Case Study: Applications for Financial Futures On August 20, 1982, Richard Myers, president of Peoples Federal Savings Bank, was appalled to learn that Peoples had paid out $1,830,000 in variation margin calls on its Treasury bill futures position while he was enjoying a two-week seaside holiday. When added to the $690,000 in variation margin Peoples had paid prior to Myers's departure on August 6, the magnitude of these futures losses was staggering. As Myers studied the hedging report (Exhibit 1) his assistant had provided to him earlier in the morning, he wondered how a strategy designed to reduce risk could have produced such disastrous results. Richard knew that the bank's board of directors would expect an explanation for these huge cash outflows at the board's next meeting on August 27. As of June 1982, Peoples Federal Savings Bank, based in Franklin, New Jersey, had accumulated assets totaling $556 million and consisting principally of fixed-rate first mortgage loans (Exhibit 2). The bank funded these assets with shortterm consumer deposits, consisting largely of three-month fixed rate savings certificates. The maturity mismatch between Peoples' assets and liabilities had produced large losses as short-term interest rates rose over the period 1979- 1982, severely eroding the thrift's capital base (Exhibit 3). In the second quarter of 1982, Richard Myers realized that the bank would soon violate regulatory capital requirements if its losses were not controlled. Fearing rising Treasury bill rates, Richard had approached a major brokerage firm for advice on hedging its interest rate exposure. The firm's financial futures analyst, Joseph Rose, had advised Peoples to hedge the risk of interest rate fluctuations in the futures market. Impressed with this proposal, Mr. Myers had decided to hedge the cost of the September 1 rollover of its $400 million in savings certificates by taking a position in 90-day Treasury bill futures. Mr. Rose had assured Mr. Myers that any increase in savings certificate rates between May and September would be offset by gains on this futures position. Anxious to lock in an acceptable cost of funds through the end of the calendar year, Richard Myers sold short September 1982 T-bill futures contracts on May 20, 1982. Because Peoples' savings certificates were priced at a fixed spread over Tbill rates, T-bill futures represented an effective vehicle for hedging the thrift's shortterm interest rate exposure. In order to fully hedge its position, Peoples had sold short 400 September 1982 T-bill futures contracts. Upon initiating this position, the bank had been required to post initial margin of $2,500 per contract, or $1,000,000. At that time, Mr. Rose had explained to Myers that at the close of each day Peoples' margin account would be credited or debited with an amount equal to the daily change in the value of its short position. In the event Peoples' margin balance fell below the maintenance level of $2,000 per contract, Peoples would be required to post variation margin sufficient to restore its margin balance to the initial margin level. Peoples would accrue interest on its margin account balance, but not on variation margin payments. Although all variation margin cash flows would be realized prior to the thrift's September 1 savings certificate issuance date, Federal Home Loan Bank Board (FHLBB) accounting standards would allow Peoples to defer net profits or losses on its futures position, matching them with interest payments on the September 1 savings certificate obligation being hedged. 2 Through late June, Peoples' expectations for rising rates proved correct and the thrift's margin balance rose to nearly $8 million. However, as rates began to fall in July the value of Peoples' futures position dropped precipitously. By the time Myers left for his vacation on August 6 the thrift had been forced to meet variation margin calls totaling $690,000. Although Myers had expressed concern over these losses to Mr. Rose before his departure, Rose had indicated that the dip in rates was expected to be temporary and advised that Peoples retain its futures position. Today, on August 20, Myers could hardly believe the results of his "hedging" strategy: the bank had paid out over $2.5 million in cash against its futures position, and would be required to post another $540,000 to close out the bank's position at the end of the day. Upon questioning, Mr. Rose contended that the hedge was working precisely as planned. However, Myers considered the magnitude of the bank's futures losses totally unacceptable. He commented ruefully: It's not the fact that we lost money that upsets me. It's the fact that we lost so much. here really should be some downside protection. As he slammed down his telephone, Myers wondered how he could possibly explain the results of his "risk reduction" strategy to the board on August 27

