Question

Financial institution use four major strategies to manage interest -rate risk. Select two for these strategies and describe how they are used to manage interest-rate risk.

Answer 1

Ans. Management of interest rate risk is very important , as mismanagement can devastate the financial institution and can later on turn it bankrupt also . The four major strategies used by financial institution to manage interest rate risk are as follows-

A) Diversification

B) Hedging

C) Selling long term bonds

D) Purchasing floating rate bonds

These strategies are used by financial institution in order to manage interest rate risk . How these strategies are used by financial institution to manage interest rate risk is as follows-

A) Diversification- Diversification of financial investments lead to reduction of interest rate risk. By diversifying the money to be invested in different areas the risk of loss in one decrease . Even if one investment causes loss , it will be less as other is invested in different areas.

B) Hedging - hedging basically refers to the buying of different types of derivatives . This way can be used to reduce the risk related to interest rate. Hedging includes -

1. Forward - in it exchange agreement is scheduled for some future date.

2. Forward Rate agreement- it is a type of forwarding where the interest rate which is applicable decide Profit or loss

3. Swap agreememt- in it both side dealers swap the interest rates.