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Hedging with

Financial
Derivatives
Starting in the 1970s, the world became a
riskier place for financial institutions.
Interest rate volatility increased, as did the
stock and bond markets. Financial
innovation helped with the development of
derivatives. But if improperly used,
derivatives can dramatically increase the
risk institutions face.

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RISK MANAGEMENT PROCESS

1. Identify the risk exposures


2. Quantify the exposure
3. Hedging decision

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What can companies do to
minimize or reduce risk exposure?
Transfer risk to an insurance company by
paying periodic premiums.
Transfer functions that produce risk to third
parties.
Purchase derivative contracts to reduce input
and financial risks.
Take actions to reduce the probability of
occurrence of adverse events and the
magnitude associated with such adverse
events.
Avoid the activities that give rise to risk.
What is financial risk exposure?

Financial risk exposure refers to the


risk inherent in the financial markets
due to price fluctuations.
Example: A firm holds a portfolio of
bonds, interest rates rise, and the
value of the bond portfolio falls.
Financial Risk Management
Concepts

Derivative a security whose value is


derived from the values of other assets.
Swaps, options, and futures are used to
manage financial risk exposures.
In this chapter, we look at the most important
derivatives that managers of financial institution
use to manage risk. We examine how the
markets for these derivatives work and how the
products are used by financial managers to
reduce risk. Topics include:
Hedging
Forward Markets
Financial Futures Markets

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Stock Index Futures
Options
Interest-Rate Swaps
Credit Derivatives

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Hedging

Hedging involves engaging in a financial


transaction that reduces or eliminates risk.
Definitions
long position: an asset which is purchased
or owned
short position: an asset which must be
delivered to a third party as a future date, or an
asset which is borrowed and sold, but must be
replaced in the future

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Difference between Hedging and
Speculation

Hedging involves taking an offsetting position in


a derivative in order to balance any gains and
losses to the underlying asset. Hedging attempts
to eliminate the volatility associated with the price
of an asset by taking offsetting positions contrary
to what the investor currently has.
The main purpose of speculation, on the other
hand, is to profit from betting on the direction in
which an asset will be moving.

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Hedging

Hedging risk involves engaging in a


financial transaction that offsets a long
position by taking an additional short
position, or offsets a short position by
taking an additional long position.
We will examine how this is specifically
accomplished in different financial markets.

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Forward Markets

Forward contracts are agreements by two


parties to engage in a financial transaction at a
future point in time. Although the contract can be
written however the parties want, the contact
usually includes:
The exact assets to be delivered by one party,
including the location of delivery
The price paid for the assets by the other party
The date when the assets and cash will be exchanged

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Forward Markets

An Example of an Interest-Rate Contract


First National Bank agrees to deliver $5 million
in face value of 6% Treasury bonds maturing
in 2023
Rock Solid Insurance Company agrees to pay
$5 million for the bonds
FNB and Rock Solid agree to complete the
transaction one year from today at the FNB
headquarters in town
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Forward Markets

Long Position
Agree to buy securities at future date
Hedges by locking in future interest rate of funds
coming in future, avoiding rate decreases

Short Position
Agree to sell securities at future date
Hedges by reducing price risk from increases in
interest rates if holding bonds

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Forward Markets

Pros
1. Flexible

Cons
1. Lack of liquidity: hard to find a counter-party
and thin or non-existent secondary market
2. Subject to default riskrequires information
to screen good from bad risk

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Financial Futures Markets

Financial futures contracts are similar to


forward contracts in that they are an
agreement by two parties to engage in a
financial transaction at a future point in
time. However, they differ from forward
contracts in several significant ways.

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Financial Futures Markets

Financial Futures Contract


1. Specifies delivery of type of security at future date
2. Arbitrage: at expiration date, price of contract = price
of the underlying asset delivered
3. i , long contract has loss, short contract has profit
4. Hedging similar to forwards: micro versus macro
hedge
Traded on Exchanges
Global competition regulated by CFTC

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Example: Hedging Interest Rate Risk

A manager has a long position in Treasury


bonds. She wishes to hedge against
interest rate increases, and uses T-bond
futures to do this:
Her portfolio is worth $5,000,000
Futures contracts have an underlying value of
$100,000, so she must short 50 contracts.

