Larry the Loan Shark is an honorable thug. He has handshake agreements (nothing in writing) with...

Larry the Loan Shark is an honorable thug. He has handshake agreements (nothing in writing) with several clients for fixed-rate loans. His enforcers are prepared for every eventuality, except a global pandemic so he has decided to "get in on this hedging thing". How he can hedge his loan portfolio against interest rate fluctuations using both Treasury futures and SWAPS.

Expert Solution

Hedging trough Treasury Futures:

Treasury Futures means the Risk Free Futures.Futures are standardised forward contracts traded aon Stock Exchanges..It has a unique feature of daily marked to market,margin requirements,high liquidity and most importantly no counter party default risk.

Hedging thorugh Futures can be done either by going long ie F+ or short ie F-

F+ is informally upside betting and F- downside betting.

1st Scenario:

If the indiviual wants to hedge his loan portfolio and goes long ie F+ and if interest rate rises then only he is in gain and could hedge the interest rate fluctuation..If the interest rate falls then he will loose as the Future will lapse.

2nd Scenario:

If the individual wants to hedge his loan portfolio and goes short ie F- and if the interest rate falls then only he is able to hedge his interest rate fluctuation exposure as the future would not lapse if interest rate fals..If the interest rate rises then the future would lapse and he wil not be able to hedge the interest rate fluctuation.

Hedging through SWAP:

A financial swap is a portfolio of Forward Contractd ie multiple betting

Aplain vanilla interest rate swap involves swaping floating payment versus fixed payments based on a notional principle and with netting feature.

Suppose the individual wants to borrow fixed rate funds.We would like to advice him to borrow floating rate funds and then he should convert the floating rate funding into fixed rate funding via a SWAP wherein it receives floating rate (for eg.LIBOR) and pays fixed rate of interest.

jeff jeffy answered 1 year ago

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