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    How can swaps reduce the risks of debt, futures, hedging

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    1. How can swaps be used to reduce the risks associated with debt contracts?
    2. Investors could use futures contracts and swap contracts. Of the two types of contracts, which one has a higher default risk? Why?
    3. What is the difference between hedging and speculating?
    4. An issue that comes up in hedging is the risk, especially when cross hedging. Why does cross-hedging lead to basis risk?
    5. The forward and future markets are regulated. What agency is the chief regulator of futures markets? Why is federal regulation necessary?

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    Solution Preview

    1. How can swaps be used to reduce the risks associated with debt contracts?

    SWAP CONTRACT: Agreement to exchange payments in the future.

    Swaps can be used to reduce risk by locking in a fixed rate when you have exposure to a floating rate. By swapping debt terms (fixed for variable), your exposure to future interest rate fluctuations is eliminated, eliminating interest rate risk. You agree to pay the fixed interest payment and the other party agrees to pay the variable rate payment.

    2. Investors could use futures contracts and swap contracts. Of the two types of contracts, which one has a higher default risk? Why?

    FUTURES CONTRACT: Forward contract with terms standardized for trading exchanges to facilitate trading of instrument.

    A futures contract is standardize in terms of quantity and quality and for a specific delivery date and are traded on futures exchanges, which acts as a middle man between the buyer and seller. The expectations are ...

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