Derivatives in Banking: A Platform for Teaching

Abstract

Risk management is the core business of a bank. The transformation of a riskless (to the customer) deposit account into a risky (to the bank) asset is how a bank adds value and earns a profit. Successfully managing this is risk is therefore vital to the success of a bank. Banks are subject to many forms of risk, including interest rate risk, credit risk, liquidity risk, funding risk, and others. While banks cannot eliminate risk, they can control certain areas of their exposure. This project describes an exercise that demonstrates a method of managing interest rate risk in an uncertain environment and the risk-reward tradeoff of using financial derivatives to reduce risk. The exercise is beneficial to students in the banking field as well as those interested in investments as it provides a method to actually see the advantages and disadvantages of the hedging process. This guided experiential learning process should better prepare both groups of students as they begin their chosen careers.