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Federal Reserve Bank of Philadelphia
IS S N 0007-7011

NOVEMBER DECEMBER 1980

Interest Rate Futures:
A Challenge
for Bankers




ow or Later?

INTEREST RATE FUTURES:
A CHALLENGE FOR BANKERS
H ow ard K een, Jr.
Federal Reserve Bank of Philadelphia
100 North Sixth Street
(on Independence Mall)
Philadelphia, Pennsylvania 19106

The BU SINESS REVIEW is published by
the Department of Research every other
month. It is edited by John J. Mulhern, and
artwork is directed by Ronald B. Williams.
The REVIEW is available without charge.
Please send subscription orders, changes
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to the Department of Public Services at the
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Editorial communications should be sent to
the Department of Research at the same
address, or telephone (215) 574-6426.
*

*

*

*

*

The Federal Reserve Bank of Philadelphia
is part of the Federal Reserve System—a




. . . Interest rate futures may help bankers
protect their portfolios against adverse
changes in interest rates.

System which includes twelve regional banks
located around the nation as well as the
Board of Governors in Washington. The
Federal Reserve System was established by
Congress in 1913 primarily to manage the
nation’s monetary affairs. Supporting func­
tions include clearing checks, providing coin
and currency to the banking system, acting
as banker for the Federal government, super­
vising commercial banks, and enforcing
consumer credit protection laws. In keeping
with the Federal Reserve Act, the System is
an agency of the Congress, independent
administratively of the Executive Branch,
and insulated from partisan political pres­
sures. The Federal Reserve is self supporting
and regularly makes payments to the United
States Treasury from its operating surpluses.

FEDERAL RESERVE BANK OF PHILADELPHIA

Paying for Public Pensions:
Now or Later?
By R obert P. In m an *
Retirement is an important moment in the
American worker’s life—for corporate presi­
dent, blue-collar technician, soldier, and civil
servant alike. Building a secure retirement has
become part of the American dream. But how
secure that retirement will be has a lot to do
with how carefully retirement income has
been planned. And public-sector workers at
all levels of government are finding that the
pensions they have planned on for their retire­
ment years are becoming more and more
controversial.
The reason is that public pension programs
typically show large funding gaps. Not enough
has been put aside in working years to cover
promised payments during retirement years,
and the difference must be made up somehow
if the expected benefits are to be paid. There
are ways to deal with the funding gap. But
because of its size, and because the whole
matter is so complex and sensitive, finding a
*Visiting Senior Research Economist.
University of Pennsylvania.




timely answ er to the public pension funding
question will test the ingenuity of policy­
makers.

PENSION GROWTH
The past 30 years have seen a significant
expansion in the retirem ent benefits afforded
this nation’s public employees. In 1950, public
employee retirement systems for state and
local and for Federal civil service and military
personnel paid approxim ately $1 billion of
benefits to a little more than half a million
b en eficiaries—an average annual payment of
$1,666 per retiree. By 1977, those numbers
had grown to $27.1 billion of benefits and five
million retirees; the average annual benefit
now is $5,400 per retired worker, i Thus public
employee pensions have becom e a significant

^Social Security Administration, Social Security
Bulletin, Annual Statistical Supplement, 1975; and
“Benefits and Beneficiaries under Public Employee
Retirement Systems, 1977,” Research and Statistics Note,
1980.

On leave,

3

BUSINESS REVIEW

NOVEMBER/DECEMBER 1980

portion of public workers’ expected compen­
sation and a significant cost to taxpayers.
Public pension obligations seem destined to
grow still larger in future years. The aggregate
financial position of major public employee
retirement systems in the U .S. shows a four­
fold growth in the current value of promised
pension payments from 1950 to 1975. The
workers who were promised pensions in 1975
will be retiring in the 1980s and 1990s with the
expectation that the promises made to them
will be fulfilled. But the level of public pension
assets needed to meet those promises has not
kept pace. The gap between promised pensions
and accumulated assets—the unfunded liabil­
ity of the pension system—has grown (see
PENSION PROM ISE COMMITMENTS . . .).
At some point between now and the time these
workers retire, either the gap must be closed
with increased taxes or they will be denied
their full pensions. Even though the gap has
been growing larger for some time, current
retirees still are receiving their pensions. But
tax relief bought in the past through unfunded
pensions has created a ticking tax bomb that
may explode in the not too distant future. The
question confronting policymakers now is
how best to defuse it.

ment salary. Such public employee pensions
are ben efit plans defined by rules which set
the fraction of preretirement salary to be paid
as the retiree’s annuity.2 Defined benefit
plans are different from defined contribution
plans, sometimes used in the private sector,
where the amount of the pension is dependent
upon only what the employee and the em­
ployer actually contribute over the worker’s
working life to a retirement fund. Defined
contribution pension plans can be managed
poorly and yield low returns, but by definition
they can’t be underfunded. Defined benefit
plans, however, can be underfunded whether
or not they are poorly managed, since promised
benefits are unrelated to contributions.
Should defined benefit plans for public
employees be fully funded to make sure that
the assets of the plan can meet the pension
obligations promised to current workers and
retirees? The answer is not obvious. The
current social security system is a form of
defined benefit pension plan and it is far from
fully funded. Indeed, no less an economist
than Nobel Prize winner Paul Samuelson has
argued that underfunding the social security
system is exactly the right thing to do to
maximize the well-being of current and future
taxpayers and retirees. 3

PENSION UNDERFUNDING:
THE DANGERS
Underfunding public pension plans has one
obvious danger—the money to pay benefits
may not be there on the day it’s due to the
pensioner. But it also has more subtle dangers
connected with levels of public service
consumption and of private savings and
capital formation. These dangers depend on
how the funding is structured and on what
level of government administers the plans.
Benefits and Contributions. Retirement
systems currently in effect for employees of
state and local governments, the Federal civil
service, and the Armed Forces all promise the
public employee a pension upon retirement.
This pension is to be paid as an annuity equal
to a fixed percentage of the worker’s preretire­




2The rules which set the fraction of preretirement
salary—the so-called replacement rate (since the annuity
replaces salary)—vary across all public employee plans.
But the usual pattern is to give the worker two percent of
preretirement salary for each year of service up to a
maximum of 50 percent or 60 percent of salary. Therefore
a worker who serves 25 years will receive one-half (25
years times two percent) of salary. The definition of
preretirement salary also can vary across plans. In the
simplest case, it is just the last year’s base pay. Some
plans allow overtime pay to be included, others average
salary over three to five years before retirement, and still
others average salary over the worker’s whole career. For
more detail, see Robert Tilove, Public Employee Pension
Funds (New York: Columbia University Press, 1976).
2See Paul Samuelson, "An Exact Consumption-Loan
Model of Interest with or without the Social Contrivance
of Money,” Journal o f P olitical E con om y 66 (December

4

FEDERAL RESERVE BANK OF PHILADELPHIA

PENSION PROMISE COMMITMENTS
EXCEED EXPECTED FUTURE ASSETS
The accompanying Figure presents new estimates of the funding status of public employee
pension plans through 1975. * Columns 1,5, and 9 give the present value level of pensions promised
to public employees in billions of 1972 dollars. Columns 2, 6, and 10 estimate the present value of
pensions less employees’ and employers’ contributions over the working life of the employee. These
estimates approximate the employees’ net gain in wealth [pension minus contributions) from the
pension plan. The military retirement system, which is a pay-as-you-go pension plan, has no
accumulated assets. Columns 4, 8, and 12 approximate the uncovered liabilities of each public
employee pension. Uncovered liabilities are estimated here as the gap between the present value of
the pensions which have been promised and the expected contributions and assets now available to
cover those promises.
The gap is sizable, and over the past 25 years it has grown significantly. When 1975 is compared to
1970, it appears that Federal uncovered liabilities have stabilized; yet state and local uncovered
liabilities continue to grow. The size of the burden is unsettling: an additional $1,270 per person
must be found if 1975 pension promises to public employees are to be met.
The results here are not strictly equivalent to an estimate of what actuaries define as the unfunded
liability of a pension plan. Hence the use of the term ‘uncovered liability’. The key difference is how
employees’ and employers’ contributions are estimated. The Philadelphia Fed estimate is based
upon a continuation of recent funding behavior, while a true actuarial estimate calculates the level
of contributions needed to fund all future benefits fully (the normal cost of the plan), thus leaving only
the effects of past underfundings in unfunded liabilities. The estimate of uncovered liabilities seems
more appropriate for understanding the current economic status and implications of public
pensions.

