week7 - Hedging Interest Risk Hedging Interest Risk Lecture...

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edging Interest Risk Hedging Interest Risk Lecture 7 Ref: FIM Chap 22, 23 and 24
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verview Overview • Hedging interest rate risk with derivatives becoming more popular, interest rate futures and swaps growing rapidly • Rapid growth of derivatives use has been controversial – Bankers Trust, Allfirst Bank (Allied Irish) • As of 2000, FASB requires that derivatives ,q be marked to market ransparency of losses and gains on financial Transparency of losses and gains on financial statements
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terest Rate Derivatives Interest Rate Derivatives terms of notional contract volumes In terms of notional contract volumes – Swaps are the largest ptions second largest – Options second largest – Futures and Forwards third largest • Contracts are held not only for hedging purposes, but FIs also serve as counterparty for other firms wishing to hedge on balance sheet risks 22-3
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pot and Forward Contracts Spot and Forward Contracts pot Contract Spot Contract – Agreement at t=0 for immediate delivery and mediate payment immediate payment. • Forward Contract greement to exchange an asset at a – Agreement to exchange an asset at a specified future date for a price which is set at =0 t0 . • Counterparty risk
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orward and Futures Contracts Forward and Futures Contracts utures Contract similar to a forward Futures Contract similar to a forward contract except: Marked to market – Exchange traded • Rapid growth of off market trading systems – Standardized contracts • Smaller denomination than forward – Lower default risk than forward contracts. – Futures used more commonly used than rwards in hedging forwards in hedging.
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pot, Forward and Future Contracts Spot, Forward and Future Contracts
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Futures and Forwards Future Forward Traded in exchang eO T C Contracts standard nonstandard Trade with exchange counterparty Maturity Date fixed in length fixed date in the future Marked to market yes no y Default risk lower Higher Suitable for hedging more less
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Symmetric payoffs of futures and forwards Short Position Long Position Payoff Payoff price price p Current Futures Current Futures price X price X
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abulate payoffs Tabulate payoffs uppose the future price X= $100 Suppose the future price X= $100 Bond Price at 1 (B) $50 <X B=$100 =X $150 >X t=1 (B) B<X B=X B>X Short $50 $0 -$50 Position X-B X-B X-B ong 50 0 50 Long Position -$50 B-X $0 B-X $50 B-X
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edging Interest Rate Risk Hedging Interest Rate Risk • Example: • Long position in 20-year $1 million face value bond, duration = 9 years. • Current price = $970,000. • Interest rates expected to increase from 8% to 10% over next 3 months. ± From duration model, change in bond value: =- × /(1+R) Δ P D P Δ R/(1 R) = -9 × $970,000 × [.02/1.08] = -$161,667
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xample Continued: Naive Hedge Example Continued: Naive Hedge ± Hedged by selling 3 months forward at rward price of $970 000 forward price of $970,000 ± Suppose interest rate rises from 8% to 10%, payoff from forward: $970,000 - $808,333 = $161,667 (forward (spot price price at t=3 months) xactly offsets the on alance heet loss ± Exactly offsets the on-balance-sheet loss ± Immunized
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This note was uploaded on 02/29/2012 for the course FINANCE FIN 3117 taught by Professor Lina during the Spring '12 term at National University of Singapore.

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week7 - Hedging Interest Risk Hedging Interest Risk Lecture...

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