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FM > 9. FM - Managing Financial Risk - Interest rates and other risks > Flashcards

9. FM - Managing Financial Risk - Interest rates and other risks Flashcards

1
Q

Define a forward?

A

A forward is a binding agreement to buy or sell (or borrow or lend) something in the future at a price agreed today

it is a tailor made agreement between 2 parties and so can be for any amount of any product at any point in time

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2
Q

What is the potential problem with a forward?

A

It is tailor made agreement between 2 parties, and requires a physical delivery of the goods/money
So it can be awkward to cancel if the need arises

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3
Q

What is a future?

A

Just a forward contract that has been standardised in terms of delivery date and quantity

The contract which guarantees the price is separated from the transaction itself, allowing the contracts to be easily traded

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4
Q

Why are futures easily traded?

A

As the contract which guarantees the price is separated from the transaction itself

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5
Q

How to businesses use futures to protect against price rises and price falls?

A

A bus will buy the future today and sell it at the expiry date (when the price will be the same as the spot price

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6
Q

What is an option

A

Gives the right but not the obligation to buy or sell (borrow or lend) a specific quantity of an item at a predetermined price within a stated period (American style) or a fixed date (European style)

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7
Q

What is an American style right?

A

Gives the right but not the obligation to buy or sell (borrow or lend) a specific quantity of an item at a predetermined price within a stated period (American style) or a fixed date (European style)

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8
Q

What is a European style right?

A

Gives the right but not the obligation to buy or sell (borrow or lend) a specific quantity of an item at a predetermined price on a fixed date (European style)

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9
Q

What are the 2 options for an option

A

Exercise if the exercise price is better than the spot rate

Abandon if the exercise price is worse than the spot rate

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10
Q

What is the fee known as that a buyer of an option pays to the writer?

A

Option premium

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11
Q

What is a call option?

A

An option to buy something (or to lend money)

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12
Q

What is a put option?

A

An option to sell something (or to borrow money)

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13
Q

What is a negotiated or ‘over the counter’ option?

A

Tailor made agreement between 2 parties

It can be for any amount pr any date

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14
Q

What are traded options?

A

A standardised derivative which can be traded (i.e. there is no requirement for physical delivery)
Standardised vision of an OTC option

Means the options contract is separated from transaction itself to allow the contract to be traded

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15
Q

TYU2: B plc manufactures fruit juice cartons for sale in supermarkets.
On 1 June it identifies that a quantity of OJ will be needed on 31 aug
A call option on OJ is identified with an exercise price of £1,600 and a premium of £30
Show the position if the call option is purchased and the price of OJ turns out to be £1,700

A

price of juice on open market (1,700)

Option position if exercised

  • > Buy at 1,600
  • > Sell at 1,700

Profit on option 100
So exercise
Option premium (30) \
Cost = (1,700 + 100 - 30) = (1,630)

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16
Q

TYU2: B plc manufactures fruit juice cartons for sale in supermarkets.
On 1 June it identifies that a quantity of OJ will be needed on 31 aug
A call option on OJ is identified with an exercise price of £1,600 and a premium of £30
Show the position if the call option is purchased and the price of OJ turns out to be £1,550

A

price of juice on open market (1,550)

Option position if exercised

  • > Buy at 1,600
  • > Sell at 1,550

Loss on option (50)
So abandon = Nil
Option premium (30)
Cost = (1,550+ Nil - 30) = (1,580)

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17
Q

What is the pooling of assets and liabilities?

A

Risks may be netted off where both assets and liabilities are subject to interest rate risk

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18
Q

What does FRA stand for?

A

Forward rate agreement

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19
Q

What is an FRA?

A

A commitment to an interest rate on a future loan
Like a normal forward, it is a tailor made product, which can be for any amount of loan for any duration
However, like a future, the contract which guarantees the interest rate is separate to the underlying loan transaction

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20
Q

Describe an FRA

A

If the company has a requirement to borrow money in the future.
To offset the risk of the interest rate, the company enters into an FRA
- Capital amount is borrowed and interest is paid on the loan to the normal way
- If the interest is greater than the agreed forward rate the bank supplying the FRA contract pays the diff to the company
- If the interest is less than the agreed forward rate the company pays the diff to the bank supplying the FRA

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21
Q

What is the outcome of an FRA

A

The company ends up suffering a fixed rate of interest

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22
Q

What is a 5-8 FRA

A

An FRA on a notional 3 month loan/ despot starting in 5 months time

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23
Q

What is an FRA prices at 3.2 - 2.6

A

Would effectively fix borrowing cost at 3.2% or investment return at 2.6%

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24
Q

Define ‘selling an FRA’

A

Fixes the interest received on a deposit

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25
Q

Define ‘buying an FRA’

A

Fixes the interest paid on a loan

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26
Q

What does IRF stand for?

