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ISSN 0007-7011
Federal Reserve Bank of Philadelphia
MAY • JUNE 1986
Loan Commitments
Insurance Contracts in a Risky World
*
Mitchell Berlin
Hedging Bank Borrowing Costs
With Financial Futures
Michael Smirlock
______
Federal Reserve Bank of Philadelphia
Ten Independence Mall
Philadelphia, Pennsylvania 19106
MAY/JUNE 1986
Increased volatility of interest rates recently has created risks for both banks and their
customers. For example, when interest rates head up unexpectedly, banks can face a profit
squeeze; their short-term borrowing costs are higher while the revenues on their long-term
loans are tied to the lower rate. Volatility imposes other risks as well, for higher borrowing
costs may limit a bank's ability to make loans available to its customers.
In this issue of the Business Review, two approaches to hedging these risks are presented.
Mitchell Berlin analyzes loan commitments in the framework of insurance contracts between
borrowers and banks. Michael Smirlock describes and discusses interest rate futures contracts,
and compares the effectiveness of various kinds of futures contracts in hedging interest rate
risk.
LOAN COMMITMENTS: INSURANCE CONTRACTS
IN A RISKY W ORLD...............................................................................................3
Mitchell Berlin
HEDGING BANK BORROWING COSTS
WITH FINANCIAL FUTURES ...........................................................................13
Michael Smirlock
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Loan Commitments
Insurance Contracts in a Risky World
Mitchell Berlin*
INTRODUCTION
Over the last fifteen years, banks have been
increasingly concerned with managing the risks
that stem from volatile interest rates, both for
themselves and for their loan customers. One
response to this uncertain environment has been a
large increase in the volume and variety of loan
commitments — promises by banks to make
future loans at the customer's demand. These
*Mitchell Berlin is an Economist in the Banking Section of
the Research Department of the Federal Reserve Bank of
Philadelphia.
agreements provide commercial borrowers with
assurance that funds will be available, often at a
contractually set rate. One can view the loan
commitment as an insurance contract, in which
borrowers purchase protection against certain
risks, and banks — as insurers — take risks upon
themselves.
The growth of loan commitments reflects a
more general trend toward the explicit pricing
of individual customer services by banks. Al
though the traditional loan relationship had al
ways provided insurance through informal
understandings and implicit promises, loan
commitments increasingly contain binding con
3
MAY/JUNE 1986
BUSINESS REVIEW
tractual promises and explicitly priced insurance
services. An analysis of the growth of commit
ments and the relative growth of different types
of commitments provides a striking illustration
of banks' attempts to adapt traditional customer
services to a riskier and less regulated environ
ment.
WHY CUSTOMERS AND BANKS
USE LOAN COMMITMENTS
Loan commitments — promises by banks to
lend up to some maximum amount over a fixed
period — are not new instruments. Their wide
spread use, though, is relatively new, especially
among smaller commercial customers. This
growth in loan commitments has been apparent
since 1977 (the first year for which detailed data
are available) for short-term, commercial and
industrial (C&I) loans of all sizes (see Table
1 ).
The first step toward understanding this trend
is to explain why customers want commitments.
Why, for instance, would a commercial customer
desire a commitment by a bank to make loans
rather than simply apply for loans as needed?
The underlying reason is that customers without
commitments face considerable uncertainty about
both the cost and availability of funds. An example
helps to illustrate the point.
Consider Shmattas and Hatts (S&H), a medium
sized clothing manufacturer. Like many clothing
firms, S&H has separate seasonal lines. Each
TABLE 1
THE SHARE OF SHORT-TERM C&I LOANS
MADE UNDER COMMITMENT a
Size of Loan (thousands)
Year
$1 - 24
$25 - 49
$50 - 99
$100 - 499
$500 - 999
$1000 and above
1977
18%
24%
26%
41%
61%
59%
1978
15
21
27
38
63
49
1979
23
31
40
46
59
55
1980
24
30
39
47
64
51
1981
26
30
40
47
66
51
1982
36
37
48
54
63
62
1983
33
37
46
49
67
67
1984
31
38
43
54
67
71
1985
36
41
52
58
70
70
aThe figures are constructed from a sample of 340 commercial banks of all sizes. The figures are short-term (one
year or less) C&I loans granted under commitment as a percent of total short-term C&I loans.
SOURCE: "Survey of Terms of Lending at Commercial Banks," Federal Reserve Bulletin (various years).
4
FEDERAL RESERVE BANK OF PHILADELPHIA
Loan Commitments
winter, the firm manufactures swimsuits to be
placed in department stores by early summer.
Every spring, S&H produces sweaters that will
be sold in the fall. Until the clothes have been
sold and the remittances received from retail
outlets, S&H requires funds to cover its material,
labor, and warehousing costs.
In the past S&H has always borrowed from
First National Bank and has built up a reputation
for prompt repayment. But when it applies for
its spring loan, the loan officer explains that the
bank has experienced unusually large loan
demand, so it can provide only half of the firm's
working capital requirement. Now S&H must
cut back production or make a costly search for
alternative sources of funds. Without a promise
to lend from the bank, S&H faces availability
risk—the possibility of getting less funds than it
needs.
In another scenario, suppose that the loan
officer says that the full loan can be accom
modated but at the prime rate plus 200 basis
points, instead of the 100 basis point markup
over prime that the bank had required on previous
loans. The higher markup raises S&H's produc
tion costs and the firm must either renegotiate
prior agreements with sales outlets or accept
lower net revenues. Therefore, when a firm ap
plies for separate loans as needed it is also subject
to markup risk — the possibility of increases in
the loan rate due to a higher markup. Loan com
mitments, though, permit customers to purchase
insurance against availability risk and markup
risk.1
A bank also finds it profitable to supply loan
commitments for several reasons. First, loan
commitments have some of the virtues of the
more traditional long-term loans: by signing a
single contract, the bank can both reduce the1
*
1Of course, the firm still bears interest rate risk — the possi
bility of loan rate increases due to rising market rates, because
virtually all loan commitments permit loan rates to move
with market rates. The customer locks in a commitment to
lend and often a markup, but not a fixed reference (or base)
rate.
Mitchell Berlin
costs of negotiating a series of shorter-term loans,
and banks can more easily plan future loan de
mand. At the same time, banks can take advantage
of customers' willingness to pay for the insurance
a loan commitment offers. The most common
form of payment, a fee based on the unborrowed
balance of the commitment, is especially attractive
to banks seeking a stable source of income in an
uncertain environment. Another benefit to the
bank lies in the regulatory treatment of loan
commitments. Unlike a long-term loan, a loan
commitment enters the bank's balance sheet
piecemeal — each time the customer borrows,
the bank enters the amount borrowed as an
asset. Thus the bank receives income based on
the total amount committed — the interest on
the loans actually made and the fee on the unbor
rowed balance — while its assets include only
the loans granted. Since regulators require banks
to maintain a minimum capital-to-asset ratio,
loan commitments place less pressure than long
term loans on the bank's capital requirement
while still producing income.
