Question

1. a) Explain how savings institutions could use interest rate futures to reduce interest rate risk.

b) Explain why many savings institutions experience financial problems at the same time.

Answer 1

(1) (a) Savings Institutions are also known as thrift institutions, are banks that serve a local community. Since their main aim is to lend money to the consumers an efficient way to protect itself from falling interest rates is to enter into an interest rate futures. The rate of lending will be fixed. This could be better explained with the help of an example.

Eg. Let us say bank has to lend money of $100000 in 3 months time. The rate of interest is 8%. Suppose in future interest rates fall to 5%.

Amount of deposit is $100000

Length of deposit is 6 months

Amount to be hedged = Amount of deposit * Length of loan/ 3

which is equal to 100000*6/3 = $ 200000
We will buy futures now at the price of 92 & sell later at the price of 95

In this way any fall in the interest rates on deposit will be compensated by profit in futures.

(b) Many savings institutions experience financial problems at the same time because hedging is a complex technique and requires a lot of expertise amongst experts. Setting up separate treasury department will help to identify the strengths and weaknesses of hedging and thereby the savings institutions will be exposed to lower foreign exchange risk.