Capital markets news jun2001

FEDERAL RESERVE BANK
OF CHICAGO
CAPITAL MARKETS NEWS
June 2001
The 23rd Annual FIA Law & Compliance Division Workshop
T
he 23rd annual Futures and
Industry Association Law &
Compliance Division Workshop,
held recently in Baltimore, attracted a
wide array ofindustry practitioners along
with regulators and, as expected, a pro-
nounced participation oflaw professionals.
This article will highlight some of the
more significant issues that emerged over
the course ofthe conference such as secu-
rity futures, access to foreign exchanges,
and block tracling.
Security Futures
Issues surrouncling efforts to develop a
new regulatory framework on- security
futures and futures on narrow-based
inclices were a prominent topic through-
out the workshop. The Commodity
Futures Modernization Act (CFMA)
views security futures as both commocli- /
ties and securities, creating an entirely
new regulatory structure under the
Commoclity Exchange Act ("CEA") and
securities laws to accommodate the trad-
ing ofsecurity futures products on individ-
ual securities or on narrow-based inclices.'
The regulatory approach taken establishes
a system of cross-designation and notice
registration which allows trading of these
products on either securities or futures
exchanges.' It mandates coorclinated reg-
ulatory oversight by both the SEC and
the CFTC,' and requires the SEC to con-
sult with the CFTC before suspencling
trading in security futures products (cir-
cuit breakers) or taking emergency action
with respect to these products.
Discussions between the SEC and CFTC
in harmonizing the regulatory framework
for security futures have centered, among
other topics,' on margin requirements,
segregation and SIPC issues, and financial
responsibility. Although the derivatives
markets are closely linked to the underly-
ing cash markets, the Act fails to address
those modifications to the regulation of
cash market securities activities that may
be necessary or appropriate in light ofthe
advent ofsecurity futures trading.
The Act empowers the Federal Reserve
Board to set margin requirements for
security futures products, and allows the
Board to delegate this authority to the
CFTC and SEC. Margin levels for security
futures products must:
• be set at levels that preserve the financial
integrity ofthe markets;
• prevent systemic risk; and
• be consistent with margin requirements
for comparable exchange-traded
option contracts to restrain excessive
speculation and ensure that security
futures products do not have an
unfair competitive advantage over
stock options.
In particular, initial and maintenance
margin levels for security futures products
may not be lower than the lowest level of
margin, exclusive of premium, required
for comparable exchange-traded option
contracts. The statute does not permit
security future product margin levels to
be based on option maintenance margin
levels. Security futures products will be
subject to a federal assessment fee, which
will be later reduced.
Rulemaking will be required by the
SEC and the CFTC to harmonize customer
property segregation requirements under
the CEA and the regime ofthe Securities
Investor Protection Act.' Security futures
products are considered securities under
the Securities Investor Protection Act,
and customer funds held for transactions
Capital Markets Ntws is published quarterly by the Capital Markets Group of the
Supervision and Regulation Department. Its primary intention is to further
examiners' understanding of topical issues pertaining to derivatives and other
capital markets subjects. Articles are not intended as exhaustive commentaries of
the subject matter; rather, they are summaries meant to convey a basic under-
standing of the issue and to serve as a foundation for further analysis. Readers
who would like further information on any ofthe articles may contact the author
directly. For additiottal copies ofback issues ofthe newsletter, please contactJoe
Cilia at 312-322-2368.
Any opinions expressed are the authors' alone and do not necessarily reflect
the views ofthe Federal Reserve Bank of Chicago or the Federal Reserve System.

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The 23rd Annual FIA Law & Compliance Division Workshop continued
in security futures products generally
would be protected by the Securities
Investments Protection Corporation
("SIPC") insurance.6
Nevertheless,
questions remain as to whether interme-
diaries who carry single stock futures will
be required to carry positions and their
associated margin funds in a securities
account subject to the jurisdiction ofthe
SIPC or in a CFTC segregated account.
Trading of security futures products
may not commence until late December
2001, the one-year anniversary of the
enactment ofthe CFMA or, in the case of
principal-to principal transactions,
August 21, 2001. The SEC and CFTC
are jointly permitted to allow the trading
of options on security futures three years
after the effective date of the
Modernization Act. The Act provides for
joint rulemaking by the SEC and CFTC
with respect to the offer and sale ofsecurity
futures traded on a non-US exchange.
Access to Foreign Exchanges7
Domestic and foreign broker-dealers
and futures commission merchants (FCMs)
provide US customers with technology to
directly trade on a foreign exchange
through a member's interface. Foreign
exchanges welcome the increase in volume
afforded by direct customer access.
Recently, the Sydney Futures Exchange
(SFE) has provided exemplary, compre-
hensive rules governing this process.
The CFTC and SEC stand in sharp
contrast in articulating an automated
order routing systems ("AORSs") policy.
In July 2000, the CFTC adopted Rule
30.12, which articulates the Commission's
current policy on AORSs.8
Under the
new rule, the CFTC permits the use of
AORSs by all foreign brokers, either affil-
iates ofa US FCM or subject to regulation
in their foreign jurisdiction, to accept
orders directly from authorized US cus-
tomers of qualifying FCMs. Authorized
customers are able to place orders directly
with a foreign broker who either carries
the FCM's customer omnibus account or
transfers the trade pursuant to a give-up
agreement to another foreign broker.
Under 30.12, an FCM is required to
establish controls governing the direct
contracts between its customers and foreign
brokers, and to monitor its own risk relative
to its customers' exposures. In contrast to
its earlier position expressed in the March
1999 proposed rules,9 the CFTC did not
explicitly place a requirement for pre-trade
credit and position filters for all accounts.
Instead, firms should adhere to best practices
in their use ofAORSs to safeguard their
financial and operational viability, including
the ability to block or restrict customer
use of AORSs. Firms should address
unauthorized access and unauthorized
trading, and adhere to regulatory require-
ments of recordkeeping and reporting.