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Example: Hedging Interest Rate Risk

As interest rates increase over the next 12


months, the value of the bond portfolio drops
by almost $1,000,000.
However, the T-bond contract also dropped
almost $1,000,000 in value, and the short
position means the contact pays off that
amount.
Losses in the spot T-bond market are offset by
gains in the T-bond futures market.

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Financial Futures Markets

The previous example is a micro hedge


hedging the value of a specific asset.
Macro hedges involve hedging, for
example, the entire value of a portfolio, or
general prices for production inputs.

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Financial Futures Markets

In the U.S., futures are traded on the


CBOT and the CME in Chicago, the NY
Futures Exchange, and others.
They are regulated by the Commodity
Futures Trading Commission. The most
widely traded are listed in the Wall Street
Journal, as we see on the next slide.

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Following the News

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Financial Futures Markets

The U.S. exchanges dominated the market


for years. However, this isnt true
anymore.
The London Intl Financial Futures
Exchange trades Eurodollar futures
The Tokyo Stock Exchange trades
Euroyen and govt bond futures
Several others as well, as seen next.

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Widely Traded Financial
Futures Contracts
Financial Futures Markets

Success of Futures Over Forwards


1. Futures are more liquid: standardized
contracts that can be traded
2. Delivery of range of securities reduces the
chance that a trader can corner the market
3. Mark to market daily: avoids default risk
4. Don't have to deliver: cash netting
of positions

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Hedging FX Risk

Example: A manufacturer expects to be


paid 10 million euros in two months for the
sale of equipment in Europe. Currently, 1
euro = $1, and the manufacturer would like
to lock-in that exchange rate.

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Hedging FX Risk

The manufacturer can use the FX futures


market to accomplish this:
1. The manufacturer sells 10 million euros of futures
contracts. Assuming that 1 contract is for $125,000
in euros, the manufacturer takes as short position in
40 contracts.
2. The exchange will require the manufacturer to
deposit cash into a margin account. For example,
the exchange may require $2,000 per contract, or
$80,000.

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Hedging FX Risk

3. As the exchange rate fluctuates during the


two months, the value of the margin account
will fluctuate. If the value in the margin
account falls too low, additional funds may
be required. This is how the market is
marked to market. If additional funds are
not deposited when required, the position
will be closed by the exchange.

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Hedging FX Risk

4. Assume that actual exchange rate is 1 euro = $0.96


at the end of the two months. The manufacturer
receives the 10 million euros and exchanges them in
the spot market for $9,600,000.
5. The manufacturer also closes the margin account,
which has $480,000 in it$400,000 for the changes
in exchange rates plus the original $80,000 required
by the exchange (assumes no margin calls).
6. In the end, the manufacturer has the $10,000,000
desired from the sale.

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Stock Index Futures

Financial institution managers, particularly


those that manage mutual funds, pension
funds, and insurance companies, also need
to assess their stock market risk, the risk
that occurs due to fluctuations in equity
market prices.
One instrument to hedge this risk is stock
index futures.

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Stock Index Futures

Stock index futures are a contract to buy or sell


a particular stock index, starting at a given level.
Contacts exist for most major indexes, including
the S&P 500, Dow Jones Industrials, Russell
2000, etc.
The best stock futures contract to use is
generally determined by the highest correlation
between returns to a portfolio and returns to a
particular index.

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Hedging with Stock Index Futures

Example: Rock Solid has a stock portfolio


worth $100 million, which tracks closely
with the S&P 500. The portfolio manager
fears that a decline is coming and what to
completely hedge the value of the portfolio
over the next year. If the S&P is currently
at 1,000, how is this accomplished?

