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November 25,1 983
Financial Futuresfor Banks
A topic generating a great deal of interest
in banking circles these days is financial
futures. Trade publications are turning out
articles on this subject by the dozens, while
seminars on hedging with financial futures
are drawing hundreds of bankers. Everyone
in the industry, it seems, is becoming aware
of the potential benefits of using financial
futures to manage interest rate risk and
reduce earnings volatility. And although the
number of banks participating in the financial futures markets is currently small,
interest in using futures is becoming widespread within the industry.
This growing interest in financial futures is
one manifestation of a more general concern about managing banks' exposure to
interest rate risk. High and volatile interest
rates of the past few years have made interest
rate risk management an important determinant of a bank's profitability and even of its
soundness over the longer run. As a result,
bankers have sought to improve their ability
both to measure their bank's exposure to
interest rate risk and to manage such risk.
This Letter examines the nature of interest
rate risk in the banking industry as well as
financial futures' potential for hedging that
risk. Next week's Letter will look at some
of the regulatory and accounting problems
that arise in connection with banks' use of
financial futures.
I nterest rate risk
Banks have always been in the businessof
assuming interest rate risk along with the
credit,or default, risks they assume in
making loans. Historically, banks have performed a "maturity intermediation" function by borrowing short and lending long. In
other words, bank assetson average have
traditionally had a longer maturity than bank
liabilities.
This may not always be the case now, however. In recent years, banks have attempted
to achieve a better overall match between
the maturities (technically, the repricing
periods) of their assetsand liabilities. By
making greater use of floating rate business
and mortgage loan contracts, among other
things, banks have been able to shorten the
repricing period, or the length of time
between interest rate adjustments, on their
assetswithout necessarily changing the contractual maturity of those assets.Nonetheless, these efforts frequently do not yield a
perfect match between the repricing periods
of assets and liabilities. Thus, theremay be
instances in which some of a bank's assets
have a shorter effective maturity than that of
the liabilities funding those assetsas well as
vice versa. To the extent that a mismatch still
exists, then a bank has assumed interest rate
risk.
Interest rate risk is the risk that fluctuations in
interest rates might cause the value of a
bank's net worth to fall. Because a change in
the level of interest rates will affect the
present value of shorter,term instruments
lessthan the present value of longer-term
instruments, banks place their shareholder's
equity at risk by mismatching. For example,
a bank with an excess of long-term assets
relative to long-term liabilities would experience a decline in its value if interest rates
were to rise because, other things equal, the
value of its assetswou Id fall by more than
the value of its liabilities. (Of course, such
a decline in value is not likely to appear
immediately as adecline in recorded capital
since banks record assetsand liabilities at
book value. However, it will show up as a
decline in the spread between a bank's yield
on assetsand its cost of funds. Such a deterioration in a bank's earnings potential is
likely to be reflected in a lower market price
for its shares.)
When interest rates were fairly stable and
the yield curve was thoughtto be wellbehaved, bankers generally regarded a
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Opinions expressed in this newsletter do not
necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal
Reserve System.
Although contracts are avai lable for a
variety offinancial instruments, bankers find
the 90-day Treasury bill, the 90-day C D and
the G N M A passthrough certificate contracts
to be the most useful in hedging interest rate
risk. Because the prices of these contracts
generally move with changes in the prices of
the underlying instrument, a position in
futures can be used to offset a bank's spot
position, thus leaving earnings largely
unaffected by movements in market interest
rates. Thus a bank that had an excess of
long-term assetsover liabilities could hedge
against rising rates (i.e., falling security
prices) by selling futures-that is, contracting to make delivery in the future. Should
interest rates in fact rise, the decline in
the value of the bank's assetsrelative to the
value of its liabilities is likely to be offset by
the rise in the value of the bank's futures
position.
strategy of actively mismatching the maturities of assetsand I iabi I ities as profitable. The
risk of a serious deterioration in the value of
bank shareholders' equity was perceivedperhaps incorrectly-as minimal. However,
the accelerating inflation of the 1970s
increased the variability of interest rates and
made the shape of the yield curve less predictable. As a resuIt, bankers became
increasingly conscious of the impact the
asset/liability mix of their bank's balance
sheet had on earnings and share values, and
they began to pay more attention to controlling exposure to interest rate risk.
Hedgingwith futures
Hedging with financial futures is one lowcost means of reducing exposure to interest
rate risk that has attracted a lot of attention
recently. Financial futures are contracts that
are traded on organized exchanges obligating the buyer (seller) to take (make) delivery
of a given financial instrument at a specified
future date and price. All transactions in
financial futures are cleared through the
exchange clearinghouse, which acts as the
opposite party to every transaction. Thus, a
position in financial futures can be readily
"closed out" without taking (or making)
delivery of the specified securities simply by
taking the opposite position with the clearinghouse before the contract del Ivery date.
Positions in financial futures are held with
small "good faith" margins and gains or
lossesfrom that position are posted to the
margin account according to daily price
movements.
