Forward/Future Purchase

Forwards and futures are similar in that they are agreements that obligate the owner of the instrument to buy or sell an asset for a specified price at a specified time in the future. ForwardsFinancial securities traded in the over-the-counter market whose characteristics can be tailored to meet specific customer needs. are traded in the over-the-counter market, and contract characteristics can be tailored to meet specific customer needs. Farmers and grain elevator operators also use forwards to lock in a price for their corn or soybeans or wheat. They may choose to lock in the basisThe amount of money above and beyond the futures price., which is the amount of money above and beyond the futures price. Alternatively, if they like (believe that the prices are at their highest likely levels) the futures’ price levels, they can lock in the entire price. Food and beverage companies use forwards to lock in their costs for grains and fruits and vegetables. Quaker Oats, for example, locks in the prices on corn and oats using forward contracts with growers. Anheuser Busch depends upon forwards to lock in the price of hops, rice, and other grains used to make beer. Dole fruit companies use forwards to price out pineapples, raspberries, grapes, and other fruits.

FuturesFinancial securities that trade on an exchange and that have standardized contract specifications., on the other hand, trade on an exchange with standardized contract specifications. Forwards and futures prices derive from the spot, or cash market, which is “today’s” price for a particular asset. An example of a spot contract would be your agreement to purchase a meal at a restaurant. The spot market is the quoted price on today’s menu. A futures or forwards market would be the price you would have to pay if you wanted the same meal one year from today. Getting back to our cereal manufacturer, Frosty O’s can either go to the spot market on an ongoing basis or use the forwards/futures market to contract to buy wheat in the future at an agreed-upon price. Buying in the spot market creates exposure to later price fluctuation. Buying in the forwards/futures market allows the manufacturer to guarantee future delivery of the wheat at a locked-in price. Hence, this strategy is known as a “lock it in” defense. Southwest Airlines’ strategy to buy oil futures during the fuel crisis of 2007–2008 allowed them to be the only profitable airline. On the other side, Continental Airline is suffering from buying aviation fuel futures when the price of oil subsequently declined dramatically. Thus, the use of futures and forwards can create value or losses, depending upon the timing of its implementation.

Swaps

SwapsAgreements to exchange or transfer expected future variable-price purchases of a commodity or foreign exchange contract for a fixed contractual price today. are agreements to exchange or transfer expected future variable-price purchases of a commodity or foreign exchange contract for a fixed contractual price today. In effect, Frosty O’s buys wheat and swaps its expected “floating” price exposure for wheat at different times in the future for a fixed rate cost. For example, if Frosty O’s normally buys wheat on the first of each month, the company will have to pay whatever the spot price of wheat is on that day. Frosty O’s is exposed to market price fluctuations for each of the twelve months over a year’s time period. It can enter into a transaction to pay a fixed monthly rate over a year’s time period instead of whatever the floating spot rate may be each month. The net effect of the swap transaction is to receive the necessary wheat allotment each month while paying a fixed, predetermined rate. The swap rate quote would be fixed using the spot market and the one-year forward market for wheat. Thus Frosty O’s eliminates any adverse price exposure by switching the “floating” price exposure for an agreed-upon fixed price. Swaps are used in the same manner to exchange floating interest rate liabilities for fixed-interest rate liabilities. Hence, this strategy is known as a “switch out of it” defense. We will show an elaborate swaps example at the end of this section.

