HEDGING GUARANTEED INTEREST CONTRACT RATES WITH FINANCIAL FUTURES BY AJ ...

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HEDGING GUARANTEED INTEREST CONTRACT RATES
WITH FINANCIAL FUTURES
BY
A. J. Senchack Jr.
Associate Professor of Finance
CBA 6.222 ~ Finance Dept.
University of Texas
Austin, Texas 78712
(512) 471-4368
February, 1986
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Hedging Guaranteed Interest Contract Rates
With Financial Futures
Financial institutions have slowly begun to increase their use of
financial futures in order to reduce their exposure to interest rate risk.
This emphasis received a dramatic boost in 1983 when the Comptroller of the
Currency and the FHLBB amended their futures hedging regulations to broaden
the use of futures hedging. Recently, a number of state insurance
regulators issued new rules that now allow the use of futures (and options)
by insurance companies for the purposes of risk management.' While these
rules vary considerably by state, they do represent an integral step in
augmenting the tools of risk management.
Drawing upon the experiences of S&Ls and commercial banks, many
potential hedging strategies exist for insurers (refer to Exhibit 1). Just
like these financial institutions, insurers are "residual risk takers" and
perform similar financial functions. For example, policyholders
(depositors) pay premiums (deposits) which are then invested in assets
(loans) to produce income. Clearly, preserving the value of such assets and
maintaining the profi t margins between the "borrowing" and "lending" rates
are crucial to overall profitability.
In addition, insurers also face a variety of asset~liability
mismatches. Unique to the insurance industry, though, is a potential asset-
liability mismatch that involves two innovative insurance products~~-
guaranteed interest contracts (GICs) and universal life annuities. This
paper will present two futures market strategies that provide an opportunity
to hedge directly and possibly to establish a more competitive, stated
interest rate on GICs (or universal life annuities). These strategies
involve placing what is referred to as an antiCipatory hedge and/or
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purchasing a strip of futures contracts that matches the time period over
which the GIC rate applies. The advantages and disadvantages as well as the
mechanics of these two approaches will also be discussed.
I. GUARARTEED IRTEREST CORTRACTS
In selling GICs to a pension fund, for example, insurers take on a
considerable degree of risk, which can be hedged through financial futures
trading. By offering GlCs, ·the insurance company is placed in the position
of agreeing to pay a specified interest rate for a specified period of time.
Two risks arise in such cases:
1. An "offering risk" wherein interest rates may fall between the time
a GIC is accepted and the actual· payment (cash flow) is received
for investment purposes.
2. An "investment risk" wherein interest rates may rise or fall over
the set period of time covered by the GIC. This can affect the
value or rollover rate of the assets backing the GIC.
With regard to the offering risk, the insurer may guarantee a return
without having the necessary funds to take advantage of the investment upon
which the guaranteed return is based. If, for example, interest rates fall
during the offering period, the GIC's profit margin will be reduced or
possibly turn negative, depending on the extent to which rates fall.
However, by purchasing interest rate futures prior to receipt of the payment
for the GIC, the insurer can lock in its yield on the investments. This is
referred to as an anticipatory buy hedge. Because most of the yield loss
(increase in price) on the yet-to-be-purchased investment will be offset by
profits from the long futures poSitions, an insurer can offer GICs with
confidence that the profit spread will not erode.
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With regard to investment risk, there are a variety of investment
alternatives than can be used to back a GIC. However, most do not offer a
"guaranteed" investment return. For example, if a coupon~bearing instrument
is purchased, an insurer will face reinvestment risk arising from the need
to reinvest the intermediate cash flows from periodic interest payments.
That is, the realized yield will be lower or higher than the promised yield
(yiel.,..,too-maturi ty) of ,the instrument at the time of purchase, depending on
the direction of interest rate changes over the life of the instrument.
Moreover, if the instrument's maturity date extends beyond the life of the
GIC, a capital gain or loss may be realized if the investment has to be sold
before maturity. On the other hand, if the instrument's maturity is less
~ the GIC's maturity, an insurer faces the risk of rolling over the
investment at an unknown future rate of interest.
One way to fix an investment rate is to purchase a strip of
futures contracts that coincides with the specified time period over which
the GIC rate is guaranteed. This strategy involves purchasing a sequence of
futures contracts that has a different contract expiring every three months.
In essence, by buying a group of futures contracts wi th different expiration
dates, an insurer is "prearranging" for the future delivery of (investment
in) a financial instrument at a known interest rate and at a known date.
