7. Hedging with futures. Assume a financial institution has more rate-sensitive
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Question
7. Hedging with futures. Assume a financial institution has more rate-sensitive assets than rate-sensitive liabilities. Would it be more likely to be adversely affected by an increase or a decrease in interest rates? Should it purchase or sell interest rate futures contracts in order to hedge its exposure?
8. Hedging with futures. Assume a financial institution has more rate-sensitive liabilities than rate-sensitive assets. Would it be more likely to be adversely affected by an increase or a decrease in interest rate? Should it purchase or sell interest rate futures contracts in order to hedge its exposure?
9. Hedging Decision. Why do some financial institutions remain exposed to interest rate risk, even when they believe that the use of interest rate futures could reduce their exposure?
10. Long versus Short Hedge. Explain the difference between a long hedge and a short hedge used by financial institutions. When is a long hedge more appropriate than a short hedge?
11. Impact of Futures hedge. Explain how the probability distribution of a financial institution
Explanation / Answer
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ANSWER: A futures contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date.
The clearinghouse records all transactions and guarantees timely payments on futures contracts. This precludes the need for a purchaser of a futures contract to check the creditworthiness of the contract seller.
ANSWER: As the market price of the security changes, so does the futures price, in a similar manner. The futures price should reflect the expectation as of settlement date, and expectations will change in accordance with changes in the prevailing market price.
ANSWER: Ideally, the underlying instrument represented by the futures contract would be similarly sensitive to interest rate movements as the assets that are being hedged.
ANSWER: Speculators should sell Treasury bond futures contracts. If they expected interest rates to increase, this implies expectations of lower bond prices. Thus, if security prices decline so will futures prices. Speculators could then close out their position by purchasing an identical futures contract.
7. Hedging with futures. Assume a financial institution has more rate-sensitive assets than rate-sensitive liabilities. Would it be more likely to be adversely affected by an increase or a decrease in interest rates? Should it purchase or sell interest rate futures contracts in order to hedge its exposure?
ANSWER: It would be more adversely affected by a decrease in interest rates. Thus, it should purchase interest rate futures contracts to hedge its exposure.
8. Hedging with futures. Assume a financial institution has more rate-sensitive liabilities than rate-sensitive assets. Would it be more likely to be adversely affected by an increase or a decrease in interest rate? Should it purchase or sell interest rate futures contracts in order to hedge its exposure?
ANSWER: It would be more adversely affected by an increase in interest rates. Thus, it should sell interest rate futures contracts to hedge its exposure.
9. Hedging Decision. Why do some financial institutions remain exposed to interest rate risk, even when they believe that the use of interest rate futures could reduce their exposure?
ANSWER: Some financial institutions prefer not to hedge because they wish to capitalize on their exposure. For example, a financial institution with rate-sensitive liabilities and rate-insensitive assets will benefit from its exposure to interest rate risk if interest rates decline.
10. Long versus Short Hedge. Explain the difference between a long hedge and a short hedge used by financial institutions. When is a long hedge more appropriate than a short hedge?
ANSWER: A long hedge represents a purchase of financial futures and is appropriate when assets are more rate-sensitive than liabilities. A short hedge represents a sale of financial futures and is appropriate when liabilities are more rate-sensitive than assets.
11. Impact of Futures hedge. Explain how the probability distribution of a financial institution
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