Options

Agreements that give the right (but not the obligation) to buy or sell an underlying asset at a specified price at a specified time in the future are known as optionsAgreements that give the right (but not the obligation) to buy or sell an underlying asset at a specified price at a specified time in the future.. Frosty O’s can purchase an option to buy the wheat it needs for production at a given strike price. The strike price (also called exercise price) is the specified price set in the option contract. In this fashion, Frosty O’s can place a ceiling on the price it will pay for the needed wheat for production in future time periods. Until the maturity date of the option passes, option holders can exercise their rights to buy wheat at the strike price. If the future spot price of wheat rises above the strike price, Frosty O’s will execute its option to purchase the wheat at the lower strike price. If the future price of wheat falls below the strike price, the company will not exercise its option and will instead purchase wheat directly in the spot market. This differentiates the option contract from the futures contract. An option is the right to buy or sell, whereas a futures/forward contract is an obligation to buy of sell. The option buyer pays the cost of the option to buy wheat at the strike price—also known as the option premium. A call option grants the right to buy at the strike price. A put option grants the right to sell at the strike price. A call option acts like insurance to provide an upper limit on the cost of a commodity. A put option acts like insurance to protect a floor selling price for wheat. Hence, option strategies are known as “cap” and “floor” defenses.James T. Gleason, The New Management Imperative in Finance Risk (Princeton, NJ: Bloomberg Press, 2000), Chapter 4 "Evolving Risk Management: Fundamental Tools".

Individuals and companies alike use derivative instruments to hedge against their exposure to unpredictable loss due to price fluctuations. The increasing availability of different derivative products has armed enterprise risk managers (ERM) with new risk management tool solutions. An importer of raw materials can hedge against changes in the exchange rate of the U.S. dollar relative to foreign currencies. An energy company can hedge using weather derivatives to protect against adverse or extreme weather conditions. And a bank can hedge its portfolio against interest rate risk. All of these risk exposures interrupt corporate cash flow and affect earnings, capital, and the bottom line, which is the value of the firm. These solutions, however, create new risk exposures. Over-the-counter market-traded derivatives, which feature no exchange acting as counterparty to the trade, expose a company to credit risk in that the counter party to the contract may not live up to its side of the obligation.

Securitization

Packaging and transferring the insurance risks to the capital markets through the issuance of a financial security is termed securitizationPackaging and transferring the insurance risks to the capital markets through the issuance of a financial security..David Na, “Risk Securitization 101, 2000, CAS Special Interest Seminar” (Bermuda: Deloitte & Touche), http://www.casact.org/coneduc/specsem/catastrophe/2000/handouts/na.ppt. The risks that have been underwritten are pooled together into a bundle, which is then considered an asset and the underwriter then sells its shares; hence, the risk is transferred from the insurers to the capital markets. Securitization made a significant difference in the way insurance risk is traded—by making it a commodity and taking it to the capital markets in addition to or instead of to the insurance/reinsurance market. Various insurance companies’ risks for similar exposures in diversified locations are combined in one package that is sold to investors (who may also include insurers). Securitized catastrophe instruments can help a firm or an individual to diversify risk exposures when reinsurance is limited or not available. Because global capital markets are so vast, they offer a promising means of funding protection for even the largest potential catastrophes. Capital market solutions also allow the industry (insurers and reinsurers) to reduce credit risk exposure, also known as counterparty riskRisk of loss from failure of a counterparty, or second party, in a derivatives contract to perform as agreed or contracted.. This is the risk of loss from failure of a counterparty, or second party, in a derivatives contract to perform as agreed or contracted. Capital market solutions also diversify funding sources by spreading the risk across a broad spectrum of capital market investors. Securitization instruments are also called insurance-linked securities (ISLs)General term for securitization instruments.. They include catastrophe bonds, catastrophe risk exchange swaps, insurance-related derivatives/options, catastrophe equity puts (Cat-E-Puts), contingent surplus notes, collateralized debt obligations (CDOs),A word of caution: AIG and its CDS without appropriate capitalization and reserves. The rating of credit rating agencies provided the security rather than true funds. Thus, when used inappropriately, the use of such instruments can take down giant corporations as is the case of AIG during the 2008 to 2009 crisis. and weather derivatives.

Catastrophe bondsBonds that seek to protect the insurance industry from catastrophic events., or CAT bonds, seek to protect the insurance industry from catastrophic events. The bonds pay interest and return principal to investors the way other debt securities do—as long as the issuer does not experience losses above an agreed-upon limit. Insurers can come to the capital market to issue bonds that are tied to a single peril, or even to a portfolio or basket of risks. Embedded in each issue is a risk trigger that, in the event of catastrophic loss, allows for forgiveness of interest and/or principal repayment.

