Question

1. What is a distressed loan?

2. 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?

Answer 1

DIstressed loan or debt or securities are the securities of a company which has either defaulted, is under bankruptcy protection or is under distress or moving towards any of these situations. It has all the instruments that are trading at discount or are quite far from the industry average. It is not issued deliberately but only when the entity is in financial distress due to market economy, industry etc. Distressed loan is generally sold at quite lesser price of its par value or actual price to be sold and offers quite high rate of return. The buyers of these loans have to bear the highest risk possible for the firm i.e bankruptcy risk and hence the returns offered are quite high. In case of banks distressed loans can simply be termed as NPAs (Non-performing assets).

I think Bank should take long positions in deriavtives market to hedge against the interest rate risk as this would provide bank with a right to exercise that contract when it finds it suitable or it expires unexercised, so this would limit the loss of the bank.

If it uses options to hedge, then it has 3 options interest rate caps, floors and collars to use. With cap it can hedge the rising interest rates and with floor it can hedge against the falling interest rates. I think banks should buy the interest rate floors as bank needs to hedge against the falling interest rates as banks major operation is to lend or to invest and for investors floor is a better option to restrict their lower side of income from the returns earned through interest received.