THE GROWTH IN COMMITMENTS
REFLECTS AN INCREASED DEMAND
FOR INSURANCE
The sources of borrowers' increased demand
for insurance lie in a combination of factors that
made loan rates more volatile in the 1970s and
1980s, and increased borrower risk. Before the
1970s, the prime rate was changed very little
and very infrequently. Deposit rate regulation,
low inflation rates, and the Fed's practice of
restricting interest rate fluctuations ensured that
bankers could attract deposits at a low, stable
cost, and this permitted them to offer stable loan
rates to borrowers. But as inflation and interest
rates moved higher in the late 1960s and 1970s,
depositors became increasingly dissatisfied with
low, regulated rates of return, and bankers came
under pressure to satisfy depositors' demands
for market rates of return. The deregulation of
interest rates on large, negotiable certificates of
deposit (CDs) in 1973 permitted banks to satisfy
this demand, at least for large depositors. Thus
5
BUSINESS REVIEW
MAY/JUNE 1986
banks became more and more dependent upon
liabilities whose cost moved directly with market
interest rates. (See Figure 1.)
The sluggishness of the prime rate that marked
the pre-1970 period was a major casualty of this
transformation of the liability side of bank balance
sheets. By the early 1970s, banks had begun
adjusting the prime rate more rapidly in response
to fluctuations in their cost of funds, and with the
Fed's change in operating procedures in October
1979, bankers faced much more volatile CD
rates. As CD rate fluctuations became more
pronounced, borrowers were increasingly con
fronted with volatile loan rates.2
Volatile Loan Rates Increased Borrower Risk.
When loan rates became more variable, cus
tomers borrowing on a loan-by-loan basis faced
2See Brian C. Gendreau, "W hen Is the Prime Rate Second
Choice?" this Business Review (May/June 1983) pp. 13-21.
both greater markup risk and greater availability
risk. The reason is that the bank's perception of a
customer's creditworthiness depends, in part,
upon the loan rate the bank charges. A firm
forced to borrow at a higher rate due to an unex
pected increase in the bank's cost of funds may
engage in riskier behavior with a higher proba
bility of default.3 For instance, to protect profit
margins, the clothing manufacturer may choose
a less traditional, more uncertain product line in
the hope that its sales revenues will be greater
than normal. Although the bank cannot predict
each customer's expected revenues with com
plete accuracy, it realizes that there are many
3For a rigorous demonstration of the relationship between
the loan rate and default risk, see Joseph Stiglitz and Andrew
Weiss, "Credit Rationing in Markets with Imperfect Infor
mation," American Economic Review 0u ne 1981) pp. 393410.
FIGURE 1
INTEREST RATES ROSE
AND BECAME MORE VOLATILE
15
10
3-M ONTH T-BILL
3-M ONTH CD
1950
1955
1960
1965
1970
1975
1980
1985
SOURCE: Data Resources, Inc.
Digitized 6 FRASER
for
FEDERAL RESERVE BANK OF PHILADELPHIA
Loan Commitments
customers like the clothing manufacturer and
raises its assessment of the average likelihood of
default. For loan customers without a contractual
commitment, the bank has two alternatives. One
is to increase the customer's markup as compen
sation for increased credit risk. The other is to
refuse to lend on the grounds that the higher
markup increases the customer's probability of
default. The first alternative confronts the loan
customer with markup risk, while the second
creates availability risk. These risks reduce the
gains to both the bank and the borrower from
maintaining a continuing loan relationship.
The greater markup and availability risk that
accompanied the interest rate volatility of the
1970s and 1980s thus raised the value of insurance
to the loan customer. This, in turn, generated a
greater demand for loan commitments. By satis
fying this demand, banks were able to maintain
a traditional clientele — customers who required
funds on a continuing basis.
Further insight into the banking industry's
innovative response to a riskier environment
requires a detailed look at how the various types
of loan commitment contracts allocate risk be
tween the bank and the borrower. Each contract
type imposes a distinctive compromise between
the customer's desire for protection against risk
and the bank's costs of providing that insurance.
Thus, it is not surprising that customers' and
banks' preferences for different types of commit
ments have shifted as banking markets have
changed.4*
REVOLVING LOAN COMMITMENTS VS.
CONFIRMED CREDIT LINES
Although all commitments involve a contrac
tual promise to lend up to some maximum amount
4For interesting recent empirical discussions of loan com
mitment contracts, see Thomas Brady, "Changes in Loan
Pricing and Business Lending at Commercial Banks," Federal
Reserve Bulletin (Jan. 1985) pp. 1-13, and John Ham and Arie
Melnick, "Bank Lending Practices and the Market for Loan
Commitments: Survey and Analysis," unpublished paper,
University of Haifa (Feb. 1984).
Mitchell Berlin
over a given period, revolving loan commitments
also contain a loan formula. This loan formula
includes a reference rate —either the prime rate
or some market rate such as the 60-day CD rate
— and a contractually fixed markup. The size of
the markup is determined by the customer's
creditworthiness. Revolving loan commitments
therefore protect the customer against both avail
ability risk and markup risk. In contrast, a com
mitment that permits the bank to set the loan
rate unilaterally each time the commitment is
used, or "taken down," is called a confirmed credit
line. This type of commitment only provides
insurance against availability risk.
The provision of insurance, however, is not
costless for the bank. While the fixed markup
provided by a revolving loan commitment is a
definite advantage to the customer, it increases
bank risk. Thus, customers with revolving loan
commitments are usually required to compensate
the bank in the form of a commitment fee. The
fact that commitment fees are seldom required
on confirmed credit lines indicates that it is the
combination of the promise to lend and the
fixed markup that poses special risks, for which
the bank requires added compensation.
The first type of risk to the bank is known as
quantity risk, the possibility that many customers
will borrow unexpectedly from the bank at the
same time. Although firms normally borrow
funds from time to time according to their indi
vidual needs, at certain times many firms will
borrow at once. This is true, in particular, when
alternative sources of funds are costly and diffi
cult to find. To satisfy an unexpectedly large loan
demand, banks must compete aggressively for
funds against other banks. This drives up market
rates, including CD rates, and leads banks to
raise the prime rate. Since loan commitments
use these rates as reference rates, part of the
bank's costs of meeting greater loan demand is
passed on to borrowers with commitments. But
the increase in the reference rate, which is only
one component of the loan rate, does not neces
sarily compensate the bank fully for the added
costs of satisfying loan demand. In particular,
7
BUSINESS REVIEW
banks are subject to regulatory capital constraints
and are not free to increase loans without limit.
If, for example, regulators require capital equal
to 6 percent of total assets outstanding, and the
total loans taken down under commitment would
drive the capital-to-asset ratio to 5 percent, the
bank either must deny new loans to customers
unprotected by commitments or must increase
its capital. Either alternative is costly to the bank
and these costs are not reflected in the reference
rate.
The second type of risk to the bank is known
as credit risk — the possibility of customer default.
While banks face credit risk on all loans, not just
loans granted under commitment, the fact that
commitments extend into the future creates added
uncertainty. Typically, commitments are made
for 1 to 3 years. A bank may be able to evaluate a
customer's creditworthiness accurately in the
near term; however, a customer's ability to repay
loans to be made in the future will be harder to
predict. This risk is compounded because firms
are especially likely to take down commitments
when alternative credit sources are unavailable
because of increased credit risk.
In sum, since under a revolving loan commit
ment, the bank is unable to adjust the markup in
response either to large loan demand or to a
decline in a customer's creditworthiness, the
contract must contain provisions that either re
duce the bank's risks or compensate the bank for
the risks it bears. The commitment fee is the
standard provision that compensates the bank
for bearing quantity and credit risk. Since the
risk borne by the bank at any time depends
upon the customer's maximum potential bor
rowings, the commitment fee usually takes the
form of a percentage payment on the unbor
rowed balance of the loan commitment (0.5 per
cent is a typical fee) .5 To limit the risks imposed
by the fixed markup, commitments also contain
provisions to renegotiate or even cancel the
agreement if there are m ajor declines in the
5See Ham and Melnick, "Bank Lending Practices..."