PUBLIC PENSION WEALTH AND ASSETS
(billions of 1972 dollars)*
CIVIL SERVICE

Gross
W ealth

MILITARY

Gross
Wealth

A ssetst
Net
W ealth

Uncovered
Liabilities*

STATE AND LOCAL

Gross
W ealth

A ssets*
Uncovered
Liabilities*

Net
Wealth

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

1950

39.42

37.76

6.73

31.03

56.87

55.20

0

55.20

1960

66.91

63.56 14.06

49.50

84.73

81.30

0

81.30

1970

103.28

95.78 24.25

71.53

133.45 122.42

0

1975

129.75

105.72 30.32

75.40

135.88 118.12

0

A ssets*
Net
W ealth

Uncovered
Liabilities*

(10)

(11)

(12)

32.96

29.82

9.65

20.17

93.25

75.55 25.86

49.69

122.42

184.65 144.98 59.37

85.61

118.12

239.86 184.09 77.52

106.57

0)

*For details of these estimates see R. P. Inman and L. S. Seidman, “Estimates of Public Employee Pension
Wealth,” Research Paper No. 60, Federal Reserve Bank of Philadelphia, forthcoming.
tA sset data from A. Munnell and A. Connolly, "Funding Government Pensions: State-Local, Civil Service,
M ilitary,” in Funding P ensions: Issu es and Im plication s fo r Fin an cial Markets, Federal Reserve Bank of Boston,
1977.
^Uncovered liabilities equals net wealth minus assets.




5

BUSINESS REVIEW

NOVEMBER/DECEMBER 1980

When a pension system is totally under­
funded, so that its accumulated assets are
zero, it is a pay-as-you-go plan and current
taxpayers contribute to cover only the benefits
of current retirees. Such a scheme works well
as long as future retirees can be assured that
payments will be made when they retire and
as long as promised pension obligations do not
grow much faster than the tax base, placing an
oppressive burden on future taxpayers. If
either of these two conditions for pay-as-yougo funding is not met, then partial funding or
full funding is preferred. For each of the three
major public employee retirement systems—
state and local, civil service, and military—
there are good reasons to believe that a move
towards full funding is in order.
State and Local Pensions. The argument
for fuller funding of state and local pension
plans turns crucially on their being paid for at
the state or local level. This arrangement
creates a unique incentive to underfund.
Current residents of the governing jurisdiction
can receive the benefits of local labor services,
promise to compensate the workers who pro­
vide them through a defined benefit pension,
and then fail to contribute towards that promise
by not funding today and by moving out
tomorrow.
It’s easy to imagine the trouble that this can
cause in a highly mobile society. State and
local pension funding begins to look very
much like a fancy dinner party where public
services are the main dish and the tab is split
evenly among the diners no matter what or
how much they consume: each has an incentive
to buy the most expensive entree, because all
the other diners will be paying part of the
extra cost. Since households can move from

town to town and from state to state, and since
everyone must live somewhere, people end up
sharing each others’ local and state pension
obligations. Just as at the dinner party where
all have an incentive to buy the expensive
entree when they share the check, so too here
there is an incentive for residents to over­
consume their local services. If every group of
local taxpayers buys local services and pays
public employees with the idea of shifting
some of the burden to other taxpayers through
underfunding, then clearly the state and local
system as a whole will overbuy when underfunding of defined benefit pensions is al­
lowed. 4
Underfunding also can create significant
inequities, since those who pay the cost don’t
garner a commensurate benefit. Future resi­
dents, not current ones, pay a major fraction
of the costs of current services. Yet future
residents do not receive any of the benefits of
such services. Those particularly hurt are
taxpayers who leave a jurisdiction that does
fund its pensions and who move into a juris­
diction that has large unfunded liabilities to
be covered. New residents might claim that
these large tax obligations for unfunded
pension liabilities are not their responsibility.
They could refuse to pay. 5 In that instance,
the burden would shift either to retired workers
(who would receive only a fraction of their4
5
4In the course of research on public pensions recently
conducted at the Federal Reserve Bank of Philadelphia, a
significant incentive to overbuy local fire services was
discovered for a sample of 70 large U.S. cities that use
defined benefit pension plans as compensation for their
firefighters. See R. P. Inman, “Public Pensions, Public
Unions, and the Local Labor Budget,” Research Paper
No. 58, Federal Reserve Bank of Philadelphia, forth­
coming.
5The courts usually have upheld the rights of workers
to their full pensions and have required payment, and
often the state will assist localities whose pension plans
are nearly bankrupt. See, for example, U.S. House of
Representatives, Committee on Education and Labor,
Subcommittee on Labor Standards, Pension Task Force
Report on Public E m ployee R etirem ent System s, 95th
Congress, March 15, 1978, pp. 98-99.

1958), pp. 467-482. Samuelson’s arguments have been
analyzed in more detail by M. S. Feldstein, “Perceived
Wealth in Bonds and Social Security: A Comment,”
Journal o f P olitical E con om y 84 (April 1976), pp. 331-336
and Robert Barro, “Reply to Feldstein and Buchanan,”
Journal o f P olitical E con om y 84 (April 1976), pp. 343-349
in their recent debate over the savings effects of social
security.




6

FEDERAL RESERVE BANK OF PHILADELPHIA

promised pensions) or to a larger pool of
taxpayers (if the state or Federal government
offers grants assistance to bail out the local
plan). Again, tax dollars are redistributed
from current nonresidents to current residents.
And underfunding is the vehicle that transfers
these dollars.
While the mobility of area residents tends to
produce inequities when pensions are under­
funded, some have suggested that it might
generate a cure as well. The cure, like most
medicines, has an imposing name—‘capitali­
zation’. Capitalization is the process by which
all the advantages and disadvantages of
owning an asset, including the relative size of
its tax liability, are reflected in its price. To
work its wonders, capitalization requires that
all buyers and all sellers of the assets know
fully just what those advantages and disad­
vantages are—for example, when they sell a
house in one community and buy a new house
elsewhere. With the residence comes not only
a living space but also a tax obligation for any
past pension underfunding. More rooms and
larger yards presumably are advantages that
increase the value of a house, but a tax
obligation for past pension underfunding is a
disadvantage and should reduce its value. If
buyers and sellers were fully informed of the
size of the underfunded obligation, then the
price of the house should decline by just the
dollar amount needed to cover the unfunded
pension promises.
How is such perfect capitalization supposed
to solve the problems of pension underfunding? First, with the capitalization of any
unfunded pension obligations, current resi­
dents no longer would be able to escape the
full price of the public services they consumed.
They would pay for those services through
current tax payments or, if they attempted to
shift those costs of current services onto new
residents with pension underfunding, through
a decline in the resale value of their houses.
Either way, they would pay the full cost of
currently provided services. The incentive to
overbuy would be removed.




Second, the redistribution from future resi­
dents to current residents or from workers to
current residents would cease. Future resi­
dents would receive a fully compensating
reduction in the price they paid for housing.
Current workers would get their pensions
because all new residents had been compen­
sated in anticipation of covering, in full, the
pensions promised to workers. 6 Capitalization
would operate as a perfect antidote to the
major ills caused by state and local pension
underfunding.
But the capitalization cure for state and
local underfunding works only in special
circumstances, and these may be so special as
to be uninteresting. Both buyers and sellers of
housing must know the true level of pension
underfunding. But most state and local pen­
sions are reviewed by actuaries only every
three or four years, and even then the results,
if publicized, are hard for the layman to
interpret. So it probably is unrealistic to look
to capitalization as a remedy for pension
underfunding at the state and local level.
Other measures, directed at increasing the
assets of pension funds, may be necessary.
Civil Service and Military Pensions. Civil
service and military pensions are different
from state and local pensions in one funda­
mental respect: they are national pension
plans whose liabilities are hard to evade. Thus
high resident mobility will not occasion diffi­
culties for them as it does for state and local
plans. But the underfunding of these pensions
will not be problem free.
These plans have the same advantages and
disadvantages as the other major underfunded
national pension program—social security.
The current pay-as-you-go method of
funding social security has come under re­
newed scrutiny in recent years. Pay-as-you-go
has come to be seen for what it really is—a
scheme of intergenerational transfers in which
current workers subsidize the retirement bene­
fits of current retirees.
®The courts are the ones who enforce this promise.