For example, suppose a bank on last May 6
funded a $1 0 million six-rnonth bullet loan
(principal and all interest due at maturity)
with 90-day CDs and wanted to preserve a
300 basis point spread on the difference
between the going C D rate of 8.31 percent
and the loan rate of 11.31 percent. The bank
was open to the risk that when the 90-day
C Ds matured on August 4 and had to be
rolled overfor another 90 days ata new rate,
the C D rate could have risen, thus reducing
its earnings spread over the six-month life of
the loan. To protect itself against this risk,
the bank could have sold ten C D futures
contracts (which qre traded in $1 million
lots) on May 6 for del ivery in September, the
contract delivery date c1osestto the roll-over
date of its CDs. Using data on the actual
closing price of the September C D futures
contract that was quoted in the Wall Street
Journal on May 6, 1983, the bank would
have acquired its short position at the going
price of 91 .43, or a discount rate of 8.57
percent. It wou ld then have closed out its
position on August 4 when it issued the new
CDs. According the the Wall Street Journal,
the closing price of the September C D contract on August 6 was 89.84 for a discount
2
rate of 1 0.1 6 percent. The bank's profit on
this transaction, then, would have been 159
basis points because, as interest rates rose
and securities prices fell, the bank could, in
essence, have met the terms of its original
contract to deliver CDs ata price of91 .43 by
purchasing those securities at 89.94, and
then selling them at the higher price. Thus,
while the C D rate had risen from 8.31 to
9.88 percent over that time, the bank would
have still earned a spread of301 basis points
over the six-month term of the loan. Unhedged, the bank's spread wou Id have averaged only 221 basis points.
those two parties were to deal directly with
each other.
Moreover, hedging with financial futures
may be more attractive than achieving the
same level of risk exposure in the spot
market because the cost of carry is lower.
Futures positions can be held with small
margins ($2,000 can typically control a $1
million C D futures contract) and payment
for the entire market value of the contract is
not required unless the position is left open
until the contract delivery date. Spot market
transactions, by contrast, involve immediate
delivery and must be paid for with cash or
financed.
Hedging with financial futures can be a very
effective means of preserving a bank's earnings. Of course, not all futures hedges are
likely to preserve a bank's spread so effectively. The effectiveness of the hedge wi II
depend on the stability of the "basis," orthe
difference between the rate on the underlying instrument and the rate on the futures
contract. In the example above, futures
prices moved closely with changes in spot
prices, but this is sometimes not the case.
Nonetheless, financial futures have a number of advantages over some of the other
alternatives open to banks for reducing
interest rate risk primarily because transactions in futures are relatively costless to
effect. The other alternatives available to
banks-matching the repricing periods of
assets and liabilities by offering only shortterm or variable rate loans or selling
unmatched assets(typically, mortgages)
to outside investors-by contrast, may
entail higher costs.
Growing interest
Given the advantages of financial futures, it
is no wonder that many bankers are investigating their use in hedging interest rate risk,
even though to date, only a hundred or so
banks (out of more than 14,000) have
actually used them. Some of the reluctance
to use futures has todo with a lack of trained
personnel as well as a realization that while
futures help to protect against downside
risks, they also limit banks' ability to take
advantage of beneficial movements in interest rates. The rather limited use of futures to
date may also be due to the regulatory and
accounting problems that arise in connection with the use of futures. These latter
issueswill be discussed in next week's
Letter.
Barbara Bennett
Thus, one advantage of hedging with financial futures is that unlike transactions which
involve matching repricing periods of assets
and liabilities, transactions in financial
futures do not require costly credit evaluations either on the part of the bank or on the
part of potential investors. Since the opposite party to everytransacton in futures is the
exchange clearinghouse, the risk of defau It
to both the bank and the investor is diversified and is therefore much lower than if
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BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
Selected Assetsand liabilities
Large Commercial Banks
Loans"(gross,
adjusted)andinvestments'"
Loans(gross,adjusted)......:.total#
Commercialandindustrial
Realestate
loans to individuals
Securitiesloans
U.s. Treasury securities'"
Other securities'"
Demand deposits - total#
Demand deposits - adjusted
Savings deposits - totalt
Time deposits - total#
Individuals; part. & corp,
(Large negotiable CD's)
WeeklyAverages
of Daily Figures
Member BankReservePosition
ExcessReserves
{+l/Deficiency (- 1
Borrowings
Net free reserves(+ llNet borrowed(-)
Amount
Outstanding
11/9/83
163.936
143,912
44.312
57,414
24,971
2,974
7,543
12,479
41,471
30,290
66,257
69,123
63,551
16,856
Weekended
11/9/83
19
224
205
Change
from
Change from
year ago
Dollar
Percent
11/2/83
1.0
586
1.699
639
2,171
1.5
- 2.2
517
1.019
0.3
24
180
6.7
0
1,569
762
66
- 34.4
903
13.6
- 49
4
- 1,375 - 9.9
-1,720
690
1.7
1,373
4.7
1,134
33,600
102.9
25
- 30.9
452
- 30.911
- 26,264
- 29.2
410
- 54.0
34
- 19,811
Comparable
Weekended
period
11/2/83
94
7
87
140
39
101
'" Excludestradingaccountsecurities.
# Includesitemsnot shownseparately.
t IncludesMoneyMarketDepositAccounts,Super-NOWaccounts,and NOW accounts.
Editorialcommentsmaybeaddressed
to theeditor (GregoryTong)or to theauthor. ... Freecopiesof
this and other FederalReservepublicationscanbe obtainedby callingor writing the Public
Information Section,FederalReserveBankof SanFrancisco,P.O.Box7702,SanFrancisco94120.
Phone(415) 974-2246.
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