Interest Rate Futures
Content
ICFAI UNIVERSITY
DEHRADUN
Name:
Gopal Krishan
Enrollment No. 09BS0002792 IUD No: 0901202792 Course Code: SLFI608 Course Name: Financial Risk Management Faculty Name: C. M. Madtha Date: 5th January, 2011 Title of the assignment: Interest rate futures case of Peoples Federal Saving bank and Interest Rate Swap Case of B. F. Goodrich and Rabobank
Sign Student Sign Faculty
Case I ± Interest rate futures
Interest rate futures: y An Interest Rate Futures is a financial derivative (a futures contract) with an interestbearing instrument as the underlying asset. y An interest rate future is a contract between the buyer and seller agreeing to the future delivery of any interest-bearing asset y Interest rate futures are used to hedge against the risk of that interest rates will move in an adverse direction, causing a cost to the company. Facts of case: y Richard Myers, President, Peoples Federal Saving Bank (PFSB) y Paid out in variation margin on T bills : $1,830,000 y Variation margin loss : $ 690,000 y Total loss : $2,520,000 y Reason for the loss: y Market scenario y ALM mismatch: short term deposits, long term loans and advances
R&UP
$11,402.00 $13,480.00 $16,605.00 $15,805.00
Total Asset $555,613.00 $509,378.00 $434,267.00 $350,714.00 Cap Ratio 2.05% $277.81 y y y Reduction in CAR Lead to liquidity of the bank when goes below 2% Steps taken by the bank to protect themselves include hedging strategy 2.65% 3.82% 4.51%
Hedging Strategy: y Hedge cost of savings certificate rollover of $400 million y Short position in 90 day Treasury Bill y Fully hedge the short term interest rate exposure This hedging strategy was working perfectly for the bank because in case the index would rise. The bank would gain on future position but and lose in its exposure. In other case, the bank would lose on the future but it¶ll get compensated by the gain in its exposure. Thus, their losses
would never exceed the limit of $277.81 million which is the maximum loss they can afford in this case.
Case II ± Interest Rate Swaps
Facts about Goodrich
y y y y y Goodrich needed $50ml for 8 years It had a credit rating of BBBHad to pay high interest in fixed rate market Market was into recession and its sales were declining They could borrow from market at a fixed rate of 12.5%
Facts about Rabobank
y y y y Rabobank had a credit rating of AAA Had assets which were loans whose rate floated with LIBOR Was funding the assets through inter-bank deposits at LIBOR or prime Eurodollar CDs They could borrow from market at a floating rate of LIBOR+0.25%
The Deal:
Rabobank Goodrich Saving Goodrich Saving Rabobank
Fixed rate 10.7% Floating rate LIBOR+0.50%
Actual 12.5% Payout 10.7% 1.8%
LIBOR+0.25% LIBOR+0.50% (0.25%)
There is an absolute advantage to Goodrich because it is saving 1.8% and there is absolute disadvantage to Rabobank because it is losing 0.25% in this deal. But together they have a comparative advantage of 1.55% which can be shared between the three parties.
Structure of the Deal:
Calculation of division of the gain:
Rabobank Payout Actual Saving
LIBOR-x2 LIBOR+0.25% x2+0.25%
Goodrich Morgan
x1+11.2% 12.50% 1.30%-x1 x1-x2
These equations can be used to find the value of x1 and x2 by putting the equations equal to the amount of gain that the party is going to get. How much gain do they share depends on the negotiating power of the party and the strength of the party. In this case the Rabobank being the dominating and powerful party is likely to get the largest share in the deal.
Saving for Goodrich 0.70 0.65 0.60 0.55 0.50 0.45 0.40 0.35 0.30 0.25 0.20 Earning to Morgan 0.55 0.50 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05
Saving for Rabobank 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 1.20 1.30
Total Gain 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55
x1 0.60 0.65 0.70 0.75 0.80 0.85 0.90 0.95 1.00 1.05 1.10
x2 0.05 0.15 0.25 0.35 0.45 0.55 0.65 0.75 0.85 0.95 1.05
Using the equations and different combinations of gains sharing, a schedule can be made which would give the likely values of x1 and x2 depending on the gain share of the party.