A

Interest rate futures

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27
Q

What is an IRF?

A

Operate in a v similar way to FRA, however these are standardised amounts, starting on predetermined dates

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28
Q

TYU3: E plc’s fin projections show an expected cash deficit in 2 months’ time of £8m, which will last for approx 3 months
It is now the 1 Nov 20X4
The treasurer is concerned that interest rates may rise before 1 Jan X5
The treasurer has identified a suitable FRA: a 205 DRA at 5.00 - 4.70
Required
Calculate the interest payable if, in 2 months’ time, the market rate is 7%

A

The FRA:
Interest payable
at 7%: 8m x 0.07 x 3/12 = £(140k)
Compensation receivable (balance) = £40k
Locked into the effective interest rate of 5% = (100,000)
= 8m x 0.05 x 3/12

In this case, the comp is protected from the rise in interest rate but hasn’t been able to benefit from fall in interest rate
A FRA hedges against both favourable and unfavourable movements

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29
Q

TYU3: E plc’s fin projections show an expected cash deficit in 2 months’ time of £8m, which will last for approx 3 months
It is now the 1 Nov 20X4
The treasurer is concerned that interest rates may rise before 1 Jan X5
The treasurer has identified a suitable FRA: a 205 DRA at 5.00 - 4.70
Required
Calculate the interest payable if, in 2 months’ time, the market rate is 4%

A

The FRA:
Interest payable

at 4% 8m x 0.04 x 3/12 = (80k)
Compensation payable (balance) = £(20)k
Locked into the effective interest rate of 5% = (100,000)
= 8m x 0.05 x 3/12

In this case, the comp is protected from the rise in interest rate but hasn’t been able to benefit from fall in interest rate
A FRA hedges against both favourable and unfavourable movements

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30
Q

What is the outcome of an IRF?

A

The company ends up suffering a fixed rate of interest

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31
Q

What is an interest rate futures are quoted at 100 - expected market reference rate

A

The interest rate would be the difference

.e. a 95.5 would imply an interest rate of 4.5%

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32
Q

What does it mean to sell a futures contract?

A

It fixes the interest paid on the borrowing

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33
Q

What does it mean to buy a futures contract?

A

It fixes the interest received on deposits

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34
Q

What must the number of contracts cover?

A
  • Size of the loan/ deposit

The length of the loan/deposit

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35
Q

How do you calculate the number of contracts?

A

= (loan or deposit amount / contract size ) x (loan or deposit period in months / 3 months)

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36
Q

What is an interest rate option?

A

Gives the buyer the right, but not the obligation, to borrow/lend at an agreed interest rate at a future date

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37
Q

What are over the counter interest rate options?

A

These are tailor made agreements between 2 parties, that give the party buying the option, the right but not the obligation to borrow (a put option) or lend (call option) at a fixed rate

Like all options, they require a premium to be paid up front, regardless of whether the option is exercised or not

38
Q

TYU4: A treasurer plans to borrow £1m in June for a period of 3 months
He therefore sells 2 3-month £500k sterling June IRFs at 95 each

Show the impact of this hedge if the interest rates on the expiry date are 6.5%

A

Interest on borrowing at the market rate:
(1m x 3/12 x 6.5%) = £16,250

Futures position
Sell price 95
Buy price 93.5
Profit = 1.5%

Total profit on future
£5m x 2 x 3/12 x 1.5% = £3,750

Net cost = £16,250 + £3,750
= £12,500

39
Q

What is a strike price?

A

Price which an indiv holder has the right to buy (call option) or sell (put option) one futures contract on or before the expiry of the option at

40
Q

What is a call option?

A

Right to buy

41
Q

TYU5: At the end of March, M plc decides to invest $3m in June for 6 months.
The treasurer is concerned that interest rates will fall in the intervening period and notes that 3month June dollar interest rate futures are trading at 94.5. A standard contract size is $1m.
On 30 June, interest rates had fallen to 5%
Show how many futures contracts are needed and how they could have been used to hedge M plc’s risk exposure

A

M plc will need to buy (because investing)
Number of contract = (loan or deposit amount / contract size) x (Loan or deposit in period in months / 3 months)
Number of contracts = ($3m/ $1m) x (6m/3m)

Number of contracts = 6

Expected interest rate in June is 100% - 94.5% = 5.5%
Expected interest on the inv would then be
$3m x 0.055 x 6/12 = $82.5k

if interest rate falls to 5%
$3m x 0.050 x 6/12 = $75k

Overall, this is a loss of $82.5k- $75k = $7.5k

However, when this will be netted off by the gain when the position is closed out by selling 6 June futures

  • > The futures contracts will rise in price by 0.5% (to 95)
  • > Treasurer will therefore gain by $1m x 6 x 3/12 x 0.005 = $7.5k
42
Q

How do you know what strike price to pick?