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927 Exhibit 2 Peoples Federal Savings Bank Comparative Statement of Conditions As of June 30 As of December 31 1982 (6 mo.) 1981 1980 1979 Assets First mortgage loans 406,124 430,201 384,667 304 812 Loans on savings accounts 821 1,282 823 Consumer and other loans 84,423 34,621 6.786 2,986 Cash on hand and in banks 2,301 1,880 2.426 2.260 Liquid investment securities 28,562 16,282 16,823 17,782 Other investment securities 1,526 2,621 7,028 8,200 Investment in subsidiary corporations 6,721 5,261 6,201 2,460 Federal Home Loan Bankstock 2,721 2,864 2,350 Building and equipment (net) 4,012 3,081 1,823 1,626 Deferred charges and other assets 19.961 10.428 4.826 7.311 TOTAL 65.613 509.374 434.267 350.714 Liabilities and Reserves Deposits 410,477 381,940 328. 146 282.960 Advances from Federal Home Loan Bank 45,891 43,826 44,567 26,462 Other advances 2.587 2,647 2.632 3,031 Other borrowed money 53,821 43,862 27.161 10,643 Loans in process 311 4,032 4,492 Deferred income 24,311 14,286 4,823 3,106 Other ilabildes 7,124 9,026 6,301 4,215 Reserves and undividend profits 11,402 13,480 16,606 15,805 TOTAL 565,613 509,378 434,267 350,714 in thousands of dollars Exhibit 3 Peoples Federal Savings Bank Comparative Statement of Operations 6 month For the year ending December 31 1982 1981 1981 1980 1979 Wan. June Income Interest on mortgage loans 22,035 22,764 41.732 30,940 23.750 Income from other loans & Investments 6,426 1,482 3,026 3,453 3,162 Loan fees 896 1,493 2.920 2,300 1,150 All other income 2,261 2,001 4,264 1,827 302 TOTAL INCOME 31,618 27.740 51,942 38,520 28,364 Expenses Operating expenses 4,327 3,102 6,240 49261 3,153 Non-operating expenses 7,834 6,061 10,261 6,292 2.450 Dividends 22,602 19,982 40,162 26,781 19,660 Income tances 01.062) 1491 11.696) 313 32 TOTAL EXPENSES 33.696 28.654 SARL 37.720 20.105 NET INCOME (2,078) (914) (3.125) 900 2.169 * Figures in nousands of dollars was interest payments on bomowing other than deposita Dentes interest paid or credited to members Case Study (refer Appendix) (a) Should Peoples Federal Savings have hedged its September 1, savings certificate rollover? (5 marks) (b) What would you have advised Mr. Myers to do on August 6? (5 marks) (c) How should Mr. Myers explain his futures losses to the board on August 27? Show the calculation on how the cash gains would precisely offset his futures losses. Assume the T-bill rates = 8% on September 1 & Mr. Myers initiated the hedge = 11.42% on May 20 (10 marks) = 927 Exhibit 2 Peoples Federal Savings Bank Comparative Statement of Conditions As of June 30 As of December 31 1982 (6 mo.) 1981 1980 1979 Assets First mortgage loans 406,124 430,201 384,667 304 812 Loans on savings accounts 821 1,282 823 Consumer and other loans 84,423 34,621 6.786 2,986 Cash on hand and in banks 2,301 1,880 2.426 2.260 Liquid investment securities 28,562 16,282 16,823 17,782 Other investment securities 1,526 2,621 7,028 8,200 Investment in subsidiary corporations 6,721 5,261 6,201 2,460 Federal Home Loan Bankstock 2,721 2,864 2,350 Building and equipment (net) 4,012 3,081 1,823 1,626 Deferred charges and other assets 19.961 10.428 4.826 7.311 TOTAL 65.613 509.374 434.267 350.714 Liabilities and Reserves Deposits 410,477 381,940 328. 146 282.960 Advances from Federal Home Loan Bank 45,891 43,826 44,567 26,462 Other advances 2.587 2,647 2.632 3,031 Other borrowed money 53,821 43,862 27.161 10,643 Loans in process 311 4,032 4,492 Deferred income 24,311 14,286 4,823 3,106 Other ilabildes 7,124 9,026 6,301 4,215 Reserves and undividend profits 11,402 13,480 16,606 15,805 TOTAL 565,613 509,378 434,267 350,714 in thousands of dollars Exhibit 3 Peoples Federal Savings Bank Comparative Statement of Operations 6 month For the year ending December 31 1982 1981 1981 1980 1979 Wan. June Income Interest on mortgage loans 22,035 22,764 41.732 30,940 23.750 Income from other loans & Investments 6,426 1,482 3,026 3,453 3,162 Loan fees 896 1,493 2.920 2,300 1,150 All other income 2,261 2,001 4,264 1,827 302 TOTAL INCOME 31,618 27.740 51,942 38,520 28,364 Expenses Operating expenses 4,327 3,102 6,240 49261 3,153 Non-operating expenses 7,834 6,061 10,261 6,292 2.450 Dividends 22,602 19,982 40,162 26,781 19,660 Income tances 01.062) 1491 11.696) 313 32 TOTAL EXPENSES 33.696 28.654 SARL 37.720 20.105 NET INCOME (2,078) (914) (3.125) 900 2.169 * Figures in nousands of dollars was interest payments on bomowing other than deposita Dentes interest paid or credited to members Case Study (refer Appendix) (a) Should Peoples Federal Savings have hedged its September 1, savings certificate rollover? (5 marks) (b) What would you have advised Mr. Myers to do on August 6? (5 marks) (c) How should Mr. Myers explain his futures losses to the board on August 27? Show the calculation on how the cash gains would precisely offset his futures losses. Assume the T-bill rates = 8% on September 1 & Mr. Myers initiated the hedge = 11.42% on May 20 (10 marks) =