how to develop a hedging strategy for a banking industry

Expert Solution

Banks are exposed to risks of interest rates changing and also currency rates mismatch for their obligations and assets. Thus for banking industry, in order to eliminate these risks, it is essential that they match the duration of their assets and liabilities closely to eliminate any unfunded obligations. This can be done by buying currency forwards or currency future contracts for their overseas loan obligations and these should match the payment obligations for the bank. Also the advances should match the duration of these loans to the extent possible to prevent any timing differences.

Another risk is the change in interest rates. So short term funds should only be used to make short term loans and long term funds to make long term advances with fully hedged currency futures or forwards to eliminate the chance of a variation in obligations. Thus using duration match between assets and liabiities and fully covering the currency risk is the strategy to be followed by banks to hedge their risks.

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