A

In the exam, you will be given a table showing premiums payable at a range of strike prices.
Normally the examiner will tell you which strike price to pick

43
Q

How do you know what strike price to pick?

A

In the exam, you will be given a table showing premiums payable at a range of strike prices.
Normally the examiner will tell you which strike price to pick
If he doesn’t, you should pick the strike price closest to the current spot rate

44
Q

What is your intention when you purchase put options?

A

Intention to borrow

45
Q

What is your intention if you purchase call options?

A

Intention to invest

46
Q

Talk through the working of a traded interest rate option

A
  • The capital amount is borrowed on the open market and interest is paid on the loan in the normal way
  • If the interest rates rise, the option is exercised, therefore the more expensive cost of borrowings is offset by a profit on the futures contract
  • If interest rates fall, the option is allowed to lapse and the company therefore benefits from a cheaper cost of borrowing
47
Q

When would a traded interest rate option be used?

A

If a company is intending to borrow money i the future

To offset the risk of an interest rate rise, the company buys a put option (right ro sell) on a futures contract

48
Q

What is the outcome of a traded interest rate option?

A

The company ends up with an interest rate no higher than the guaranteed maximum - but which could be lower if rates fall

49
Q

Give some examples of standardised products.

Describe what this means for them

A

Futures
Traded options

They come in a standard size with standard expiry dates

50
Q

Why are hedges not perfectly efficient for futures and traded options

A

They are standard sizes with standard expiry dates (i.e. standardised products) so may be inefficient for 2 reasons
- Rounding the number of contracts
> if the transaction isn’t an exact number of contracts, then it must be rounded. So an element of risk remains
- Closing out before the expiry date
> if the transaction occurs (and the future is closed out) before the expiry date, the future prices may not exactly match the spot rate at the date it is closed out. This diff (known as basis risk) will mean that the hedge is imperfect.

51
Q

Why is rounding the number of contracts a reason that standardised products are not perfectly hedged?

A

if the transaction isn’t an exact number of contracts, then it must be rounded. So an element of risk remains

52
Q

Why does closing out before the expiry date a reason that standardised products are not perfectly hedged?

A

if the transaction occurs (and the future is closed out) before the expiry date, the future prices may not exactly match the spot rate at the date it is closed out. This diff (known as basis risk) will mean that the hedge is imperfect.

You will not need to calc the basis risk, but you may be required to identify it or explain what it is

53
Q

What is the basis risk?

A

if the transaction occurs (and the future is closed out) before the expiry date, the future prices may not exactly match the spot rate at the date it is closed out. This diff is known as basis risk

It will mean that the hedge is imperfect

54
Q

What is a basic swap?

A

An agreement whereby 2 parties agree to swap a floating stream of interest payments for a fixed stream of interest payments and vice versa

There is no exchange of principle

The parties involved are termed ‘counter parties’

55
Q

What is another name for a basic swap?

A

Plain vanilla swaps

56
Q

What are the parties involved in a basic swap known as?

A

Counter-parties

57
Q

Describe the scenario for a basic swap

A

Comp A will want to borrow at a fixed rate, but has been offered a relatively good deal on a variable loan
Comp B will want to borrow at a variable rate, but has been offered a relatively good fixed rate loan

Instead of the companies borrowing as they want

  • A will borrow at variable rate and B borrows at fixed rate
  • B will make variable interest payment to A and A make fixed payments to B- thereby they effectively swap interest payments
58
Q

How do you calculate the payments for a basic swap?

A
  1. Establish the total benefit be gained from the swap (the reduction in the total interest rate paid by doing the swap)
  2. Establish the final rates that can be achieved by each party, by splitting the benefit between them (equally unless told otherwise)
  3. Establish the payments between the parties that will achieve this result
59
Q

What are the main reasons for swaps?

A
  • Can be used to hedge against adverse movement in interest rates
  • A swap can eb used to obtain cheaper finance. Should result in a comp being able to borrow what it wants at a better rate under a swap arrangement, than borrowing it directly itself
  • Swaps can run up to 30 years, so preferable to futures for LT borrowing
  • Transaction costs involved in a swap may be cheaper than refinancing costs
60
Q

What are the disadvantages of swaps?

A
  • Counterparty risk (the risk the counter party will default)
  • Market risk (the risk of an adverse movement in interest or exchange rates)
  • Transparency risk (the risk that the accounts may be misleading)
61
Q

What is counter-party risk?

A

The risk the counter party will default

62
Q

What is market risk?

A

The risk of an adverse movement in interest or exchange rates

63
Q

What is transparency risk?

A

Risk that the accounts will be misleading

64
Q

What can help protect companies that have significant stock market portfolios and why?