DEHRADUN
Name:
Gopal Krishan
Enrollment No. 09BS0002792 IUD No: 0901202792 Course Code: SLFI608 Course Name: Financial Risk Management Faculty Name: C. M. Madtha Date: 5th January, 2011 Title of the assignment: Interest rate futures case of Peoples Federal Saving bank and Interest Rate Swap Case of B. F. Goodrich and Rabobank
Sign Student Sign Faculty
Case I ± Interest rate futures
Interest rate futures: y An Interest Rate Futures is a financial derivative (a futures contract) with an interestbearing instrument as the underlying asset. y An interest rate future is a contract between the buyer and seller agreeing to the future delivery of any interest-bearing asset y Interest rate futures are used to hedge against the risk of that interest rates will move in an adverse direction, causing a cost to the company. Facts of case: y Richard Myers, President, Peoples Federal Saving Bank (PFSB) y Paid out in variation margin on T bills : $1,830,000 y Variation margin loss : $ 690,000 y Total loss : $2,520,000 y Reason for the loss: y Market scenario y ALM mismatch: short term deposits, long term loans and advances
R&UP
$11,402.00 $13,480.00 $16,605.00 $15,805.00
Total Asset $555,613.00 $509,378.00 $434,267.00 $350,714.00 Cap Ratio 2.05% $277.81 y y y Reduction in CAR Lead to liquidity of the bank when goes below 2% Steps taken by the bank to protect themselves include hedging strategy 2.65% 3.82% 4.51%
Hedging Strategy: y Hedge cost of savings certificate rollover of $400 million y Short position in 90 day Treasury Bill y Fully hedge the short term interest rate exposure This hedging strategy was working perfectly for the bank because in case the index would rise. The bank would gain on future position but and lose in its exposure. In other case, the bank would lose on the future but it¶ll get compensated by the gain in its exposure. Thus, their losses
would never exceed the limit of $277.81 million which is the maximum loss they can afford in this case.
Case II ± Interest Rate Swaps
Facts about Goodrich
y y y y y Goodrich needed $50ml for 8 years It had a credit rating of BBBHad to pay high interest in fixed rate market Market was into recession and its sales were declining They could borrow from market at a fixed rate of 12.5%
Facts about Rabobank
y y y y Rabobank had a credit rating of AAA Had assets which were loans whose rate floated with LIBOR Was funding the assets through inter-bank deposits at LIBOR or prime Eurodollar CDs They could borrow from market at a floating rate of LIBOR+0.25%
The Deal:
Rabobank Goodrich Saving Goodrich Saving Rabobank
Fixed rate 10.7% Floating rate LIBOR+0.50%
Actual 12.5% Payout 10.7% 1.8%
LIBOR+0.25% LIBOR+0.50% (0.25%)
There is an absolute advantage to Goodrich because it is saving 1.8% and there is absolute disadvantage to Rabobank because it is losing 0.25% in this deal. But together they have a comparative advantage of 1.55% which can be shared between the three parties.
Structure of the Deal:
Calculation of division of the gain:
Rabobank Payout Actual Saving
LIBOR-x2 LIBOR+0.25% x2+0.25%
Goodrich Morgan
x1+11.2% 12.50% 1.30%-x1 x1-x2
These equations can be used to find the value of x1 and x2 by putting the equations equal to the amount of gain that the party is going to get. How much gain do they share depends on the negotiating power of the party and the strength of the party. In this case the Rabobank being the dominating and powerful party is likely to get the largest share in the deal.
Saving for Goodrich 0.70 0.65 0.60 0.55 0.50 0.45 0.40 0.35 0.30 0.25 0.20 Earning to Morgan 0.55 0.50 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05
Saving for Rabobank 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 1.20 1.30
Total Gain 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55 1.55
x1 0.60 0.65 0.70 0.75 0.80 0.85 0.90 0.95 1.00 1.05 1.10
x2 0.05 0.15 0.25 0.35 0.45 0.55 0.65 0.75 0.85 0.95 1.05
Using the equations and different combinations of gains sharing, a schedule can be made which would give the likely values of x1 and x2 depending on the gain share of the party.