7

BUSINESS REVIEW

NOVEMBER/DECEMBER 1980

Current workers need not be net losers
under social security. They can legislate re­
tirement benefit increases in excess of the
taxes they have just paid to the current elderly
and then ask the next generation of workers to
fund their increased benefits. The increase in
benefits over taxes will constitute an increase
in the net wealth of the current working
population, and the burden of funding passes
once again to the next working generation.
And this next generation, like its predecessor,
can increase benefits in excess of taxes paid
and make itself better off as well. And so it
goes. Through pay-as-you-go financing and
legislated retirement benefit increases, each
generation of workers can continue to increase
its net wealth at the expense of the next
generation.
Unfortunately, however, the game may not
go on forever, i If benefits grow faster than
worker income, the day may come when one
working generation, having been asked to
contribute what it considers an excessive
share of its earned income, refuses to contrib­
ute any more and declares the system bank­
rupt. The losers would be the retirees who had
lost their social security pensions or the last
round of workers who had contributed some­
thing to the system with no hope of recouping
their contributions. Something like this could
happen to civil service and military pension
plans as well as to social security.
There is a second, more subtle difficulty
with national pay-as-you-go pension plans.
As Martin Feldstein has pointed out, the
increases in net wealth enjoyed by plan
members before the system goes bankrupt
may encourage these workers to save less and
consume more. In effect, the creation of
wealth through social security displaces each

generation’s incentive to save for its own
retirement. Feldstein estimated the size of this
effect. 8 And although Social Security Admin­
istration econom ists have uncovered a pro­
gramming error that biased the initial estimates
sharply upward, Feldstein reports that his
corrected estim ates are “very sim ilar” to the
conclusions reported in the earlier study (T he
N ew Y ork Times, O ctober 5, 1980]. Another
recent study estimated that the stock of pro­
ductive equipment is sm aller by some 14
percent as a result of the social security
program. 9

Unfunded civil service and military pensions
face both the bankruptcy and the savings loss
which threaten social security. There is
nothing to prevent current taxpayers from
financing civil service and military pensions
through Federal government borrowing,
thereby shifting the tax burden onto future
generations, while continuing to enjoy the
services today of those Federal employees.
But eventually the debt must be repaid.*
9
o
See M. S. Feldstein, “Social Security, Induced Retire­
ment, and Aggregate Capital Accumulation,” Journal of
Political Economy82 (September/October 1974], pp. 905926.
9See L. Kotlikoff, “Social Security and Equilibrium
Capital Intensity,” Q uarterly Journ al o f Economics 93
(May 1979), pp. 233-254.
Professor Barro has presented the ingenious argument
that social security wealth, like all government debt, will
not affect private savings because households fully
anticipate the future taxes which such debt will impose.
While the future income from publicly created wealth is
expected to reduce current savings (Feldstein's position),
families will realize they will have to pay taxes at a later
date to cover the associated wealth creation, and in
anticipation of this tax increase they will save more
(Barro’s counterargument). The two effects offset each
other, according to Barro, and thus government debt
should have no effect on savings.
Deciding who is correct—Feldstein or Barro—will have
to wait for the empirical evidence. Some empirical
analysis shows a significant public wealth effect on
savings, but Barro’s work shows no such effect. The
Philadelphia Fed work on this question generally supports
the conclusion that public wealth does reduce private
savings, but the issue still must be treated as an open
question.

7Though Samuelson thought it might. If the working
population and worker productivity together grow at a
faster rate than legislated benefit increases, then retire­
ment benefits need not become an excessive share of
earned income and Samuelson is correct. The current
evidence, however, is against him.




8

FEDERAL RESERVE BANK OF PHILADELPHIA

service and military pensions also raises the
specter of bankruptcy. And finally, the underfunding of either state and local, civil service,
or military pensions could lead to a reduction
in private savings without any compensating
increase in government pension fund accumu­
lation. The net effect would be a drop in U.S.
capital accumulation. But these difficulties
can be dealt with.

Further, current government employees
reduce their private savings in anticipation of
their promised retirement annuity. And so do
nongovernment employees, since they needn’t
set anything aside to cover future civil service
and military pension costs. Thus the total
savings of government employees and non­
government workers could be decreased with
unfunded Federal pensions. 10 This same
depressing effect on private savings can occur
with underfunded state and local pensions. A
recent study of U .S. savings behavior
conducted at the Federal Reserve Bank of
Philadelphia, for example, has found a sig­
nificant private savings offset from unfunded
public employee pension plans. Of course, the
unfunded public employee pension system is
much smaller than social security. But in the
aggregate the Philadelphia Fed study estimates
a 10-percent to 20-percent reduction in the
current rate of capital accumulation because
of unfunded public employee pensions.n
Thus the underfunding of state and local
pensions may create a false incentive to expand
the provision of state and local services while
at the same time redistributing tax dollars
from future residents (and possibly workers if
the system goes bankrupt) to current residents.
Full capitalization of state and local pension
underfunding would prevent these misallocations, but there are good reasons to doubt that
full capitalization will occur in very many
cases. Further, the underfunding of civil

DEFUSING THE TIME BOMB
While the new contributions required to
fund public pensions are large—approximately
$5,000 for a family of four—the funding need
not take place all at once. The outstanding
pension bill will come due in small amounts as
workers retire over the next 30 years, and so
the payments can be spread out over time.
Further, the exact payment schedule is less
important than the commitment to make those
payments.
In 1971 the Federal government made this
kind of a commitment to the civil service
retirement fund. To stabilize the level of
uncovered liabilities, the Treasury began to
make additional contributions. Such contri­
butions are expected to reach 33 percent of
payroll in the 1980 budget. Yet for Federal
pension funds such as the civil service and the
military funds, contribution increases must be
matched by an increase in taxes or a reduction
in spending for the funding increase to be
meaningful. If the debt from the civil service
pension fund goes down by $10 billion but
general government debt rises by $10 billion,
for example, the whole exercise is just an
economically meaningless bookkeeping trans­
fer. Taxpayers still face a $10-billion liability.
It is not sufficient to run surpluses in the
Federal pension accounts; full and mean­
ingful funding will require a larger surplus or
a smaller deficit in the total Federal budget
(see TREASURY CONTRIBUTIONS . . .).
There is evidence also of a growing commit­
ment to increased funding of state and local
employee pensions. Federal legislation similar
to that which covers private pensions has

10Professor Barro’s arguments against a savings effect
with social security apply here as well. Again it becomes
a matter for empirical analysis.
A savings offset may occur also with unfunded state
and local pensions, but here the argument is complicated
further by the possibility of capitalization. Capitalization
of unfunded pensions means lower property wealth
which should stimulate private savings to replace the lost
wealth. Whether capitalization in fact will increase
aggregate private savings is an important question for
empirical work.
11R. P. Inman, “Public Employee Pensions and U.S.
Aggregate Savings Behavior,” Research Paper No. 59,
Federal Reserve Bank of Philadelphia, forthcoming.




9

NOVEMBER/DECEMBER 1980

BUSINESS REVIEW

TREASURY CONTRIBUTIONS
TO THE CIVIL SERVICE RETIREMENT FUND
MAY HOLD THE LINE ON THE FUND’S STATED LIABILITIES
WITHOUT RESTRAINING GROWTH IN THE TOTAL DEBT
Billions o f D ollars

*Fiscal Years
SOURCES: U .S. Bureau of the Budget, U .S. Treasury Department.

been proposed, 12 and this legislation would
mandate insurance and funding for state and

local pensions. Whether such legislation
passes remains to be seen, but legislators at

■^The Pension Reform Act of 1974, also known as the
Employee Retirement Income Security Act or ERISA.
For a useful discussion of the economic implications of




this act, see Jeremy Bulow, “Analysis of Pension Funding
under ERISA,” National Bureau of Economic Research,
Working Paper No. 402, November 1979.

