Floating rate loans eliminate interest rate risk for

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Floating rate loans eliminate interest rate risk for the bank, but only by passing it onto the borrower HEDGING: adv. of hedging over matching maturities = liabilities are short term, easier for bank to borrow short term and hedge than it is to borrow long term. hedge is easier to change based on new info, changing circumstances (loans could be prepaid, bank may want to profit from unexpected change in rates) Hedging with futures: by offering fixed rates, the bank essentially sells a forward contract in interest rates, providing protection against interest rate risk - can offset the risk by taking a short position in futures (selling them) Adv. o easier to borrow short term and hedge than borrow long term (to match maturities) o easier to adjust hedge to changing circumstances (loans may be prepaid, bank wants to profit from an expected change in rates) o inconsistencies in accounting rules make losses appear that don’t really exist - are balanced by gains in assets, but the two are recognized at different times adv. = net return less variable and less risky Disadv. = hedge not perfect bc timing of gain or loss on futures position does not match timing of gain or loss on underlying position, smaller banks lack trained personnel to hedge effectively, futures hedging has some regulatory problems, inconsistencies in accounting rules create problems (generally gains and losses on futures recognized immediately, gains and losses on balance sheets not recognized until they are realized when asset matures or is sold, can lead to bank looking like its taking a loss when it’s really not) regulatory restrictions, requires high level of expertise and exposure to market risk to make it worthwhile Hedging with options: buy put options o Profit from interest rates rising, price of futures drop, sell for an exercise price o does worse when rates rise because must pay for the options, but does better when rates fall because the gain is left intact Disadv. = bank does worse with options than it does w futures when rates rise. still protected by hedge but hedge is more expensive. when rates fall, bank does better w options (futures hedge eliminates this gain but options hedge leaves it – cost of option)
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bank can become fixed rate payer on swap w maturity matching assets its funding: if interest rates rise, profits bc paying fixed rate. Hedging with swaps: returns are about the same whether rates increase, decrease, or remain the same, but aren’t as high as they could be 3. “There is no such thing as a bad risk, only bad pricing.” Discuss. This is the belief that lenders who charge appropriate rates on their loans should be compensated fairly for the risks they take - if the rate can be set at the appropriate level then there is no such thing as bad risk. The lender earns a risk premium - the difference between the expected return of risky loans and that of government securities - for taking on the extra risk.
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