The council can recommend methods to ensure that banks do not rely on
regulatory bailouts, which may prevent situations where a large financial institution is
viewed as too big to fail. Furthermore, it can recommend rules such as higher capital
requirements for banks that are perceived to be too big and complex, which may prevent
these banks from becoming too risky.
The act assigned specific regulators with the authority to determine whether any
particular financial institution should be liquidated. This expedites the liquidation process
and can limit the losses incurred by a failing financial institution. The act calls for the
creation of an orderly liquidation fund that can be used to finance the liquidation of any
financial institution that is not covered by the Federal Deposit Insurance Corporation.
Shareholders and unsecured creditors are expected to bear most of the losses of failing
financial institutions, so they are not covered by this fund. If losses are beyond what can
be absorbed by shareholders and unsecured creditors, other financial institutions in the
corresponding industry are expected to bear the cost of the liquidation. The liquidations
are not to be financed by taxpayers.
The act mandates that commercial banks must limit their proprietary trading, in
which they pool money received from customers and use it to make investments for the
bank’s clients. A commercial bank can use no more than 3 percent of its capital to invest
in hedge fund institutions, private equity funds, or real estate funds (combined). This
requirement has also been referred to as the Volcker rule, and it has led to much
controversy. The implementation of the limits on proprietary trading has been deferred to
July 2014. This gives banks time to sell divisions if they exceed the limit. This provision
had a larger impact on securities firms (such as Goldman Sachs and Morgan Stanley) that
had converted to bank holding companies shortly before the act, because those firms had
previously engaged in heavy proprietary trading.
T. Bank Goals, Strategy, and Governance
The underlying goal behind the managerial policies of a bank is to maximize the
wealth of the bank’s shareholders. Thus, bank managers should make decisions that
maximize the price of the bank’s stock. However, bank managers may make decisions
that serve their own goals rather than the preferences of shareholders. For example, if
they receive a fixed salary without a bonus, they may prefer to make very conservative
decisions that avoid the risk of failure. In this way, they may secure their existing job
position for a long-term period. Bank shareholders might prefer that bank managers take
some risk in order to strive for higher returns, and this may justify why bank manager
compensation is typically tied to a measure of performance such as earnings.
In order to ensure that managers serve shareholder interests, banks commonly
implement compensation programs that provide bonuses to high-level managers that
satisfy bank goals. For example, managerial compensation may include stock options,
which encourage managers to serve shareholders because they become shareholders.
However, this might encourage bank managers to forgo the development of some long-
term projects in order to focus more exclusively on increasing the current stock price in
order to achieve a high bonus. Compensation programs that provide stock options are
thus more effective (in terms of realizing the bank’s goals) when managers are required
to hold their stock for several years before selling it. Banks have been criticized for
implementing compensation programs that are overly generous and that do not
necessarily align compensation with long-term performance. Many compensation
programs of banks are based on existing compensation programs used by other banks. It
is difficult to correct for deficiencies in compensation programs when they are fairly
standard across the industry.
A bank’s strategy involves the management of its sources of funds (liabilities) and
its uses of funds (assets). Its managerial decisions will affect its performance, as
measured by its income statement, in the following ways. First, a bank’s decisions on
sources of funds will heavily influence its interest expenses on the income statement.
Second, its asset structure will strongly influence its interest revenue on the income
statement. The bank’s asset structure also affects its expenses; for example, an emphasis
on commercial loans will result in a high labor cost for assessing loan applicants.
In addition to the board of directors, publicly traded banks are subject to potential
shareholder activism. In particular, institutional investors holding a relatively large
amount of shares can attempt to influence the approach taken by the bank’s managers.
Shareholders may also pursue proxy contests if they want to change the composition of
the board, and they can pursue lawsuits if they believe that the board is not serving
shareholder interests. The market for corporate control serves as an additional form of
governance over publicly traded banks, since a bank that performs poorly may be subject
to a takeover. To the extent that a bank’s management serves its own rather than
shareholder interests, the bank’s prevailing stock valuation may be low, which could
encourage another bank to acquire it. The market for corporate control serves as a form of
governance because bank managers recognize that they could lose their jobs if their bank
is acquired.
U. Managing Liquidity, Interest Rate Risk, Credit Risk, and Market Risk
Healthy banks tend to have easy access to liquidity. However, banks can
experience illiquidity when cash outflows (due to deposit withdrawals, loans, etc.) exceed
cash inflows (new deposits, loan repayments, etc.). Bank liquidity problems are typically
preceded by other financial problems such as major defaults on their loans. A bank that is
performing poorly has less ability to obtain short-term funds because it may not be able
to repay the credit that it desires.Banks can resolve liquidity problems with proper
management of their liabilities or their assets.
