Currency and interest rate swaps Swaps: –Agreement between two counterparties to exchange cash flows based upon some notional principal amount of money, maturity, and interest rates. Risks associated with swaps Price risk: –Interest rate changes can cause the gap position of a bank or firm to change. OTC Options, Futures, and Forwards OTC options: –Nonstandardized contracts, unlike exchange-traded options.
OTC Options, Futures, and Forwards Forward rate agreements (FRAs): –OTC interest rate futures contract for bonds or other financial asset.
OTC Options, Futures, and Forwards Securitization: –Home loans, auto loans, credit-card receivables, computer leases, mobile home loans, and small business loans.
Other off-balance sheet activities Loan sales: –Banks can sell loans to a third party as a source of funds.
Other off-balance sheet activities Trade finance: –Acceptance participations Bankers’ acceptances are contingent liabilities that do not appear on the balance sheet. Lecture 14 - Derivatives and Risk Management Derivatives are financial weapons of mass destruction.
FINANCIAL FUTURES, FORWARD RATE AGREEMENTS, AND INTEREST RATE SWAPS Chapter 10 Bank Management 5th edition. 7 May 2001 International Swaps and Derivatives Association Mexico City Derivatives and Risk Management in Mexico Interest Rate and Currency Derivatives. Most commercial and industrial loans are made under some form of guarantee (informal or formal).
Recent securitization of commercial and industrial loans (collateralized loan obligations or CLOs) and commercial mortgage-backed securities or CMBSs). For a fee the selling bank often continues to service the loan payment and handle other responsibilities of the loan. The Development of Modern Banking In the middle ages, metalsmiths performed a safekeeping function and issued depository. 2 This Lecture Financial Market Typology U Non-tradadable and non-transferable products U Securities U Derivatives. Real and Financial Assets Real and financial assets are created through the capital formation process that. The Relationship Between Liquidity Requirements, Cash, and Funding Sources The amount of cash that a bank holds. Standby letters of credit: –SLCs obligate the bank to pay the beneficiary if the account party defaults on a financial obligation or performance contract.
Other terms for similar financial guarantees are revolving underwriting facilities (RUFs) and standby note issuance facilities (SNIFs). Two derivatives markets: (1) privately traded OTC market, and (2) organized exchanges (CBOT, CME, CBOE, and other countries). Counterparty interest: –The other party may not want to exchange the same amount of cash flows.
Revolving line of credit -- Formal agreement by a bank to lend funds on demand to a client firm under the terms of the contract.
Reduce credit risks, gap risk, improve diversification, and provide stable, low-risk service revenues. Three types of interest rate swaps: (1) Coupon swaps -- fixed and floating coupon payments.
As such, the bank is the writer of a call option in interest rates (or, alternatively stated, a put option in prices). Synthetic loans: –Use interest rate futures and options to create synthetic loans and securities. For example, a bank may refer a customer to a brokerage firm and earn part of the customer fee. The bank is a buyer of a put option in interest rates in this case (or, alternatively stated, a call option in prices).
Commercial letters of credit -- a letter of credit (LOC) issued by a bank is a guarantee that the bank’s customer will pay a contractural debt. Funding risk -- Risk that many borrowers will take down commitments at the same time and thereby strain bank liquidity. Interest rate collar -- Combines a cap and floor agreement to set max and min interest rate limits on a loan.
However, the bank would prefer to make a fixed rate loan in this interest rate environment.
However, securitized credit card loans can still expose the bank to credit risk if credit payments fall below some predetermined level. If interest rates fall, and T-bill prices rise, the gain on the futures position would offset the lower interest earnings on the cash loan position.
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