The SEC has traditionally had a different
focus than the CFTC on AORSs, placing
primary importance on attaining the best
price. Consistent with this posture, the
SEC has not established specific standards
governing AORSs, but has only
addressed issues of operational capability
and capacity. In November 2000 the SEC
adopted three new rules which address
disclosure requirements for both market
centers and brokers relating to order exe-
cution and routing practices.10
The rules
seek to ensure attaining the best possible
price for investor orders by making execu-
tion quality more transparent.
The CFTC and the SEC also differ in
opening up the US market to foreign
exchanges.The CFTC has issued no-action
letters to foreign exchanges to permit
them to place their electronic trading and
order matching systems in the US.
EUREX, Euronext, HKFE, IPE, LIFFE,
LME, OM/London, the Singapore
Exchange, and SFE/NZFE have received
no-action letters from the Commission,
granted on the basis of:
• comparability between the home reg-
ulatory environment of the exchange
and the CFTC;
• technical standards complying with
IOSCO principles for screen-based
trading;
• the exchange's intended US activities;
and
• the Commission's ability to access
necessary information.
2
In contrast to the CFTC regulation,
the SEC does not allow foreign exchanges
to directly access the US market. Under
the current SEC regulatory framework, a
foreign exchange that trades products
subject to SEC jurisdiction must register
as a national securities exchange to place
its terminals in the US. The only excep-
tion remains Tradepoint, PLC, a UK
Recognized Investment Exchange which
obtained exemption from registration
requirements based on low volume.
Block Trading"
Block trading has a long history in US
securities markets but has emerged only
as recently as the year 2000 in the futures
markets. In a 1999 response to a request
from the industry to allow block trading,
the CFTC issued an advisory indicating
that it would leave it up to the exchanges
to determine rules on block trading that
would suit their markets, and would con-
sider each application on a case by case basis.
The Commission studied block trading
in the securities markets in search of an
appropriate template. On the NYSE, the
role of the specialist is central to trading
and allows for floor participation in block
trading.12
While opportunities for floor
participation are also present in block
trading at the CBOE, this template could
not be directly applied to the futures mar-
kets. In reviewing the first application for
block trading submitted by the Cantor
Financial Futures Exchange, a set ofstan-
dards began to evolve dictated by trans-
parency, the need for the price of the
block to be integrated into the pricing of
the market as quickly as possible, and
exercise requirements. These standards
needed to be sufficiently broad in their
underpinnings to be applied to different
markets. In applying these standards in its
review of block trading applications, the
Commission focused its attention on issues
of liquidity, transaction size, reasonable
pricing, transparency, limiting participation
to sophisticated participants, and having
the price of the block reported as
promptly as possible.
In 2000 block trading was approved
for the CX (Cantor Financial Futures

Exchange}, the CME (Chicago Mercantile
Exchange), and ONXBOT {the on-
Exchange Board of Trade}, while two
additional applications from the CBOT
(Chicago Board of Trade) and BTEX
(BrokerTec Futures Exchange) are cur-
rently pending. Outside the US,13
LIFFE
has a block trading facility limited to
wholesale participants which slightly pre-
ceded the introduction of block trading
in the US. The block trading rule for
LIFFE was very much a reflection of the
regulatory philosophy of the FSA,
emphasizing transparency, the integration
of block trading into the vitality of the
markets, assuring a fair and reasonable
price within tolerance limits, and prompt
reporting. Volume requirements for each
contract and non-aggregation rules,
though, continue to be controversial.14
As aform ofessentially non-competitive
trading, block trading should not com-
promise the integrity of the markets and
the process of price discovery. The
potential for mispricing does exist, as
block trading procedures give participants
considerable flexibility in privately nego-
tiating a price outside a competitive setting.
As such, end-users may (falsely) assume
that the price is reasonable since the trade
was executed on a regulated contract market.
There is also the potential that block
trades will be traded outside the pit to
facilitate money passes for tax purposes,
dressing up the balance sheet, or fixing
trading errors. Given that a pre-arrange-
ment, collusion, and collaboration is
needed to engineer a wash trade, block
trades may be the perfect tool for con-
temporaneous buy and sell in the same
market for a single customer. There are
also potential frontrunning issues with
block trading; for example, pre-positioning
in the futures markets does not violate the
trading ahead requirement, but would
violate the frontrunning prohibition in
CBOE. Iffutures exchanges permit pre-
positioning in security futures products,
they will have a competitive advantage
over securities and options exchanges,
unless the latter alter their rules.
Although the CFMA does not directly
address block trading, with the changes in
the structure of the markets enabled by
the new legislation, block trading might
become a significant catalyst in altering
the traditional competitive nature of the
futures markets.15
Conclusion
The Law & Compliance Workshop
presented a valuable opportunity for
industry practitioners and regulators to
meet and discuss changes precipitated by
the CFMA, update their understanding
ofnew rules effected or pending, establish
a direct and open dialogue with regula-
tors, and gain precious insights into what
the future might hold for the exchanges.
-Gloria lkosi
1 Until the CFMA, only furures on broad-based
stock indexed could be traded. The definition ofa
broad-based securities index has proved controversial
over the years, the controversy coming into sharper
focus most recently with efforts by the CBOT to
trade futures on certain Dow Jones indices. In the
new regulatory framework, the SEC will no longer
have any regulatory interest in broad-based index
contracts, which now come under the exclusivejuris-
diction ofthe CFTC. All stock index contracts traded
on US futures exchanges on the effective date ofthe
Act have been grandfathered. Foreign stock index
contracts authorized to be offered in the US on the
date ofthe Act were grandfathered for a period of18
months, pending adoption ofrules to bejointly estab-
lished by the SEC and the CFTC.
In the CFMA, the term "security future" is
defined to mean a contract ofsale, for future delivery,
of a single security or of a narrow-based security
index. A narrow-based security index is an index that
has nine or fewer components in which no single
component accounts for more than 30% ofthe index's
weighting, and the aggregate contribution ofthe top
five components does not exceed 60%. The lowest-
weighted components accounting for 25% of the
index's weighting have in terms of aggregate dollar
value, less than $SOM.
2
The Act establishes a notice registration procedure
under which exchanges or intermediaries registered
under one ofthe acts may register under the other for
the limited purpose oftrading security futures. With
respect to regulatory oversight, the National Futures
Association ("NFA"), a self-regulatory organization
for futures intermediaries, will need to qualify as a
3
"limited purpose" national securities association
under the Securities Exchange Act of1934.