The ability to securitize assets such as automobile and mortgage loans can
enhance a bank’s liquidity position. The process of securitization commonly involves the
sale of assets by the bank to a trustee, who issues securities that are collateralized by the
assets. The bank may still service the loans, but the interest and principal payments it
receives are passed on to the investors who purchased the securities. Banks are more
liquid as a result of securitization because they effectively convert future cash flows into
immediate cash. In most cases, the process includes a guarantor who, for a fee,
guarantees future payments to the investors who purchased the securities. The loans that
collateralize the securities normally either exceed the amount of the securities issued or
are backed by an additional guarantee from the bank that sells the loans.
The performance of a bank is highly influenced by the interest payments earned
on its assets relative to the interest paid on its liabilities (deposits). In some cases, net
interest margin is defined to include only the earning assets so as to exclude any assets
(such as required reserves) that do not generate a return to the bank. Because the rate
sensitivity of a bank’s liabilities normally does not perfectly match that of the assets, the
net interest margin changes over time. The change depends on whether bank assets are
more or less rate sensitive than bank liabilities, the degree of difference in rate sensitivity,
and the direction of interest rate movements. During a period of rising interest rates, a
bank’s net interest margin will likely decrease if its liabilities are more rate sensitive than
its assets, as illustrated in Exhibit 19.2. Under the opposite scenario, when market interest
rates are declining over time, rates offered on new bank deposits (as well as those earned
on new bank loans) will be affected by the decline in interest rates.
Gap analysis and duration analysis are based on the bank’s balance sheet
composition. Alternatively, a bank can assess interest rate risk simply by determining
how performance has historically been influenced by interest rate movements. This
approach requires that proxies be identified for bank performance and for prevailing
interest rates and that a model be chosen that can estimate the relationship between the
proxies. Common proxies for performance include return on assets, return on equity, and
the percentage change in stock price. To determine how performance is affected by
interest rates, regression analysis can be applied to historical data.
A bank can consider the measurement of its interest rate risk along with its
forecast of interest rate movements to determine whether it should consider hedging that
risk. The general conclusions resulting from a bank’s analysis of its interest rate risk are
presented in Exhibit 19.5. This exhibit shows the three methods commonly used by banks
to measure their interest rate risk. Since none of these measures is perfect for all
situations, some banks measure interest rate risk using all three methods. Other banks
prefer just one of the methods. Using any method along with an interest rate forecast can
help a bank determine whether it should consider hedging its interest rate risk. However,
since interest rate movements cannot always be accurately forecasted, banks should not
be overly aggressive in attempting to capitalize on interest rate forecasts. They should
assess the sensitivity of their future performance to each possible interest rate scenario
that could occur to ensure that they can survive any possible scenario.
One obvious method of reducing interest rate risk is to match each deposit’s
maturity with an asset of the same maturity. For example, if the bank receives funds for a
one-year CD, it could provide a one-year loan or invest in a security with a oneyear
maturity. Although this strategy would avoid interest rate risk, it cannot be implemented
effectively. Banks receive a large volume of short-term deposits and would not be able to
match up maturities on deposits with the longer loan maturities. Borrowers rarely request
funds for a period as short as one month or even six months. In addition, the deposit
amounts are typically small relative to the loan amounts. A bank would have difficulty
combining deposits with a particular maturity to accommodate a loan request with the
same maturity.
Most of a bank’s funds are used either to make loans or to purchase debt
securities. For either use of funds, the bank is acting as a creditor and is subject to credit
(default) risk, or the possibility that credit provided by the bank will not be repaid. The
types of loans provided and the securities purchased will determine the overall credit risk
of the asset portfolio. A bank also can be exposed to credit risk if it serves as a guarantor
on interest rate swaps and other derivative contracts in which it is the intermediary.
An important part of managing credit risk is to assess the creditworthiness of
prospective borrowers before extending credit. Banks employ credit analysts who review
the financial information of corporations applying for loans and evaluate their
creditworthiness. The evaluation should indicate the probability of the firm meeting its
loan payments so that the bank can decide whether to grant the loan. If a bank wants to
minimize credit risk, it can use most of its funds to purchase Treasury securities, which
are virtually free of credit risk. However, these securities may not generate a much higher
yield than the average overall cost of obtaining funds. In fact, some bank sources of funds
can be more costly to banks than the yield earned on Treasury securities.
Banks should diversity their loans to ensure that their customers are not dependent
on a common source of income. For example, a bank in a small farming town that
provides consumer loans to farmers and commercial loans to farm equipment
manufacturers is highly susceptible to credit risk. If the farmers experience a bad growing
season because of poor weather conditions, they may be unable to repay their consumer
loans. Furthermore, the farm equipment manufacturers would simultaneously experience
a drop in sales and may be unable to repay their commercial loans.