An example of a CAT bond is the issue by Oriental Land Company Ltd., owner and operator of Tokyo Disneyland. Oriental Land used CAT bonds to finance one facility providing earthquake coverage and the other to provide standby financing to continue a $4 billion expansion of the theme park. Each facility raised $100 million via the bond market to cover property risk exposure and subsequent indirect business interruption loss in case of catastrophic loss from an earthquake. The trigger event was for an earthquake, regardless of whether the event caused any direct physical damage to the park.Sam Friedman, “There’s More Than One Way to Skin a Cat,” National Underwriter, Property & Casualty/Risk & Benefits, May 8, 2000. For more about how CAT bonds provide protection, see “The CAT Bond Story” in this chapter.

With catastrophe equity puts (Cat-E-Puts)Financial instrument that gives an insurer the option to sell equity (e.g., preferred shares) at predetermined prices, contingent upon the catastrophic event., the insurer has the option to sell equity (e.g., preferred shares) at predetermined prices, contingent upon the catastrophic event. Contingent surplus notesOptions to borrow money in case of a specific event. are options to borrow money in case of a specific event. Collateralized debt obligations (CDOs)Securities backed by a pool of diversified assets. are securities backed by a pool of diversified assets; these are referred to as collateralized bond obligations (CBOs) when the underlying assets are bonds and as collateralized loan obligations (CLOs) when the underlying assets are bank loans.Definition from Frank J. Fabozzi and Laurie S. Goodman, eds., Investing in Collateralized Debt Obligations (Wiley, 2001). Weather derivativesDerivative contracts that pay based on weather-related events. are derivative contracts that pay based on weather-related events. All are examples of financial market instruments that have been used to transfer risk and to provide risk-financing vehicles.A comprehensive report by Guy Carpenter appears in “The Evolving Market for Catastrophic Event Risk,” August 1998, http://www.guycarp.com/publications/white/evolving/evolv24.html.

Investors’ advantages in insurance-linked securities are diversification, as these instruments allow noninsurance investors to participate in insurance-related transactions and above-average rates of return. Advantages to the issuers of such instruments include greater capacity and access to the capital markets. Insurance-linked securities provide issuers with more flexibility and less reliance on reinsurers. The presence of new instruments stabilizes reinsurance pricing and provides higher levels of risk transfer with cutting-edge understanding for both insurance and capital markets.

We have shown that enterprise risk management (ERM) for a corporation is indeed complex. Full enterprise-wide risk management entails folding financial risk management into the CRO’s department responsibilities. A chief risk officer’s role is multifaceted. Today, risk managers develop goals to widen the understanding of risk management so that employees take into account risk considerations in their day-to-day operations. Risk awareness has become imperative to the overall health of the organization. Sound practices must incorporate the advancements on the technology front so that companies can compete in the global environment. Viewing all integrated segments of risk from across the enterprise in a holistic manner facilitates a global competitive advantage.

History

In the early years of U.S. banking history, banks seemed to have the easiest job in the corporate world. All a bank manager had to do was receive deposits in the form of checking, savings, and deposit accounts (bank liabilities), and provide mortgage and other lending services (bank assets). Throughout the twentieth century, the banking industry prospered. For most of the post–World War II era the upward-sloping yield curve meant that interest rates on traditional thirty-year residential mortgage loans exceeded rates on shorter-term savings and time deposits.Anthony Saunders, Chapter 1 "The Nature of Risk: Losses and Opportunities" Financial Institutions Management: A Modern Perspective, 3rd ed. (New York: McGraw-Hill Higher Education, 2000), ch. 1. The positive net margin between the two rates accounted for banks’ prosperity. All of this ended abruptly when the Federal Reserve changed its monetary policy in October 1979 to one of targeting bank reserves instead of interest rates. Figure 5.3 "Thirty-Year Treasury Rates—Secondary Market" and Figure 5.4 "Three-Month Treasury Bills Rates—Secondary Market" provide a historical perspective of interest rates.

