Financial Markets and Institutions (2-downloads)

http://quicken.intuit.com/personal-

finance-tips/financial-planning/Credit-Score-Q-

and-A.html

and assess your own creditworthiness.

What can you do to improve your appeal to lenders?

2. The FDIC is extremely concerned with risk management

in banks. High-risk banks are more likely to fail and cost

the FDIC money. The FDIC regularly examines banks

and rates them using a system called CAMELS. Go to

http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/

el99-19.html

. What does the acronym CAMELS stand

for? Go to Part II. 7.1 on the website, and review the dis-

cussion of market risk. Summarize the FDIC interest-

rate risk-measurement methods.

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Hedging with Financial

Derivatives

Preview

Starting in the 1970s and increasingly in the 1980s and 1990s, the world

became a riskier place for financial institutions. Swings in interest rates

widened, and the bond and stock markets went through some episodes of

increased volatility. As a result of these developments, managers of financial

institutions have become more concerned with reducing the risk their institu-

tions face. Given the greater demand for risk reduction, the process of financial

innovation described in Chapter 19 came to the rescue by producing new

financial instruments that help financial institution managers manage risk bet-

ter. These instruments, called financial derivatives, have payoffs that are linked

to previously issued securities and are extremely useful risk-reduction tools.

In this chapter we look at the most important financial derivatives that

managers of financial institutions use to reduce risk: forward contracts, financial

futures, options, and swaps. We examine not only how markets for each of

these financial derivatives work but also how each can be used by financial

institution managers to reduce risk.

24

C H A P T E R

Hedging

Financial derivatives are so effective in reducing risk because they enable financial

institutions to hedge, that is, engage in a financial transaction that reduces or elim-

inates risk. When a financial institution has bought an asset, it is said to have taken

a long position, and this exposes the institution to risk if the returns on the asset

are uncertain. On the other hand, if it has sold an asset that it has agreed to deliver

to another party at a future date, it is said to have taken a short position, and this

can also expose the institution to risk. Financial derivatives can be used to reduce

risk by invoking the following basic principle of hedging: Hedging risk involves

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Chapter 24 Hedging with Financial Derivatives

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