Digitized 8 FRASER
for
MAY/JUNE 1986
customer's creditworthiness. Many commit
ments require that borrowers achieve a zero
balance at least once a year, because the bank
can use the customer's ability to clear its balance
periodically as an indicator of the customer's
creditworthiness. If the firm cannot clear, then
the bank may decide to examine the firm's books
and determine whether the commitment should
be discontinued or renegotiated.6
Revolving Loan Commitments Have Become
a Larger Share of Total Commitments... The
growth in the use of revolving loan commitments
has outpaced the growth of confirmed credit
lines (see Table 2). How can the apparent in
creasing preference for revolving loan com
mitments be explained? Perhaps the primary
reason is that the risks facing borrowers have
changed with the deregulation of deposit rates.
While markup risk and availability risk due to
loan rate volatility have increased, another tradi
tional source of availability risk has declined in
importance because of banks' expanded liability
powers. In the years before the deregulation of
deposit rates, when market rates rose above
deposit rate ceilings, funds flowed out of the
banking system. This outflow of funds has been
termed "disintermediation." Depositors shunned
the below market returns offered by banks and
shifted their funds into financial instruments
paying higher interest rates offered by unregu
lated competitors. Unable to purchase sufficient
funds, banks were compelled to reduce the avail
ability of loans to customers unprotected by
commitments. Since the restricted availability of
loans resulted from banks' restricted access to
funds rather than the increased credit risk due to
high loan rates, confirmed credit lines provided
adequate protection against the risk faced by the
borrower in obtaining a loan.
However, the threat of disintermediation has
6Some contracts require the firm to maintain working
capital above some minimum level. Such clauses have the
same basic intent as provisions that require customers to
clear their balance periodically.
FEDERAL RESERVE BANK OF PHILADELPHIA
Loan Commitments
diminished as banks have acquired enhanced
powers to compete for funds. In periods of high
interest rates banks can secure funds, but only at
a higher cost. Thus availability risk due to disinter
mediation has declined in importance, while the
risks arising from loan rate volatility have in
creased. Accordingly, revolving loan commit
ments have becom e relatively more attractive
than confirmed credit lines, which provide no
markup protection.7*
...But It Is Still Efficient for Banks to Offer
Both Types. The declining share of confirmed
credit lines is by no means evidence that they
are falling into disuse. Because different loan
customers have different needs, banks will try to
satisfy them with differentiated products. For
example, a large firm may be confident that it
will remain creditworthy and that its credit status
will be verified by public rating agencies such as
Standard and Poor's. This firm will find the markup
protection of revolving loan commitments less
valuable than will a small, unrated firm with
more uncertain prospects. Also, by offering both
revolving loan commitments and confirmed
credit lines, banks can generate information about
customers that is otherwise difficult to collect,
because the customer's choice between contract
types can reveal his likelihood of borrowing.
Thus banks increase the predictability of loan
demand.
To see this, consider a very simplified example
with two different loan customers, firm A and
firm B. Imagine that firm A is more likely than
firm B to require funds, but that it is difficult for
7Another explanation of the move to revolving loan com
mitments involves the different sizes of borrowers. Since
the largest increase in the use of loan commitments appears
to have occurred among smaller borrowers, the greater than
proportional growth of revolving loan commitments may
reflect the different characteristics of large and small bor
rowers. If, for instance, small borrow ers' creditworthiness is
more likely to vary over the 2- to 3-year life of a commitment,
then they are more likely to demand markup protection and
banks are more likely to require fee compensation for a
commitment to lend. Currently available data do not permit
a test of this hypothesis.
Mitchell Berlin
TA BLE 2
C&I LOANS MADE
UNDER REVOLVING LOAN
COMMITMENTS
Dollars3
Year
(billions)
Percent of All C& I Loans
Made Under Commitment
1977
19.7
24.7%
1978
23.5
24.8
1979
31.0
27.1
1980
36.6
29.1
1981
46.3
32.6
1982
62.9
40.1
1983
62.5
41.2
1984
73.5
44.2
1985
75.0
47.8
aRefers to the monthly average for each year.
SOURCE: "Commercial and Industrial Loan Commit
ments at Selected Large Commercial Banks," Federal
Reserve Statistical Release G.21 (423). The survey
includes 119 large banks.
the bank to determine either firm's probable
need for funds by direct examination. Clearly, in
many cases firms know a great deal more than
the bank does about their likely need for a loan.
The different characteristics of the two types of
commitments may induce firm A to choose a
revolving loan commitment and firm B to choose a
confirmed credit line, and in the process they
reveal their probability of borrowing. The re
volving loan commitment requires a commit
ment fee, but limits upward movements in the
loan rate by fixing the markup; the confirmed
credit line, however, requires no fee, but also
places no restriction on the bank's prerogative
to raise the markup and hence the loan rate.
Everything else equal, firm A will be willing to
pay the commitment fee to gain protection against
9
BUSINESS REVIEW
drastic loan rate increases because it is more
likely to borrow. For this type of firm, protection
against the loan rate increasing is very valuable.
On the other hand, firm B, which is less likely to
borrow, will be less concerned with the possibility
of a high loan rate, and will choose the confirmed
credit line to avoid paying the commitment fee.
Without this kind of information about cus
tomers, the bank is forced to plan its future
funding needs as if all its customers were identical,
"average" loan customers. But if customers reveal
their individual probabilities of borrowing
through their choice of contract type, the bank
can reduce its uncertainty about likely loan de
mand, and can plan its funding accordingly.
Since loan demand has been made more pre
dictable, the bank bears less quantity risk.8
MAY/JUNE 1986
FIXED VS. FLOATING
REFERENCE RATES
Choice among loan commitment contracts is
not limited to deciding whether or not the markup
should be contractually fixed. In addition, loans
taken down under commitment differ according
to the variability of the reference rate, which
may be either a fixed or floating rate. For a floating
rate loan, the reference rate is adjusted continu
ously throughout the life of the loan. The actual
loan rate paid is some weighted average of the
rates prevailing until the loan is repaid. For a
fixed rate loan, the reference rate prevailing on
the day the loan is taken down remains in force
until the loan is repaid. The fixed rate loan pro
vides the customer with insurance against interest
rate risk — the possibility of a rise in the reference
rate during the life of the loan.
Floating Rate Loans Have Become More Preva
lent... Published data that aggregate ordinary
loans and loans made under commitment reflect a
trend toward increasing use of floating rate loans
(see Table 3). This trend can be observed across
all loan sizes except the very largest, which tend
to have very short maturities (one month or
less). The growth of floating rate loans is usually
ascribed to the greater volatility of bank funding
costs. When the cost of funds is variable, a bank
making fixed rate loans funded by liabilities of
shorter maturity faces interest rate risk. If, for
example, the bank funds a 6-month fixed rate
loan with 3-month CDs, an unanticipated rise in
the CD rate reduces the bank's profit margin. To
avoid interest rate risk, though, the bank has an
alternative to the restrictive policy of matching
each loan with a liability of identical maturity. If
the reference rate is allowed to float, the bank
can shift interest rate risk to the customer.
