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)oif treasury rate falls, asset prices rise, so futures prices riseoso, buy futures contracts in long positionwants to hedge against drop in interest ratesif 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 principalbuy futures contracts bc now they benefit from fall in interest rateif 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 amountlong position in futuresseller of futures contract in short position – gains from fall in underlying price, rise in interest ratesbuyers of futures contract in long position – gains from rise in underlying price, fall in interest ratesbuy 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 orintermediary (actual price at maturity – exercise price) x notional amount. buying call option is long position, taken to hedge short positiondo a swap with dealer who is net floating rate payer bc we are currently a net fixedrate payer right now. 7. Why do there exist both OTC derivatives and exchange-traded derivatives in interest rates and exchange rates?exchange = futures and optionsOTC = 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 oLiquidity oSecurities dealers oFinancial intermediaries (banks)oAnd 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) oNonfinancial corporationsLiquidityoExchange: more liquid, less expensive, ability to close out and take position is very easyoOTC: replacement risk in changing position, much less liquid, harder to close out positionFlexibilityoExchange: basis risk because standardized, less flexibility for customeroOTC: instrument tailored to customerCostoExchange: lower cost, competitive, arm’s lengthoOTC: expensive, relationship, reduce competition MaturityoExchange: shorter maturityoOTC: swaps have longer maturitiesRegulationoExchange: futures and options tightly regulated oOTC: free to offer new instrument, unregulatedReplacement risk oExchange: noneoOTC: dealers substitute their own risk, purely wholesale price discoveryoExchange: better for exchange, big market, appealing to info tradersoin OTC market price discovery based off price discovery that occurs in exchangeease of entryo
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