3
The SEC and the CFTC are required to issue
regulations to avoid duplicative or conflicting reg-
ulation of dually registered FCM/broker-dealers
and exchanges.
• Elizabeth Fox, attorney-advisor ofthe Office of
General Counsel ofthe CFTC, indicated that matters
offinancial responsibility and the equivalency rule
between floor brokers and market makers received con-
siclerable attentionin discussions by the SEC andCFTC.
5 With certain limited exceptions, broker-dealers
must be members ofthe Securities Investor Protection
Corporation, which administers an insurance fund
established by assessments of members to protect
customers of insolvent broker-dealers. The SIPC
liquidation plan is designed to return securities to
customers. SIPC funds are available to satisfy claims
of each customer up to a maximum of $500,000
with respect to securities and cash in custody at the
broker-dealer.
7
This section is based on the presentation byJane
Kang Thorpe ofthe law firm ofBrown & Wood, LLP
in a SCSfilOn on order handling.
8
Prior to this rule, only foreign affiliates ofUS
FCMs with Part 30 reliefwere permitted to accept
foreign futures and options orders fi:om customers of
theFCMs.
9
These rules met with considerable opposition
fi:om the industry and were withdra~
10
SEC Rule 11Ac1-5 for market centers and
SEC rules 11Ac1-6 and 11Ac1-7 for brokers.
11
In a session entitled "Block Trades, EFPs and
Give-Ups:• Alan Seifert, Deputy Director of CFTC
the Division of Trading and Markets provided the
history ofblock trading transactions in the futures and
securities markets. Michael M. Phillip ofthe law firm
Katten Muchin Zavis presented his views on potential
mispricing, fi:ontrunning, manipulation and fraud
relating to block trading.
12
On the NYSE, the specialist can manage the
market, manage participants, and establish the price in
that market at any moment in time with no uncer-
tainty and no ambiguity as to who has priority. When
a block trade is effected on the NYSE, there is sub-
stantial opportunity for floor participation predicated
on the principle that the floor should include the
price of the block and the discrete requirement of
knowing who is on each side ofthe trade.
13
In contrast to LIFFE, block trading at Eurex is
treated as an OTC transaction basically booked for
clearing without a requirement for prompt price
dissemination.

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14
Non aggregation rules do not allow to aggregate
contracts to meet threshold requirements for block
trading. According to Nick Weinreb, Director and
Market Secretariat, ofLIFFE, block trading at LIFFE
accounts for 5--10% ofthe volume. There is no con-
sistent pattern in usage.
15
The pending application for block trading by
BTEX addresses the factors ofminimum size, timely
NIM Structures
Overview
W
all Street is nothing if not a
haven of creativity when it
comes to assigning acronyms
to financial instruments or deals. A fair
number of these monikers reflect animal
themes (CATs, TIGRs, STEERs,
SPYDRs); fitting, perhaps, in light ofthe
ever-present bear and bull motif played
out each day on the Street. Others that
have crept into our vocabulary are less
discernible yet still recognizable (PACs,
TACs, CUBEs). One ofthe newest prod-
ucts to be tagged is known as a NIM or
net interest margin structure. This article
yvill introduce the concept and discuss its
structure and risk characteristics.
NIM Structure
A net interest margin (NIM) securiti-
zation structure is created when an issuer
securitizes residual cash flows from exist-
ing asset-backed transactions. Residual
certificates receive cash flow on a
monthly basis only after all fees and
expenses related to the transaction and
amounts due on all other classes ofcertifi-
cates have been paid. Suffice it to say that
this is particular type of structure is not
without its share ofrisks. Cash flow available
to a NIM deal is typically subordinated to
the rest of the underlying deal structure,
with no specified amount of principal
and interest targeted directly to the NIM.
As such, the timing and amount of cash
flow that does reach NIM bonds is des-
tined to be highly volatile.' Numerous
factors and conditions discussed herein
application of information on block transaction, and
appropriate participant limitations. However, it does
not address the issue offair and reasonable price and
prompt reporting requirements. BTEX minimum
transaction reporting time could range from 15
trading session minutes for transactions offewer than
500 contracts up to 500 trading session minutes for
transactions ofgreater than 10,000 contracts. A trading
can affect the availability ofthis cash, not
the least of which are the prepayment
experiences of the underlying collateral.
Figure 1 illustrates the positioning of a
session at BTEX comprises 1320 minutes. A block
traded effected during one trading session might not
be reported until sometime during the next session.
There is, clearly, an issue is ofreporting and materiality
in the market place as tied to price requirements.
Excess spread can be viewed akin to an
interest-only strip (IO) off of a pool of
mortgages. Like any mortgage IO, future
cash flows are extremely sensitive to the
Figure 1 - Anatomy ofa NIM Securitization
I Net Loan Interest 10% I
l
I
Securityholders' I_...Interest 8%
Excess Spread 2%
L..current Losses
L..Overcollateralization Buildup
L..Residual Holder
s ·ource: MOODY's
NIM within the typical securitization
cash flow waterfall.
NIM structures typically emanate
from home equity and subprime mortgage
securitizations, as those are backed by
loans with interest rates above and
beyond that required to pay certificate
interest and other associated trust
expenses. This additional interest, also
known as excess spread, varies from deal
to deal but is usually between 2.5%-3.5%
on an annualized basis for subprime
mortgage deals according to Fitch, and
on home equity deals can be anywhere
from 1% to 6% according to Moody's.
Excess spread can also vary depending on
market conditions. To illustrate, when
spreads on asset-backed securities are
relatively wide, certificate interest rates
will be higher and initial excess spread
will be smaller. Conversely, when spreads
on asset-backed securities are relatively
tight, certificate interest rates will be lower
and initial excess spread will be higher.2
4
L..Net Interest Margin (NIM)
Securities
prepayment rate ofthe underlying mort-
gage pools. It stands to reason that, as pre-
payment rates increase, future cash flow
from excess spread would fall below what
was previously forecasted. Conversely, if
prepayments fall, future cash flows from
excess spread will be greater than what
was anticipated.3
Prepayment speeds,
then, have a tremendous effect on the per-
formance and relative value of a NIM
structure. It is imperative that the analyst
model these speeds using appropriate vec-
tors that reflect the dynamic nature of the
underlying collateral given varying market
and economic conditions.
