Saturday, August 1, 2009

Hedging Eurodollar interest rate risk

A number of new international financial markets have emerged in recent years to provide alternative instruments for spreading risk related to both foreign exchange and future interest rates. Having discussed in the previous topic how foreign exchange forward, future and options markets provide means for reducing or avoiding foreign exchange risk, we now briefly introduce several of the more important instruments or tools that are available in the international financial markets to hedge interest rate risk. These financial instruments are belonging to category of financial tools referred to as derivatives. Derivatives are simply financial contracts whose value is linked to or derived from an underling asset. Examples of the underlying assets include stocks, bonds, commodities, loans, certificates of deposit (CDs), and foreign exchange. For many financial institutions, interest rate risk management is critical to their successful operation inasmuch as they often can anticipate future lending and future borrowing actions both at home and abroad and would prefer to reduce the risk of possible changes in the market interest rate prior to when the anticipated borrowing or lending occurs. Several of the more commonly used types of financial instruments or tools from which the manager can choose to hedge against unforeseen interest rate changes include (1) maturity mismatching, (2) future rate agreements, (3) Eurodollar interest rate swap (4) Eurodollar cross-currency interest swaps (5) Eurodollar interest rate futures, (6) Eurodollar interest rate options, (7) options on swaps, and (8) equity financial derivatives.

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