10

FEDERAL RESERVE BANK OF PHILADELPHIA

will respond with new legislation to regulate
their own and their localities’ funding practices
remains to be seen.
The speed with which the states act will
have an important bearing on whether the
U.S. Congress steps in to fill the void. Congress
clearly is concerned. The U.S. House of Repre­
sentatives study of public employee pensions
notes the high level of underfunding and con­
cludes that it would “be sheer folly for individ­
ual plans and the purse collectively to con­
tinue to ignore the true level of pension costs
by . . . resorting to actuarial gimmickry in
order to reduce contribution levels.” 16 Legis­
lation has been introduced in each of the last
two sessions of Congress to impose funding,
disclosure, and investment standards upon
state and local pension systems.
But while increased pension underfunding
should not be tolerated, rules to improve
pension funding are hard to formulate. Any
Federal regulation of increased state and local
pension funding must be sensitive to the
benefit levels, workforce characteristics, and
local public economies (is there capitalization?)
of each state. Simple, enforceable funding
rules that make sense for all states and locali­
ties will be very hard to write. Perhaps the
most sensible governmental level at which to
legislate pension funding regulations is the
state level, but most states have avoided this
responsibility so far. Whether they will meet
their policy obligation in the future or let their
public employee pension systems sink still
further into debt is the unanswered $100billion question.

both the Federal and state levels have become
aware of the dangers of large unfunded state
and local pensions. Massachusetts, for exam­
ple, ran its public employee pension schemes
on a pay-as-you-go basis for many years. But
recently the Massachusetts legislature estab­
lished a pension reserve account to which it is
making voluntary contributions. 13 Local
governments also may make voluntary contri­
butions to this fund to cover their local pension
liabilities, but to date only 15 of the 99 eligible
localities have contributed. Boston, with the
largest local pension debt in the state, has not.
Pennsylvania too has felt the urgency of
funding local pensions. Sensing the need to
rationalize a system of over 1,400 local pension
plans governed by more than 40 separate state
laws, the Pennsylvania Senate passed a reso­
lution in 1979 calling for a special committee
“to undertake a complete and thorough inves­
tigation of all aspects of the local pension
systems and legislation which would be nec­
essary to correct any deficiencies found
therein .” 14 In February 1980, the committee

submitted its report with a detailed list of
recommendations. It included a call for a
pension recovery fund to be financed by the
state and local governments. This fund is
designed to assist communities whose pension
plans are nearing bankruptcy and to encourage
less immediately threatened communities to
increase their own funding. 15 The state legisla­
ture has yet to act.
Recognizing the situation and dealing with it
are two different matters. Whether the states

SUMMING UP
In short, the issue of public pension underfunding is not an easy one to deal with. The
sheer size of the funding gap has become
staggering with the passing of the years. And
no one single approach will cure the funding
ills of all public pension programs everywhere.4

■^The legislature rejected, however, the recommenda­
tion of their advisory committee to amortize their un­
funded liability over 40 years through required percentof-salary contributions. See A. Munnell and A. Connolly,
“Financing Public Pensions,” N ew England Economic
Review, January/February 1980, pp. 30-42.
14Senate Resolution 34 passed June 11, 1979.
15Report of the Special Senate Committee on
Municipal Retirement Systems, Senator H. Craig Lewis,
Chairman, and S. Howard Kline, Esq., Special Counsel,
February 8, 1980.




4®U.S. House of Representatives, Pension T ask F orce
Report, p. 181.
11

BUSINESS REVIEW

NOVEMBER/DECEMBER 1980

the right set of formulae for reducing these
liabilities without increasing other govern­
ment debt in the process, but to do so before
the funding gap becomes even larger and more
unwieldy.

But measures can be taken to improve the
structure of public pensions. Policymakers at
all levels of government are considering
methods for gradual reduction of unfunded
pension liabilities. The task is not only to find




12

FEDERAL RESERVE BANK OF PHILADELPHIA

Interest Rate Futures:

A Challenge for Bankers
B y H ow ard K een, Jr *
and the New York Stock Exchange opened its
own futures floor in August of this year.
Interest rate futures contracts provide an
opportunity to protect against changes in
market interest rates, and so they may be
attractive for commercial banks. They are not
without pitfalls, however, and the challenge
to bankers is to get the gains they offer while
avoiding the pitfalls. At the same time, bank
regulators face the challenge of adopting a
regulatory stance that both provides appro­
priate safeguards and lets banks get the most
mileage out of this financial innovation.

Contracts for future delivery of commodities
have been around for what seems time
immemorial. For the most part, these have
been contracts for agricultural goods such as
grains and livestock. Recently, however,
markets have been organized to trade contracts
for future delivery of debt securities—contracts
whose price goes up and down with changes
in the interest rate on the underlying securities.
These interest rate futures contracts debuted
in October 1975 when trading in Government
National Mortgage Association (GNMA)
certificates began at the Chicago Board of
Trade. Since that time, futures contracts have
been developed for Treasury securities (bills,
notes, and bonds) and commercial paper as
well. Trading volume has grown rapidly. By
year-end 1979, interest rate futures were being
traded at four organized exchanges in the U .S .,

NEW TWIST ON AN OLD IDEA
Trading in contracts for future delivery has
a long history. It’s reported that a futures
market in rice was operating in Japan as early
as 1697, and a futures transaction was recorded
in England in 1826. In the United States,
trading in futures first took place at the
Chicago Board of Trade in the 1860s. By 1880,
futures contracts were being traded in wheat,
corn, oats, and cotton, and as time went by,

T h e author, who received his Ph.D. from Bryn Mawr
College, is a Senior Economist at the Philadelphia Fed.
He specializes in banking and business conditions
analysis.




13

NOVEMBER/DECEMBER 1980

BUSINESS REVIEW

contracts for other commodities came into
use. Futures trading in sugar, oats, rye, barley,
eggs, and butter started about the time of
World War I. Contracts for soybeans, potatoes,
and copper and silver began to be traded in the
1930s, for turkeys in the 1940s, and for platinum
in the 1950s. Cattle, hogs, lumber, and frozen
orange juice concentrate were added to the list
in the 1960s.i
Like contracts for other commodities,
interest rate futures contracts are traded on
commodity exchanges—nonprofit organiza­
tions that provide facilities for trading. An
integral part of each exchange is a clearing
agency or corporation. All futures contracts
and related financial settlements are handled
through the clearinghouse.
The exchanges and clearinghouses together
establish rules governing the operations of
futures markets. (Futures trading is regulated
also by the Federal government through the
Commodity Futures Trading Commission.)
These rules standardize the contracts traded
on a given exchange by stipulating precise
descriptions of commodities traded, delivery
methods, delivery times, requirements for
security deposits (margins), frequencies of
adjusting the value of contracts, and limits on
daily price fluctuations. These standards are
roughly similar across the several exchanges,
though they differ according to the kind of
security for which the contract is being traded
(see Appendix).
Besides regulating futures trades, the
clearinghouse plays a central role in every
futures transaction. While futures are bought•
*
•*The history of early futures trading can be found in
Henry H. Bakken, ‘‘Futures Trading: Origin, Develop­
ment, and Present Economic Status.” Reprinted from
Futures Trading Seminar Volume III (Madison,
Wisconsin: Mimir Publishers, Inc., 1966). A listing of
commodities traded on organized exchanges in the U.S.
along with dates of initial trading is given in Annual
Report 1978 (Washington: Commodity Futures Trading
Commission). A detailed treatment of interest rate futures
can be found in Allan M. Loosigian, Interest R ate Futures
(Princeton: Dow Jones and Company, 1980).




