23-47 Managing interest rate risk for less creditworthy FI's by running a cap/floor book may require the backing of external guarantees such as standby letters of credit because of the nature of the options.

Question

Quizplus · Accepted Answer

Cap/floor options are financial derivatives that provide a hedge against interest rate risk. However, they are not without risks themselves, particularly for less creditworthy financial institutions. Running a cap/floor book may require the backing of external guarantees, such as standby letters of credit, to mitigate the risk of default. This is because options represent a right, but not an obligation, to buy or sell an underlying asset. In the event that the option is exercised, the counterparty may be exposed to significant losses if the institution is unable to fulfill its obligations. Therefore, external guarantees may be necessary to provide assurance of payment and reduce counterparty risk.

23-47 Managing Interest Rate Risk for Less Creditworthy FI's by Running