Question

1. What are some of the advantages and disadvantages of the following methods for hedging interest-rate risk?

a)Forwards

b) Futures

c) Buying options

c) Writing options

d) Swaps

2. How does the credit risk on swaps differ from the credit risk on loans?

Answer 1

Ans 1)

Advantage of interest rate Forwards:

1. It can be customized.

Disadvantage:

1. It carry counterparty risk.

Advantage of intereset rate futures:

1. Very less counterparty risk.

2. Standard contracts.

Disadvantage:

1. It can't be customized.

Advantage of buying options for interest rate risk:

1. There is no obligation to pay if trade goes unfavorable.

Disadvanatge:

1. One has to pay premium

Advantage for writing options for interest rate risk

1. One can get premium amount if interest rate not fluctuate much or within the region.

Disadvantage:

1. It can bring huge loss if trade goes opposite direction.

Advanatage of swaps for interest rate risk:

1. It can give option to both party to see there favorable position and try to maximize there profits.

Disadvantages:

1. If other party not fulfil its obligation then there is counterparty risk.

Ans 2) Credit risk on loans are bear by banks or party who lend the money but in case of swaps there is credit risk associated with both party of loans and it is called counterpartry credit risk.

In swaps any party can be on loss position due to change in interest rates.