Financial Update (January-March 1999)


Cover Story

Default-Risky Securities

ACH Survey

New ACH Trends

Direct Payment

Board of Directors Announcements


Did You Know?

Data Bank

The Docket

Derivative Securities Use Grows
As Banks Strive to Hedge Risks

by Lucy Ackert, senior economist

I n the last decade banks have significantly increased their holdings of derivative securities. Risk hedging is an important motive for this change. With derivative securities, commercial banks can hedge pre-existing exposure in their portfolios and assist their customers in managing financial risks.

Two risks that banks and their customers are often exposed to are interest rate and foreign exchange rate volatility. This volatility increased in the late 1970s and early 1980s, as did the number of cross-border financial transactions, spurring growth in both the types and complexity of hedging instruments.

Derivative securities are useful in hedging many types of risk, including those caused by movements in interest rates, exchange rates, stock prices and oil prices.

Types of Derivatives

Banks find interest rate and foreign exchange rate instruments particularly useful in managing risks. These derivative contracts are assets whose prices depend on the level of the interest rate or exchange rate; they may be exchange traded or privately negotiated. For exchange-traded contracts the performance of the party on the other side of the transaction is guaranteed by the exchange. Both parties to a transaction are required to post margins, or good faith deposits, to an account. In contrast, privately negotiated contracts offer flexible terms, and margin deposits are frequently not required.

Although many types of derivative securities are available to meet risk management needs, forwards, futures, options and swaps are of particular interest to depository institutions.

Forwards. A forward contract is an agreement between a buyer and seller to buy or sell an asset for a specified price at a future date. Forward contracts are over-the-counter or private agreements and are not exchange traded. They can be written on numerous assets, and the terms are flexible. For example, a contract may specify the exchange of a foreign currency and U.S. dollars between an institution and its client (or between two institutions) at a specific exchange rate at a future time.

Futures. A futures contract is similar to a forward contract in that it is an agreement to buy and sell an asset for a specified price at a future date. Unlike forward contracts, futures contracts are exchange traded and have standardized terms. Another important distinction between forwards and futures is their pattern of cash flows. Profits and losses in futures contracts are realized daily as the contracts are marked to market and losers settle up with winners whereas forward contracts are settled at the end of the contract period. Futures contracts are traded on a wide variety of assets, including commodities, stock indexes, interest rates and foreign currencies.

Options. An options contract is an agreement between a buyer and seller that gives the buyer the right to buy (call option) or sell (put option) an asset in the future at a price agreed upon today. Note that an option confers a right, not an obligation, to its buyer. For example, a call option on the British pound gives the holder the right to buy pounds for U.S. dollars on any date during the life of the option (American option) or on the contract maturity date (European option). The option holder would exercise the option only if a favorable exchange rate movement takes place.

Swaps. Swaps are private agreements between two parties to make periodic cash payments to each other. In an interest rate swap, the parties exchange interest rate payments; typically, one party pays a fixed rate and the other pays a rate based on a floating index such as the London Interbank Offer Rate (LIBOR). Another popular swap agreement is the currency swap, in which the parties exchange payments in two currencies.

Derivatives Position Indicators for U.S. Banks

The dramatic increase in banks' use of derivative securities is illustrated in the table; for example, banks' use of interest rate swaps more than doubled between Dec. 31, 1995, and Sept. 30, 1998.

The nominal values of derivatives positions for U.S. banks shown in the table should be interpreted with some caution, however, because they substantially overstate banks' risk exposure for at least two reasons. First, actual cash payments associated with these contracts are a small proportion, often 10 percent or less, of their gross amount. Second, these values overstate banks' exposure to interest rate, foreign exchange rate and other risks because banks have typically hedged almost all of their exposure to derivatives with offsetting positions in other derivatives or cash market instruments (such as government securities).

Additional Derivatives Research
For additional information on derivatives and their regulation, see these articles:
  • "Bank Capital and Value at Risk," Patricia Jackson, David J. Maude and William Perraudin, Journal of Derivatives 4 (Spring 1997): 73-89.
  • "Recent Developments in Bank Capital and Regulation of Risk Markets," P.H. Kupiec and J.M. O'Brien, Board of Governors of the Federal Reserve System, Finance and Economics Discussion Paper No. 95-51, December 1995.
  • "Capital Requirements for Interest Rates and Foreign Exchange Hedges," Larry D. Wall, John J. Pringle and James E. McNulty, Federal Reserve Bank of Atlanta, Economic Review 75 (May/June 1990): 14-28.

Managing Risks with Derivatives

Derivative securities are useful in hedging many types of risk, including those caused by movements in interest rates, exchange rates, stock prices and oil prices. For example, suppose a U.S.-based company has contracted to purchase supplies in marks from a German manufacturer. The U.S. company is exposed to exchange rate risk because of the possibility of an unfavorable change in the exchange rate over the contract period. To hedge this risk, the U.S. company can purchase German mark futures contracts that will, in effect, fix the price in dollars to be paid to the German firm.

As another example, a bond fund portfolio manager who is concerned about interest rate volatility could take a short position in Treasury bond futures contracts that mature in a month's time. This hedge is not perfect, of course — the characteristics of the manager's portfolio are not likely to be identical to those of a Treasury bond, so a certain amount of risk remains.

Knowing Pitfalls Can Help in Managing Risks

Clearly, regulators recognize that banks' risk exposure can be significantly altered by participation in derivative markets, particularly if the banks do not properly hedge. Regulators also recognize the importance of incorporating this risk into risk-based capital standards. Financial institutions that use derivatives, and those interested in using them, should be fully aware of the risks and regulations.

Off-Balance-Sheet Derivatives Position Indicators for U.S. Banks
(Foreign and domestic data, $millions)
  Interest Rate
Contracts as of
Foreign Exchange
Contracts as of
Equity Derivative
Contracts as of
Commodity and Other
Contracts as of
  12-31-95 9-30-98 12-31-95 9-30-98 12-31-95 9-30-98 12-31-95 9-30-98
Futures contracts 1,335,179 2,881,498 11,352 14,843 47,583 27,795 9,946 22,414
Forward contracts 1,728,772 3,057,853 4,209,427 5,579,659 63 132 57,434 61,339
Exchange-traded option
  Written options 402,409 1,144,037 7,680 8,022 22,881 24,171 8,115 5,273
  Purchased options 399,059 1,076,664 9,979 12,284 19,084 51,366 5,833 4,796
Over-the-counter option
  Written options 861,231 1,942,278 398,948 869,553 61,878 181,927 18,702 36,549
  Purchased options 830,063 2,064,635 399,942 846,453 57,417 168,788 20,252 36,263
Swaps 5,551,236 11,685,133 349,902 624,579 27,714 32,333 21,043 31,729