The most recent data distinguish fixed and
floating rate loans according to whether they
were granted under commitment or not. The
data from the last four loan surveys indicate that
a loan granted under commitment is more likely
to have a floating rate than an ordinary loan. In
dollar terms, the share of committed loans with
floating rates in these four surveys ranged from
a high of 37 percent to a low of 24 percent, while
the fraction of noncommitted loans with floating
rates ranged from 27 percent to 18 percent.9
Loan commitments come with a variety of
repayment options, and customers have some
flexibility in determining when to repay the
loan. Uncertainty about the repayment time
creates difficulty for a bank that wishes both to
offer fixed rate commitments and to limit its own
interest rate risk. Unless the bank can confidently
predict the maturity of the loan, it is unable to
fund the loan with a matching CD. Thus, banks
are more likely to insist on the floating rate
option for loans granted under commitment.
...But It Is Still Efficient for Banks to Offer
Fixed Rate Loans. Although banks have increased
8For a formal model, see Anjan Thakor and Gregory Udell,
"An Economic Rationale for the Pricing Structure of Bank
Loan Commitments," Banking Reasearch Center Working
Paper, Northwestern University (April 1984).
9See "The Survey of Terms of Bank Lending," Federal
Reserve Statistical Release E.2. The four surveys are from
November 5-9, 1984; February 4-8, 1985; May 6-10, 1985;
and August 5-9, 1985.
10
FEDERAL RESERVE BANK OF PHILADELPHIA
Mitchell Berlin
Loan Commitments
TABLE 3
THE SHARE OF SHORT-TERM C&I FLOATING RATE LOANS
Size of Loan (thousands)
Year
$1-24
$25-49
$50-99
$100-499
$ 5 0 0 - 999
$1000 and above
1977
25%
31%
43%
53%
55%
67%
1978
32
34
44
51
57
66
1979
22
27
36
43
62
65
1980
22
33
48
59
71
35
1981
29
39
48
59
71
35
1982
35
44
56
61
64
23
1983
35
46
52
64
68
30
1984
33
44
51
64
69
32
1985
35
49
65
73
75
21
aThe figures are constructed from a sample of 340 commercial banks of all sizes. The figures are short-term (one
year or less) C&I loans made with floating rates as a percent of total short-term C&I loans.
SOURCE: "Survey of Terms of Lending at Commercial Banks," Federal Reserve Bulletin (various years).
the share of floating rate loans, many loans are
still granted at fixed rates. This is especially appar
ent for smaller loan sizes. The continued popu
larity of fixed rate loans indicates that in many
cases there are efficiency gains when the bank
provides insurance against interest rate risk.
The most important reason why the bank and
customer may elect to use the fixed rate alternative
is to reduce the customer's risk of default. The
positive relationship between interest rate risk
and default risk is a particular concern for loans
granted to small borrowers, who in general find
it difficult to insure against interest rate risk on
their own. The bank can increase its profits by
bearing the risk of increases in its cost of funds,
thereby increasing the customer's probability of
repayment.
In addition, banks have access to other hedging
strategies that are available to only their largest
loan customers. Although relatively few banks
— primarily the largest money center and regional
banks — have actively experimented with hedging
interest rate risk through the use of futures,
there has been substantial recent interest in their
use. The use of such instruments as an alternative
means of hedging interest rate risk has the desir
able feature that risk is actually reduced for both
the bank and the borrower rather than simply
shifted to the borrower.
CONCLUSION
Banks have traditionally been specialists in
maintaining ''loan relationships" — long-term,
repeated dealings with individual borrowers. In
a stable and regulated world, banks and their
commercial customers relied on informal promises
11
BUSINESS REVIEW
to support a series of individual loan agreements.
But the transformation of the liability side of
banks' balance sheets has entailed changes in
traditional lending practices. In particular, loan
commitments that explicitly provide customers
with insurance increasingly have replaced "im
plicit" or informal agreements. Thus, the terms
of loan commitment contracts reflect a compro
mise between customers' demand for insurance
and banks' costs of satisfying this demand.
Although interest rate volatility was an impor
tant factor behind the growth of commitments, a
period of lower, more stable rates is not likely to
Digitized12 FRASER
for
MAY/JUNE 1986
lead to a decline in their use. The formalization
of the loan relationship is part of a more general
trend in bank-customer relations. By making the
traditionally informal promises of the loan rela
tionship explicit and binding, loan commitment
contracts mirror the trend toward explicit pricing
of deposit and payments services by banks. Im
plicit charges and informal agreements were
hallmarks of highly regulated banking markets.
The explicit pricing of services, including the pro
vision of insurance to loan customers, is a direct
outcome of deregulation that is not likely to be
reversed.
FEDERAL RESERVE BANK OF PHILADELPHIA
Hedging Bank Borrowing Costs
with Financial Futures
Michael Smirlock*
In response to the increased volatility of interest
rates, many banks have sought to reduce their
interest rate risk by offering floating rate loans to
their commercial customers. This allows banks
to make the revenues on their longer-term loans
more responsive to the interest rates that deter
mine their shorter-term borrowing costs.
The problem with these floating rate loans is
that they do not eliminate interest rate risk; instead,
^Michael Smirlock is a Visiting Scholar at the Federal Reserve
Bank of Philadelphia and Assistant Professor of Finance,
The Wharton School, University of Pennsylvania.
such loans transfer the risk from the lender to
the borrower, which may not be a very good
solution for the bank after all. Floating rate loans
may cause the cash flow of the borrower to
fluctuate with interest rates, introducing an ele
ment of uncertainty into the borrower's planning
and budgeting program. Since many bank custom
ers will be reluctant to accept this uncertainty,
they will seek fixed rate financing from sources
other than the bank. As a result, the bank may
lose not only the customer's loan business, but
also the firm's other banking business. Another
problem for banks is that, because a floating rate
loan can have a significant impact on the cash
flow of the customer, it may increase the riskiness
13
BUSINESS REVIEW
of the loan. Further, since borrowers are generally
willing to pay a premium to avoid interest rate
risk, the bank is passing up additional revenue
by not offering a fixed rate loan. There are thus
incentives for the bank not to transfer this interest
rate risk to the borrower. To the extent the bank
can hedge the interest rate risk at low cost, how
ever, it can make a fixed rate loan, maintain good
customer relations, and earn additional income
while incurring minimal interest rate risk.
Interest rate futures can provide banks with a
low-cost method for hedging the interest rate
risk in making fixed rate loans. Bankers recognize
this and recent surveys show that the most fre
quently cited actual and potential use of interest
rate futures is to hedge the interest expense of
anticipated borrowings.1 Banks that use futures
for this purpose have concentrated their futures
trading in those contracts that best reflect their
short-term borrowing costs. These are the futures
contracts for domestic certificates of deposit
(CDs), Eurodollars, and Treasury bills (T-bills).
Despite this choice of contracts, however, most
analyses of the effectiveness of hedging bank
borrowings have concentrated entirely on T-bill
futures contracts as the hedging instrument.
While these analyses find that banks can substan
tially reduce their interest rate exposure by
hedging with futures, they do not consider wheth
er T-bill futures are as good as, better, or worse
than using CD futures or Eurodollar futures to
hedge. But, in order to see whether one futures
contract is a better hedge than another, we first
need to establish a good understanding of banks'
interest rate risk and how futures in general
hedge that risk.
BANK INTEREST RATE RISK
Bank interest rate risk manifests itself in changes
in the net interest margin—and therefore net
1See, for example, James Booth, Ron Smith, and Robert
Stolz, "Use of Interest Rate Futures by Financial Institutions,"
Journal of Bank Research 15 (Spring 1984) pp. 15-20.
14
MAY/JUNE 1986
income—when interest rates change.2 Most inter
est rate risk is a result of asset and liability mis
matches, that is, when assets and liabilities have
different maturities.3 This is precisely the cause
of interest rate risk in offering a fixed rate loan.