Below, we describe how the futures markets might be used to hedge away
both the offering risk and investment risk inherent in GICs. To simplify
our analysis, our discussion will be developed around the Treasury bill (T~
b1l1) futures contract.
II. FIOICUL rtmIRES FtmlAMlDfTALS
A primary purpose of the financial futures market is to transfer pri ce
(interest rate) risk from hedgers, such as insurers, to speculators. The
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hedger's objective in taking on a futures position (avoiding risk~ is just
the opposite of a speculator's (risk taking). That is, a hedger wants to
minimize the effect of a potential adverse change in interest rates on an
actual or anticipated investment (cash) position. An effective hedge,
therefore, will result in a futures gain (loss) that offsets a loss (gain)
in the cash market position.
In contrast, a speculator begins with no risk exposure but assumes the
hedger's risk with the expectation that the futures price will move in a
direction that will produce a return on his/her position. That is, the
hedger plays both markets by taking opposite positions in them, while the
speculator only plays one side---the futures market.
Interest Rate Futlres Contract
Futures contracts are traded on exchanges such as the Chicago Board of
Trade or Chicago Mercantile Exchange. These exchanges represent centralized
trading facilities for buyers and sellers. An interest rate futures
contract is a standardized contract calling for future delivery of a
financial instrument on a specific delivery date. If delivery is taken,
then the contract also calls for the specific price (see example below).
However, most futures contracts typically are made with the intent to close
out the futures positions prior to the delivery date. In this situation,
the price will be unknown (again. see example below).
Each futures exchange contains clearinghouse members whose
responsibility is to act as the opposite party to every trade. This enables
the future partiCipant to rely on the creditworthiness of the clearinghouse
rather than on that of the original buyer or seller.
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Margins on Futures Contracts
The minimum dollar value of a financial futures contract is $100,000
but it can range as high as $1 million. However, sellers/buyers do not have
to provide the full amount of securi ties or cash at the time a contract is
sold/bought. Instead, they are only required to put up a small amount of
cash, called the initial margin, for every transaction. This deposit serves
as a "good faith" or "performance" bond. In addition, to guarantee
integrity of the market, market positions are "markedKt~market· daily. If
an adverse price move reduces the margin balance below a specified
maintenance level, the participant must bring his/her account back up to the
initial margin amount.
The 90~Day T~lll Futures Contract
T-bill futures began trading in January 1976 on the International
Monetary Market (IMM) of the Chicago Mercantile Exchange. This contract
calls for the delivery of $1 million of T-bills having a maturity of 90-
days.' The contracts have delivery (expiration) months of March, June,
September and December. Trading ceases on the second day following the
third, weekly T-bill auction of the expiration month (usually a Wednesday).
Delivery occurs the following day and is accomplished through banks that are
registered with the Exchange and are members of the Federal Reserve System.
The delivery procedure is relatively simple and occurs over the bank wire
transfer system, with the T-bills being delivered to the buyer's account
located in any major city.
The contract prics is not the true price of a T~bill. Rather, it is an
~ determined by subtracting the T~bill futures yield from 100.00. For
example, if the futures yield is quoted as 7.50$, the 11+1 index ·price"
would be 92.50. (In effect, this index represents the annualized T~bill
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price.) The minimum price fluctuation of this contract is 0.01~ or one
basis point. This is equivalent to $25 on a $1 million T~bill futures·
contract (0.01 x $1,000,000 x 90/360).
IIEDGIBG All IJISUBER'S CPFERIJIG RISK
During the time period between the acceptance and eventual payment for
a GIC, the level of interest rates could move adversely to an insurer's
position. For example, assume that an insurer offers a one-year, $10
million GIC to a pension fund at a guaranteed rate of 6.80J. Moreover,
assume that this 6.80~ rate is based on the yield of a l-year T-bill. If
the offer is accepted, say on November 19, but the receipt of payment is not
expected until December 2, the insurer immediately faces the risk that
interest rates may fall before the funds can be invested. In this case, an
anticipatory buy hedge can be implemented in the futures market to hedge any
adverse interest rate changes.
Referring to Exhibit 2, let's first examine what could happen if the
insurance canpany did ~ employ a futures strategy. Note that under the
"cash market" heading that if T-bill rates fell fran 6.80~ to 6.40~ over the
offering period, the insurer would incur a "loss" of $40,000 on the $10
million investment. By remaining in an unhedged poSition, the insurer
essentially is speculating on the movement in interest rates. This is
referred to as being "short the cash market."