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Hedging with Stock Index Futures

Value of the S&P 500 Futures Contract =


250 index
currently 250 x 1,000 = $250,000
To hedge $100 million of stocks that move
1 for 1 (perfect correlation) with S&P
currently selling at 1000, you would:
sell $100 million of index futures =
400 contracts

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Hedging with Stock Index Futures

Suppose after the year, the S&P 500 is at 900


and the portfolio is worth $90 million.
futures position is up $10 million

If instead, the S&P 500 is at 1100 and the


portfolio is worth $110 million.
futures position is down $10 million

Either way, net position is $100 million

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Hedging with Stock Index Futures

Note that the portfolio is protected from


downside risk, the risk that the value in the
portfolio will fall. However, to accomplish this,
the manager has also eliminated any
upside potential.
Now we will examine a hedging strategy that
protects again downside risk, but does not
sacrifice the upside. Of course, this comes at
a price!

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Options

A contract that gives its holder the right, but


not the obligation, to buy (or sell) an asset
at some predetermined price within a
specified period of time.
Most important characteristic of an option:
It does not obligate its owner to take action.
It merely gives the owner the right to buy or
sell an asset.

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Option terminology

Call option an option to buy a specified


number of shares of a security within some
future period.
Put option an option to sell a specified number
of shares of a security within some future period.
Exercise (or strike) price the price stated in the
option contract at which the security can be
bought or sold.
Option price the market price of the option
contract.
Option terminology

Expiration date the date the option matures.


Exercise value the value of an option if it were
exercised today (Current stock price - Strike price).
Covered option an option written against stock held
in an investors portfolio.
Naked (uncovered) option an option written without
the stock to back it up.
Option terminology

In-the-money call a call option whose


exercise price is less than the current price of
the underlying stock.
Out-of-the-money call a call option whose
exercise price exceeds the current stock price.
LEAPS: Long-term Equity AnticiPation
Securities are similar to conventional options
except that they are long-term options with
maturities of up to 2 1/2 years.
Option example

A call option with an exercise price of $25, has


the following values at these prices:

Stock price Call option price


$25 $3.00
30 7.50
35 12.00
40 16.50
45 21.00
50 25.50
Determining option exercise value
and option premium

Stock Strike Exercise Option Option


price price value price premium
$25.00 $25.00 $0.00 $3.00 $3.00
30.00 25.00 5.00 7.50 2.50
35.00 25.00 10.00 12.00 2.00
40.00 25.00 15.00 16.50 1.50
45.00 25.00 20.00 21.00 1.00
50.00 25.00 25.00 25.50 0.50
How does the option premium
change as the stock price
increases?

The premium of the option price over the


exercise value declines as the stock
price increases.
This is due to the declining degree of
leverage provided by options as the
underlying stock price increases, and
the greater loss potential of options at
higher option prices.
Options

Hedging with Options


Buy same number of put option contracts as would sell
of futures
Disadvantage: pay premium
Advantage: protected if i gains

if i falls:
Additional advantage if macro hedge: avoids
accounting problems, no losses on option if i falls

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Options
Factors Affecting Premium

1. Higher strike price, lower premium


on call options and higher premium on
put options.
2. Greater term to expiration, higher
premiums for both call and put options.
3. Greater price volatility of underlying
instrument, higher premiums for both call
and put options.

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Hedging with Options

Example: Rock Solid has a stock portfolio


worth $100 million, which tracks closely
with the S&P 500. The portfolio manager
fears that a decline is coming and what to
completely hedge the value of the portfolio
against any downside risk. If the S&P is
currently at 1,000, how is this
accomplished?

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Hedging with Options

Value of the S&P 500 Option Contract =


100 index
currently 100 x 1,000 = $100,000

To hedge $100 million of stocks that move


1 for 1 (perfect correlation) with S&P
currently selling at 1000, you would:
buy $100 million of S&P put options =
1,000 contracts

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Hedging with Options

The premium would depend on the strike price.


For example, a strike price of 950 might have a
premium of $200 / contract, while a strike price of
900 might have a premium of only $100.
Lets assume Rock Solid chooses a strike price of
950. Then Rock Solid must pay $200,000 for the
position. This is non-refundable and comes out
of the portfolio value (now only $99.8 million).