Suppose a bank decides to fund a 6-month fixed
rate loan with two consecutive 3-month CDs.
The bank's expected costs then depend on the
current rate on a 3-month CD, and on the rate
expected on a 3-month CD in three months.
Typically a bank would estimate the expected
cost by simply assuming that today's 6-month
CD rate is the average of today's 3-month rate
and the expected 3-month rate three months
from now. So, for example, if today's 6-month
rate is 12 percent, and today's 3-month rate is 10
percent, the expected rate in three months on a
3-month CD would be 14 percent. But, in an
environment of volatile interest rates, by the
time the bank goes to roll over the CD in three
months, the 3-month rate might be 16 percent. If
the bank were dealing in $1 million CDs, the
additional costs of this rate change would be
substantial: since a one basis point change in the
3-month borrowing rate implies an additional
$25 in interest expense, a difference of 200 basis
points amounts to $5,000 more interest expense
2Net interest margin is defined as the difference between
interest revenue and interest expense over a given time
period. It is frequently expressed as a percent of assets.
3This is true assuming the bank is hedging its cash flow.
Recent literature on bank interest rate risk has also emphasized
hedging the value of bank equity. Hedging the value of bank
equity, however, involves determining the market value of
assets and liabilities, which can be very difficult, and their
price sensitivity or duration, which again can be quite difficult.
Many banks instead choose to match or hedge cash flows
over particular time intervals (for example, less than one
year, or one to two years) or between particular balance
sheet items. Both these methods can partially protect the
value of the bank's equity and can also smooth the reported
income of the bank. The example considered in this paper is
that of hedging between balance sheet items. For an explana
tion and example of market value hedging using a duration
analysis, see George Kaufman "Measuring and Managing
Interest Rate Risk: A Primer," Federal Reserve Bank of Chicago
Economic Perspectives (Jan./Feb. 1984) pp. 16-29.
FEDERAL RESERVE BANK OF PHILADELPHIA
Hedging with Financial Futures
than the bank expected. This additional unex
pected interest expense—the interest rate risk—
means that the profitability of the loan falls, and
the reason it arises is because the maturities of
the asset and the liability are mismatched.
Indeed, the most common mismatch of maturi
ties for a bank is much like the example, when
liabilities are short-term and assets are relatively
long-term. Futures may provide an inexpensive
way to hedge the interest rate risk that results
from this mismatch.4 To illustrate this we can
evaluate the effect of using a futures contract to
hedge the interest rate risk in the example. But
first, a few fundamentals about futures contracts.
A PRIMER ON INTEREST RATE FUTURES
An interest rate futures contract, simply stated,
is a promise between two parties to exchange a
financial instrument for a stated price and terms
of delivery at a specified time and place in the
future. An interest rate futures contract is stan
dardized as to the quantity of the financial instru
ment to be bought or sold, the minimum charac
teristics or quality of the instrument, and the
specification of where and when the exchange is
to be made. This standardization is a major dis
tinguishing feature between futures contracts
and forward contracts, which are not standardized
in any of these terms.
Another unique feature of futures is that the
trading party is always the clearinghouse, which
is made up of exchange members who also act as
traders. W hen one trader agrees to deliver and
another to take delivery, they do so not with
each other but with the clearinghouse. The clear
inghouse thereby acts as guarantor of perfor-
4Financial futures provide an inexpensive hedging method
relative to adjusting the actual balance sheet. There are,
however, definite costs to a bank using futures contracts. In
addition to brokerage costs, first-time users must set up
internal auditing and accounting systems, hire traders or
open a futures account with a trader, and handle the daily
cash flow associated with futures contracts. These transaction
costs are often deemed substantial enough to preclude small
banks from trading futures.
Michael Smirlock
mance of all futures contracts traded on a particu
lar exchange. In this way, the clearinghouse cre
ates a futures contract that can be traded without
concern for the identity or creditworthiness of
the other party to the contract. At the end of the
day, the clearinghouse matches "buy" and "sell"
contracts for the day and informs every exchange
member of its net settlement status.
In fact, delivery is rarely ever made or taken
because most traders "close out" their position
before delivery is due by taking an offsetting
position of equal size.5 For example, a trader
who agreed to deliver 10 contracts of some good
simply takes a position to accept delivery of 10
contracts of the same good. The final result is
simply a profit or loss to the trader.
When a trader buys or sells a $1 million 90day T-bill futures contract he opens a margin
account that might require an initial deposit,
known as the initial margin, of only $1,500. Yet
the value of the futures contract and the futures
position changes in the same magnitude as the
T-bill or underlying instrument.6 That is, a one
basis point change in the discount rate on an
actual $1 million T-bill changes its price by $25;
5Traders in futures are considered either hedgers or specu
lators. A hedger in the futures market is an individual or
institution whose futures market position is designed to
offset the risk created by a financial position in some other
market. A speculator is an individual who tries to anticipate
price changes in commodities or financial instruments (such
as futures) in order to profit through the sale or purchase of
futures contracts or of the actual physical commodity.
6A straightforward way to see this is to consider the investor
who buys a financial futures contract for a security for $100.
He pays nothing for this contract except that he puts up a
margin. Suppose the security is currently priced at $100. In
this case, nobody would pay him for his right to buy it. But
suppose the price of the security rose to $110. In this case,
the holder of the futures contract could buy the security for
$100, and turn right around and sell it for $110, making a
profit of $ 1 0 — which reflects the rise in the price of the
security. Other investors will now be willing to pay the
holder of the futures contract up to $10 for the right to buy
the security at $100. This change once again reflects the
change in the value of the security that underlies the futures
contract.
15
BUSINESS REVIEW
a one basis point change in the discount rate on a
T-bill futures contract results in the same $25
change, but, in the case of the futures contract,
the investor puts up less than 1 percent of the
invested funds.7
This leverage is not without cost. Unlike the
cash market, daily settlements of profits and
losses on futures contracts are made to each
trader's margin account; that is, futures positions
are "marked to market."8 This means that daily
changes in the value of the futures position due
to changes in the price of the futures contract (s)
are used to adjust the margin account. Profits
increase the dollar amount in the margin account,
while losses reduce this amount. If the margin
account falls below a given level, termed the
maintenance margin, the trader must bring the
margin account to its initial level. Thus, futures
contracts involve a cash flow to adjust the margin
account that does not characterize the cash market
and which introduces an additional element of
risk.
The "Long" and "Short" of Profits and Losses
in the Futures Market. As with any other exchange,
a financial futures market participant can take
one of two positions: long or short. A buyer of a
futures contracts takes a long position. That is,
he contracts to take delivery of securities in the
future at a specific price that is determined today.
A seller, on the other hand, takes a short position.
That is, he agrees to deliver securities in the
future at a specific price that is determined today.
To see how profits and losses are made in the
7The discount rate expresses the return as a percentage of
the face value of the instrument, whereas the interest rate
expresses the return as a percentage of the market value of
the instrument.
8The cash market refers to a market in which transactions
for the purchase or sale of financial instruments are immediate
and are conducted at agreed on prices and terms. For a bank,
even if the market value of securities bought or issued in the
cash market changes, the value on the bank balance sheet
does not change. The only exception to this is if the cash
market transaction involved the trading account of the bank's
securities portfolio.
16
MAY/JUNE 1986
futures markets, consider first the buyer of a
futures contract. The buyer has agreed to take
delivery of some securities at a specified date at
some specified price. If, at the time of delivery,
the cash price is higher than the delivery price,
the trader can take delivery of the securities at
the price specified in the contract and turn around
and sell them at the higher market price, making
an immediate profit. If the cash price on the
delivery day is lower than the stated delivery
price in the contract, the buyer incurs losses.
