20

Question 1

what is interest rate risk

Answer 1

this is the risk arising from changes interes rate onloan/borrowing

• variable interest on existing loan/deposit
• when you want to borrow/ deposit in the future

Question 2

What are the 3 theory to the term structure of interest rates

Answer 2

• Liquidity preference theory
• expectations theory
• market segment theory

Question 3

what is liquidity preference theory?

Answer 3

It’s that investors prefer liquid investments.

• Shorter the period of time till maturity, the more liquid the investment
• If investors invest for longer, they’ll demand a higher yield

Question 4

what is the expectations theory?

Answer 4

shape of curve is influenced by expectations of changes in Short Term interest rates in the long term.

Question 5

what is the market segmentation theory?

Answer 5

Suggests there are 2 different groups of investors who invest in short and long term

therefore the demand and supply relationship for short is different to long term debt

Question 6

what are the ways of hedgin against interest rate risk?

Answer 6

Smoothing
matching
asset and liability management (gap exposure)
interest rate guarantees
Derivatives ( futures and options, swaps)
Forward rate agreements

Question 7

what is forward rate agreement

Answer 7

contract to fix an interest rate that will apply in the future

Question 8

FRA: 3-6 FRA at 6%-5%

Answer 8

(3) - rate starts in 3months time.
(6) rate ends in 6 months time

difference between is the period the deposit or the borrowing.

(6-5%) are the interest rate ANNUALLY
high 6- borrowing rate
low 5% deposit rate

and OFC Bank always will win

Question 9

how is FRA done with bank regardless of position

Answer 9

1) interest on the loan paid to bank
2) (Additional payment of % difference in the interst that had actually decreased ) OR have it decreased with the difference)

Question 10

What is the aim of forward rate agreement

Answer 10

: The aim of a forward rate agreement (FRA) is to lock the company into a target interest rate and hedge both adverse and favourable interest rate moveme

Question 11

what is an interest rate guarantee

Answer 11

An interest rate guarantees (IRG) is more expensive than an FRA as one has to pay for the flexibility to be able to take advantage of favourable interest rate movements

Question 12

If you sell a futures contract you have a contract to borrow OR lend?

Answer 12

If you sell a futures contract you have a contract to borrow money (not lend). What you are selling is the contract to make interest payment

Question 13

what is basis risk

Answer 13

Basis risk is the possibility that movements in the currency futures price and spot price will be different.

It is one of the reasons for an imperfect currency futures hedge

Question 14

what is basis

Answer 14

The difference between the price of a futures contract and the spot price on a given date is known a basis

Question 15

Which one is more expensive- cost of Interest rate floor or collar?

Answer 15

Interest rate floor

Question 16

what is negative gap

Answer 16

A negative gap is when interest sensitive liabilities maturing at a certain time in the future are greater than interest sensitive assets maturing at the same time. In this situation the business will suffer a loss if interest rates rise.

Question 17

what is positive gap

Answer 17

A positive gap is when interest sensitive assets maturing at a certain time in the future are greater than interest sensitive liabilities maturing at the same time. In this situation the business will suffer a loss if interest rates fall.

Question 18

what is gap exposure

Answer 18

Gap exposure can be used by any company to determine the likely impact on the company of interest rate changes. It is often used by financial institutions like banks who often have interest sensitive assets (money lent out) and interest sensitive liabilities (money deposited with the bank).

Question 19

what is matching

Answer 19

Matching is the idea that every future cash outflow arising from interest rates is matched by a future cash inflow from interest rates.

In a practical sense this means that if a company has a surplus of cash that it deposits at a variable rate of interest then it should also borrow at a variable rate of interest. It is matching the type of interest that it earns when money is deposited with the type of interest it will pay when money is borrowed. The company will therefore be less exposed to interest rate changes than would otherwise be the case.

Question 20

what is smoothing

Answer 20

This is the idea that a company should have some fixed rate borrowings and some variable rate borrowings. By doing so it seeks to strike a balance between being exposed to a rise in interest rates and being able to take advantage of a fall in interest rates.

If all of the company’s borrowings are at a variable rate then when interest rates rise the company is completely exposed. If, however, all of the company’s borrowings are at a fixed rate then when interest rates fall the company will be unable to take advantage of this.

Question 21

what is asset and liability management

Answer 21

Gap exposure was identified earlier as a problem. Asset and liability management seeks to reduce interest rate risk by seeking to avoid either a negative or positive gap.

To achieve this a company will seek to have approximately the same amount of interest sensitive assets and interest sensitive liabilities maturing at the same time in the future.

Question 22

what is FRA

Answer 22

An FRA is a forward contract on an interest rate for a future short-term loan or deposit. An FRA can be used to fix the interest rate on a loan or deposit starting at a date in the future.

It is a contract relating to the level of a short-term market interest rate, such as three month LIBOR or six-month LIBOR. FRA’s are normally for amounts of more than £1 million.

FRA’s are typically quoted as follows:
3 – 7 FRA at 4.00% - 3.80%

The 3 and 7 refer to the months until the FRA starts and the months until the FRA ends. In this case the FRA will start in 3 months’ time and end in 7 months’ time.
The FRA is therefore an agreement for a period of 5 months.

Question 23

WHAT IS INTEREST RATE GUARANTEE

Answer 23

An interest rate guarantee is an option to enter into an FRA agreement.
Like all options this means that a company has a right to enter into an FRA agreement but does not have the obligation to do so.

A company taking out an IRG is therefore able to protect against adverse risk (when borrowing this is the risk that interest rates will risk) whilst at the same time take advantage of favourable interest rate risk. If interest rates fall the option can be allowed to lapse.
An IRG is expensive! A premium will be payable in advance.

The premium is payable irrespective of whether or not the option is exercised or allowed to lapse.

Question 24

What is interest rate futures

Answer 24

These are fixing instruments which are very similar to FRA’s. They protect against adverse interest rate risk but do not allow a company to take advantage of favourable interest rate risk.
The key differences between futures and FRA’s are:
▪ Futures are standardised contracts whereas FRA’s are tailor made.
▪ Futures are traded on a futures exchange. FRA’s cannot be traded.

Question 25

how do you set up interest rate futures hedge

Answer 25

▪ If borrowing – sell an interest rate future when setting up the hedge and buy an interest rate future when closing out the hedge

▪ If depositing – buy an interest rate future when setting up the hedge and sell an interest rate future when closing out the hedge