starting in the 1970s and increasingly in the 1980s and 1990s the world became a ris 638337

Starting in the 1970s and increasingly in the 1980s and 1990s, the world became a riskier place for financial institutions. Swings in interest rates widened, and the bond and stock markets went through some episodes of increased volatility. As a result of these developments, managers of financial institutions have become more concerned with reducing the risk their institutions face. Given the greater demand for risk reduction, the process of financial innovation described in Chapter 19 came to the rescue by producing new financial instruments that help financial institution managers manage risk better. These instruments, called financial derivatives, have payoffs that are linked to previously issued securities and are extremely useful risk reduction tools. In this chapter we look at the most important financial derivatives that managers of financial institutions use to reduce risk: forward contracts, financial futures, options, and swaps. We examine not only how markets for each of these financial derivatives work but also how each can be used by financial institution managers to reduce risk.