Financial Markets and Institutions (2-downloads)

Hedging with Interest-Rate Swaps

You might wonder why the managers of the two financial institutions find it advan-

tageous to enter into this swap agreement. The answer is that it may help both of

them hedge interest-rate risk.

fall and bond prices rise well above the exercise price, the bank will not have large

losses on the option contracts because it will just decide not to exercise its options.

The bank will not suffer the accounting problems produced by hedging with financial

futures. Because of the accounting advantages of using futures options to conduct

macro hedges, option contracts have become important to financial institution man-

agers as tools for hedging interest-rate risk.

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For more details of how interest-rate risk can be hedged with futures options, see the appendix to this

chapter which can be found on the book’s Web site at