As with many securitizations, subprime
deals are structured so that excess spread is
used either to absorb realized losses
incurred on defaulted loans in a given
month or to build credit enhancement to
absorb future losses (or, in some cases,
both). According to Fitch, foreclosure
and liquidation proceedings relative to
defaulted loans can take months to work

NIM Structures continued
out. As a result, realized losses typically
don't occur for the first six through 12
months of a deal. Excess spread is thus
available in those early months for purposes
other than absorbing losses, and can flow
directly to a residual certificate, which is
often retained by the issuer. If the issuer
wants to subsequently monetize the cer-
tificate, it can sell it directly to a third
party or issue a separate security, collater-
alized by the certificate, known as a
NIM.• For the most part, it is this
unneeded cash - in other words, a deal's
excess excess spread - that is securitized in
a NIM transaction.5
A NIM securitization is effectively a
repackaged interest in the residual cash
flows from outstanding asset-backed
deals. The basic structure ofa NIM trans-
action involves transferring the residual
interests from earlier securitizations into a
new trust, with the trust issuing certificates
backed by these interests. NIM investors
are paid in full only if the cash flows
received on the transferred residuals are
sufficient to pay interest and principal on
the NIM securities. As noted, these cash
flows are themselves dependent upon the
amounts by which excess interest on the
underlying deals exceeds losses and credit
enhancement requirements. Several factors,
some of which we've already touched
upon, can directly influence the amount
ofcash that a NIM security can expect to
receive, most notably:•
• The expected amount and timing of
prepayments and liquidations, which
can act to reduce the principal balance
on which excess spread is earned;
• The expected magnitude and timing
oflosses, which can reduce residual
cash flows on a dollar-for-dollar basis;
• The possible compression ofspreads
due to interest-rate movements,
which reduces residual cash flows; and
• The overall strength ofthe issuer,
including underwriting and servicing
capabilities. Anticipated principal and
interest in aNIM securitization is
usually determined by its issuer.7
Prepayment Penalty Fees
Recent data provided by Fitch from
the subprime and home equity mortgage
sectors reflect a high percentage of new
loans being originated with attached pre-
payment penalty fees. In fact, over 80% of
the loans in some subprime mortgage
pools contain prepayment penalty fees,
and the attendant amount of cash flow
generated from these fees can be significant.•
Securitizers of these loans can monetize
the cash flow stream from prepayment
penalty fees by pledging them to NIMs,
done by creating a security certificate
entitled to receive all prepayment penalty
fees that become legally due under the
terms ofeach ofthe mortgage notes. The
certificate is then transferred to the trust
issuing the NIMs and becomes part ofthe
trust estate. It's important to note that
most deals are structured so that prepayment
penalty fees bypass the traditional cash
flow waterfall, and as such are not used to
cover losses. Prepayment penalty fees are
an important source of cash flow for
NIMs and can serve as a partial hedge
against prepayment risk as it pertains to
excess spread. If, for instance, the underlying
mortgage loans backing a particular deal
prepaid at a faster rate than anticipated,
the level ofexcess spread would decline as
a result. Minus the cash flow from prepay-
ment penalty fees to offset the decline in
excess spread, total cash flow to the NIM
structure would be severely curtailed.9
It is likewise noteworthy to point out
how value is derived for these fees. Fitch,
for instance, assigns value to prepayment
penalty fees in a NIM transaction if two
conditions are satisfied. First, rights to the
prepayment penalty fee cash flows must
be transferred to the trust issuing the
NIMs. This would occur via the creation
of a security class within the underlying
securitization, which is then sold to the
NIM trust. Second, the servicer or master
servicer of the mortgage loans backing
the securitization is precluded from waiving
any prepayment penalty fees that become
legally due, except for cases when waiving
them will maximize recoveries on
defaulted loans. If the servicer or master
servicer were to waive the collection of
the prepayment penalty fees for any reason
5
other than loss mitigation purposes, the
same would be required to pay the waived
amount to the holder of the security
entitled to those cash flows. This condition
is typically satisfied through representa-
tions made within the poolingand servicing
agreement of the underlying securitiza-
tion. Data provided to Fitch by many
subprime mortgage originators and ser-
vicers indicate that, over the last few
years, nearly 100% of the prepayment
penalty fees that were owed were in fact
collected by servicers, as opposed to prior
years when prepayment penalties were
often waived by servicers to encourage
borrowers to refinance their loans with
their existing lender rather than lose them
to competitors.10
Concl11sion
Within the perpetual ethos of cash
flow uncertainty and volatility that is a
hallmark of the securitization process, if
one were to gauge a security's popularity
by its manifestation of those attributes,
the NIM structure clearly represents one
of the sector's up and coming stars.
Residual cash flows have historically been
notorious for their insusceptibility to
accurate predictions." Overlay this tenant
with the well-documented and equally
subjective concerns regarding prepay-
ment risk, and the result is the profile of
an interesting and highly complex but (if
not understood properly) potentially
devastating instrument that demands a
thorough analytical scrubbing.
-Joseph Cilia
1 Wolf, Jeffrey L., "Net Interest Margin
Securitizations: Understanding the Risks;' Moody's
Investors Service.July 7, 2000, pt.
2 Albertson, Thomas, and Stephen Lei "NIMs:
Rating and Analysis of Mortgage Residual Cash
Rows", Fitch Structured Finance, March 16, 2001, p.2.
3 Albertson/Lei p.2.
4
Wolfp.2.
5
Wolfp2.
6
Wolfp.3.
7
Wolfp. 3
8 Albertson/Lei p.2.
9
Albertson/Lei p.6.
10
Wolfp.5.
11
Wolfp11.

