Question

Briefly explain one internal hedging technique that financial institution may use to manage interest rate risk. Why might it be impossible to eliminate the risk completely?

Define each of the following hedging techniques and explain how each is used to minimize interest rate risk

a) Global cash netting

b) Embedded options in debt

c) Forward Rate Agreements

d) Zero-Coupon Swaps

Answer 1

Question 1)

Interest rate risk refers to the risk arising from interest rate fluctuations in assets. Interest rate risks and the prices of some securities like bonds are inversely related, hence any unfavourable fluctuation in interest rates will adversely impact the prices of securities held by financial institutions.

Interest rate risk can be managed by entering into an interest rate derivatives like swaps. Swaps may be used to hedge against adverse interest rate movements or to achieve a desired balanced between fixed and variable rate debt. Interest rate swaps allow both counterparties to benefit from the interest payment exchange by obtaining better borrowing rates than they are offered by a bank.

Hedging interest rate risk with various hedging tools can be possible but fully eliminating this risk is not possible owing to various external factors which are out of control of market participants, like wars, recession, significant changes in government policies etc.