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APPLICATION. Hedging with Futures Options

Earlier in the chapter, we saw how the First National Bank could hedge the interest-rate risk on its $5 million holdings of 6s of 2023 by selling $5 million of T-bond futures. A rise in interest rates and the resulting fall in bond prices and bond futures contracts would lead to profits on the bank's sale of the futures contracts that would exactly offset the losses on the 6s of 2023 the bank is holding.

As panel (b) of Figure 1 suggests, an alternative way for the manager to protect against a rise in interest rates and hence a decline in bond prices is to buy $5 million of put options written on the same Treasury bond futures. As long as the exercise price is not too far from the current price as in panel (b), the rise in interest rates and decline in bond prices will lead to profits on the futures and the futures put options, profits that will offset any losses on the $5 million of Treasury bonds.

The one problem with using options rather than futures is that the First National Bank will have to pay premiums on the options contracts, thereby lowering the bank's profits in an effort to hedge the interest-rate risk. Why might the bank manager be willing to use options rather than futures to conduct the hedge? The answer is that the option contract, unlike the futures contract, allows the First National Bank to gain if interest rates decline and bond prices rise. With the hedge using futures contracts, the First National Bank does not gain from increases in bond prices because the profits on the bonds it is holding are offset by the losses from the futures contracts it has sold. However, as panel (b) of Figure 1 indicates, the situation when the hedge is conducted with put options is quite different: Once bond prices rise above the exercise price, the bank does not suffer additional losses on the option contracts. At the same time, the value of the Treasury bonds the bank is holding will increase, thereby leading to a profit for the bank. Thus using options rather than futures to conduct the micro hedge allows the bank to protect itself from rises in interest rates but still allows the bank to benefit from interest-rate declines (although the profit is reduced by the amount of the premium).

Similar reasoning indicates that the bank manager might prefer to use options to conduct the macro hedge to immunize the entire bank portfolio from interest-rate risk. Again, the strategy of using options rather than futures has the disadvantage that the First National Bank has to pay the premiums on these contracts up front. By contrast, using options allows the bank to keep the gains from a decline in interest rates (which will raise the value of the bank's assets relative to its liabilities), because these gains will not be offset by large losses on the option contracts.

In the case of a macro hedge, there is another reason why the bank might prefer option contracts to futures contracts. Profits and losses on futures contracts can cause accounting problems for banks because such profits and losses are not allowed to be offset by unrealized changes in the value of the rest of the bank's portfolio. Consider what happens when interest rates fall. If First National sells futures contracts to conduct the macro hedge, then when interest rates fall and the prices of the Treasury bond futures contracts rise, it will have large losses on these contracts. Of course, these losses are offset by unrealized profits in the rest of the bank's portfolio, but the bank is not allowed to offset these losses in its accounting statements. So even though the macro hedge is serving its intended purpose of immunizing the bank's portfolio from interest-rate risk, the bank would experience large accounting losses when interest rates fall. Indeed, bank managers have lost their jobs when perfectly sound hedges with interest-rate futures have led to large accounting losses. Not surprisingly, bank managers might shrink from using financial futures to conduct macro hedges for this reason.

Futures options, however, can come to the rescue of the managers of banks and other financial institutions. Suppose that First National conducted the macro hedge by buying put options instead of selling Treasury bond futures. Now if interest rates fall and bond prices rise well above the exercise price, the bank will not have large losses on the option contracts, because it will just decide not to exercise its options. The bank will not suffer the accounting problems produced by hedging with financial futures. Because of the accounting advantages of using futures options to conduct macro hedges, option contracts have become important to financial institution managers as tools for hedging interest-rate risk.

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