In Chapter 9 we have learned that derivatives (an instrument or contract that derives its value from another underlying asset, instrument, or contract) when used prudently can represent a cost- effective means to manage risk. Banks can replicate on-balance sheet transactions with off balance sheet contracts.

The most common interest rate derivatives are:

• Interest rate swaps, caps, and floors.
• Financial futures contracts
• Credit default swaps.

I would like you to pick one of the following situations below and tell me how you might use a derivative to reduce the risk that is faced by the Bank. I would like a good explanation of the derivative that you plan to use and how it will work to solve your banks problem.

1. Associated Bank, National Corporations management team has determined that market interest rates are going to decrease rather dramatically. They need for liquidity purposes need to sell a portion of their bond portfolio to meet depositors needs for coming quarter. However, the bonds they wish to sell if held for the next few months could be sold for a profit. How could the Bank get their liquidity and profit both?