Ch 10

Question 1

Lending vs Depositing Rates

Answer 1

two interest rates quoted by a bank to a customer

lending rate always higher as the bank wants to make a profit

Question 2

LIBOR

Answer 2

London Inter Bank Offer Rate

the interest at which a major bank can borrow wholesale s/t funds from another bank in the London money markets

different rates exist for different time periods (typically overnight to one year)

most floating rate loans are linked to LIBOR - e.g. LIBOR plus 1.25% (or 125 basis points) - the interest payable is reset at the beginning of each payment period (e.g. every three months)

Question 3

LIBID

Answer 3

London Interbank Bid Rate

Less important than LIBOR

rate of interest that a top-rated London bank could obtain on s/t wholesale deposits with another bank in the London money markets

always lower than LIBOR

Question 4

Overview - Interest Rate Risk

Answer 4

interest rates are less volatile than exchange rates but changes can still be substantial

risk that interest rates might change in value - between when the company identifies need to borrow/invest and the actual date they enter into a tx

e.g. a company might anticipate future borrowing needs nbut but unclear how much/when - in the interim, interest rates rise and the delay decision causes higher interest payments

Question 5

Term Structure of Interest Rates

Answer 5

provides an implicit forecast of interest rates according to market expectations

the relationship between interest rates / bond yield and different terms/maturities - also known as “yield curve”

the “term structure” reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy considerations

generally - yields increase in line with maturities, giving an upward-sloping yield curves - bonds with longer maturity dates tend to have higher yields

theoreticallyy - shape of cruve reflects expectations of future interest rates - a borrower requiring a 1–year loan may be tempted by ten 1-year loans if s/t debt is cheaper. Market expectation is that overall cost of debt is the same in either case.

Question 6

Methods of Interest Rate Risk Management

Answer 6

INTERNAL METHODS

Smoothing

Matching

Netting

EXTERNAL METHODS

Forward rate agreements

Interest rate guarantees

Interest rate futures

Exchange traded interest rate options

Interest rate swaps

Question 7

Internal Hedging Strategies for managing interest rate risk

Answer 7

restructuring the company’s assets and liabilities in a way that minimizes interest rate exposure

SMOOTHING

trying to maintain a certain balance between fixed rate and floating rate borroinwg

portfolio of fixed and floating rate debts thus provide a natural hedge against interest rate changes - less exposure to adverse effects and also less exposure to favorable movements

MATCHING

company matches assets and liabilities to have a common interest rate (i.e. loans and investments bothg with floating rates)

NETTING

company aggregates all positions - assets and liabs - to determine net exposure

Question 8

Categories of External Hedging Techniques for Interest Rate Risk

Answer 8

“Fixing” = locked into an interest rate, thus CF certainty

“Insurance” = upside flexibility whilst protection from adverse

OTC are bespoke // exchange-traded are ready-made and standardized

Question 9

Definition - Forward Rate Agreement

Answer 9

Forward contract on an interest rate for a future s/t loan or deposit - thus used to fix the interest rate on a loan/deposit at a future date

typically for amounts > GBP 1m and s/t rates such as 3- or 6-mo LIBOR

Question 10

Key Feature - Forward Rate Agreement

Answer 10

The agreement is independent of the loan/deposit itself

It concerns the rate of interest on a NOTIONAL amount of principal (loan/deposit) starting at a future date

FRA does not replace taking out the loan (deposit) - but rather the combination of the loan (depoist) and FRA result in a fixed effective interest rate

Question 11

Settlement of Forward Rate Agreements

Answer 11

buyer and seller must settle contract at settlement date

if the fixed FRA rate > LIBOR reference rate, FRA buyer makes a cash payment to seller for the difference

if the fixed FRA rate < LIBOR reference rate, FRA seller makes a cash payment to the buyer for the difference

Question 12

Setting up an FRA hedge

Answer 12

hedging achieved by combining FRA with the “normal” loan or deposit

BORROWING (thus worried about rate increases)

firm borrows the req’d sum and thus contracts at market rate on this date

previously the firm will have BOUGHT a matching FRA to a bank to receive compensation if rates rise

DEPOSITING (concerned about falling rates)

firm deposits required sum on target date, contract at that day’s market rate

previously the firm will have SOLD a matching FRA to a bank and thus receives compensation if rates fall

in both cases the rate is effectively fixed

Question 13

Terminology - Forward Rate Agreements

Answer 13

an FRA on a notional three-month loan/deposit starting in five months’ time is called a “5–8 FRA” or “5v8 FRA”

Question 14

Illustration - hedging using FRAs

Answer 14

Company wants to borrow GBP 10m in six months’ time for a three-month period

can normally borrow from bank at LIBOR+0.50% // current 3-month LIBOR is 5.25% but company worried about sharp intrerest rate increase in future

FRA rates quoted are:

3v9 = 5.45% - 5.40%

6v9 = 5.30% - 5.25%

company looking to start in six months’ time - borrowing rather than depositing - thus 6v9 is the correct FRA and the rate is 5.30% (higher of the two)

imagine that at settlement date, LIBOR has risen to 6.5%

in this case, FRA rate is lower than reference rate, thus the seller makes a cash payment to the buyer.