On the other hand, say the fnsurer decides to place an antiCipatory buy
hedge, referred to as being "long the futures market." Again, referring to
Exhibit 2 under the "futures market" heading, notice that 40 December Trbill
futures contracts would need to be purchased on November 19 at a yield (IHM
price) of 7.00J (93.00). In other words, ~ $1 million, 90~day T~blll
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contracts need to be purchased for every $1 million in the anticipated cash
market position. The reason is because a one basis point change on a I-year
T-bill amounts to $100, while a one basis point change on a 90-day T-bill is
equal to only $25.
Then, on December 2, the hedge would be lifted by selling 40 December
contracts. In this case, because of the parallelism exhibited by cash and
futures rate changes, the futures rate (price) has also fallen (risen) to
6.50% (93.50). Liquidation of this trade poSition generates a $50,000 gain,
which is used to offset the loss in the cash market. That is, the insurer's
effective yield would become 6.90%.
But why did the insurance company end up with a 6.90% yield rather than
the desired target yield of 6.80%? First, notice that the baSiS, defined as
the cash yield minus the futures yield, was 20 basis points on November 19.
However, by December 2, the basis had narrowed to 10 basis points. This
narrowing of the basis arises from the principle of convergence whereby the
cash and futures rates must converge together as the expiration date is
approached ~ must be equal to each other at delivery. In effect, the
insurer "captured" an extra 10 basis points above the original 6.80% target
rate. Alternatively, this 10 basis pOint change represents a $25xl0 basis
points x 40 contracts. $10,000 increase in interest earned above the
originally desired 0.0680 x $10 million· $680,000 interest expected to be
earned, or $690,000 + $10,000,000 • 6.90%.
IIEDGIIIG U IIISURER'S IJIVESnmRT RISK
A related, interest rate risk exposure that GICs introduce is with
regard to realizing the "promised yield" on the investment backing the GIC.
For instance, if an insurer purchases a coupon-bearing instrument, the
(intermediate) coupon interest payments will be reinvested at future,
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unknown rates of interest. This means that the promised yield (yield-to
maturity) is not likely to be equal to the realized yield~M~even if the
financial instrument is held to maturity. For example, if interest rates
fall over the life of the instrument, the coupon interest will be reinvested
at lower rates than the initial yield~tonmaturity, which will result in a
lower realized return than expected.
To illustrate how the futures market can be utilized to hedge this
exposure, consider a situation in which an insurer is evaluating three
alternative investments to back a GIC:
1. Purchase a l~year Treasury note at 8.18J.
2. Purchase a 1-year Treasury bill at 7.~2J.
3. Purchase simultaneously a 76~day (cash) Treasury bill plus a strip
of Treasury bill futures maturing in March, June and September
1986.
Because T-bills are quoted on a banker's discount yield baSiS, their
yields must be converted to a bondnequivalent yield basis to make them
comparable to yields on coupon-bearing instruments such as Treasury notes
and bonds. Exhibit 3 contains an analysis of which investment alternative
is the most attractive.
First, purchasing the 1-year Treasury note indicates a promised
(compounded) yield of 8.18J. However, this is not a guaranteed yield
because the intermediate coupon payments must be reinvested at an unknown
interest rate.
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Next, purchasing the l-year Treasury bill avoids the reinvestment risk
associated with the Treasury note but has a lower bOnd~eQuivalent
(uncompounded) yield of 8.13J.
Finally, the cash T~biII/T-bill futures strip strategy produces a
guaranteed bOnd~eQui valent yield of 8.23J. Thus, not only does it provide a
higher effective yield but there is no reinvestment risk. Moreover, this
8.23J is understated because it was derived assuming simple interest when,
in fact, interest would be compounding each Quarter as one cash T-bill
matured and deli very of the next T~b1l1 futures contract was accepted.
One reason, perhaps, for this higher yield is that the cash T-biII/T
bill futures strip strategy is obviously more complex than the other two
strategies because it involves four different investments: 1 cash T-bill
and 3 different T-bill futures contracts. Moreover, each T~bill futures
contract requires an initial margin of $2,500. However, the cash T-bill can
be used to satisfy this initial margin throughout the life of the contract.
But, if a maintenance margin call occurs because of rising interest rates,
this call must be met with new cash, and the new cash will have an
opportunity cost associated with it that needs to be considered.
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