Hedging Principle Situtation

RISK STEMMING FROM RISING INTEREST RATES

The principle of hedging was applied to a hypothetical situation for a bank to illustrate how such application may be used to reduce exposure to risk stemming from rising interest rates. Two methods of applying the hedging principle were consideredthe use of financial futures and interest rate swaps.

It was held that the best way of implementing an optionbased (futures) hedging strategy to address the bank's potential for an increase in its negative interest rate gap was, for a specified future time, to simultaneously contract to sell $375 million of interestsensitive liabilities in a portfolio paying an average 6.30 percent interest, and to buy $375 million in interestsensitive liabilities paying an average 6.30 percent interest. Thus, if the interest rate were to increase by onepercent, the bank's existing $675 thousand interestsensitive earningsexpenses negative gap would not change. It was held that the best way for the bank to address the problem through an interest rate swap would be to locate another institution that has longterm non interestsensitive assets and longterm non interestsensitive liabilities, and also has a shortterm mismatch that causes negative taxation consequences, an interest rate swap may be structured to benefit both institutions. In such an instance, the bank would agree to pay the interest on $375 million in n

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llful, risk can be fully hedgeda situation where the transaction will have no impact on the owner's assets. The typical intent of the hedger, however, usually is not to enter into a series of transactions which will insure that no impact on the hedger's assets occur. Rather, the usual intent a hedger is to limit the extent of any risk, while still preserving the potential for gain, through the set of transactions. The hedger, by limiting risk, purposefully limits the potential of any gain; however, most have no desire to create a no impact situation. Hedging is most commonly used by producers and traders in commodities, as a means of limiting risk in the face of significant uncertainty, although speculators also make use of the concept of hedging. When speculators use hedging procedures, they are, in effect, creating risk where none previously existed. Thus, speculators are more gamblers than they are hedgers. Hedgers, if they are speculators, are betting that prices on items will change over time, while hedgers, if they are producers or traders, are protecting themselves, in the event that prices on items do change. The difference between the two types of hedgers is subtle but significant. Hedging is also applied to
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Approximate Word count = 1681
Approximate Pages = 7 (250 words per page)