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Hedging with derivatives

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Because of your impending MBA, you are the chair of the pension committee at the hospital where you work. Itââ?¬â?¢s a small, young hospital with a $40 million pension account-50% invested in an international bond index fund, and 50% invested in a S & P 500 index fund. Your economics/financial consultant expects a rise in interest rates and constant stock prices during the next two years.
a. Cite a strategy using derivatives to hedge against the possible rise in interest rates.
b. Explain how covered calls (long calls) can be used to create additional income on the equity portfolio during periods when the market is flat, i.e., cyclically constant stock prices.

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Solution Summary

using derivatives to hedge against the possible rise in interest rates; use of covered calls to generate additional income

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A forward rate agreement (FRA) could be used to hedge against interest rate hikes. If the pension fund foresees a need to borrow in the future, in order to meet its obligations, it would want to fix the interest rate at today's lower rate rather than borrow the money later at the higher rate. The hospital's pension fund would enter into an agreement with a FRA dealer that specifies a fixed interest rate. If at the ...

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