Can hedge temporarily in futures market or can

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can hedge temporarily in futures market, or can balance position more permanently in interdealer market (interdealer market for swaps is brokered market like inside market for government securities or interbank market for Eurodollars) o if treasury rate falls, asset prices rise, so futures prices rise o so, buy futures contracts in long position wants to hedge against drop in interest rates if interest rate drops below swap rate (fixed rate that bank pays which is 7.5%) then intermediary must pay floating rate payer (swap rate – LIBOR) x notional principal buy futures contracts bc now they benefit from fall in interest rate if interest rates fall, price rises, so if actual price is above futures price, seller of future contract will pay intermediary or buyer of contract (actual price – futures price) x notional amount long position in futures seller of futures contract in short position – gains from fall in underlying price, rise in interest rates buyers of futures contract in long position – gains from rise in underlying price, fall in interest rates buy call option for treasury bonds. if interest rates drop, prices will go up, so if actual price is above exercise price, can exercise option and seller will pay buyer or intermediary (actual price at maturity – exercise price) x notional amount. buying call option is long position, taken to hedge short position do a swap with dealer who is net floating rate payer bc we are currently a net fixed rate payer right now. 7. Why do there exist both OTC derivatives and exchange-traded derivatives in interest rates and exchange rates? exchange = futures and options OTC = swaps Serve much of the same function
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THEY ARE BOTH HERE BECAUSE THE DIFFER IN IMPORTANT ASPECTS, because of these differences they largely serve different clienteles which is why competition hasn’t pushed one form out of the market. ET’s are more liquid, less expensive, and involve less replacement risk. Because standardized they’re BETTER FOR MARKET MAKERS o Liquidity o Securities dealers o Financial intermediaries (banks) o And market makers for OTC derivatives OTC provides better hedges but they’re more expensive, less liquid, and subject to replacement risk- hedgers that have known and unchanging risk. They’re BETTER FOR HEDGERS (mainly because less basis risk) o Nonfinancial corporations Liquidity o Exchange: more liquid, less expensive, ability to close out and take position is very easy o OTC: replacement risk in changing position, much less liquid, harder to close out position Flexibility o Exchange: basis risk because standardized, less flexibility for customer o OTC: instrument tailored to customer Cost o Exchange: lower cost, competitive, arm’s length o OTC: expensive, relationship, reduce competition Maturity o Exchange: shorter maturity o OTC: swaps have longer maturities Regulation o Exchange: futures and options tightly regulated o OTC: free to offer new instrument, unregulated Replacement risk o Exchange: none o OTC: dealers substitute their own risk, purely wholesale price discovery o Exchange: better for exchange, big market, appealing to info traders o in OTC market price discovery based off price discovery that occurs in exchange ease of entry o
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