and sold by traders on the floor of the exchange
(in the trading pits), the resulting contracts
have the clearinghouse on one side and a
trader on the other rather than traders on both
sides as buyers and sellers. Buyers of futures
contracts are obliged to make payment to the
clearinghouse while sellers are entitled to
receive payment from it. Consequently, buyers
and sellers of futures contracts need not be
concerned with the creditworthiness of each
other but only with that of the clearinghouse.
This arrangement lowers the risk of default
and adds to the attractiveness of futures
m arkets.2
Thus the markets for interest rate futures
offer well-organized trading opportunities for
prospective investors.
HEDGING CAN BENEFIT BANKERS
The real usefulness of futures markets is
that they provide a relatively low-cost method
for transferring the risk of unanticipated
changes in interest rates. In principle, futures
can be used both to increase exposure to
interest rate risk (speculate) and to reduce
exposure (hedge). But because current regula­
tions prohibit banks from speculating (see
SPECULATING WITH IN TEREST RATE
FUTURES), if bankers are to find interest rate
futures beneficial, it has to be as a tool for
hedging.
Hedging With Interest Rate Futures. To
make money, banks borrow at one rate and
lend at a higher one. But changes in interest
rates can complicate this seemingly simple
process, especially if they’re unanticipated. If
borrowing costs rise relative to lending rates,
earnings may be reduced. And if bank stock­
holders have a preference for steady income,
frequent interest rate changes can cause
A greem ents for delivery in the future can also be made
with forward contracts. The latter differ from futures
contracts in that they are not usually traded on organized
exchanges, lack standardized terms, can be canceled only
by both transactors, and typically require no margin
payments.

14

FEDERAL RESERVE BANK OF PHILADELPHIA

SPECULATING WITH INTEREST RATE FUTURES
A speculator is a person or firm that is willing to bear added risk for the opportunity of earning a
profit. With interest rate futures, the risk that speculators are willing to bear is the risk of
unexpected changes in interest rates. Speculators can make a profit if they guess correctly about
rate movements; but they can lose if they guess incorrectly.
If Cash Market Rate
Winning Strategy
Turns Out To Be:_____________________________________________________ Would Have Been:
Below Futures Rate
Above Futures Rate (yield on futures contract)

Long (buy then sell)
Short (sell then buy)

If the actual rate is expected to be lower than the rate implied in the futures contract today, a
speculator can profit from buying a contract (going long) and then selling it as the delivery date
approaches. Because yields and prices move in opposite directions, an actual rate in the future that
is below the futures rate today implies an increase in the value of the underlying securities and
therefore an increase in the value of the futures contract itself. Thus the speculator gains as he sells
the contract for more than he paid for it. Similarly, an actual rate in the future that is above the
implied futures rate today will cause the price of the underlying securities and thereby the price of
the futures contract to fall so that a short (sell then buy) strategy would result in a gain as the sale
price is higher than the purchase price. For example:
On October 1,1976 the implied yield in the futures contract for delivery of three-month Treasury
bills in the third week of December 1976 was 5.28 percent—above the then current cash market
yield of 5.04 percent. A speculator who thought that by mid-December the rate would be below 5.28
percent would take a long position in October then offset it by selling another futures contract
before the delivery date in December. If the anticipation was for the rate to be above 5.28 percent,
the reverse strategy could be followed.
By December 1, 1976, three-month Treasury bill yields in the cash market had fallen to 4.41
percent while yields on the December futures contract fell to 4.43 percent and its price rose by
$2,125, or $25 for every basis point. The long strategy would have resulted in a gain while a short
strategy would have shown a comparable loss.
Yields
Futures Contract
Cash Market
Date
Futures Market*
Pricef
October 1, 1976
December 1, 1976

5.04%
4.41%

5.28%
4.43%

$986,800
$988,925

Change

-.63%

-.85%

+$2,125

Strategy Results: f
Long
Short

+$2,125
-$2,125

•Treasury bill futures are reported on an index of 100 minus the futures market yield. The index for the above
was 94.72 and 95.57 on October 1 and December 1 respectively.
tFutures contract price is computed as $1 million minus (yield times $1 million times 90/360) for 90-day Tbills.
^Ignores brokerage fees and commissions and any opportunity cost of margins.




15

BUSINESS REVIEW

NOVEMBER/DECEMBER 1980

impact of unexpected changes in interest rates
on the profitability of anticipated cash market
transactions. These are transactions that in­
volve the purchase or sale of securities for
immediate delivery. The cash market position
is hedged by taking an opposite position in the
futures market (see MECHANICS OF
TRADING . . . ).4
A Short Hedge. A short hedge involves the
sale of one futures contract with the intention
of offsetting it later by buying another contract
for the same instrument with the same delivery
date. If the price of the futures contract falls,
the investor gains. A futures position of this
kind can be used to protect the value of a
portfolio and to lock in the cost of borrowing
at some future date.
Consider a mortgage banker who in June
makes a commitment to buy a pool of mortgages
the following January at a set price with the in­
tention of profiting by reselling them to investors
at a higher price. If the value of the mortgage
pool falls by January, the banker could take a
loss on this transaction. Because the prices of
fixed-income securities (like mortgages) fall
when their interest rates rise (and vice versa),
the mortgage banker will suffer a loss if long­
term interest rates increase.
To hedge his exposure to loss, the banker
may want to take a position that will produce
a gain in the futures market if long-term rates
do rise. This could be done by selling (shorting) a
GNMA futures contract in June and then
buying an identical contract in January. Just
as the increase in rates will reduce the value of4

additional problems for bank managers by
creating volatility in earnings. Hedging with
interest rate futures could help bankers deal
with both of these problems.
A banker might find futures useful when
other methods of hedging are closed off by
regulation or are considered to be too costly. If
rates on all of a bank’s financial assets and
liabilities were to adjust proportionately in
line with some common rate, for example,
then unexpected changes in interest rates
would have no impact on that bank’s earnings.
An unexpected change in the common rate
would raise or lower the prevailing rates on
assets and liabilities by the same amount
while leaving earnings unchanged. But things
usually don’t turn out this way. Bank assets
and liabilities aren’t perfectly homogeneous,
and their rates don’t move exactly in line with
each other. At the same time, regulatory
restrictions such as ceilings on interest rates
restrict movement in explicit rates of certain
assets and liabilities. Finally, competitive
pressures might discourage a bank from issuing
floating rate loans even though its own sources
of funds are sensitive to changes in rates. 3
Under such conditions bankers should con­
sider the use of interest rate futures to protect
their positions against unanticipated changes
in interest rates.
Bankers can use futures for three purposes
—protecting the value of a portfolio, locking
in borrowing costs, and locking in the return
on investments. In the first two cases, the sale
of a futures contract (a short hedge) would
guard against interest rates that turn out to be
higher than expected, while in the third, the
purchase of a futures contract (a long hedge)
would protect against interest rates that turn
out to be lower than expected. In each case the
objective is to protect or hedge against the

4Hedging can be viewed from several different per­
spectives. Traditional theory focuses on the potential for
reducing risk and probably is the view most applicable to
commercial bank use of interest rate futures. Hedging
also has been viewed as undertaken primarily to earn a
profit from a change in the relationship of the cash and
futures prices. These two approaches are combined in the
framework of portfolio theory, and its implications for
hedging differ from those of the other two alone. For a
discussion of these views, see Louis H. Ederington, “The
Hedging Performance of the New Futures Markets,”
Journal of Finance 34 (March 1979), pp. 157-170.

^For a discussion of this point and a more complex
example of using interest rate futures to lock in borrowing
costs, see James Marvin Blackwell, “The Ramifications
of Hedging Interest Rates by Commercial Banks,” The
University of Texas at Austin, May 1979.