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Using Interest Rate Options to Alter Rate Sensitivity
Introduction
I
n light of recent proposed modifica-
tions' to FAS 133 that relax hedge
accounting treatment for options,
financial institutions may now have a
greater incentive to use these instruments
to control interest rate risk. As a result
examiners may encounter, with more fre-
quency, financial institutions that use
options to alter interest rate risk exposure.
Interest rate options contain inherent
advantages and risks, and it is imperative
that the examiner understand both before
he or she reviews the safety and sound-
ness of an end-user. The purpose of this
article is to assist the examiner in better
understanding option usage within an
interest rate risk management framework.
Using Options to Hedge IRR
It stands to reason that a liability sensi-
tive bank will be less well off in a rising
rate environment. As interest rates
increase, liabilities reprice at the higher
market rate by a larger magnitude or on a
more frequent basis than do assets, caus-
ing net interest margin to narrow. A long
put option, also known as an interest rate
cap, can hedge and neutralize the liability
s_ensitivity of the bank. The following
example will help illustrate how this can
be accomplished.
Exhibit Al depicts the balance sheet
and GAP statement of the Liability
Sensitive State Bank, a $100 million
financial institution. As the statement
shows, this bank holds a preponderance
offixed rate assets, most ofwhich will not
reprice over the ensuing year, and a pre-
ponderance ofvariable rate deposits such
as money market accounts. Liability sen-
sitivity, as indicated by the negative 20%
GAP ratio, reflects an earnings stream
vulnerable to an increase in interest rates.
Indeed, the earnings simulation in
Exhibit A2 shows that if market interest
rates increase by 200 basis points at the
beginning of the period, net interest
income would equal only $4.1 million,
$400,000 less than if rates remain
unchanged. This $400,000 difference
represents net interest income at risk of
nearly 9%, or a 44 basis point tightening
ofthe margin.
Suppose, however, that the bank's
interest rate risk policy limits earnings at
risk to only+/- 5%, thus requiring the
asset/liability (A/L) manager to bring this
position back to policy limits within the
month. She can effect these changes in
EXHIBIT A1 - LIABILITY SENSITIVE STATE BANK
GAP REPORT - 31-DEC-O0
ASSETS
LOANS: 9% fixed rate
SECURITIES: 7% fixed rate
NONEARNING ASSETS
TOTAL ASSETS
RSA
UABILmES AND CAPITAL
VR DEPOSITS: 4% avg rate
FR DEPOSITS: 4% rate
NONINTEREST BEARING
CAPITAL
TTL LIAB AND CAPITAL
RSL
GAP RATIO
RSA/RSL
BALANCE
SHEET TOTALS
$70,000
20,000
10,000
$100,000
50,000
30,000
10,000
10 000
$100,000
REPRICEABLE
WITHIN 1YEAR
$10,000
20,000
0
$30,000
50,000
$50,000
-20.00%
60.00%
REPRICEABLE
AFTER1YEAR
$60,000
0
30,000
6
several ways; for instance she can • .
' lllSti-
tute a promotion to generate $20 milli
. fix d on
m e rate deposits or a loan promotion
to generate the same volume in variable
rate loans. However, ifrates are expected
to increase (as the NL manager believes)
these programs may not generate the
needed volumes within this short time
frame. Instead, the AIL manager could
use a long put option Qong interest rate
cap) to hedge the position. Off-balance
sheet methods such as this have the
advantage of immediately impacting the
interest rate sensitivity ofthe bank.
The terms ofthe cap are tailored to fit
the hedging needs and risk appetite ofthe
bank. In the case ofour Liability Sensitive
Bank, management wishes to completely
hedge downside risk to bring earnings at
risk within the +/- 5% policy limit. To
do so, a long interest rate put option can
be purchased with the notional value of
the contract set at $20 million, represent-
ing the dollar amount that rate sensitive
liabilities exceed rate sensitive assets
(within a one-year time frame). Using a
lower notional value would allow for
some residual liability sensitivity, while
using a higher notional value would
reverse the sensitivity ofthe bank, result-
ing in an asset sensitive balance sheet.
Since the AIL manager believes that
interest rates will increase sometime over
the next twelve months, a one-year
expiry is chosen. Another important
contract term to consider is the strike
rate, which is usually set at or near the
current level of interest rates depending
on the degree ofrisk the AIL manager is
willing to assume. Suppose 3 month
LIBOR is currently at 4% and the man-
ager does not wish to assume any down-
side risk; then, a 4% (at-the-money)
strike would provide the desired hedge.
Some banks may opt to purchase caps
having a higher strike rate, say 4.5%. This
"out of the money" cap still protects the
bank if a large increase in rates were to
occur, but the bank assumes the risk if a
small increase in rates (i.e. less than 50
basis points) occurs. Typically, purchasing
an out-of- the-money cap is a strategy
employed to reduce the cost (or pre-
mium) paid at the onset of the contract.
-

Using Interest Rate Options To Alter Rate Sensitivity continued
EXHIBIT A2 - NET INTEREST INCOME AT RISK
- 200 BASIS POINTS NO RATE MOVEMENT
INTEREST INCOME
LOANS ($10M X 7%)+($60M X 9%) $6,1,00 ($70MX9%) $6,300
SECURITIES ($20MX5%) 1,000 (20MX7%) 1,400
TOTAL 7,100 7,700
INTEREST EXPENSE
DEPOSITS ($50M X 2%)+($30M X 4%) 2,200 ($80MX4%) 3,200
TOTAL 2,200 3,200
NET INTEREST INCOME $4,900 $4,500
NII/EA 5.44% 5.0%
A long 4% strike $20 million one-yeai:
cap specifies that if interest rates are
higher than the strike rate, the dealer will
pay to the bank the difference between
the current interest rate and the strike
rate, multiplied by the notional value of
the contract. (Since the contract stipulates
a quarterly reset, the amount paid would
be prorated on a quarterly basis). If rates
don't increase, or ifthey fall, the contract
doesn't pay out anything, though the
bank still pays the premium for this
hedge. Exhibit B shows how the at-the-
money option described above reduces
EXHIBIT B - NET INTEREST INCOME AT RISK
INTEREST INCOME - 200 BASIS POINTS
LOANS
SECURITIES
SUBTOTAL
($10MX7%)+($60MX9%) $6,100
($20M X 5%) 1,000
7,100
LIBOR RECEIPTS
ON OPTION
TOTAL INTEREST INCOME
INTEREST EXPENSE
DEPOSITS ($50M X 2%)+($30M X 4%)
SUBTOTAL
OPTION PREMIUM PAID
TOTAL INTEREST EXPENSE
NET INTEREST INCOME
NII/EA
2,200
2,200
50
2,250
$4,850
5.39%
NO RATE MOVEMENT
($70MX9%)
(20MX7%)
($80MX4%)
$6,300
1,400
7,700
3,200
3,200
50
3,250
$4,450
4.94%
7
+200 BASIS POINTS
($10M X 11%)+($60M X 9%) $6,500
($20MX9%) 1,800
8,300
($50M X 6%) + ($30M X 4%) 4,200
4,200
$4,100
4.56%
EARNINGS AT RISK 8.9%
the interest" rate sensitivity of the bank.
