TAILIEUCHUNG - THE USE OF DERIVATIVES TO MANAGE INTEREST RATE RISK IN COMMERCIAL BANKS

In the past, the government often tried to ensure that we pay "a fair rate" of interest by implementing usury ceilings or limits on the rates that lenders can charge. During the 1980s there was a general trend toward eliminating or raising these limits as policy-makers reacted to the high inflation and record interest rates of the late 1970s. During the early 1990s, however, the trend reversed as some suggested that caps should be placed on credit card rates, which remained at historically high levels while other key interest rates declined significantly. On the surface, capping interest rates seems to be perfectly logical. To protect people. | 60 Investment Management and Financial Innovations 2 2004 The Use of Derivatives to Manage Interest Rate Risk in Commercial Banks Soretha Beets1 Abstract Interest rate risk can be seen as one of the most important forms of risk that banks face in their role as financial intermediaries. Innovation in financial theory increased computerization and changes in foreign exchange markets credit markets and capital markets have contributed to the need to supplement traditional methods to measure and manage interest rate risk with more recent methods. Interest rate risk can thus be controlled optimally by using of derivatives along with traditional methods in order for banks to experience less interest rate uncertainty and to increase their lending activities which can result in greater returns and higher overall profitability. 1. Introduction A commercial bank can serve as a financial intermediary in two ways. First it can serve as a broker in which it channels funds from surplus units to deficit units without modifying the rate-sensitivities. Second it can serve as an asset transformer in which it modifies the rate sensitivities to appease the deficit units. The bank s choice will depend on the uncertainty of interest rates and the cost of funds Madura Zarruk 1995 . Interest rate risk is one of the most important forms of risk that banks face in their role as financial intermediaries Hirtle 1996 . Nowadays apart from traditional ways to measure and manage interest rate risk derivatives are also used. Banks participate in derivative markets especially because their traditional lending and borrowing activities expose them to financial market risk and doing so can help them to hedge or reduce risk and to achieve acceptable financial performance Brewer Moser 2001 . In section 2 the importance the definition and the most important sources of interest rate risk will be discussed. Section 3 deals with the traditional approaches to interest rate risk management. Section 4 handles

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