MANAGING RISK RELATED TO FINANCIAL ORSERVARLES

As we have shown, development institutions tend to practice static hedging, meaning that a trade is hedged as a block at inception and with a virtually perfect off-setting position. This is different from dynamic (continuous) hedging practiced by traditional financial institutions where specific elements of a trade are hedged separately at numerous points throughout the life of the trade. Nonetheless, within the static hedging framework, it is useful to paint a picture of how an institution manages the risk associated with a few key parameters linked to financial variables. We shall begin with what relates to interest rate and FX risk (the two can be viewed together) and then a brief description of the (explicit) management of credit risk.

Since we focus mainly on the hedging itself, that is, the interaction between the asset and the swap, we shall treat together situations originating from the lending, borrowing, or investing activity of the institution. Between

TABLE 7.1 The hedging of a fixed-coupon bond issued to borrow capital.

Instrument type

Pay/Receive

Leg structure

Fixed/Structured Bond

Pay

Fixed/Structured Swap Leg

Receive

Floating Swap Leg

Pay

Result

Pay

these different situations, the difference in the sign and in the discounting used will be crucial.

Interest Rate and FX Risk

The underlying theme of this book is that credit is ever present in the value of basically any (and particularly fixed income) financial instrument. The presence of credit can be, however, more or less explicit. In this section we shall focus mainly on interest rate and FX when they dominate a certain instrument value or its corresponding hedge. We shall focus on the hedge of bonds, loans, and, insofar as the corresponding hedge is swap driven, instruments such as equity positions and credit-linked investments such as asset-backed securities.

 
< Prev   CONTENTS   Next >