16

FEDERAL RESERVE BANK OF PHILADELPHIA

MECHANICS OF TRADING INTEREST RATE FUTURES
Suppose an individual or business firm decides in January to buy a futures contract for delivery of
three-month Treasury bills two months out (in March). This would be a March futures contract. The
first step is to contact a futures broker (a futures commission merchant). After deciding on
acceptable bid prices and providing the broker with a security deposit, the buy order is sent to a
broker on the floor of the commodity exchange. The floor broker shouts out the bid in the trading
pits, and if a seller can be found, the transaction takes place. After the trade is consummated, the
buyer and seller have no further dealings with each other as far as this transaction is concerned. But
the buyer has an obligation to make payment (in March) to the clearinghouse while the seller is
obliged to deliver securities (in March) to the clearinghouse.
Although the minimum amount for a futures contract is $100,000, buyers and sellers do not have
to provide the full amount of cash or the actual securities at the time the futures contract is bought or
sold. Instead, each puts up a relatively small amount of cash (margin) as a security deposit. The
clearinghouse requires a minimum initial margin of between approximately $ 5 0 0 and $ 2 ,5 0 0 ,
depending on the contract. At the end of each trading day, the clearinghouse adjusts the value of
each outstanding contract to reflect final settlement prices for that day. This procedure, known as
marking-to-market, means that gains and losses on futures contracts are computed daily.
In essence, the broker has an account with the clearinghouse and the customer has one with the
broker. When the value of a contract rises, the buying broker’s account with the clearinghouse is
credited. If the value of a contract falls, the two accounts are reduced accordingly. And if the value
falls sufficiently, it might drop below the maintenance margin at which the broker’s account with
the clearinghouse (and the customer’s account with the broker) must be replenished (through a
margin call) to restore it to the initial margin. Such daily marking of contracts to market value
together with maintenance margins ensure that the minimum security deposit will be preserved.
C o n sid er an e x a m p le — the I M M ’s $ l-m illio n p ar v alu e 90-d ay T re a su ry b ill c o n tra c t w ith in itial
m argin o f $ 1 ,5 0 0 and m a in te n a n ce m argin o f $ 1 ,2 0 0 . If the v alu e o f th is c o n tra c t fa lls b y m ore than
$ 3 0 0 , a c a ll fo r fu n d s w ould o cc u r to resto re the m argin to $ 1 ,5 0 0 . B e c a u se e a ch b a s is p oint (.01
p ercen t) re p rese n ts $25 fo r th is c o n tra c t ($1 m illio n tim es .01 p e rc e n t tim es 90/360 days), a rise in
yield o f m ore th an 12 b a sis p o ints w ould trigger a m argin c a ll.

Once buyers and sellers are holding futures contracts, they can satisfy their obligations by taking
or making delivery of the specified securities according to the terms of delivery in the contract, or
they can cancel their contract by taking an offsetting position. Buyers cancel by selling identical
contracts and sellers cancel by purchasing identical contracts. Most futures contracts are
terminated by cancellation, which suggests that participants use the markets for something other
than locking in future sales or purchases.

rates would be offset to some degree by the
gain that results from the transaction in the
futures market when rates increase.
A Long Hedge. In contrast to a short hedge
which is used to guard against a rise in rates, a
long hedge is designed to protect against a fall
in rates. A long hedge entails the purchase of a
futures contract with the intention of offsetting
it later by selling an identical contract. This
type of hedge can be used to lock in the return
on an investment that is planned for a date in
the future.
Suppose, for example, that on April 1 a

the mortgage pool, it will lower the price of
the GNMA futures contract and result in a
gain for the banker, as he buys a contract for
less than he sold one for earlier (Figure 1
overleaf).
In a similar manner, a short hedge can be
used to lock in future borrowing costs. Such
a strategy might be used, for example, if a
fixed-rate loan of some particular maturity is
to be financed by rolling over shorter term
liabilities during the life of the loan. If interest
rates increase, the bank would have to pay
higher rates on its liabilities, but these higher




17

NOVEMBER/DECEMBER 1980

BUSINESS REVIEW

FIGURE 1

A SHORT HEDGE CAN PROTECT A PORTFOLIO
AGAINST A RISE IN RATES
Cash Market
Mortgage banker
commits to buy
pool of mortgages
in January to be
resold to investors
at that time.

June

Futures Market
Sells March GNMA
futures contract,

Long-term rates rise; the value of the pool of mortgages as well
as the value of the GNMA futures contract falls.
January

Acquires mortgage
pool and resells
to investors at a
loss.

Buys March GNMA
futures contract,

Net Result *

Loss.

Gain.

‘ Ignores brokerage fees and commissions and any opportunity cost of margins.
SOURCE:

Hedging Interest Rate Risks. 1st revised edition. Chicago: Chicago Board of Trade, September 1977,
p. 17.

banker anticipates that on June 1 he will
receive $1 million from a maturing investment.
He plans to reinvest the funds in three-month
Treasury bills when the older investment
matures. The yield on the bills as of April 1 is
13 percent, but the banker has a premonition
that rates will fall in the meantime and he
wants to hedge against such a fall. The
hedging can be done by purchasing a threemonth Treasury bill futures contract for
delivery in June. 5 By June 1, if rates in the cash 5

5Other methods of hedging a cash market position
include use of forward contracts, standby contracts,
repurchase agreements, and spot market transactions.
See Treasury/FederaJ Reserve Study of Treasury Futures
Markets, Volume II, May 1979, pp. 23-29 and Appendix
A, pp. 5-6.




18

market had fallen to 12.55 percent, the invest­
ment in Treasury bills would result in an
opportunity loss of $1,125. But if expected
future short-term rates were to fall equally,
the price of the futures contract would rise
and the sale of the contract would result in an
exactly offsetting gain of $1,125. The net
effect would be a yield of 13 percent, since $1
million of bills could be purchased in June for
a net outlay of $967,500—$968,625 less the
$1,125 gain from the futures transaction
(Figure 2).
In the case of both short and long hedges,
interest rate futures can benefit a banker by
enabling him to ensure (before paying broker­
age fees and commissions of about $50-$60
per hedge) either the value of a portfolio, the
cost of borrowing, or the investment yield

FEDERAL RESERVE BANK OF PHILADELPHIA

FIGURE 2

A LONG HEDGE GAN PROTECT
AN ANTICIPATED INVESTMENT
AGAINST REDUCED YIELDS
Cash Market

Futures Market

April 1

Proceeds of $1 million from maturing
investment expected June 1. Banker
wishes to lock in current yield of 13%.
Cost of $1 million in 3-mos. T-bills at
13% is $967,500.*

Purchases one ($1 million) June 3-mos.
T-bill contract for $967,000 (13.20%).

June 1

Buys $1 million of 3-mos. T-bills for
$968,625 (12.55%).

Sells (offsets) one ($1 million) June 3mos. T-bill contract for $968,125
(12.75%).

Net Result t

Opportunity loss =$1,125.

Gain =$1,125.

* The price of $1 million of 3-mos. T-bills in both the cash and futures markets is computed as $1 million minus
(yield times $1 million times 90/360).
t Ignores brokerage fees and commissions and any opportunity cost of margins.
SOURCE: Mark F. Polanis and David C. Fisher, “Banking on Interest Rate Futures,” Bank Administration,
August 1979, p. 39.

equally by changes in market interest rates. 6
In this case the portfolio would be hedged
already, and taking a position with futures
would serve only to establish a new unhedged
position. In short, the impact of interest rate
futures on a bank is determined by its total
balance sheet. Thus an analysis of the extent
to which a bank’s earnings are sensitive to
interest rate changes is an absolute must if
hedging is to reduce a bank’s exposure to
interest rate risk.
Bankers undertake a futures market hedge
expecting to lock in a level of earnings from a
particular investment strategy. However, the
outcome may differ from their expectations.
A change in earnings relative to anticipations6
*

from a transaction in the future. In this way,
the banker is getting an insurance policy
which like any such policy reduces the risk
associated with unexpected events.
BUT THERE ARE PITFALLS
While interest rate futures provide oppor­
tunities for bankers to reduce exposure to
interest rate risk, they have their pitfalls as
well. Their use actually will increase risk
under certain conditions, and it can result in
lower earnings in some cases. Further, in the
extreme case, the use of interest rate futures
could jeopardize bank solvency.
Risk Can Be Higher, Earnings Lower.
Although interest rate futures can help a
banker to reduce exposure to adverse move­
ments in rates, they also can increase that
exposure. An increase in exposure could occur
if a bank’s assets and liabilities are affected




6See George M. McCabe and Robert W. McLeod,
“Regulation and Bank Trading in the Futures Markets,”
Issues in B an k Regulation 3 (Summer 1979), pp. 6-14.

