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The expert examines hedging interest rate risks for financial futures for Bay Street Bankcorp.
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Bay Street Bankcrop
Bay Street Bankcrop (BSB) is a highly successful and innovative minority-lending bank. The bank has just got an approval for the funding of $5 million from Fannie Mae for starting a new branch office in the inner city to extend its minority lending services to African American community. BSB has developed an aggressive $30 million lending plan offering long term, fixed rate mortgage financing to black owned business ventures. The plan would be financed through equity capital of $5 million for which approval has been received from Fannie Mae and an innovative savings deposit program which would raise $25 million. BSB offers mortgage to its customers at fixed rate for long term. Offering long-term credit at fixed rates is riskier as unexpected changes in the interest rates can cause a high variation in the market value of the assets and liabilities and hence can cause high variability in the profits. BSB want to reduce this risk and would like to make use of financial futures contracts to hedge the interest rate risk of its portfolio, which consists of interest sensitive deposit accounts, and mortgages of unmatched maturities. This case analysis deals with number of issues related to this risk exposure such as what is the cash market risk exposure, how the risk should be managed i.e. which part of the risk should be hedged and which part of the risk should be taken, what alternatives are available for risk management, and how these alternatives should be evaluated, implemented and monitored.
1. Cash Market Risk Exposure:
The cash market risk exposure is an existing or anticipated position in the cash market for which trading in the futures contracts market is intended to reduce the risk associated with uncertain changes in the value of the cash. In this case, the changes in the value of cash are mainly because of the interest rate risk.
Phase 1: BSB would receive $5 million from Fannie Mae. The bank plans to invest this money temporarily in treasury bills. The cash market risk exposure here is the risk that BSB may earn a return different from the expected 5.10%, which is the current spot rate on one-year treasury securities. Amount at exposure is $5 million.
Phase 2: BSB would issue $25 million in new certificates of deposit. The cash market risk exposure here is the risk that BSB may have to pay a return different from the expected 5.54%, which is the current spot rate on one-year bank certificates of deposit plus 50 basis point BSB premium. Amount at exposure is $25 million.
Phase 3: BSB would give $30 millions in new commercial mortgage loans. The cash market risk exposure here is the risk that BSB may earn a return different from the expected 7.21%, which is the bank's current price for fixed rate commercial mortgage loans. Amount at exposure is $30 million.
2. Direction of Hedge:
When we are making interest payments, we are worried about the increase in interest rates, as we will have to shell out more money on interest payments. However, we may not bother about the interest rate decline while committing interest payments. Taking short position (sell futures contract) is the appropriate position to take when one is worried about the interest rate increase.
When we are receiving interest payments, we are worried about the decline in interest rates, as we will receive less money on our investments. However, we may not bother about the interest rate increase. Taking long position (buy futures contract) is the appropriate position to take when one is worried about the interest rate decline.
Phase 1: BSB is investing money to earn interest. Take long position (buy futures contract). If spot interest rates decline, futures interest rates will typically also decline so that the value of the futures position will likely increase. This would offset any loss in the cash market due to interest rate decline. However, if the interest rates rise, the interest received will increase but it will be offset by the decrease in the value of futures position. Hence, the bank will be immunized from losses if the market rates rise of fall due to opposite offsetting profits / losses from futures contracts.
Phase 2: BSB is raising money and will pay interest. Take short position (sell futures contract). If spot interest rates increase, futures interest rates will typically also increase so that the value of the futures position will likely decrease. So we will gain from the short position in the future's market, which would offset any loss in the cash market due to interest rate decline. Similarly, if the interest rates fall, the value of the futures contract would increase and one will loss money from the short position in the futures market. Therefore, the gains in the spot market would be offset by the loss in the futures market. Hence, the bank will be immunized from losses.
Phase 3: BSB is originating commercial mortgage loans and would earn interest income. Take long position (buy futures contract). Reasons for immunization would be same as for phase 1.
3. Best Futures Contract:
The best futures contract for hedging a cash market risk exposure is one ...
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