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
How is a futures hedge closed out?
- If borrowing, BUY same number of futures
If lending, SELL same number of futures
And receive the gain/loss - Borrow money from the bank at spot rate
What is the equation for gain/loss on settlement of futures?
(Sell price - buy price) / 100 x #contracts x contract value x 3/12
How do you calculate the number of futures needed?
Borrow value / contract value x borrowing period /3
What is the net cost of borrowing using futures?
Cost of borrowing from the bank -/+ profit/loss from futures settlement
What are the 2 main pros of interest rate futures?
- Hedge away downside risk
- Can be closed out at any time
What are the 4 main cons of futures?
- Remove upside potential
- Can be over/under hedged
- Basis risk if futures maturity date ≠ borrowing start date
- Most post margin to the exchange
What are interest rate guarantees?
OPTIONS on FRAs
What does a call option on an FRA do in effect?
Provides a maximum interest rate for borrowers
What does a put option on an FRA do in effect?
Provides a minimum interest rate for lenders
What are call vs put options?
Allow the holder to buy / sell FRAs and so pay/ receive interest at a fixed rate
When would a borrower exercise a call option on an FRA?
If the market interest rate has risen above the FRA rate
What is a collar for a borrowing company?
Buying a call option and selling a put option in order to set an interest rate cap and a floor
What are exchange traded interest rate options?
OPTIONS on interest rate futures
Does a borrower buy call or put options on futures options?
Puts (option to sell futures)
Does a lender buy call or put options on futures options?
Call (option to buy futures)
How do you calculate the number of futures contracts needed to sell to borrow?
Borrowing value / contract value x borrowing period / 3
How do you calculate the premium paid on a futures option?
contracts x contract value x premium % x 3/12
What is the outcome of a borrowing futures option if the market rate rose above the strike price?
- SELL FUTURES (had put option to sell)
- Close out buy BUYING the same number of futures
- Borrow from bank at spot rate
What is the outcome of a borrowing futures option if the market rate fell below the strike price?
Let the option lapse and borrow money from the bank at spot rate
What is the main pro of a traded interest rate option?
Protects from downside risk and allows to benefit from upside risk
What are the 3 cons of traded interest rate options?
- Option premium can be expensive and must be paid now
- May under / over hedge as standardised contracts
- Exposed to basis risk
What are the 5 steps to calculate the two legs of an interest rate swap?
- Set out the rates each company would pay and could pay and calculate the total rates in each case
- Calculate the potential benefit by finding the difference between the two totals
- Split the saving between the two companies in relation to the borrowing amounts
- Calculate each company’s overall effective rate by removing the saving from their original intended rate
How do you set up the variable leg on an interest rate swap?
Assume A wants to pay variable and B wants fixed
- Force A to arrange fixed borrowings and B to arrange variable borrowings with the bank
- A pays B a variable rate and B pays A a fixed rate, to achieve the net interest position
In swap terminology, which is the ASK and which is the BID rate?
The BID rate is higher, as you are paying more interest
What are the 5 pros of interest rate swaps?
- Transaction costs are low
- Flexible in size
- Can both borrow to lead to lowest mutual borrowing costs
- Allow capital restructuring without the need for new debt
- Company taking on the fixed rate is immune to interest rate rises
What are the 4 cons of interest rate swaps?
- The other party may default
- The company who takes on variable rate is exposing to adverse movements
- Might be difficult to find a swap partner so need to go through a bank and pay fees
What does a currency swap involve?
The swap of both principles and interest payments, benefiting from favourable interest rates available in the others currency