Although the option is an off-balance
sheet instrument, it will generate cash
flows that, when combined with on-bal-
ance sheet cash flows, create a different
risk profile than the original balance sheet
position. In the case ofthe above option,
+ 200 BASIS POINTS
($10M X 11%)+($60M X 9%) $6,500
($20M X 9%) 1,800
($20M X [6%-4%])
($50M X 6%) + ($30M X 4%)
EARNINGS AT RISK
8,300
400
8,700
4,200
4,200
50
4,250
$4,450
4.94%
0.0%

CAPITAL MARKETS N E W S - - - - - - - - - - - - ' - - - - - - - - - - - - - - - - - - - - - -
EXHIBIT C - NET INTEREST INCOME AT RISK
INTEREST INCOME - 200 BASIS POINTS NO RATE MOVEMENT
LOANS ($10M X 7%)+($60M X 9%) $6,100 ($70MX9%) $6,300
SECURITIES ($20MX5%) 1,000 (20MX7%) 1,400
SUBTOTAL 7,100 7,700
OPTION PREMIUM RECEIVED 50 50
TOTAL INTEREST INCOME 7,150 7,750
INTEREST EXPENSE
DEPOSITS ($50M X 2%)+($30M X 4%) 2,200 ($80MX4%) 3,200
SUBTOTAL
LIBOR PMTS ON OPTION
NET INTEREST INCOME
NII/EA
its cash flows neutralize those of the bal-
ance sheet, but only when rates increase.
For example, when interest rates increase
200 basis points (that is, LIBOR increases
from 4% to 6%) the option becomes "in
the money", and the bank receives, from
the dealer, a cash inflow equaling
$400,000 [$20 million x (6% - 4%)]. In a
sense, this cash flow augments on-balance
sheet interest income which didn't
increase as fast as liabilities over the rising
rate environment. As a result, net interest
income equals $4,450, representing a
margin of 4.94%. The reader will note
that this is identical to net interest income
(NII) and net interest margin (NIM) gen-
erated under the "no rate movement"
scenario, demonstrating the effectiveness
ofthis hedge. Put another way, earnings-
at-risk have been reduced to 0%.
It is interesting to observe what hap-
pens when rates fall while the option
hedge is in place. When interest rates fall,
the liability sensitivity of the bank causes
NIM to widen while the option hedge
goes unused. However, unlike interest
rate swaps which require that a payment
be made to the dealer when rates decline,
2,200 3,200
0 0
2,200 3,200
$4,950 $4,550
5.50% 5.06%
the bank gets to retain the upside gain
(the incremental increase in the margin).
Stated differently, a swap neutralizes earn-
ings volatility in both a rising and falling
rate environment, thereby producing a
NIM that is constant in all interest rate
scenarios. The bank gives up potential
gain for unlimited protection in this case.
A long option, however, protects the
bank from downside risk, but allows the
bank to enjoy all potential gain. This
one-sided benefit is not without its cost,
namely the bank has to pay a premium for
such protection regardless ofwhether the
option is exercised or not. In other
words, ifthe option is purchased and rates
subsequently don't increase the premium
is still paid, slightly impacting the NIM.
In our example, a $50,000 premium costs
the bank roughly 6 basis points in NIM.
Refer to the NIMs under the "no rate
movement" scenario in Exhibits A2 and
B. Without the option, the NIM would
be 5%, whereas with the option, the
NIM is 4.94%. The premium that the
bank pays to the dealer at the inception of
the contract represents the market value
ofthe option at that point in time.
8
+ 200 BASIS POINTS
($10M X 11%)+($60M X 9%) $6,soo-
($20MX9%) 1,800
8,300
50
8,350
($50M X 6%) + ($30M X 4%) 4,200
4,200
($20MIL[6%-4%]) 400
4,600
$3,750
4.17%
While this illustration is shown from
the perspective of a liability sensitive
bank, an interest rate option can also be
purchased by an asset sensitive bank to
hedge against reductions in interest rates.
These options, also known as floors or
calls, are structured the very same way
except that the bank would receive cash
flow from the dealer if rates were lower
than the strike rate. In this case, the pay-
ment would be calculated as the notional
amount x (strike rate - LIBOR).
Examples ofSpeculative Activities
The above example demonstrates how
options may be used for hedging.
However, A/L managers have been
known to use derivatives to speculate on
the direction or volatility ofinterest rates,
and the examiner should know how to
spot such risky activity as well. Suppose
that the A/L manager of the Liability
Sensitive Bank believes that market inter-
est rates will decline and wants to capital-
ize on her hunch in order to increase rev-
enue for the bank. Rather than entering
into a cap to hedge, the A/L manager
could purchase a $20 million 4% strike

-
EXHIBIT D - NET INTEREST INCOME AT RISK
INTEREST INCOME - 200 BASIS POINTS NO RATE MOVEMENT
LOANS ($10M X 7%)+($60M X 9%) $6,100 ($70MX9%) $6,300
SECURITIES ($20MX5%) 1,000 (20M X7%) 1,400
SUBTOTAL 7,100 7,700
OPTION PREMIUM RECEIVED 50 50
TOTAL INTEREST INCOME 7,150 7,750
INTEREST EXPENSE
DEPOSITS ($SOM X 2%)+($30M X 4%) 2,200 ($80MX4%) 3,200
SUBTOTAL
LIBORPMTS
ON OPTION ($20MIL[4%-2%])
NET INTEREST INCOME
NII/EA
floor to speculate on this anticipated rate
movement. If rates decline, this bet will
pay offnicely, and the position will gener-
ate a net interest margin of 5.83% com-
pared to 5.44% without this option.
