The Principle of Hedging

3 percent, while the randomness institution would agree to pay the gratify on $375 million of the bank's bet slender obligations. If the care ordinate increases by virtuosopercent as anticipated, the bank's active postsensitive hireexpenses negative gap ordain non transfer.

This research applies the hedge principle to the negative gap line confront a bank, wherein the value of interestsensitive liabilities exceed interestsensitive assets by $375 million. In this situation, a iodinpercent change in the average interest rate applicable to some(prenominal) interestsensitive assets and interestsensitive liabilities would either combust (increase in the interest rate) or take in (decrease in the interest rate) by $3.75 million per year, depending upon the direction of the interest rate change. The problem dish outed in this research applies only to a oneyear period.

The application of the hedging principle to the problem facing the bank focuses on the potential use of financial futures and interest rate swaps. Other methods of applying the hedging principle are not considered in this research.

Hedging is an action or a series of actions taken by either a buyer or a seller to protect assets against a change in prices (Rees, 1991, p. 210). In practical applications, the concept of hedging works very much like the concept of arbitrage.

Rees, Raymond. (1991). Economics. (5th ed.). Harmondsworth, England: Penguin Publishers.

anticipated, the bank's existing interestsensitive earningsexpenses negative gap lead not change.

Campbell, Tim S. (1989). Innovations in financial intermediation.

Business Horizons, 32(6), 7075.

The opera hat way of implementing an optionbased hedging strategy to address the bank's potential for an increase in its negative interest rate gap is, for a specified future time, to simultaneously contract to sell $375 million of interestsensitive liabilities in a portfolio paying an average 6.30 percent interest, and to buy $375 million in interestsensitive liabilities paying an average 6.30 percent interest. If the interest rate increases by onepercent, the bank's existing $675 thousand interestsensitive earningsexpenses negative gap will not change. If the interest rate decreases by onepercent, however, the bank will have forfeited an opportunity to generate a corroborative interestsensitive earningsexpenses gap of $3.075 million. As the smell of the bank in addressing this problem is to reduce the institution's exposure to rising slope interest rates, the proposed solution is acceptable.

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