Thus, his profit or loss is the difference between
the cash and futures contract prices, less trans
action costs (such as brokerage commissions).
Prior to the actual delivery date, market partici
pants form expectations about what the prevailing
cash price for the securities will be on the delivery
date. At any time, the change in the value of the
futures position reflects the difference between
the expected price of the securities on the delivery
day and the delivery price agreed to in the futures
contract. Accordingly, a long position makes
profits when the price of the futures contract
rises and incurs losses when it falls.
The analysis of the short position is similar.
The seller of a futures contract has agreed to
deliver securities at a specified date at the price
agreed upon in the contract. The seller can be
viewed as having to buy the securities at the
prevailing market price at the time of delivery
and delivering them to the buyer at the price
specified in the futures contract. If the actual or
expected price at the time of delivery exceeds
the futures contract price, then the seller must
pay more for the securities than he receives
upon delivery, so that he will incur losses. If the
market price is below the futures contract price,
the seller can purchase the securities at a lower
price than he receives for delivery and thus that
short position earns profits. Accordingly, a short
position incurs losses when the actual price of a
futures contract rises and makes profits when it
falls.
In sum, changes in the prices of interest rate
futures contracts primarily reflect changes in the
prices of the underlying deliverable security. If
FEDERAL RESERVE BANK OF PHILADELPHIA
Hedging with Financial Futures
expectations change and interest rates in June
are expected to be higher than previously thought,
an interest rate futures contract calling for June
delivery will fall in price (since interest rates and
bond prices are inversely related). On the other
hand, if interest rate expectations decrease, the
futures contract price will rise. This implies that
the buyer of a financial futures contract makes
profits when interest rates fall unexpectedly and
incurs losses when interest rates rise unexpect
edly, while a short position loses money when
interest rates fall unexpectedly and makes profits
when interest rates rise unexpectedly.
Whether a financial institution takes a long or
short position in its hedging strategy depends
entirely on how increases or decreases in interest
rates affect bank profits, which in turn depends
on the maturity structures of its assets and liabil
ities. If a bank's profits fall when interest rates
rise, it will want a futures position that increases
in value when interest rates rise; that is, a short
position in the futures market. Conversely, if
interest rate increases result in additional cash
market profits, it will want a long position in the
futures market.
CD, Eurodollar, and T-Bill Futures Contracts.
The CD, Eurodollar, and T-bill futures markets
have many common features and can all be used
to hedge bank interest rate risk. The major trading
center for the 90-day T-bill, 90-day CD, and 90day Eurodollar time deposit futures contracts is
the International Monetary Market of the Chicago
Mercantile Exchange, known on the street as the
IMM or "M erc."
The m ajor difference among these contracts
involves the delivery process (see FINANCIAL
FUTURES CONTRACT TERMS, p. 18). In deliv
ery on a T-bill futures contract, the short simply
delivers to the long a $1 million T-bill with 90
days to maturity. Delivery on the CD futures
contract is more complex. Since many banks
issue CDs, the exchange must decide which
banks' CDs are deliverable. In financial markets,
some banks' CDs are exchanged on a "no-name"
basis, meaning that one of those bank's CDs is
considered the same high quality as another
Michael Smirlock
"no-nam e" bank's CD. Since "top-tier" banks,
those whose CDs form the deliverable set, are
somewhat interchangeable, the risk in this deliv
ery process may not be great. More important,
CDs do not have to have 90-day maturity and
can range from between iVz to 3V2 months to
maturity from the time of delivery. Additionally,
since deliverable CDs comprise less than 10
percent of the total CD market, there is some
price risk due to limited supply. These three
factors introduce an element of uncertainty into
pricing CD futures that is at least partially respon
sible for its relatively light trading activity.
Unlike their CD and T-bill counterparts, there is
no delivery instrument for Eurodollar futures
contracts and all settlements are made in cash.
This simply means that no delivery of a Eurodollar
deposit occurs, and profits or losses on any day
are simply the crediting or debiting to a trader's
account the difference between the value of the
contract at final settlement and the previous
day's settlement price. The final settlement price
is determined by the clearinghouse. This price is
determined by first obtaining 3-month Eurodollar
time deposit rates from twelve major banks in
the London Eurodollar market. The clearinghouse
then drops the two highest and lowest quotes
and uses the arithmetic mean of the remaining
eight quotes as the settlement price.
The contract size for each futures instrument
is $1 million in face value of the underlying
instrument. Futures contracts for each of these
instruments are traded that mature in March,
June, September and December up to 2 V2 years
in the future. The prices of these futures contracts
are quoted according to the IMM index. This
index is equal to 100 less the yield (in percent)
on the futures contract. Thus if the yield on the
futures contract is 10 percent, the IMM index
value is 90.
The minimum price change from the previous
price for each of these contracts is .01, which is
equal to one basis point. Each basis point change
in prices changes the value of each of these
futures contracts by $25. As a result, computing
changes in the value of the position is straight17
MAY/JUNE 1986
BUSINESS REVIEW
FINANCIAL FUTURES CONTRACT TERMS
Treasury Bill
Certificate of Deposit
Eurodollar
Exchange
IMM Division of Chicago Same as T-bill
Mercantile Exchange
Same as T-bill
Contract Size
$1,000,000
Same as T-bill
Sam e as T-bill
Deliverable
Grade
U.S. Treasury bill with
90, 91, or 92 days to
maturity
"N o N am e" CDs; deliver
able banks announced 2
business days before 15th
of delivery month and must
mature 2l/i to
months
after delivery3
Cash settlement with
clearing corporation
Price Quotation
Index: 100 minus
discount yield
Index: 100 minus
add-on interest
Index: 100 minus
add-on interest
Minimum
Fluctuation
.01%
(1 basis point = $25)
Same as T-bill
Same as T-bill
Initial Marginb
$1,500
Same as T-bill
Same as T-bill
Maintenance
Margin1
3
$1,200
Same as T-bill
Same as T-bill
Trading Hours
8:00 a.m. to 2:00 p.m.
Chicago time
7:30 a.m. to 2:00 p.m.
Chicago time
Same as CD
Months Traded
March, June, September,
and December
Same as T-bill
Same as T-bill
aSee Exchange rules for additional restrictions.
bSubject to changes in Exchange rules.
forward. If a buyer purchases any one of these
futures contracts at 90 and its price rises to 91,
the buyer earned 100 basis points times 25 or
$2,500.
THE HEDGING STRATEGY
Returning to our example, suppose a bank (or
any financial institution) is going to make a 6month fixed rate loan of $ 1 million that is funded
Digitized 18 FRASER
for
with a 3-month CD. At the same time, the bank is
concerned that interest rates will rise unexpect
edly by the time it goes to roll over the CD in
three months to retain the funds needed to finance
the last three months of the loan. To hedge this
risk, the bank will use the futures market.
The bank's hedging strategy is as follows. Since
the bank is worried about interest rates rising, at
the time the loan is made the bank initiates the
FEDERAL RESERVE BANK OF PHILADELPHIA
Hedging with Financial Futures
hedge by taking a short position in the futures
market; it will then remove the hedge by taking
an offsetting long futures position when it rolls
over the CD in three months. The length of the
hedge thus corresponds to the length of time the
bank is exposed to interest rate risk. The gain or
loss per $1 million futures contract is equal to
$25 multiplied by the difference between the
price of the futures contract when the hedge is
initiated and the price of the futures contract
when the hedge is closed out. This amount is
then multiplied by the number of futures con
tracts in the transaction to determine the total
dollar gain or loss from the futures position.
