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SUMMARY

1. Interest-rate forward contracts, which are agreements to sell a debt instrument at a future (forward) point in time, can be used to hedge interest-rate risk. The advantage of forward contracts is that they are flexible, but the disadvantages are that they are subject to default risk and their market is illiquid.

2. A financial futures contract is similar to an interest-rate forward contract, in that it specifies that a debt instrument must be delivered by one party to another on a stated future date. However, it has advantages over a forward contract in that it is not subject to default risk and is more liquid. Forward and futures contracts can be used by financial institutions to hedge (protect) against interest-rate risk.

3. An option contract gives the purchaser the right to buy (call option) or sell (put option) a security at the exercise (strike) price within a specific period of time. The profit function for options is nonlinear—profits do not always grow by the same amount for a given change in the price of the underlying financial instrument. The nonlinear profit function for options explains why their value (as reflected by the premium paid for them) is negatively related to the exercise price for call options, positively related to the exercise price for put options, positively related to the term to expiration for both call and put options, and positively related to the volatility of the prices of the underlying financial instrument for both call and put options. Financial institutions use futures options to hedge interest-rate risk in a similar fashion to the way they use financial futures and forward contracts. Futures options may be preferred for macro hedges because they suffer from fewer accounting problems than financial futures.

4. Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments and have default risk and liquidity problems similar to those of forward contracts. As a result, interest-rate swaps often involve intermediaries such as large commercial banks and investment banks that make a market in swaps. Financial institutions find that interest-rate swaps are useful ways to hedge interest-rate risk. Interest-rate swaps have one big advantage over financial futures and options: They can be written for very long horizons.

5. Credit derivatives are a new type of derivatives that offer payoffs on previously issued securities that have credit risk. These derivatives—credit options, credit swaps and credit linked notes—can be used to hedge credit risk.

6. There are three concerns about the dangers of derivatives: They allow financial institutions to more easily increase their leverage and take big bets (by effectively enabling them to hold a larger amount of the underlying assets than the amount of money put down), they are too complex for managers of financial institutions to understand, and they expose financial institutions to large credit risks because the huge notional amounts of derivative contracts greatly exceed the capital of these institutions. The second two dangers seem to be overplayed, but the danger from increased leverage using derivatives is real.

 
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