A
  • Futures and traded options are available to protect against this
    Risk is that they are subject to the risk of the stock market falling
65
Q

What is an index future?

A

An index future is a futures contract whose value depends on the value of the FTSE100 Index

66
Q

Describe how index futures can help protect companies with significant stock market portfolios

A
  • if a company has a portfolio of shares which it will need to sell in the future
  • To protect against a fall in the market, the comp will sell index futures
  • Later on the portfolio is sold on the open market and the futures position is closed out (futures contracts are bought back)
  • If the market has fallen, the loss in value of the portfolio is offset by the profit on the futures contract
  • If it has risen, the increased value of the portfolio is offset by a loss on the futures contract
67
Q

What is the outcome of index futures

A

Regardless of what happens to the FTSE100, the company receives a guaranteed value for its portfolio

68
Q

What is the terminology for what the index futures are quoted in?

A

Index futures are quoted in ‘points’ (just like the stock market index)

69
Q

What is the terminology for what the index futures are quoted in?

A

Index futures are quoted in ‘points’ (just like the stock market index)

70
Q

What is the contract size of an index future?

A

Contract size is always equal to the futures price x £10 (i.e. if the futures price stands at 4,500 points, then each future contract will cover a value of £45k)

71
Q

What is an index option?

A

An option to buy (call) or sell (put) a notional portfolio of shares whose value mirrors the FTSE index

72
Q

How does an index option work?

A

Imagine a company has a portfolio of shares which it will need to sell in the future
To protect against a fall in the market, the company will buy put options on index futures

73
Q

How does an index option work?

A
  • Imagine a company has a portfolio of shares which it will need to sell in the future
  • To protect against a fall in the market, the company will buy put options on index futures
  • Later on, the portfolio is sold on the open market
  • If the market has fallen, the option will be exercised ad the loss in value of the portfolio is offset by the profit in the futures contract
  • If it has risen, the option is allowed to lapse and the company benefits from an increased value of the portfolio
74
Q

What is the outcome of an index option?

A

The company ends up with a minimum price for its portfolio - but this could be higher if the stock market rises more than expected

75
Q

What is the premium paid by purchasers to the writer of a option made up of?

A

Intrinsic value - diff between exercise price of the option and the current market value of the product

Time value - Difference between the actual premium and the intrinsic value

76
Q

What is the intrinsic value?

A

makes up part of the premium paid by purchasers to the writer of an option

Intrinsic value - diff between exercise price of the option and the current market value of the product

77
Q

What is time value?

A

makes up part of the premium paid by purchasers to the writer of an option

Time value - Difference between the actual premium and the intrinsic value

78
Q

What is an option with intrinsic value known as?

A

Known as ‘in the money’

i.e. if it was to be exercised today, a profit would be made

79
Q

What is an ‘out the money’ option?

A

an option which has no intrinsic value

80
Q

What is an ‘in the money’ option?

A

An option with intrinsic value

81
Q

What causes the time value of a call option to increase?

A
  • Increases with time to expiry
  • Increases with volatility of the underlying share
  • Increases with interest rates (since the PV of the exercise price decreases)
82
Q

What are the benefits of a forward/future?

A
  • Eliminates risk completely

- No downside risk

83
Q

What are the adv and disadvantages of a forward/future?

A
  • Eliminates risk completely
  • No downside risk, but no upside potential
  • If the underlying transaction falls through, the business is re-exposed to risk
84
Q

What are the adv and disadvantages of options

A
  • Downside risk is eliminated
  • Upside potential is retained
  • If the underlying transaction falls through, there is still no cost.
  • They are more flexible than a forward, but therefore more expensive
85
Q

Describe an OTC vs standardised product

A

OTC

  • Can be for any amount and any date
  • Tend to be more expensive unless for large amounts

Standardised

  • Only set dates and amounts, therefore may not provide a perfect hedge
  • Can be closed out easily if the underlying transaction falls through
86
Q

Summarise Forward rate agreement

A

Enter into loan as normal
Arrange FRA with bank
If interest rate moves against - bank reimburses
if interest rates move in favour - co reimburses bank

87
Q

Summarise interest rate swaps

A

Counter-party swap fixed and floating rates
Both parties can now borrow more cheaply
Can hedge LT

88
Q

Summarise interest rate futures for loans

A

Loan:

  • Sells futures contracts now
  • Close out by buying futures when loan needed
  • Borrow at spot rate when loan is needed
  • Gain/loss on futures = difference in interest cost
89
Q

Summarise interest rate futures for investments

A
  • Buy futures now and close out by selling

- Invest at spot rate

90
Q

Summarise Interest rate options

A
  • Used to fix the interest rate
  • Hedges rates for up to a year
  • Traded options: right to buy or sell a future
  • Loan - buy a put
  • Investment - buy a call

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