The size of the bank's futures position, that is,
the number of contracts the bank sells, depends
on the effect of changing interest rates on its
future borrowing cost, which will depend on the
size and maturity of the cash market position,
and on the specific futures contract used in setting
the hedge. For a bank issuing a $1 million CD in
three months, the change in borrowing cost in
the cash market is equal to $25 multiplied by the
difference between the actual borrowing rate
and the expected borrowing rate. This change in
borrowing cost is equal to the gain or loss from
an unhedged position.
In sum, the gain or loss from the hedged position
is equal to the change in borrowing costs in the
cash market plus the change in the value of the
futures position. As an example, suppose at the
time the loan is made the expected interest rate
on a 3-month CD to be issued in three months is
10 percent. If, when the bank rolls over the CD,
interest rates have risen to 12 percent, the interest
expense of the (unhedged) bank will be $5,000
higher than expected. Suppose, however, that at
the time the loan is made the bank sold one
futures contract and the interest rate on this
contract rose from 10 to 12 percent over the life
of the hedge. In this case, the futures position
would yield a $5,000 profit. Thus, there is no
change in net borrowing costs. Likewise, in this
case, there would be no change in net borrowing
costs if interest rates fell, for the bank would gain
$5,000 in the cash market and lose $5,000 from
Michael Smirlock
its futures position. This is an example of a "per
fect" hedge, that is, one where gains (losses) in
the futures market position are exactly offset by
losses (gains) in the cash market.
Setting the Hedge Ratio and Basis Risk. An
important issue in effective hedging is deter
mining the appropriate number of futures con
tracts to use in the hedge. The number of futures
contracts per $1 million CD to be issued is termed
the hedge ratio. Studies of the hedge ratio have
traditionally suggested that a way to arrive at a
perfect hedge is to equate the face value of the
securities to be hedged with the securities used
to hedge. Since the face value of the hedging
securities is also $1 million, the dollar-for-dollar
hedging technique sets the hedge ratio equal to
1. This hedging strategy is termed a naive hedge,
in part because it ignores basis, which is the
difference between cash and futures market rates.
The use of a naive hedging strategy may yield
poor hedging results. Suppose, for example,
that every time the cash market rate changes 10
basis points, the futures market rate changes by
only 5 basis points. In this case, if the CD rate
rose 100 basis points the futures rate would rise
only 50 basis points. The hedged position would
have resulted in a net increase in borrowing
costs of 50 basis points or $1,250, which is far
from a perfect hedge.
If the hedge ratio had instead been set equal to
2 —that is, two futures contracts sold for every
CD to be issued—the hedge would have been
perfect. The 100 basis point rise in the CD rate
would have increased borrowing costs by $2,500
and each futures contract would have risen in
value by $1,250. The increase in cash market
borrowing costs of $2,500 would have been exactly
offset by the increase in the value of the futures
market position so that there would be no change
in net borrowing costs.
There are few perfect hedges. This is so because
of basis risk, which refers to unexpected changes
in the cash-futures rate relationship. If there
were no basis risk, a hedge would always be
perfect. To see this, consider the example where
the CD rate is 11 percent, the T-bill futures rate is
19
BUSINESS REVIEW
10 percent and the hedge ratio is two. Suppose
the rate on T-bill futures rose 50 basis points to
10.50 percent. Given the hedge ratio of 2, we
would expect the CD rate to rise by 100 basis
points to 12.00 percent. Note that even though
the basis has increased to 150 basis points, this
change was expected and accounted for via the
hedge ratio. If the CD rate increase had not been
100 basis points, then there would have been an
unexpected change in the basis and the hedge
would not have been perfect. What the actual
relationship between these rates will be over the
life of the hedge, and therefore the exact hedge
ratio that would result in a perfect hedge, cannot
be known with certainty at the time the hedge is
placed. Accordingly, hedgers rely on historical
data to estimate the relationship that is expected
to prevail over the life of the hedge.9
Choosing the Hedging Instrument. In setting
a hedge, the hedger should attempt to minimize
basis risk. In general, a direct hedge, that is, hedging
a cash market instrument with a futures contract
on the same underlying instrument, involves
less basis risk than a cross hedge, that is, hedging a
cash market instrument with a futures contract
on a different underlying instrument. This sug
gests that using a CD futures contract to hedge a
CD issue will provide superior results to using
T-bill or Eurodollar futures contracts to hedge
CD issues.
For several reasons, however, this may not be
the case. First, the rate on the CD futures contract
is, unlike its counterparts, not strictly related to a
3-month borrowing rate since the deliverable
k
instrument may have a maturity of between 2x
to 3V2 months. Further, deliverable grade CDs
comprise only 10 percent of the entire CD market,
so that the supply and demand for these CDs
affects the futures contract price. This supply
constraint may be reflected in the cash rate on
deliverable CDs being different from the cash
9In practice, the appropriate hedge ratio is typically mea
sured as the regression coefficient on futures rates in a linear
regression of cash market rates on futures rates.
20
MAY/JUNE 1986
rate on other CDs, so that the futures price may
not only reflect prevailing cash market rates.10*
1
Additionally—and in part because of the above
reasons—there is a potential lack of liquidity in
the CD futures market. The CD futures contract
has had less than one-quarter the trading activity
of either the T-bill or Eurodollar futures contract.
This relatively small trading volume suggests
potentially large hedgers might face adverse
price movements at the time of their transactions.
That is, when large hedgers go to buy CD futures
contracts, the price will increase because of their
demand so that these hedgers may not be able to
purchase the desired number of contracts at the
quoted futures price.
We might expect Eurodollar futures to provide
a better cross hedge of bank CDs than T-bill
futures since Eurodollar rates reflect an actual
bank borrowing rate, whereas T-bills reflect a
default-free borrowing rate. In periods of a "flight
to safety," T-bill and CD rates may even move in
opposite directions.11 Both T-bill and Eurodollar
rates, however, are dominated by general move
ments in interest rates so that they may provide
very similar hedge results.
HEDGING EFFECTIVENESS
To investigate which contract provides the
most effective hedge, hypothetical 3-month
hedges of CD borrowings were formed and evalu
ated for five banks from three different geo
1Specifically, this supply constraint implies that there
may not be enough deliverable grade CDs available to meet
the demand for delivery against futures contracts. In this
case, the futures price may change solely because of the
supply and demand conditions for deliverable grade CDs
and not because of more general movements in CD interest
rates. This will decrease the effectiveness of any hedge.
n A "flight to safety" is characterized by investors switching
from risky securities, such as CDs, to risk-free Treasury
securities. The demand for risk-free securities will increase
relative to the demand for risky securities. As a result, there
will be a drop in the risk-free rate and an increase in the risky
rate. A good example of this was the movem ent in T-bill and
CD rates during the time period when the severe financial
difficulties of Continental Illinois were announced.
FEDERAL RESERVE BANK OF PHILADELPHIA
Michael Smirlock
Hedging with Financial Futures
graphical regions: Citibank, Chase Manhattan,
and Manufacturers Hanover in New York; First
Chicago in Chicago; and Bank of America in San
Francisco. The current 3-month and 6-month
CD rates and prices of the CD, T-bill, and Euro
dollar futures contracts were obtained from Data
Resources, Inc., for every Thursday from January
1,1984 through Decem ber 31,1984. The futures
price data are obtained for the same sample
period for the CD, T-bill and Eurodollar market.
