chap24 - My interest is in the future because I am going to...

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Saunders and Cornett, Financial Institu 1 “My interest is in the future because I am going to spend the rest of my life there.” Charles F. Kettering
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Saunders and Cornett, Financial Institu 2 Hedging Risk for FIs Microhedge Hedge the risk of a specific asset or liability. Macrohedge Naïve Hedge = Perfect Hedge for a Microhedge = Routing Hedge for Macrohedge Eliminates all risk of a position. Immunized. Most FIs hedge selectively. Basis Risk Residual Risk that cannot be hedged because price fluctuations on cash and derivatives position differ. Step-by-Step Hedging Procedure
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Saunders and Cornett, Financial Institu 3 Step-by-Step Hedging Procedure Step 1 Risk analysis of underlying cash position. Step 2 Quantification of impact on the cash position of interest rate/exchange rate changes. Step 3 State the goal of the hedge Step 4 Set up perfect hedge to use as a benchmark to implement hedge.
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Saunders and Cornett, Financial Institu 4 Macrohedge Procedure Step 1 Step 2 Step 3 Step 4 Interest rate risk Cash flows when: Hedge goal: + cash flows when: Examples of hedge: DG > 0 Interest rates Interest rates : Short hedge Sell financial futures Buy put options DG < 0 Interest rates Interest rates : Long hedge Buy financial futures Buy call options Exchange rate risk Net exposure > 0 Exchange rates Exchange rates : Short hedge Sell forwards Buy put options Net exposure < 0 Exchange rates Exchange rates : Long hedge Buy forwards Buy call options
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Saunders and Cornett, Financial Institu 5 Futures/Forwards: A Definition The obligation to buy (long) or sell (short) An underlying financial security At a predetermined price = futures/forwards price = P F On a preset date – the delivery date.
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