Question

The National Bank uses funds acquired from variable rate certificates of deposits to make long-term fixed rate loans to local construction companies. To hedge its increased exposure to interest rate risk, the bank could enter into an interest rate swap. It could also consider (buying/selling) treasury bond futures contracts or buying (put/call) options on treasury bonds. Circle the correct choice and explain why this is the case.

Answer 1

National banks have to employ efficient techniques to reduce interest rate risks. One of them is entering into futures contracts of treasury bonds. It gives the bank an option to deposit funds as if it had agreed on a fixed rate in some future time which will apply for a particular duration.

Interest rate swap is a combination of contracts agreed between two counterparties, it specifies exchange of payments which are benchmarked against an index of interest rate which might vary. Options on treasury bonds are used by investors to speculate on the direction of bond prices.

Thus national banks would consider entering into a treasury bond futures contract as in a way it is a fixed interest rate.