For any given day, the expected 3-month CD
rate in three months is calculated from the current
3-month and 6-month CD rates. To assess the
unhedged position, we then look at the rate at
which the second CD actually is issued in 13
weeks (91 days or approximately three months).
The difference between the issuing rate and the
expected borrowing rate gives the difference in
basis points between the actual and expected
borrowing costs in the cash market. Multiplying
this difference by $25 gives the dollar difference
in interest expense per $1 million borrowed.
Taking the average of the absolute basis point
difference between the actual and expected bor
rowing rate over the sample period provides a
good measure of the interest rate exposure from
remaining unhedged.12 The higher this average
is, the greater the deviation of actual from expected
borrowing costs and the more uncertainty there
is in future bank costs. As shown in the first row
of Table 1, the average difference ranged between
12This is superior to a simple average of the difference,
because in the latter large errors of opposite signs cancel
each other out yielding an improperly low measure of interest
rate risk. When the absolute value is used these errors rein
force each other to give a more accurate measure of risk
exposure. This risk measure is also used by Michael Smirlock
in, "A n Analysis of Cross Hedging CDs with Treasury Bill
Futures: Bank Specific Evidence," (Federal Reserve Bank of
Philadelphia Working Paper No. 85-4, 1985). That paper
also contains a more extensive discussion and analysis of
hedging CDs with T-bill futures.
TABLE 1
HEDGING EFFECTIVENESS
Row
Variable
Description
1.
Unhedged
Interest Rate
Exposure3
2.
Hedge Ratios for
Futures Contracts1
*
T-bill
CD
Eurodollar
3.
Hedged Interest
Rate Exposure3
T-bill
CD
Eurodollar
Bank of
America
Chemical
Bank
Chase
Manhattan
First
Chicago
Manufacturer's
Hanover
64
63
73
62
65
1.21
1.04
.97
1.16
1.07
.99
1.30
1.03
1.04
1.27
1.09
1.07
1.09
.98
.98
34
42
47
27
25
26
21
18
18
17
20
20
26
28
26
aMeasured as the absolute average basis point difference between actual and expected borrowing rates.
bThe hedge ratios are calculated using ordinary least squares to estimate the equation CDit = a + bFUTjt + et where
CDit is the CD rate of bank i at time t and FUTjt is the rate on futures contract j at time t. There are 5 banks and 3 futures
contracts, so that 15 regressions were estimated. The estimates of coefficient b are the hedge ratios reported in the
Table.
21
BUSINESS REVIEW
MAY/JUNE 1986
62 and 73 basis points for each bank. This implies
an average dollar difference in actual from expect
ed borrowing costs of between $1,550 and $1,825
per $1 million borrowed.
If the bank is concerned that interest rates will
rise unexpectedly, a short position in the futures
market would be taken when the expected bor
rowing rate is calculated. The size of the futures
position will depend on the hedge ratio, which
will differ depending on the bank and the futures
contract instrument. These hedge ratios, shown
in the second row of Table 1, were estimated
using historical data on the relationship between
cash market and futures market rates. The futures
contract used in setting the hedge is the contract
whose maturity is closest to, but after, the date
the CD is rolled over.13 When the second 3month CD is issued, the bank takes a long position
in the futures contract, thus closing out the futures
position. The change in the futures price over
the life of the hedge represents the gain or loss
from the futures position.
To assess the hedged position, we look at the
change in the rates in both the CD and futures
markets.14 The net change in the rates in these
two markets represents the change in the bor
rowing rate from a hedged position (using the
estimated hedge ratios). This amount multiplied
by $25 gives the dollar difference in the interest
expense per $1 million borrowed from a hedged
position. As with the unhedged position, the
average of the absolute basis point difference
between the realized and expected borrowing
costs is used to measure interest rate exposure
under a hedging strategy. This average difference,
reported in the third row in Table 1, is between
17 and 47 basis points, depending on the bank
and futures contract used. This implies an average
dollar deviation from target borrowing cost of
between $425 and $1,175 per $1 million bor
rowed.
Comparing the average basis point deviations
from the expected borrowing rate for the hedged
and unhedged position gives some idea of the
effectiveness of futures contracts in decreasing
bank risk. In all cases, the average deviation
from expected costs using futures was less than
that of the unhedged position. With the exception
of Bank of America, this average deviation is less
than one-half and closer to one-third that of the
unhedged position. Although the banks had
different levels of risk exposure, the risk reduction
from hedging was reasonably uniform across
banks. These findings suggest that banks can
achieve a substantial reduction in risk exposure
from hedging with futures.
The futures contract that provides the most
risk reduction is the one that minimizes deviations
from the expected borrowing rate. No futures
contract clearly dominates the other two. In par-
13So, for example, a futures position taken in April to
hedge a 3-month CD to be issued in July would involve
selling a September futures contract. Additionally, since
futures rates are actually biased estimates of expected cash
market rates and converge to the expected cash market rate
at maturity, it may be argued that the time to delivery should
be included as an independent variable in the hedge ratio
regressions. Given the contracts used here and their relatively
short maturity, this bias is likely to be small and to have very
little effect on the hedge ratios. Accordingly, time to delivery
is not included as an independent variable.
contracts in combination will result in a lower deviation
from expected borrowing cost than using any one single
contract to hedge. They argue that there is less basis risk
when a portfolio of futures is used than when a single futures
contract is used to hedge. The rationale is the same as that for
using a portfolio of stocks to eliminate risk or price move
ments not related to general market movements. While the
Anderson and Danthine insight is valid, that approach is not
taken here because it does not allow for direct comparison of
hedging effectiveness among specific futures contracts. Also,
transaction costs are probably lower and expertise higher
when one futures contract is used so that a bank might want
to concentrate in one instrument. Finally, reducing basis risk
is more important when the futures market and cash market
instruments are substantially different, which is not the case
in this study.
14Anderson and Dan thine ("Hedging and Joint Production:
Theory and Illustration," Journal o f Finance, May 1980, pp.
487-498) suggest that a portfolio of futures contracts will
provide a more effective hedge than using a single futures
contract. That is, using the T-bill, CD, and Eurodollar futures
22
FEDERAL RESERVE BANK OF PHILADELPHIA
Hedging with Financial Futures
ticular, using CD futures to hedge a CD issue
does not necessarily result in the most effective
hedge. Cross-hedging with either T-bill futures
or Eurodollar futures was superior to CD futures
in several cases. The only bank for which the
choice of futures contract makes a notable differ
ence is Bank of America, and in this case the
T-bill contract is superior.
CONCLUSIONS
The results of this analysis suggest that banks
can hedge CD funding risk and better meet the
financial needs of their customers through the
use of financial futures. A comparison of several
hedging instruments suggests that regardless of
which futures contract a bank selects as a hedging
instrument, the bank can substantially reduce
interest rate exposure by hedging. Thus, futures
Michael Smirlock
can provide the bank with an effective way to
"lock in" future borrowing costs.
In terms of specific hedging instruments, there
is little difference in the hedging effectiveness of
the different futures contracts in all but one of
the cases examined. Further, given the potential
liquidity problem inherent in the CD futures
market, these findings suggest a bank hedging
its CD funding risk can use either the Eurodollar
or T-bill futures contract as its hedging instrument.
Neither of these two contracts, however, clearly
dominated the other in terms of hedging effective
ness. Whichever alternative is used, financial
futures can provide a bank with an efficient
method to manage interest rate rate risk and, in
turn, allow a bank to improve its ability to meet
the financial service needs of its customers.
23
Business Review
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