Actual Interest 7% (LIBOR + 0.5%)

less Effective Interest 5.8% (FRA plu 0.5%)

= Gain on FRA 1.2%

Question 15

Definition - Interest Rate Guarantees

Answer 15

Options on FRAs so the treasurer has the choice whether to exercise or not // sometimes called interest rate options or interest rate caps/floors

Question 16

Features - Interest Rate Guarantees

Answer 16

over-the-counter, arranged directly with bank, maximum maturity one year

org wanting to BORROW in the future can hedge by BUYING an FRA - thus will need an IRG providing a CALL option on FRAs

org wanting to SELL in the future can hedge by SELLING an FRA - thus will need an IRG providing a PUT option on FRAs

the option would only be exercised to protect against adverse interest rate mvmt

Question 17

Interest Rate Guarantees - Decision Criteria

Answer 17

Adverse movement in interest rate =>

EXERCISE the option to protect

Favorable movement in interest rate =>

allow the option to LAPSE

IRGs cost more than FRAs - you have to pay for the flexibility to take advantage of a favorable movement

Question 18

Definition - Interest Rate Futures

Answer 18

Similar in principle to forward rate agreements - give a commitment to an interest rate for a set period

tradable contracts and operate for set three-month period, terminating in months 3, 6, 9, 12

as with currency futures, the position will normally be closed out for cash and the gain/loss used to offset rate changes

Question 19

Two Types of Interest Rate Futures

Answer 19

SHORT-TERM INTEREST RATE FUTURES (STIRs)

standardized exch-traded forward contracts on notional deposit of standard amount, starting on contract settlement date

used to hedge S/T risk

BOND FUTURES

contracts on std quantity of notional govt bonds

if position not closed at settlement date, contracts must be settled by physical delivery

used to hedge L/T interest rate changes

Question 20

Features - Interest Rate Futures

Answer 20

the future operates by the customer making a commitment to effectively deposit/borrow a fixed amount of capital at a fixed interest rate

notional sterling deposit/loan on the London Futures Exchange (LIFFE) is GBP 500k

Future is priced by deducting the interest rate from 100 - thus 5% int rate = price of 95.00

thus if rates increase, the value of the future falls

Gains/losses on s/t int rate futures (STIRs) calculated with ref to interest rate at date of closure - with the difference between futures price at inception being the gain or loss

Question 21

Calculations for Futures Hedging (S/T Int Rate Futures)

Answer 21

companies can hedge using futures buy buying/selling a # of futures contracts covering a loan period and value

most companies use futures to hedge BORROWINGS and thus hedge against int rate RISES - they do this by SELLING futures

Question 22

Reasons Int Rate Futures are complicated

Answer 22

Contract sizes and standard contract lengths of 3 months

Margins/deposits payable at the START of the hedge

Speculators dominate the market

Question 23

Using STIRs (s/t int rate futures) to hedge against rate increases

Answer 23

company plans to borrow s/t in the future and wants to set up a hedge against rate increase before hand - the hedge is created by SELLING s/t interest rate futures

needs a position with futures that will give a profit if rates increase - profit from futures trading will offset higher interest cost on loan when the loan is eventually taken out

conversely - if rates go down, the hedge will create a loss on the futures position - thus the benefit of borrowing at lower rate on the actual loan is offet by the loss on the futures position

when actual loan period begins, futures position should be CLOSED by BUYING equal number of futures contracts for the same settlement date as the loan

rates have gone up = market price of futures will have fallen = company will profit from having SOLD futures to open the position at higher rates and then BOUGHT futures at a lower price to close the position => the profit should offset the increased interest rate

rates have gone down = the futures SOLD to open the position will have been at a lower price whereas those BOUGHT to close the position on date of loan at a higher price => overall loss which should offset lower interest rate

in theory - elimination of downside/upside risk and paying the desired interest rate

Question 24

Challenges with Interest Rate Futures

Answer 24

STANDARD CONTRACT SIZE

e.g. USD 1m contract size means a loan of USD 9.5m is likely unhedged in part - although this is likely to be an immaterial portion compared to the hedged amount

BASIS RISK

the future rate (as defined by future prices) moves approximately but not exactly in line with cash market rate

current futures price for an item is usually different than current “cash market” price – for IRFs, current IRF market price and current interest will be different, will only converge when settlement date for futures contract approaches - difference known as BASIS

if there was no convergence, speculators could make an instant profit through ARBITRAGE - trading between futures market and spot “cash” market

most futures positions will be closed out before contract reaches final settlement - thus there will still be some basis due to residual divergence between current market price of underlying item and futures price at date of close-out

Question 25

Forward Rate Agreements vs S/T Int Rate Agreements (FRAs vs STIRs)

