Notes

Part 2: Question 4

The first step in managing risk for financial institutions, particularly interest rate risk, is to first predict interest rates. One method to predicting (nominal) interest rates, or interest rates that take into account inflation, is using the Fisher Effect. The Fisher Effect uses the real rate of interest, r, and the expected rise in prices—or the expected inflation rate—p^e. The sum of r and p^e produces an approximate nominal interest rate. Even though interest rates can be predicted to some degree these predicted interest rates still lack accuracy. Therefore, the risk from interest rate changes is still present.


Some derivatives that are used to help manage risks are forwards, options, and futures.

Forwards are specialized contracts which has the benefit of allowing banks to get exactly the insurance from risk that banks will want, but forwards are much more costly to compensate for the specialization. Whereas futures are standardized and a more basic amount of insurance coverage, but are less expensive than forwards.

Futures are traded through a financial intermediary—exchanges— which decreases the default risk. This is due to the exchange taking on the default risk as it buys the available futures that are being sold by sellers of futures and then the exchange sells the futures it bought to buyers of futures. Options are the right to buy or sell a given asset of a given quality and quantity, at a given price, at—or until—a given point in the future. Options are a more effective way to gamble on a price change.