The Moorad Choudhry Anthology, + Website

CHAPTER 2Derivative Instruments and Hedging

“The spread of secondary and tertiary education has created a large population of people, often with well‐developed literary and scholarly tastes, who have been educated far beyond their capacity to undertake analytical thought.”

—Peter Medawar, quoted in Richard Dawkins,The Greatest Show on Earth: The Evidence for Evolution, Bantam Press, 2009.

Reiterating our “95–5” rule from Chapter 1, most customer finance requirements – whether long or short of cash – can be met with essentially plain vanilla products. That said, some financial market derivatives have made a positive contribution to society; a good example of this would be the humble interest‐rate swap, without which banks in many countries would not be able to offer fixed‐rate residential mortgages or corporate loans to their customers.

This illustrates the principal reason why derivative instruments are “popular” – they enable an institution to hedge risk exposure. An inability to hedge exposure is the main impediment to a bank offering a customer a desired product such as a fixed‐rate loan. So in this chapter we present previous book extracts that are pertinent to an understanding of the main derivative instruments and the main hedging applications that such products are used for.

The new material in the chapter includes an up‐to‐date discussion on using the asset swap measure to ascertain bond relative value. We also consider the impact of the 2008 crash on the hitherto ...