Financial Risk Management: Futures, VaR, ABS, and Hedging

Futures Markets: Margins and Hedging

The Role of Margin Payments

Margin payments exist to eliminate counterparty credit risk in futures markets. Futures contracts are marked-to-market daily and losses are settled through variation margin, while initial margin acts as collateral. This system ensures that neither party can default at maturity.

Speculation vs. Hedging

Futures can be used for speculation by taking long or short positions to profit from expected price movements. They can also be used for hedging to offset the price risk of an existing exposure. For example, an equity portfolio can be hedged by shorting stock index futures. If the market falls, portfolio losses are offset by gains on futures, and if the market rises, portfolio gains are offset by futures losses.

Remaining risks after hedging include:

• Basis risk
• Beta estimation error
• Non-parallel price movements
• Timing mismatch

Value at Risk (VaR) and Portfolio Risk

Interpreting 5-Day VaR

A 5-day Value at Risk (VaR) of $200m at the 5th percentile means there is a 5% probability that losses will exceed $200m over a five-day period. It does not imply that losses will never exceed this amount.

The Single Index Model

Using the Single Index Model, daily portfolio volatility is calculated as beta times market volatility. This volatility is scaled to a 10-day horizon using the square-root-of-time rule. VaR is then calculated using the 5th percentile of the normal distribution.

Key assumptions include:

• Normal returns
• Constant beta
• Stable correlations

Potential errors arise from fat tails, beta instability, and model risk.

Incorporating Exchange Rate Risk

For a US investor holding German stocks, exchange rate risk must also be included. Total VaR must account for both equity market risk and currency risk, including their correlation.

Asset-Backed Securities and CDOs

Asset-Backed Securities (ABS) and Collateralized Debt Obligations (CDOs) are constructed by pooling mortgages and dividing cash flows into tranches. Equity tranches absorb losses first, followed by mezzanine and senior tranches. This structure makes senior tranches safer while increasing risk for junior tranches.

Advantages of ABS include:

• Risk diversification
• Tailored risk-return profiles

Disadvantages include:

• Complexity
• Opacity
• Model risk

ABS and ABS-CDOs played a key role in the 2008–2010 crisis due to poor loan quality, mispricing of risk, and excessive leverage.

Hedging Floating Rate Deposits

A USD 10 million bank deposit paying floating 180-day LIBOR can be hedged using interest rate derivatives to manage exposure to changes in interest rates. Several instruments can be utilized:

• Interest rate swaps: May be used to receive a fixed rate and pay LIBOR, effectively locking in a fixed return and reducing uncertainty.
• Eurodollar futures: Can be employed by taking a long position in the contracts to hedge against falling LIBOR rates.
• Forward Rate Agreements (FRAs): Allow the investor to lock in a future interest rate for the deposit period.
• Interest rate options: Such as floors, can be used to guarantee a minimum return while still allowing the investor to benefit if LIBOR increases.