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Lecture Financial markets and institutions: Chapter 23 - Anthony Saunders, Marcia Millon Cornett

Chapter 23 - Managing risk off the balance sheet with derivative securities. This chapter analyzed the risk-management role of forwards, futures, options, and swaps. These (off-balance-sheet) derivative securities provide FIs with a low-cost alternative to managing risk exposure directly on the balance sheet. | 8- McGraw-Hill/Irwin Chapter Twenty-Three Managing Risk off the Balance Sheet with Derivative Securities 23- McGraw-Hill/Irwin Managing Risk off the Balance Sheet Managers are increasingly turning to off-balance-sheet (OBS) instruments such as forwards, futures, options, and swaps to hedge the risks their financial institutions (FIs) face interest rate risk foreign exchange risk credit risk FIs also generate fee income from derivative securities transactions 23- McGraw-Hill/Irwin Managing Risk off the Balance Sheet A spot contract is an agreement to transact involving the immediate exchange of assets and funds A forward contract is an agreement to transact involving the future exchange of a set amount of assets at a set price A futures contract is an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily futures contracts are marked to market daily—i.e., the prices on outstanding futures contracts are adjusted each day to reflect current futures market conditions 23- McGraw-Hill/Irwin Hedging with Forwards A naïve hedge is a hedge of a cash asset on a direct dollar-for-dollar basis with a forward (or futures) contract Managers can predict capital loss (ΔP) using the duration formula: where P = the initial value of an asset D = the duration of the asset R = the interest rate (and thus ΔR is the change in interest) FIs can immunize assets against risk by using hedging to fully protect against adverse movements in interest rates 23- McGraw-Hill/Irwin Hedging with Futures Microhedging is using futures (or forwards) contracts to hedge a specific asset or liability basis risk is a residual risk that occurs because the movement in a spot asset’s price is not perfectly correlated with the movement in the price of the asset delivered under a futures (or forwards) contract firms use short positions in futures contracts to hedge an asset that declines in value as interest rates rise . | 8- McGraw-Hill/Irwin Chapter Twenty-Three Managing Risk off the Balance Sheet with Derivative Securities 23- McGraw-Hill/Irwin Managing Risk off the Balance Sheet Managers are increasingly turning to off-balance-sheet (OBS) instruments such as forwards, futures, options, and swaps to hedge the risks their financial institutions (FIs) face interest rate risk foreign exchange risk credit risk FIs also generate fee income from derivative securities transactions 23- McGraw-Hill/Irwin Managing Risk off the Balance Sheet A spot contract is an agreement to transact involving the immediate exchange of assets and funds A forward contract is an agreement to transact involving the future exchange of a set amount of assets at a set price A futures contract is an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily futures contracts are marked to market daily—i.e., the prices on outstanding futures contracts are .