Financial Update (January-March 1999)
Did You Know?
Derivative Securities Use Grows
|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:
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)
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|Commodity and Other
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