Question

A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates?
a. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates.
b. Purchase principal only (PO) strips that decline in value whenever interest rates rise.
c. Enter into a short hedge where the bank agrees to sell interest rate futures.
d. Sell some of the bank's floating-rate loans and use the proceeds to make fixed-rate loans.
e. Buying inverse floaters.

Answer 1

Answer: c. Enter into a short hedge where the bank agrees to sell interest rate futures.

Explanation:

Futures are a derivative instrument that aims to give stability. It works by the seller of the future agreeing to sell the underlying asset or what it is being traded for a set price in future and at a certain time.

This way even if market conditions cause the price of the asset to change in the market, the parties to this contract will still trade at the price agreed.

If the bank sells interest rate futures, they can lock in a set interest rate for the future that will not change regardless of what happens in the market thereby keeping their Net Income stable.