Figure 5.3 "Thirty-Year Treasury Rates—Secondary Market" and Figure 5.4 "Three-Month Treasury Bills Rates—Secondary Market" graphically present interest rate risk exposure that banks face. The noticeable change is the absolute pickup in interest rate volatility from 1979 forward. As Figure 5.4 "Three-Month Treasury Bills Rates—Secondary Market" shows, three-month T-bill interest rates reached above 16 percent in the early 1980s. Yet many banks’ assets were locked into low-interest, long-term loans, mostly thirty-year mortgages. The financial crisis that followed the rapid rise in interest rates (on both short- and long-term liabilities) was catastrophic in proportion; many banks failed by positioning their loan portfolios incorrectly for the change in interest rates. Locked-in long-term mortgage loan rates provided insufficient cash inflows to meet the higher cash outflows required on deposits. Those that survived had to make major changes in their risk management style. Later we will introduce how a specific bank, Hometown Bank, manages its interest rate exposure using derivatives.

“Modern banks employ credit-scoring techniques to ensure that they are making good lending decisions, use analytical models to monitor the performance of their loan portfolios, and implement financial instruments to transfer out those credit risks with which they are not comfortable.”Sumit Paul-Choudhury, “Real Options,” Risk Management Magazine, September 2001, 38. Bankers learned a costly lesson in the 1980s by not being adequately prepared for a changing interest rate environment. Risk management must be enterprise-wide and inclusive of all components of risk. Hometown Bank is a surviving bank, with lofty goals for the future. The current focus for CEO John Allen has three components:

1. Review the primary elements of Hometown’s financial risks:

   • Interest rate risk—those risks associated with changes in interest rates
   • Market risk—risk of loss associated with changes in market price or value
   • Credit risk—risk of loss through customer default
2. Review Hometown’s nonfinancial, or operational, risks: those risks associated with the operating processes or systems in running a bank
3. Monitor the success of risk mitigation techniques the bank employs

Interest Rate Risk

Hometown Bank’s primary financial objective is to grow its assets. Net worth, also known as shareholder value, is defined as:

Shareholders' Equity = Total Assets – Total Liabilities.

Thus, when assets grow more than liabilities, shareholder value also increases. Hometown Bank’s assets, as noted on its consolidated balance sheet in Table 5.7 "Hometown Bancorp and Subsidiaries Financial Statements (in Thousands)", primarily consist of loans; at year-end 2001, $649 million of Hometown’s $785 million total assets were in the form of loans (see Table 5.8 "Loan Portfolio Composition, Hometown Bancorp (in Thousands)" for loan portfolio composition). Hometown obtains funding for these loans from its deposit base. Note that for Hometown Bank, as for all banks, deposit accounts are recorded as liabilities. Hometown Bank has an outstanding obligation to its deposit customers to give the money back. For Hometown, deposits make up $467.5 million, or 65 percent, of total outstanding liabilities. The mismatch between deposits and loans is each element’s time frame. Hometown’s main asset category, retail mortgage loans, has long-term maturities, while its main liabilities are demand deposits and short-term CDs, which have immediate or short-term maturities.

Hometown’s net cash outflows represent payments of interest on deposits. Because of the deposits’ short-term maturities, these interest payments are subject to frequent changes. Demand depositors’ interest rates can change frequently, even daily, to reflect current interest rates. Short-term CDs are also subject to changes in current interest rates because the interest rate paid to customers changes at each maturity date to reflect the current market. If bank customers are not happy with the new rate offered by the bank, they may choose not to reinvest their CD. Interest rate risk for Hometown Bank arises from its business of lending long-term, with locked-in interest rates, while growing their loan portfolio with short-term borrowings like CDs, with fluctuating interest rates. This risk has increased dramatically because of the increase in interest rate volatility. During the period of January 2001 through October 2002, three-month treasury bills traded in a range from 6.5 percent to 1.54 percent. (Refer to Figure 5.3 "Thirty-Year Treasury Rates—Secondary Market"). During periods of inverted yield curves (where longer-term investments have lower interest rates than short-term investments), a bank’s traditional strategy of providing long-term loans using deposits is a money-losing strategy. Note the normal yield curve and inverted yield curve inset below in Figure 5.5 "Yield Curves".