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Hedging with Options

Suppose after the year, the S&P 500 is at 900


and the portfolio is worth $89.8 million (= 0.9*99.8).
options position is up $5 million (since 950 strike price)
in net, portfolio is worth $94.8 million

If instead, the S&P 500 is at 1100 and the


portfolio is worth $109.8 million.
options position expires worthless, and portfolio is
worth $109.8 million

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Hedging with Options

Note that the portfolio is protected from any


downside risk (the risk that the value in the
portfolio will fall ) in excess of $5 million.
However, to accomplish this, the manager
has to pay a premium upfront of $200,000.

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What are the assumptions of the
Black-Scholes Option Pricing
Model?

The stock underlying the call option


provides no dividends during the call
options life.
There are no transactions costs for the
sale/purchase of either the stock or the
option.
kRF is known and constant during the
options life.
Security buyers may borrow any fraction
of the purchase price at the short-term,
risk-free rate.
What are the assumptions of the
Black-Scholes Option Pricing
Model?

No penalty for short selling and


sellers receive immediately full cash
proceeds at todays price.
Call option can be exercised only on
its expiration date.
Security trading takes place in
continuous time, and stock prices
move randomly in continuous time.
Which equations must be solved to
find the Black-Scholes option price?

ln(P/X) [k RF t]
2
d1
t
d2 d1 - t

V P[N(d1 )] - Xe -k RF t
[N(d2 )]
Use the B-S OPM to find the option value
of a call option with P = $27, X = $25,
kRF = 6%, t = 0.5 years, and 2 = 0.11.

ln($27/$25 ) [(0.06 0.11 )] (0.5)


d1 2 0.5736
(0.3317)(0 .7071)
d2 0.5736 - (0.3317)(0 .7071) 0.3391

From Table A - 5 in the textbook


N(d1 ) N(0.5736) 0.5000 0.2168 0.7168
N(d2 ) N(0.3391) 0.5000 0.1327 0.6327
Solving for option value

-k RF t
V P[N(d1 )] - Xe [N(d2 )]
-(0.06)(0.5 )
V $27[0.7168] - $25e [0.6327]
V $4.0036
How do the factors of the B-S
OPM affect a call options value?
As the factor increases Option value
Current stock price Increases
Exercise price Decreases
Time to expiration Increases
Risk-free rate Increases
Stock return variance Increases
Interest-Rate Swaps

Interest-rate swaps involve the exchange


of one set of interest payments for another
set of interest payments, all denominated in
the same currency.
Simplest type, called a plain vanilla swap,
specifies (1) the rates being exchanged,
(2) type of payments, and
(3) notional amount.

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Interest-Rate Swap Contract Example

Midwest Savings Bank wishes to hedge rate


changes by entering into variable-rate contracts.
Friendly Finance Company wishes to hedge
some of its variable-rate debt with some fixed-
rate debt.
Notional principle of $1 million
Term of 10 years
Midwest SB swaps 7% payment for T-bill + 1%
from Friendly Finance Company.
Interest-Rate Swap Contract Example

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Hedging with Interest-Rate Swaps

Reduce interest-rate risk for both parties


1. Midwest converts $1m of fixed rate assets to
rate-sensitive assets, RSA, lowers GAP
2. Friendly Finance RSA, lowers GAP

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Hedging with Interest-Rate Swaps

Advantages of swaps
1. Reduce risk, no change in balance-sheet
2. Longer term than futures or options
Disadvantages of swaps
1. Lack of liquidity
2. Subject to default risk
Financial intermediaries help reduce
disadvantages of swaps (but at a cost!)
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Credit Derivatives

Credit derivatives are a relatively new


derivative offering payoffs based on
changes in credit conditions along a variety
of dimensions. Almost nonexistent twenty
years ago, the notional amount of credit
derivatives today is in the trillions.

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Credit Derivatives

Credit derivatives can be generally


categorized as credit options, credit swaps,
and credit-linked notes. We will look at
each of these in turn.

