7 • 1

CHAPTER

7

INTEREST RATE AND FOREIGN

EXCHANGE RISK MANAGEMENT

PRODUCTS: OVERVIEW OF

HEDGING INSTRUMENTS AND

STRATEGIES

Richard C. Stapleton

Strathclyde University, United Kingdom

Marti G. Subrahmanyam

New York University

CONTENTS

7.1 Introduction 1
(a) Forward Contracts 2
(b) Futures Contracts 2
(c) Option Contracts 2
7.2 Foreign Exchange and Interest
Rate Volatility 3
7.3 Hedging Foreign Exchange and
Interest Rate Risk 5
(a) Forward and Long-Term Loan
Contracts 6
7.4 Hedging with Foreign Exchange
and Interest Rate Derivatives 6
7.5 Hedging with Futures/Forward
and Option Contracts 7
7.6 Hedging Foreign Exchange and
Interest Rate Risk with Forward
Contracts 9

7.7 Foreign Exchange Forward

Contracts 9

7.8 Forward Rate Agreements 10

7.9 Foreign Exchange Options 11

(a) Interest Rate Options 12

7.10 Interest Rate Swaps 14

7.11 Interest Rate Caps and Floors 15

(a) Foreign Currency Swaps,

Caps, and Floors 16

7.12 Foreign Exchange and Interest

Rate Risk and Hedging

Instruments 17

7.13 Summary 17

SOURCES AND SUGGESTED

REFERENCES 18

7.1 INTRODUCTION. Most economic agents, such as firms and investors, face
foreign exchange or interest rate risk when they have future cash inflows or outflows
arising from their capital investments, operations, and financing. The main factors
that determine the magnitude of these flows, foreign exchange rates, and interest
rates, both real (i.e., net of inflation) and nominal, are volatile. Indeed, there is a close