Chapter 23 - MANAGING RISK WITH DERIVATIVES
FIs can use derivatives to manage interest rate, credit and FX risk.
Cash transactions for immediate delivery (1-3 days) of commodities, securities (bonds,
: Agree on P and Q, for future delivery (1 week to 10 years), often customized,
nonstandardized contracts for FX, commodities, securities. Actual exchange of commodity, FX,
securities takes place, on expiration (settlement) date. Secondary markets for forward contracts are
usually thin or nonexistent. Some possibility for default.
: Exchange-traded standardized securities (size and settlement date), organized
exchanges, active secondary market, daily settlement to eliminate default risk, cash settlement, daily
price limits. $3T market for FIs.
Hedging with Forward Contracts
Naive Hedge -
Full (100%) "perfect" hedge of a cash asset with a forward or futures contract.
Example p. 631:
Portfolio manager holds $1m face value 20-year T-Bonds, current price is 97%, or
$970,000. Interest rates are 8%, but the FI forecasts that interest rates will rise to 10% over the next 3
months, causing a large capital loss for FI. D = 9 years. To calculate the possible capital loss:
Δ% PV Bond =
-D * [ΔR / (1 + R)]
%P = -9 * ( .02 / 1.08) = -.16667 or -16.6667% OR
%P = -9 * ( 2% / 1.08) = -16.6667%
$970,000 - 16.6667% = $808,333 (or a loss $161,667)
$97 - 16.6667% = $80.8333
Manager can make an off-balance-sheet hedge with a forward contract. Manager is worried about
interest rates rising and bond prices falling, so would want to take a short position and sell T-Bonds
forward 3 months, and find a buyer to go long at 97 for $1m face value of T-Bonds in 3 months. The
buyer could be someone who is worried about interest rates going down in the next three months, i.e., a
life insurance company planning to invest $1m in three months. Assume that the life insurance does
not have the same forecast about interest rates rising. Payoff Diagram:
Spot Price Expiration
BUS 468 / MGT 568: FINANCIAL MARKETS – CH 23
Professor Mark J. Perry