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Credit Derivatives

Credit options are like other options, but


payoffs are tied to changes in credit
conditions.
Credit options on debt are tied to changes in
credit ratings.
Credit options can also be tied to credit
spreads. For example, the strike price can be
a predetermined spread between AAA-rated
and BBB-rated corporate debt.

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Credit Derivatives

Credit options are like other options, but


payoffs are tied to changes in credit
conditions.
Credit options on debt are tied to changes in
credit ratings.
Credit options can also be tied to credit
spreads. For example, the strike price can be
a predetermined spread between BBB-rated
corporate debt and T-bonds.

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Credit Derivatives

For example, suppose you wanted to issue


$100,000,000 in debt in six months, and
your debt is expected to be rated single-A.
Currently, A-rated debt is trading at 100
basis points above the Treasury. You
could enter into a credit option on the
spread, with a strike price of 100 basis
points.

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Credit Derivatives

If the spread widens, you will, of course,


have to issue the debt at a higher-than-
expected interest rate. But the additional
cost will be offset by the payoff from the
option. Like any option, you will have to
pay a premium upfront for this protection.

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Credit Derivatives

Credit swaps involve, for example,


swapping actual payments on similar-sized
loan portfolios. This allows financial
institutions to diversify portfolios while still
allowing the lenders to specialize in local
markets or particular industries.

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Credit Derivatives

Another form of a credit swap, called a


credit default swap, involves option-like
payoffs when a basket of loans defaults.
For example, the swap may payoff only
after the 5th bond in a bond portfolio
defaults (or has some other bad credit
event).

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Credit Derivatives

Credit-linked notes combine a bond and a


credit option. Like any bond, it makes
regular interest payments and a final
payment including the face value. But the
issuer has an option tied to a key variable.

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Credit Derivatives

For example, GM might issue a bond with a


5% coupon rate. However, the covenants
would stipulate that if an index of SUV
sales falls by more than 10%, the coupon
rate drops to 3%. This would be especially
useful if GM was using the bond proceeds
to build a new SUV plant.

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Are derivatives a time bomb?

In the 2002 annual report for Berkshire


Hathaway, Warren Buffett referred to
derivatives (bought for speculation) as
weapons of mass destruction. (although
also noting that Berkshire uses derivatives).
Is he right?

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Are derivatives a time bomb?

There are three major concerns with the


use of financial derivatives:
Derivatives allow financial institutions to
increase their leverage (effectively changing
their capital), possibly to take on more risk
Derivatives are too complicated
The derivative positions of some banks exceed
their capital the probability of failure has
greatly increased

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Are derivatives a time bomb?

As usual, the blanket comments are usually


not accurate. For example, although the
notional amount of derivatives exceeds
capital, often these are offsetting positions
on behalf of clients the bank has no
exposure. In other words, you have to look
at each situation individually. Further,
actual derivative losses by banks is small,
despite a few news-worthy exceptions.

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Are derivatives a time bomb?

In the end, derivatives do have their


dangers. But so does hiring crooks to run a
bank (Lincoln S&L ring a bell). But
derivatives have changed the sophistication
needed by both managers and regulators
to understand the whole picture.

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Chapter Summary

Hedging: the basic idea of entering into an


offsetting contract to reduce or eliminate
some type of risk was presented.
Forward Markets: the basic idea of
contracts in this highly specialized market,
as well as a simple example of eliminating
risk was presented.

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Chapter Summary (cont.)

Financial Futures Markets: these exchange


traded markets were presented, as well as
their advantages over forward contacts.
Stock Index Futures: the specific
application of stock index futures was
presented, exploring their ability to reduce
or eliminate risk for equity portfolios.

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Chapter Summary (cont.)

Options: these contracts, which give the


buyer the right but not the obligation to act,
were presented, as well as an example
showing their costs.
Interest-Rate Swaps: the idea of trading
fixed-rate interest payments for floating-rate
payments was presented, as well as the
pros and cons of such contracts.

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Chapter Summary (cont.)

Credit Derivatives: we examine this


relatively new market for hedging the credit
risk of portfolios and the dangers involved.

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