im10 - Chapter 10 Financial Futures, Forward Rate...

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Chapter 10 Financial Futures, Forward Rate Agreements, and Interest Rate Swaps Chapter Objectives 1. Describe the characteristics of financial futures contracts, how they are priced, and basic trading activity. 2. Demonstrate differences between speculation and hedging activity. 3. Explain how banks can use financial futures to manage interest rate risk associated with specific transactions (microhedging). 4. Explain how banks can use financial futures to manage interest rate risk associated with the entire portfolio (macrohedging). 5. Describe the characteristics of forward rate agreements. 6. Explain how banks can use forward rate agreements to manage interest rate risk with specific transactions. 7. Describe the mechanics of basic interest rate swaps and demonstrate their use in managing interest rate risk. Key Concepts 1. Futures contracts differ from forward contracts because they are traded on formal exchanges, involve standardized instruments, and positions require a daily marking to market. Forward contracts are negotiated between parties, do not necessarily involve standardized assets, and require no cash exchange until expiration. 2. Futures traders who take speculative positions purposefully increase their overall risk position with the hope of earning extraordinary profits. 3. Futures traders who hedge take a position to reduce overall risk. This is accomplished by positioning the futures contract to increase in value when the cash position decreases in value, and vice versa. With financial futures, risk cannot be eliminated, only reduced. Traders normally assume basis risk in that the basis (futures rate minus the cash rate) might change adversely between the time the hedge is initiated and closed. 4. Microhedges with futures involve taking a futures position to reduce interest rate risk associated with a specific asset, liability, or commitment. Macrohedges involve taking a futures position to reduce interest rate risk associated with a bank's total portfolio. 5. A hedger will sell financial futures contracts based on fixed-income securities to reduce risk of loss if cash rates were to rise. A hedger will buy the same financial futures contracts to reduce risk of loss if cash rates were to fall. 6. The size of a futures position depends on the value of the cash market exposure to changing interest rates, the time over which the exposure exists, the face value of the futures contract, and the relative sensitivity of expected rate movements on the cash position compared to the futures instrument. It also reflects the extent to which the trader wants to hedge the cash market exposure or speculate. 7. A forward rate agreement (FRA) is a forward contract based on interest rates. The buyer of a FRA agrees to pay a fixed-rate coupon payment (at the exercise rate) and receive a floating-rate payment against a notional principal amount at a specified future date. The seller of a FRA agrees to make a
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This note was uploaded on 04/14/2010 for the course BANK 2312 taught by Professor William during the Spring '09 term at 東京大学.

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im10 - Chapter 10 Financial Futures, Forward Rate...

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