However, ifthe A/L manager is wrong and
rates increase instead, the margin will nar-
row by the degree of liability sensitivity
inherent in the balance sheet coupled with
the cost ofthe option. For example, a 200
basis point increase in interest rates would
generate a net interest margin of 4.5%,
representing an earnings-at-risk of 10%,
slightly more than the 8.9% incurred ifthe
balance sheet were completely unhedged.
When caps and floors are purchased, as
in the above examples, the downside risk
of using the instrument is limited to the
amount ofpremium paid for that option,
regardless how much rates change. In
other words, if rates don't move in the
anticipated direction, the most that the
bank could lose from using the option is
the premium. However, the situation is
different when a bank sells options. When
a bank sells a cap or a floor, upside benefit
is limited to the premium received for the
option, whereas downside risk can be large
2,200 3,200
400 0
2,600 3,200
$4,550 $4,550
5.06% 5.06% ·
when rate movements are large. Although
the business of selling options is mostly
associated with dealing environments of
larger financial institutions, there have been
occasions when banks without organized
trading desks have engaged in writing (sell-
ing) options as a way to enhance revenue.
Exhibit C illustrates the potential
impact of writing options.2
In this exam-
ple, the Liability Sensitive Bank has writ-
ten a floor (shorted a call option) on
LIBOR as a strategy to earn extra income
(for example, a $50,000 premium).
Assume that the option contract has a
notional value of $20 million, a strike of
4%, and an expiration ofone year. By sell-
ing a floor, the bank is betting that interest
rates will remain stable or fall. If interest
rates fall, not only does the bank benefit
from its own balance sheet position (its
margin widens), but it also earns the
$50,000 premium up-front from selling
the option. In a 200 basis point falling rate
environment, the margin increases to
5.5%, which includes 5.5 basis points from
the premium. Even ifinterest rates remain
unchanged, the bank still earns the
$50,000 premium.
9
+200 BASIS POINTS
($10MX 11%)+($60M X 9%) $6,500
($20MX9%) 1,800
8,300
50
8,350
($SOM X 6%) + ($30M X 4%) 4,200
4,200
0
4,200
$4,150
4.61%
However, the situation changes if the
bank writes the floor and interest rates
increase. Although the bank still earns the
$50,000 premium, it now must make
interest payments in the amount of $20M
x (LIBOR less 4%) to the counterparty
that purchased the option. The higher the
market LIBOR rate, the larger the p~y-
ment the bank must make. Ifrates increase
200 basis points, the bank must make a
payment of $400,000, which more than
offsets the $50,000 received for the selling
the option. Under this scenario, net int~r-
est margin would decline from 5% to
4.17%, and earnings-at-risk would equal
17.6%. Clearly, this revenue enhancing
strategy increases the liability sensitivity of
this bank in this case, pushing it further out
ofcompliance with policy.
For completeness, it is interesting to see
the impact ofa liability sensitive bank that
writes a cap (shorts a put option) on
LIBOR as a speculative strategy to
enhance revenue. Refer to Exhibits A2
and Exhibit D, which illustrate the finan-
cial impact of this strategy. Without the
option (Exhibit A2), the bank's margin
widens in a falling rate environment and
j

CA p ITAL MARKETS N E W S - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
narrows in a rising rate environment.
However, with the option, (Exhibit D) the
margin remains unchanged ifrates fall but
still narrows ifrates increase. Stated differ-
ently, the option doesn't reduce earnings-
at-risk in a rising rate environment, but
eliminates any potential for the margin to
widen in afalling rate environment, clearly
a volatility play. The bank is betting that
rates will remain unchanged (have low
volatility} over the contract period so that
it can earn the premium income.
Risks ofUsing Interest Rate Options
As demonstrated above, options may
provide a quick and effective means for
reducing interest rate risk if used and
structured properly. There are acute
financial risks in using options, and these
were detailed in the examples above.
Using options introduces several other
types ofrisks that an AIL manager should
be aware ofas well.
Premium Valuation Risk
As noted, the premium that the bank
pays or receives at the inception of the
option contract represents the market
value of the option at that point in time.
These premiums are mathematically
derived from option pricing formulas
such as the Black Model or the Cox
Ingersol Ross model. The premium gener-
ated by the model is a function ofseveral
factors including underlying interest
rates, an estimate of the future volatility
of interest rates, strike rate, and time to
expiration. These inputs are fed into the
pricing model, which then produces a
price for the option. It is, however, incor-
rect to assume that the quoted price ofa
cap or a floor would be the same across all
dealers. While the strike rate, time to
expiration, and underlying interest rates
are known factors (and therefore consis-
tent from dealer to dealer) the future
volatility ofinterest rates is neither known
nor consistent among dealers. The pricing
model input for future volatility represents
a dealer's best estimate based on its
knowledge and intuition of the market.
Consequently, differences in dealer senti-
ment regarding the future volatility of
interest rates will produce variations in
the price (premium) of an otherwise
identical option contract.
Examiners should determine that a
bank has taken the necessary steps to
ensure it has paid (or has received) a fair
price when it purchases (or sells) an
option. Too often, banks blindly agree to
the price quoted byjust one dealer, with-
out understanding the underlying future
volatility input assumptions made by that
dealer and, most importantly, how those
volatility assumption compare with other
dealers'. An important question that
banks need to ask is "How can we be
assured that the price we are paying (or
receiving) for an option is fair given its
inherent risks?" In other words, how can
a bank be sure that it is not overpaying (or
under-receiving) for the option? One
way is for the bank to "shop the option".