19

BUSINESS REVIEW

NOVEMBER/DECEMBER 1980

can occur because the so-called basis (the cash
market yield minus the futures market yield)
may not be the same at the time a futures
position is offset as it was when the position
first was taken. 7 If a hedge is perfect, the
opportunity loss in the cash market will be
offset exactly by the gain in the futures
market. But sometimes a gain or loss in the
cash market won’t be offset exactly. Thus a
crucial element to the success of hedging with
interest rate futures is what happens to the
basis. Regardless of which direction rates in
the cash market move, if the basis does not
change, the loss in one market will be just
matched by the gain in the other market. If
futures rates don’t move proportionately with
cash market rates and the basis does change,
however, the extent of the offset will be
affected. Depending upon the size and direc­
tion of the change in basis, income could rise
or fall (Figure 3).
Bankers need not be completely in the dark
about how a change in the basis will affect
their earnings. As the delivery date of a
futures contract approaches, the price of that
contract and the cash market price of the
underlying securities should move toward
equality. Thus the basis should be approxi­
mately zero by the last trading day of a futures
contract, and this characteristic can be used to
get some idea of how the basis might change.
If the basis for a June-delivery contract is

-.20 on April 1, for example, a reasonably
good guess is that from April 1 to the last
trading day around the third week in June, the
change in the basis would be +.20. An
increase in the basis would add to the earnings
from a long hedge and reduce those from a
short hedge. This is not to say that the basis
won’t jump around prior to the last trading day
of a contract. But recognizing that the basis
should be about zero at delivery can provide a
fairly good idea of how the basis will move as
the delivery date approaches.
For bankers contemplating the use of
interest rate futures, it’s a good idea to become
familiar with past behavior of the basis.
Hedging substitutes basis risk for risk from
the cash market, and the less volatile the
change in the basis, the greater the potential
for reducing risk by hedging with interest rate
futures.8 When the entire cash market position
is matched with a futures position, risk can be
reduced if, as is typical, the volatility of the
change in the basis is less than that of the
change in the cash price. 9
Hedging with interest rate futures can reduce8

8This is illustrated by Ederington, p. 161. In this article
it is estimated that in the period 1976-77, some reduction
in interest rate risk could have been achieved in two-week
and four-week hedges with 8-percent GNMA futures and
with 90-day T-bill futures, although the GNMA futures
seemed to be more effective in reducing risk, especially
for two-week hedges. For both GNMAs and T-bills,
greater risk reduction was possible in four-week than
two-week hedges. It should be noted that the relationship
between the cash price of one type of security and the
futures price of a different security is usually not as close
as it is for similar securities. As a result, cross hedging—
hedging a cash market position with a different security
in the futures market—is considered to provide less
opportunity for reducing interest rate risk than the straight
hedging illustrated in the text.

7Although the basis usually is defined as the cash
market price minus the futures market price, numerical
examples typically compute the basis as the difference
between the cash market yield and the futures market
yield. Examples in this article follow the latter and the
only point to be aware of in this regard is that when the
basis increases algebraically as measured by the difference
in yields, it decreases algebraically as measured by the
difference in prices and vice versa. W hichever measure
of the basis is used, the appropriate cash market compo­
nent will be determined by the transaction to be hedged.
For example, if a short hedge is undertaken to protect the
value of securities held by an investor, the cash market
component in the calculation of the basis would be that
for securities with the same term to maturity as those in
the investor’s portfolio.




^Whether hedging reduces the variance of returns
depends upon two things. One is the relative volatility of
the change in the basis and that of the cash price and the
other is the percentage of the cash market position that is
hedged. Although traditional theory assumes this per­
centage to be one hundred, portfolio theory implies that
the risk-minimizing percentage can be different. See
Ederington.

20

FEDERAL RESERVE BANK OF PHILADELPHIA

FIGURE 3

A CHANGE IN BASIS WILL HAVE AN IMPACT
ON A LONG HEDGE*
Cash Market
April 1

Futures Market

Basis

$967,500 (13.00%)

$967,000 (13.20%)

-.20

Net Result

Rates Fall, Basis Unchanged
June 1

$968,750 (12.50%)
(-$1,250)

$968,250 (12.70%)
(+$1,250)

-.20

0

+.05

$625

-.45

-$625

-.20

0

+.05

$625

-.45

-$625

Rates Fall, Basis Increases
June 1

$968,750 (12.50%)
(-$1,250)

$968,875 (12.45%)
(+$1,875)

Rates Fall, Basis Decreases
June 1

$968,750 (12.50%)
(-$1,250)

$967,625 (12.95%)
(+$625)

Rates Rise, Basis Unchanged
June 1

$966,250 (13.50%)
(+$1,250)

$965,750 (13.70%)
(-$1,250)

Rates Rise, Basis Increases
June 1

$966,250 (13.50%)
(+$1,250)

June 1

$966,250 (13.50%)
(+$1,250)

$966,375 (13.45%)
(-$625)

Rates Rise, Basis Decreases
$965,125 (13.95%)
(-$1,875)

•Changes in the cash market yield and the basis represent average two-month changes for 90-day T-bills using
figures for the first business day in each month over the period January 1976 through March 1980. Although
changes in both directions are illustrated above, averages were positive for both measures.

earnings in another way by limiting any gains
from unexpected changes in interest rates.
Recall that the goal of the long hedge in Figure
3 is to guard against a rate of return less than
13 percent. If the banker has correctly antici­
pated a fall in interest rates, he’ll be better off
having locked in that higher rate than he
would have been if he hadn’t used the futures
market. If rates unexpectedly rise, however,
his hedge will limit the rate of return to 13
percent instead of the unhedged return of




13 1/2 percent. Thus the possibility that
hedging could limit earnings in certain in­
stances should be viewed as part of the price
for reduced exposure to loss.
Regulatory Concern. Because of these
pitfalls and because relatively low required
margins may make it easier for trading to take
place without the authorization of top bank
decisionmakers, interest rate futures are a
concern to regulators who are charged with
maintaining the soundness of individual banks
21

BUSINESS REVIEW

NOVEMBER/DECEMBER 1980

taken (though regulators may not always find
it an easy matter to distinguish speculative
from hedging transactions]. And a bank’s
participation is to take place in a prescribed
manner. Involvement is to begin at the top
with a bank’s directors endorsing a policy on
strategies, internal monitoring and control,
position limits, and the like. In addition,
regulations prescribe explanatory notes in
financial statements to describe futures activ­
ity that materially affects a bank’s financial
condition. At the same time, Federal regulators
plan to keep a close watch on how banks use
interest rate futures.

as well as the banking system .10
The prime concern over banks’ use of
interest rate futures is that it might result in
insolvency. Trouble could occur, for example,
if highly risky futures positions were taken or
if lack of experience led to injudicious trading.
In response to such concerns, Federal regula­
tors have issued trading guidelines to the
banks, n
Futures positions that increase exposure to
loss from interest rate changes are not to be

^ F o r a fuller discussion of this point, see Brian
Charles Gendreau, “The Regulation of Bank Trading in
Futures and Forward Markets” (Washington: Board of
Governors of the Federal Reserve System, June 1979).
There are additional areas of concern about interest rate
futures that are not covered in this article. They include
the possibility of cornering or squeezing the market, the
effect on the stability of spot prices, trading of futures by
uninformed users, the impact on the flexibility of Treasury
debt management, adequacy of required margins, and
the accounting and tax treatment of interest rate futures
transactions. Many of these worries emanate from the
growing popularity of financial futures in recent years
and the ensuing proliferation of contracts. Concern was
heightened, however, by events in the silver market
earlier this year when prices plummeted and there was
difficulty in satisfying calls for additional margin.

SUMMING UP
All in all, interest rate futures pose a
challenge for both bankers and bank regula­
tors. On the positive side, interest rate futures
provide bankers with a convenient way to
hedge their exposure to interest rate risk. At
the same time, however, they have pitfalls,
and some of these could lead to serious
financial difficulties. For bankers the
challenge is to decide how futures can be used
to improve their banks’ performance, while
for policymakers the challenge is to provide
an environment within which banks can take
advantage of the benefits of interest rate
futures while at the same time maintaining the
soundness of the banking system. As time
goes by and bankers gain more experience
with interest rate futures, both they and the
policymakers should find these challenges
easier to meet.

