What is microhedging? What is
What is microhedging?
What is macrohedging?
What is basis risk?
Wells Fargo owns $2 million in 10-year Treasury bonds
It hedges the interest-rate risk by “shorting” 10-year Treasurybonds using futures contracts
If each futures contract is worth$100,000, how many must Wells Fargo sell to completely hedge therisk?
What happens if interest rates on10-year Treasuries increase?
Suppose Wells Fargo has more rate-sensitive liabilities thanrate-sensitive assets
As interest rates increase, what happens to the bank’s networth?
Should the bank generally be long orshort in derivatives markets to hedge the interest-rate risk oftheir entire portfolio?
If it uses options to hedge, what type of option should itbuy?
Wells Fargo pays Safeco a fixed rate of 7% on $1 million ofnotional principal for 10 years. Safeco pays Wells Fargo theone-year Treasury Bill rate plus 1% on $1 million of notionalprincipal for 10 years.
Why do Wells Fargo and Safeco want to do this?
Who is considered the swap “buyer” andwho is considered the swap “seller” in this transaction?
Why do swaps have significant credit risk?
How does the credit risk on swaps differ from the credit risk onloans?
What are some of the advantages and disadvantages of thefollowing methods for hedging interest-rate risk?
Forwards
Futures
Buying options
Writing options
Swaps
What is a currency swap?
Describe a situation in which it would be beneficial for twofinancial institutions to enter into a currency swap with eachother.
Prior to the financial crisis, you could buy a CDS on a securitywithout actually owning that security.
Why is that a problem? (this questionis not answered in the book, but you should be able to figure itout).
Answer:
I am going to answer the first 4 parts to the question:
What is MicroHedging
Process of eliminating risk of a single asset from a largerportfolio. Thereby, it includes taking offsetting (position) longor short in a single asset.
What is MacroHedging
Process of eliminating risk of the entire portfolio.
What is Basis Risk
Basis is the risk that the value that the value of the futurescontract will not move in line with that of the underlyingexposure. This might deem your hedging strategy ineffective bycreating excess gains or losses.
Wells Fargo owns $2 million in 10-year Treasurybonds
It hedges the interest-rate risk by “shorting” 10-yearTreasury bonds using futures contracts
If each futures contract is worth $100,000, how manymust Wells Fargo sell to completely hedge the risk?
Number of contracts required: 2,000,000/100,000=20
What happens if interest rates on 10-year Treasuriesincrease?
If interest rates on 10 Year Treasuries increase the value ofthe portfolio will fall. However, the loss in the portfolio will beoffset by gain in 10 Year treasury futures contract.
Suppose Wells Fargo has more rate-sensitive liabilitiesthan rate-sensitive assets
As interest rates increase, what happens to the bank’snet worth?
Bank’s Net worth = Asset – Liabilities
Since more rate sensitive liabilities than asset, the value ofliabilities will fall more than the value of the assets. This willincrease the value of Bank’s net worth.
Should the bank generally be long or short inderivatives markets to hedge the interest-rate risk of their entireportfolio?
Since it is long on treasury bonds (negatively related tointerest rates) it needs to short treasury bonds futures to hedgeinterest rate risk.
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