This simply entails obtaining quotes and
underlying volatility assumptions from
several different dealers, and then select-
ing the option from the dealer offering
the best price. This method is generally
sufficient for banks that only occasionally
enter into option contracts. A more
sophisticated approach would entail the
bank pricing these options internally
with its own option pricing model. This
would be expected of banks that rou-
tinely write a high volume of options
and, commensurately, have expertise in-
house relative to options and pricing
models. Finally, although differences in
models used to price options can gener-
ate differences in prices, these differences
are not that significant relative to the dif-
ferences generated by volatility estimates.
Basis Risk
Basis risk stems from adverse move-
ment in less-than-perfectly correlated
indices. To illustrate, suppose the variable
rate deposits of the Liability Sensitive
Bank were priced according to the
Treasury market (i.e. 3 month T-Bills},
but the option was indexed to 3 month
LIBOR. Basis risk occurs when LIBOR,
received from the option, does not corre-
late perfectly with movements in the
Treasury rate. For example, if the spread
10
between LIBOR and the Treasury market
tightens; that is, if LIBOR decreases or
T-Bill yields increase or both, the net
interest margin will narrow. Examiners
should ensure that AIL managers under-
stand and monitor this risk, and likewise
perform correlation studies to support the
use of one index as a proxy for another.
An index is considered to be a good proxy
ifits R-squared is 90% or greater.
Credit Risk
Counterparty credit risk is the risk
that one counterparty will default on its
quarterly interest payments to the other
counterparty. Given the structure of
options, counterparty credit risk is an
issue for option purchasers because they
receive, (ifthe option is "in-the-money")
or have the potential to receive, quarterly
interest payments from the dealers who
write the options. All things being equal,
the more a long option is "in-the-
money", the greater the degree of credit
risk attendant to it. In addition, all things
being equal, the longer the expiration
date, the greater the degree ofcredit risk,
as the longer time to expiration increases
the probability that the selling counter-
party could default. There are two com-
ponents to credit risk: actual and poten-
tial. Actual credit risk is the loss that one
party would incur if its counterparty
defaulted today, and is measured as the
market value of the option. Potential
credit risk is the estimate of the market
value exposure that might occur in the
future ifthe counterparty defaults at some
later date. The examiner should ensure
that the bank conducts adequate due dili-
gence on it counterparties to limit these
sources of counterparty credit risk. At a
minimum, the bank should monitor a
dealer's credit rating on an ongoing basis,
and the bank should also review the asso-
ciated ISDA agreements to understand the
netting and default terms of the options.
Identifying Speculative Derivative Usage
Examiners should review the bank's
option activity since the last examination
to determine whether hedging and/or
speculative activity is taking place. The

(
t Rate Options To Alter Rate Sensitivity continued
Using Interes
. should focus on the follow-
exa!1llner
ing points:
• Is the option long or short? Short
options are primarily used for specula-
tive (non-hedging) purposes, but long
options can be speculative as well. For
example:
• Is a long cap being used by an asset
sensitive bank, or, is a long floor
being used by a liability sensitive
bank? As described above, these
positions tend to increase risk, not
hedge it.
• Does the notional (or aggregate
notional of like-positions) over-
hedge the balance sheet? Over-
hedging may increase risk ifthe posi-
tion exceeds IRR sensitivity limits.
For each option (or group of similar
options), the examiner should review the
bank's interest rate risk reports just prior
to and immediately after the date each
option is booked (e.g. month end or
sooner, ifavailable). This will provide the
examiner with a way of quantifying the
impact of the option on the interest rate
sensitivity ofthe balance sheet. Ifinterest
rate risk statistics decline as a result ofthe
option, then the bank is hedging.
However, if these statistics increase, then
the bank may be speculating. If the A/L
manager is increasing risk, but this risk
remains within approved IRR limits, it is
likely still considered to be speculation,
but may not be subject to criticism as
long as the directorate is fully aware and
understands the speculative strategy and
potential outcome.
Implications Regarding FAS 133
Understanding the functionality and
risks associated with option use in altering
interest rate sensitivity is becoming
increasingly important with the recently
proposed modification to FAS 133, the
derivatives accounting rule that many
firms adopted this year. As a result of
intense lobbying efforts by more than 40
firms, the Financial Accounting Standards
Board released, on April 16, 2001, a pro-
posed change concerning the treatment of
options. Originally, under FAS 133, the
day-to-day change in market price of an
option would be reported in the compa-
ny's earnings each quarter, regardless of
whether the option was being used to
hedge or not. The proposed modification
allows corporations to use hedge account-
ing treatment for options that hedge. This
is a boon for financial institutions that had
been reluctant to use options because of
their potential earnings volatility, and set-
tled instead on using linear instruments .
such as futures, forwards, or interest rate
swaps to get favorable hedge accounting
treatment even though the instrument
didn't produce the desired risk profile.
11
Summary
Interest rate options are useful instru-
ments to hedge risk, as they provide a
quick means for altering the interest rate
risk profile ofthe bank. However, they can
also be used for speculation, and an exam-
iner should thoroughly investigate all trans-
actions to ascertain the manager's strategies.
-Cheryl L Sulima, CPA
1 Issue G20 April 16, 2001 - Statement 133
Implementation Issue " Cash Row Hedges: Assessing
and Measuring the Effectiveness ofan Option Used in
a Cash Row Hedge"
http://accounting.rutgers.edu/raw/fasb/new/in
<lex.html
2 Written options, as well as other options that do
not qualify for hedge accounting treatment, are
marked to market on the balance sheet, with changes
in value flowing directly through earnings. In the
examples that follow, speculative options are shown as
cash flow transactions to better illustrate the impact of
these options on the bank's net interest margin.
Normally, these options would be accounted for on a
mark-to-market basis.

FEDERAL RESERVE BANK
OF CHICAGO
P.O. BOX834
CHICAGO, ILLINOIS 60690-0834
. RETURN SERVICE REQUESTED
Publisher
Adrian D'Silva (312) 322-5904
Director, Capital Markets
Editors
Joe Cilia (312) 322-2368
Senior Capital Markets Analyst
Craig West (312) 322-2312
Senior Capital Markets Analyst
Capital Markets Group of
Supervision and Regulation
14th Floor
Federal Reserve Bank ofChicago
P.O. Box 834
Chicago, IL 60690-0834

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