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Off-balance sheet strategies Use of financial derivatives to hedge risks. More elegant than on balance sheet strategies due to
Lower cost ( les risk capital) Tailor made solutions Being market related products measurable more accurately Risk management more easier Reversal of strategies far more easier than on balance sheet solutions
Without Hedging
With Hedging
Types of derivatives
Classic derivatives Firm Derivatives Interest rate swaps
Currency swaps Forward Forex Asset-swaps-Issue swaps FRAS
Optional derivatives FRA options Caps & Floors Collars European Swaptions
Participating swaps Extendable swaps Profit sharing swaps Second Generation swaptions
Strategy which involves taking risks, but only opportunity risks : neutral strategy swaps, FRAs
Strategy which involves taking risks, including real risks : offensive strategy Selling a swaption
Bank has raised a loan of USD 100 million for five years at floating rate basis ( 6 monthly LIBOR) Assumptions: zero carry (the difference between the rate of the loan and current short-term rates. If the short term rate is less than the rate of the loan ,then its called the carrying cost. Financial risk if short term rates rise. Expectation- Rising USD yield curve
Initial debt
Forecast
ST rates no view LT rates no view Risk aversion -strong Payment of a premium-no Strategy: Vanilla IRS
Current LIBOR
With swap
LIBOR
Advantages: Total cover by a swap is the only instrument which enables no risk to be taken if one does not want to pay an option premium. Drawbacks: In a configuration where the yield curve is rising ,the carrying cost is high. There is an opportunity cost in case of fall in long term rates. Risk mitigation: Do a cancellable swap
Initial debt
LT ratesRise Expected
Current LIBOR
LIBOR
Advantages: The cap enables the to take advantage of low short term rates while remaining fully covered. Drawbacks: The price of the cap may be high. Risk mitigation: One could buy a cap for a shorter duration and hedge the structure with a delayed start swap or purchase of a swaption less expensive than a cap.
Initial debt
Risk aversion
-strong
Payment of a premium -No Strategy: Purchase of a collar Advantages:
Current LIBOR
LIBOR
Cost of carry is less than that which would have been obtained with an IRS. One can elect to pay no premium at all or to pay a premium in order to lower the ceiling rate Drawbacks: If the level of the short term rates is lower than the floor ate the cost of carry will not be zero. There is opportunity cost the rates fall This strategy is attractive when one is uncertain of the amplitude of the fall in the short term rates.
Forecast
ST ratesSteady rates or fall with limited amplitude
Initial debt
Payment of premiumNo
With swap
LIBOR
Advantages: Cost of carry is zero at the time of the transaction The participating swap is particularly well adapted to concave curves as the extra cost compared to a simple swap is small. Fall in short term rates up to the lower limits can be taken advantage of Ceiling rat is lower than that of a collar. Drawbacks: If the short term rates fall below the lower limit the synthetic debt rate will rise abruptly The fixed rate is higher than that of a vanilla swap. This strategy is attractive when one is sure of the stability of the short term rates or a fall of limited amplitude.
Forecast
ST rateexpected fall or steady
Initial debt
Payment of premium-
With swap
No
Strategy:
Current LIBOR Advantages: Reduced carry compared to a vanilla swap Drawbacks: Fixed rate higher than that of a classic swap. This strategy is half-way between an interest rate swap and a classic cap which is attractive when one is uncertain of the amplitude of the fall in rates
LIBOR
Initial debt
Aversion to riskweak
With swap
Payment of a premium-No
Forecast Short term rates- down Long term rates- down Risk aversion- medium or weak Payment of a premium- indifferent Strategy: Do Nothing
Forecast: Short term rates- down Long term rates- down Risk aversion- weak Payment of a premium- no Strategy: Sell a right to receive swaption.
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