From a bank management perspective, market risk results from changes in the
value of securities due to changes in financial market conditions such as interest rate
movements, exchange rate movements, and equity prices. As banks pursue new services
related to the trading of securities, they have become much more susceptible to market
risk. For example, some banks now provide loans to various types of investment funds,
which use the borrowed funds to invest in stocks or derivative securities. Thus these
loans may not be repaid if the prices of the stocks or derivative securities held by the
investment funds decline substantially. The increase in banks’ exposure to market risk is
also attributed to their increased participation in the trading of derivative contracts. Many
banks now serve as intermediaries between firms that take positions in derivative
securities and will be exchanging payments in the future. For some of these transactions,
a bank serves as a guarantor to one of the parties if the counterparty in the transaction
does not fulfill its payment obligation. If derivative security prices change abruptly and
cause several parties involved in these transactions to default, a bank that served as a
guarantor could suffer major losses. Furthermore, banks that purchase debt securities
issued in developing countries are subject to abrupt losses resulting from sudden swings
in the economic or currency conditions in those countries.
Banks commonly measure their exposure to market risk by applying the value-at-
risk (VaR) method, which involves determining the largest possible loss that would occur
as a result of changes in market prices based on a specified percent confidence level. To
estimate this loss, the bank first determines an adverse scenario (e.g., a 20 percent decline
in derivative security prices) that has a 1 percent chance of occurring. Then it estimates
the impact of that scenario on its investment or loan positions given the sensitivity of
investments’ values to the scenario. All of the losses that would occur from the bank’s
existing positions are summed to determine the estimated total loss to the bank under this
scenario. This estimate reflects the largest possible loss at the 99 percent confidence
level, since there is only a 1-in-100 chance that such an unfavorable scenario would
occur. By determining its exposure to market risk, the bank can ensure that it has
sufficient capital to cushion against the adverse effects of such an event.
If a bank determines that its exposure to market risk is excessive, it can reduce its
involvement in the activities that cause the high exposure. For example, the bank could
reduce the amount of transactions in which it serves as guarantor for its clients or reduce
its investment in foreign debt securities that are subject to adverse events in a specific
region. Alternatively, it could attempt to take some trading positions to offset some of its
exposure to market risk. It could also sell some of its securities that are heavily exposed
to market risk.
V. Integrated Bank Management
Bank management of assets, liabilities, and capital is integrated. A bank’s asset
growth can be achieved only if it obtains the necessary funds. Furthermore, growth may
require an investment in fixed assets (such as additional offices) that will require an
accumulation of bank capital. Integration of asset, liability, and capital management
ensures that all policies will be consistent with a cohesive set of economic forecasts. An
integrated management approach is necessary to manage liquidity risk, interest rate risk,
and credit risk.
Assume that you are hired as a consultant by Atlanta Bank to evaluate its
favorable and unfavorable aspects. Atlanta Bank’s balance sheet is shown in Exhibit
19.9. A bank’s balance sheet can best be evaluated by converting the actual dollar
amounts of balance sheet components to a percentage of assets. This conversion enables
the bank to be compared with its competitors. Exhibit 19.10 shows each balance sheet
component as a percentage of total assets for Atlanta Bank (derived from Exhibit 19.9).
To the right of each bank percentage is the assumed industry average percentage for a
sample of banks with a similar amount of assets. For example, the bank’s required
reserves are 4 percent of assets (the same as the industry average), its floating-rate
commercial loans are 30 percent of assets (versus an industry average of 20 percent), and
so on. The same type of comparison is provided for liabilities and capital on the right side
of the exhibit. A comparative analysis relative to the industry can indicate the
management style of Atlanta Bank.
The future performance of Atlanta Bank relative to the industry depends on future
economic conditions. If interest rates rise then it will be more insulated than other banks;
if interest rates fall, other banks will likely benefit to a greater degree. Under conditions
of a strong economy, Atlanta Bank would likely benefit more than other banks because of
its aggressive lending approach. Conversely, an economic slowdown could cause more
loan defaults, and Atlanta Bank would be more susceptible to possible defaults than other
banks. This could be confirmed only if more details were provided (such as a more
comprehensive breakdown of the balance sheet).
The ratio (assets/equity) is sometimes called the leverage measure because
leverage reflects the volume of assets a firm supports with equity. The greater the
leverage measure, the greater the amount of assets per dollar’s worth of equity. The
preceding breakdown of ROE is useful because it demonstrates how Atlanta Bank’s
capital can affect its ROE. For a given level of return on assets (ROA), a higher capital
level reduces the bank’s leverage measure and therefore reduces its ROE.
If Atlanta Bank is holding an excessive amount of capital, it may not need to rely
on retained earnings to build its capital and so can distribute a high percentage of its
earnings to shareholders (as dividends). Thus its capital management is related to its
dividend policy. If Atlanta Bank is expanding, it may need more capital to support
construction of new buildings, office equipment, and other expenses. In this case, it
would need to retain a larger proportion of its earnings to support its expansion plans.
