Question

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 Treasury bonds using futures contracts

If each futures contract is worth $100,000, how many must Wells Fargo sell to completely hedge the risk?

What happens if interest rates on 10-year Treasuries increase?

Suppose Wells Fargo has more rate-sensitive liabilities than rate-sensitive assets

As interest rates increase, what happens to the bank’s net worth?

Should the bank generally be long or short in derivatives markets to hedge the interest-rate risk of their entire portfolio?

If it uses options to hedge, what type of option should it buy?

Wells Fargo pays Safeco a fixed rate of 7% on $1 million of notional principal for 10 years. Safeco pays Wells Fargo the one-year Treasury Bill rate plus 1% on $1 million of notional principal for 10 years.

Why do Wells Fargo and Safeco want to do this?

Who is considered the swap “buyer” and who 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 on loans?

What are some of the advantages and disadvantages of the following 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 two financial institutions to enter into a currency swap with each other.

Prior to the financial crisis, you could buy a CDS on a security without actually owning that security.

Why is that a problem? (this question is not answered in the book, but you should be able to figure it out).

Answer 1

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 larger portfolio. Thereby, it includes taking offsetting (position) long or 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 futures contract will not move in line with that of the underlying exposure. This might deem your hedging strategy ineffective by creating excess gains or losses.

Wells Fargo owns $2 million in 10-year Treasury bonds

It hedges the interest-rate risk by “shorting” 10-year Treasury bonds using futures contracts

If each futures contract is worth $100,000, how many must 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 Treasuries increase?

If interest rates on 10 Year Treasuries increase the value of the portfolio will fall. However, the loss in the portfolio will be offset by gain in 10 Year treasury futures contract.

Suppose Wells Fargo has more rate-sensitive liabilities than rate-sensitive assets

As interest rates increase, what happens to the bank’s net worth?

Bank’s Net worth = Asset – Liabilities

Since more rate sensitive liabilities than asset, the value of liabilities will fall more than the value of the assets. This will increase the value of Bank’s net worth.

Should the bank generally be long or short in derivatives markets to hedge the interest-rate risk of their entire portfolio?

Since it is long on treasury bonds (negatively related to interest rates) it needs to short treasury bonds futures to hedge interest rate risk.