Essay: Hedging in Future Markets

Sample Essay

Interest rate futures thus allow effective hedging to be carried out against a risk of unfavorable changes in the interest rates. This reduces the costs to the company in terms of not increasing the interest expense much on account of possible alterations in monetary policy or other actions. Borrowers can hedge against rising interest rates while sellers can hedge against falling interest rates. Participants in the market tend to use the inverse relationship to hedge Treasury bond holdings, diverse debt instrument or even to hedge costs of borrowing at some time in the future.

The firm AABC has borrowed an amount at 3 month Euribor plus 200 basis points. It thus wants to hedge itself against a possible rise in Euribor which will increase the interest payments that have to be made. This requires taking an offsetting position in an underlying security that will move in opposite direction on a shift in the Euribor. Hence the firm can enter a short position in three month Euribor with notional value equal to the amount of the borrowing. This would result in the value of the underlying debt instrument falling on a rise in Euribor leading to cash settlement which will see the opposite party pay AABC the difference, hence hedging against interest rate changes.

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