Exam 24: Hedging with Financial Derivatives

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A long hedge could be used by a bank to protect itself from the risk of rising interest rates before a loan is funded. In this scenario, the bank would enter into a long hedge position by buying interest rate futures contracts. By doing so, the bank would lock in a predetermined interest rate for a future date, effectively protecting itself from potential interest rate increases.

For example, let's say a bank plans to lend money at a fixed interest rate in six months' time. To protect itself from the risk of rising interest rates, the bank could enter into a long hedge by buying interest rate futures contracts that expire in six months. If interest rates were to rise during this period, the value of the futures contracts would increase, offsetting the higher cost of funding the loan.

By using a long hedge, the bank can mitigate the risk of rising interest rates and ensure that it can fund the loan at the predetermined rate, thus protecting its profit margins and financial stability.

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Option contracts can be used to protect against losses in portfolio value that may occur as interest rates increase by using interest rate options. These options allow investors to hedge against interest rate risk by providing the right, but not the obligation, to buy or sell a specified amount of a financial instrument at a predetermined price within a specific time period.

For example, if an investor holds a portfolio of fixed-income securities such as bonds, they can purchase interest rate put options. These put options would increase in value as interest rates rise, effectively offsetting the decrease in the value of the bonds in the portfolio. Similarly, if an investor expects interest rates to decrease, they can purchase call options to protect against potential losses in the value of their fixed-income securities.

By using option contracts in this way, investors can mitigate the impact of interest rate changes on their portfolio value. This can provide a level of security and stability, especially in a rising interest rate environment, where the value of fixed-income securities typically decreases. Additionally, using option contracts allows investors to customize their hedging strategies based on their specific portfolio composition and risk tolerance. Overall, option contracts can be a valuable tool for protecting against losses in portfolio value caused by changes in interest rates.