13. Interest Rate Risk Flashcards
What is interest rate risk?
The risk to a company’s profitability/cash flow resulting from changes in interest rates
What are the 3 main elements that affect interest rate risks?
- Borrowing at a fixed rate in times of falling interest or borrowing at a variable rate in times of rising interest rates
- Being exposed to rising interest rates when re-financing
- Depositing at a variable rate in time for falling interest or depositing at a fixed rate in times of rising interest
What is the risk free rate?
A benchmark variable rate that is referenced by much variable rate debt
What are the 3 internal methods of hedging interest rate risk?
- Matching (investments and loans)
- Smoothing (mix fixed and floating)
- Netting (aggregate net exposure)
What are over the counter (OTC) hedging instruments?
Bespoke hedging instruments to the company’s needs
What are the 3 OTC hedging instruments?
- Forward Rate Agreements (FRA)
- Interest Rate Guarantees
- Interest Rate Swaps
What are exchange traded hedging instruments?
Standardised instruments
What are the 2 Exchange Traded Instruments?
- Interest Rate Futures
- Traded Interest Rate Options
What is a Forward Rate Agreement?
OTC contracts which are used to fix the effective rate of interest to be paid on future short term borrowings (receive difference between spot and forward rate at settlement)
Who buys an FRA and who sells one?
Borrowers buy FRAs and lenders sell FRAs
What happens on the settlement date of an FRA?
Net settlement of the FRA: (Spot rate - FRA rate) x nominal value x #months/12
Borrow money from bank @ spot rate
What are the 2 main pros of FRAs?
- FRAs hedge away downside risk
- FRAs are tailored to the investor
What are the 3 main cons of FRAs?
- FRAs usually only available on loans >£500k and periods of < 1 year
- Remove upside potential
- Difficult to exist
What are interest rate Futures?
Standardised, traded hedging instruments that attempt to set fixed rates for future borrowing/ lending
What is the price of a future?
100 - r (r being the fixed interest rates)
Who buys a future and who sells one?
Borrowers sell futures now (and buy on date that borrowing starts) and lenders buy futures now (and sell on date that lending starts)
What futures start date should be chosen?
The first date after the date that borrowing/lending will start