When interest rates are inverted, cash outflows associated with interest payments to depositors will exceed cash inflows from borrowers such as mortgage holders. For example, a home buyer with a thirty-year mortgage loan at 6 percent on $100,000 will continue to make principal and interest payments to Hometown at $597.65 per month. Interest cash flow received by Hometown is calculated at the 6 percent stated rate on the $100,000 loan. If short-term interest rates move higher, for example to 10 percent, Hometown will have interest cash outflows at 10 percent with interest cash inflows at only 6 percent. How will Hometown Bank deal with this type of interest rate risk?

Swaps as a Tool

An interest rate swap is an agreement between two parties to exchange cash flows at specified future times. Banks use interest rate swaps primarily to convert floating-rate liabilities (remember, customers will demand current market interest rates on their deposits—these are the floating rates) into fixed-rate liabilities. Exchanging variable cash flows for fixed cash flows is called a “plain vanilla” swap. Hometown can use a swap as a tool to reduce interest rate risk.

European banks are the opposite of U.S. banks. European bank customers demand floating rate loans tied to LIBOR (London Interbank Offer Rate); their loans are primarily variable rate and their deposit base is fixed-rate time deposits. If two banks, one U.S. and one European, can agree to an exchange of their liabilities the result is the following:

The swap creates a match of interest-rate-sensitive cash inflows and outflows: fixed rate assets and liabilities for the U.S. bank and floating rate assets and liabilities for the European bank as shown in Table 5.10 "Objective of Mitigating Interest Rate Risks". The following steps show how Hometown Bank employs the financial instrument of a swap with SwissBank for $100 million of their mortgage loans as a risk management tool.

In our simplified example, Hometown agrees to swap with SwissBank cash flows equal to an agreed-upon fixed rate of 3 percent on $100 million, a portion of their total assets. The term is set for ten years. At the same time, SwissBank agrees to pay Hometown cash flows equal to LIBOR an indexed short-term floating rate of interest on the same $100 million. Remember, the contract is an agreement to exchange, or swap, interest payments only. The amount is determined by the desired amount of assets the two parties wish to hedge against interest rate risk. They agree to do this because, as explained above, it better aligns each bank’s risk. They agree to swap to minimize interest-rate risk exposure. For Hometown Bank, when interest rates rise, the dollars they receive on the swap increase. This creates a gain on the swap that offsets the loss or supplements the smaller margins are available to the bank because of interest rate moves. Keep in mind that the interest margin may have been profitable at the time of the original transaction; however, higher interest rates have increased cash outflows of interest paid to depositors.

In our example in Table 5.11 "Swap Cash Flow", we show what happens if interest rates increase. Over the sample four years shown, short-term interest rates move up from 2.50 percent to 4.50 percent. If Hometown Bank was not hedged with the interest rate swap, their interest expenses would increase as their deposit base would be requiring higher interest cash outflows. With the swap, Hometown Bank can offset the higher cash outflows on their liabilities (higher interest payments to depositors) with the excess cash payments received on the swap. The swap mitigates the risk of increasing interest rates.

Why, you might ask, would SwissBank agree to the swap? Remember, SwissBank has floating rate loans as the majority of their asset base. As interest rates rise, their cash inflows increase. This offsets their increasing cash flows promised to Hometown Bank. The risk of loss for SwissBank comes into play when interest rates decline. If interest rates were to decline below the fixed rate of 3 percent, SwissBank would benefit from the swap.