Risk management - Essay Example

Banks therefore, make investments in various areas in order to be able to reduce the adversity risks due to price movements in a security it trades in simply by taking a position that will offset the related security. The Bank of England has played a very pivotal role in the economic development of the country primarily, by diversifying risks for all the economic agents. As with any other bank, the greatest financial risk it faced was the interest rate risk. During the last financial crisis i.e. the financial crisis of the year 2007, banks were able to employ certain strategies before and after the crisis which were geared towards mitigating them from such risks brought about by the crisis (Dietrich, 2006).

The Bank of England was among those banks which were affected by this crisis and had to therefore apply a risk management theory such as the Forward Trade Agreement before and after the crisis to mitigate itself from the various forms of interest rate exposure. This is because, fluctuations in its interest rate had the capability of altering its interest income and value thus, making the management of interest rate risk using hedging methods vital to its success. The Asset and Liability Committee of the Bank of England as the body tasked with ensuring that interest rates are properly maintained and managed to avoid any interest rate risk exposures before and after the financial crisis, applied the following strategies to hedge out the risk.

Hedging strategies/methods used a. The use of interest rate swaps Interest rate swaps refers to a type of highly popular instrument as a liquid financial derivative that is used by two parties in the exchange of interest rate cash flows. The two parties agree exchange the cash flows of the interest rate basing their agreement on a specified notional amount obtained from a rate that is fixed to a floating rate or even vice versa. The same can also be from a floating rate to any other rate. A clear understanding of how the Bank of England used it would be to consider the two parties agreeing to pay a rate fixed or floating, denominated in the pound to the other party.

The rate was then multiplied by a notional principal amount in the US$. The outcome was given an appropriate accrual value for the day count convention. If both the legs featured in similar currency, the notional amount was typically not exchanged between the parties but, instead used to calculate the cash flow sizes to be exchanged (Dietrich, 2006). The notional amount was exchanged if the legs appeared in different currencies. A more common interest rate swap in use has been the LIBOR. With the LIBOR there is a ‘payer’ and a ‘receiver’.

One party pays the LIBOR plus a trade percentage plus the rate offered by the other party in this kind of trade activity. Since interest rate swaps are over-the-counter (OTC) instruments, the various varieties the bank could have used include: floating for floating rate swap with different currencies, the floating for floating rate swap with similar currencies, and the fixed for fixed rate swaps. Regardless of the changes in the LIBOR rates in future, the rolling deposit value will always equal the notional amount at the reset date. b. Used of forward derivatives The bank also used derivatives during the period to manage the risks.

A particular one used was the forward contracts. In the management