■^Guidelines were announced by the Comptroller of
the Currency, the Federal Deposit Insurance Corporation,
and the Federal Reserve Board on November 15,1979 and
became effective January 1,1980. Revisions to the guide­
lines were announced March 14,1980 and dealt primarily
with the accounting treatment of futures, forwards, and
standby contracts. Details can be found in Federal Register,
November 20, 1979, pp. 66673 and 66722; November 28,
1979, p. 68033; March 20, 1980, pp. 18116 and 18120.




22




FEDERAL RESERVE BANK OF PHILADELPHIA

Appendix.

•

•

DIFFERENT EXCHANGES STIPULATE DIFFERENT CHARACTERS ICS FOR INTEREST RATE FUTURES CONTRACTS*
*■

Intermediate-term Treasury
Coupon Securities

■

>

Treasury Bills
ACE
Deliverable items

$1 million par
value of Treasury
bills with not more
than 92 days or less
than 77 days to
maturity

COMEX
$1 million par
value of Treasury
bills with 90, 91,
or 92 days to
maturity

IMM

IMM
$1 million par
value of Treasury
bills with 90 days
to maturity

$250 thousand par
value of Treasury
bills due in
52 weeks

CBT

IMM

ACE

CBT

$100 thousand
principal balance
US Treasury notes
and noncallable bonds
bonds with an 8%
coupon rate.
Maturity no less
than 4 years and
no greater than
6 years from the
day of delivery

$100 thousand
principal balance
US Treasury notes
with a 7% coupon
rate. Maturity
no less than 3
years 6 months and
no greater than
4 years from day
of delivery

$100 thousand
face value US
Treasury bonds with
a maturity of at
least 20 years

$100 thousand
face value US
Treasury bonds.
Maturity at
least 15 years
from delivery
day

$900

$500

$2,000

$2,500

V

$600

$300

$1,500

$2,000

*

$2,000

$750

$2,000

$2,000

March, June,
September,
December

’

February, May,
August, November

February, May,
August, November

March, June,
September,
December

*
»

*
L

►

A

♦

V

-

Initial margin!
(per contract)

$800

$1,500

$1,500

$600

Maintenance margin
(per contact)

$600

t

$1,200

$400

$1,250 (50 basis
points)

$1,500 (60 basis
points)

$1,250 (50 basis
points)

$1,250 (50 basis
points)

January, April,
July, October

February, May,
August, November

March, June,
September,
December

March, June,
September,
December

Daily limits

Delivery months

Treasury Bonds

r

'

*

J

----- 1
---Government National Mortgage Association
Modified Pass-through Mortgage-backed Certificates

T s

r

Commercial Paper

;

CBT (old)
Deliverable items

CBT (new)

ACE

COMEX

$100 thousand
principal balance
of GNMA 8% coupon
or equivalent

$100 thousand
principal balance
of GNMA
certificates

$100 thousand
principal balance
of 8% GNMA
certificates

$100 thousand
principal balance
of 8% GNMA
certificates

CBT (30-day)

•

m

>

-c l

Initial margin!
(per contract)

$ 2 ,5 0 0

$2,500

$2,000

f
!f

$2,000

j

$1 million face
value of prime
Commercial paper
rated both A -l by
Standard and Poor’s
and P-1 by Moody’s.
Maturity not more
than 90 days from
date of delivery

$1,500

$1,500

$1,200

•

CBT (90-day)

$3 million face
value of prime
Commercial paper
rated both A -l by
Standard and Poor’s
and P-1 by Moody’s.
Maturity not more
than 30 days from
date of delivery

1

$1,200

$1,250 (50 basis
points)

$1,250 (50 basis
points)

March, June,
September,
December

March, June,
September,
December

\.

it

■

-

Maintenance margin
(per contract)

$2,000

$2,000

$1,500

!

Daily limits

$2,000

$2,000

$2,000

$1,000

*

-•

Delivery months




March, June,
September,
December

March, June,
September,
December

February, May,
August, November

January, April,
July, October

-

'

........
* Information in this table was received
from the commodity exchanges in late Juneearly July 1980 and is subject to change.
More detailed information is available from
a futures broker or from the exchanges
themselves. Exchange abbrevations are as
follows: ACE = AMEX Commodity Exchange; COMEX = Commodity Exchange;
IMM = International Monetary Market:
and CBT = Chicago Board of Trade.
! The speculative margin is shown where
margins vary according to whether the
contracts cover speculative, hedged, or
spread positions.
f The amount of the maintenance margin
is not specified by COMEX; however,
brokerages often apply maintenance
margins that run about 75 percent of the
initial margin.




FROM THE PHILADELPHIA FED

• • •

This new pamphlet
describes
economic
growth and what can be
done to encourage it.
Copies are available
without charge from
the
Department
of
Public Services, Federal
Reserve Bank of Phila­
delphia, 100 North Sixth
Street,
Philadelphia,
Pennsylvania 19106.

Research
BVPERS
PHILADELPHIA

FED ^

The Philadelphia Fed’s Department of Research occasionally publishes research papers
written by staff economists. These papers deal with local, national, and international
economics and finance. Most of them are intended for professional researchers and
therefore are relatively technical.
The following papers recently have been added to the series:
No. 47. Howard Keen, Jr., “Dual-Decision Models of Household Demand for Checking
Account Money: A Description and Diagrammatic Illustration.”
No. 48. Timothy H. Hannan, “Bank Robberies and Bank Security Precautions: An
Examination of Criminal Behavior with Victim-Specific Data.”
No. 49. John J. Seater, “The Market Value of Outstanding Government Debt, 19191975.”
No. 50. John J. Seater, “Are Future Taxes Discounted?”
No. 51. John J. Seater, “On the Estimation of Permanent Incom e.”
No. 52. Aris Protopapadakis, “The Endogeneity of Money During the German Hyper­
inflation.”
No. 53. Mark J. Flannery, “Market Interest Rates and Commercial Bank Profitability:
An Empirical Investigation.”
No. 54. Werner Z. Hirsch and Anthony M. Rufolo, “Effects of Prevailing Wage and
Residency Laws on Municipal Government W ages.”
Copies may be ordered from RESEARCH PAPERS, Department of Research, Federal
Reserve Bank of Philadelphia, 100 North Sixth Street, Philadelphia, Pennsylvania 19106.



FEDERAL RESERVE BANK OF PHILADELPHIA
BUSINESS REVIEW CONTENTS 1980
JANUARY/FEB RUARY
Laurence S. Seidman, “Fighting Inflation with a
Tax-Based Incomes Policy”
Gary P. Gillum, ‘TIP Is Not the Answer to Inflation”
MARCH/APRIL
Edward G. Boehne (Commentary), “Bank Super­
visory Trends in the ’80s”
Timothy Hannan, “The Productivity Perplex: A
Concern for the Supply Side”
Janice M. Moulton (Westerfield), “How U.S.
Multinationals Manage Currency Risk”
MAY/JUNE
John Gruenstein, "Jobs in the City: Can Philadelphia
Afford To Raise Taxes?”
Nicholas Carlozzi, “Pegs and Floats: The Changing
Face of the Foreign Exchange Market”

100 North Sixth Street
Philadelphia, PA 19106




JULY/AUGUST
Timothy Hannan, “Foiling the Bank Robber: What
Makes a Difference?”
Anthony M. Rufolo, “What’s Ahead for Housing
Prices?”
SEPTEMBER/OCTOBER
John J. Mulhern, “The National Stock Market:
Taking Shape”
Mark J. Flannery, “How Do Changes in Market
Interest Rates Affect Bank Profits?”
NOVEMBER/DECEMBER
Robert P. Inman, "Paying for Public Pensions:
Now or Later?”
Howard Keen, Jr., "Interest Rate Futures: A
Challenge for Bankers”
Contents 1980