Answer 25

s/t IRFs are an alternative hedging method to FRAs - similarities between the two

both are binding forward contracts on a s/t int rate

both are contracts on a notional amount of principal

both are cash-settled at the START of the notional interest period

FRA advantage - tailor-made in terms of principal, length of notional interest period, settlement date

however - STIR are more flexible for settlement - position can be closed quickly and easily at any time up to settlement date for the contract

given the efficiency of the financial markets, difference between the two in terms of effective interest rate is unlikely to be large

Question 26

Hedging with bond futures

Answer 26

Bond Futures may be used to hedge risk of future change in bond prices - esp useful to bond investors for hedging against risk of inc in l/t interest rates and thus fall in bond prices

as with STIRs, a hedge is constructed such that a gain on bond futures position offsets any adverse interest rate movement

bond futures fall in value when interest rates increase - thus for a bond investor, the required hedge is to SELL BOND FUTURES

if the rates do increase, the futures position can be closed by BUYING FUTURES at a lower price - resulting in a gain which should match the loss in the value of the bonds themselves

Question 27

Exchange Trade Interest Rate Options

Answer 27

a product that can cap interest rates for borrowers in same way as an interest rate guarantee (IRG)

option gives the buyer the right to buy/sell an interest rate future, at a specified future date at a fixed exercise rate - thus to have the “right to bet” on an interest rate increase as shown on the futures market

option rather than commitment - thus requires payment of a premium by the option holder to the option writer

Question 28

Features - Exch-Traded Interest Rate Options

Answer 28

can fix the interest amount or be allowed to lapse if int rate changes are favorable

for a given interest period (e.g. six months) starting on or before a date in the future

the int rate options are options on rates only - not the option to take a loan - the loan is taken separately

options are to buy or sell futures - thus all information still valid - e.g. standard contract sizes (GBP 500k, USD 1m), standard duration of 3mo, maturity dates in months 3, 6, 9, 12

note - exch-traded options are standard - it is possible to purchase a bespoke option but requires a willing counterparty

CALL option gives right to BUY a futures contract

PUT option gives right to SELL a futures contract

option is always BOUGHT - what you are buying is right to buy or right to sell

Question 29

Diagram - Futures and Options

Answer 29

Question 30

Definition - Collar

Answer 30

premiums can be reduced by using a collar

simultaneously buying a put and selling a call option creates a collar - thus a cap and floor is established but the premium is saved

premium saved comes at expense of forgoing any benefits of interest rate falls beneath floor value

Question 31

Collars versus options

Answer 31

OPTIONS protect against adverse mvmts and allow participation in favorable mvmts - but the flexibility of having an option comes with a cost

COLLARS achieve some flexibility at a lower cost

the company limits its ability to participate in favorable movement by buying “a cap” / buying the right to sell (a put option) as normal - but also selling “a floor” / selling the right the buy (a call option) on the same futures contract but with different exercise prices

Question 32

Diagram - Collars

Answer 32

The floor sets a minimum cost for the company

the counterparty is willing to pay the company for this guaranteed minimum income

thus the company is paid for limiting its ability to participate in favorable interest rate movement

Question 33

Diagram - Coillars for Loan Interest

Answer 33

Question 34

Diagram - Collars for Deposit Interest

Answer 34

Question 35

Diagram - using collars for loan vs deposit interest

Answer 35

Question 36

Definition - Swaps

Answer 36

a contract to exchange payments of some sort in the future

can be used to change the interst rate or currency profile of borrowings (e.g. fixed to floating, EUR to GBP) in line with capital structure targets and to manage risk

when considering the kind of debt finance to be used - risk, cost, practicality are key considerations

Question 37

Definition - Interest Rate Swap

Answer 37

an agreement whereby two 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 principal

might be cheaper for an org to issue a bond plus enter a swap to change the interest profile, rather than raising floating rate bank borrowings directly – thus an interest rate swap could be used to alter the interest rate profile from fixed to floating

Question 38

Features of Interest Rate Swaps

Answer 38

in practice, interest rate swaps the most common form of interest rate hedge used - they can be used to hedge borrowings of up to 30 years

syllabus limited to “plain vanilla” swap of fixed or floating rate (or vice versa), no consideration of practical complications

banks act as swap counterparties

large and liquid market in swaps in major currencies exists, banks will quote bid/offer rates against a reference rate such as 6-mo LIBOR / 12-mo LIBOR

Question 39

Cross Currency Swap

Answer 39

where org requires foreign currency borrowings, may be easier/cheaper to raise funds in local currency and enter into a x-currency swap to access foreign funds

in other cases, may be cheaper to borrow in a global currency (USD, EUR) and then use a x-currency swap to change currency to home currency (or another foreign currency)

e.g. parent company raising finance in a popular global currency and swapping into different currencies to lend on to foreign subs requiring borrowings in their home currencies

Question 40

Calculations involving the bank’s quoted swap rates

Answer 40

In practice a bank arranges the swap and will quote as follows:

“offer rate” = bank willing to receive a fixed interest cash flow stream in exchange for paying LIBOR

“bid rate” = bank willing to pay in exchange for receiving LIBOR

difference between the two gives bank’s profit margin, usually at least 2 basis points

alternate presentation = “3.00% - 3.10% against 12-mo LIBOR”

meaning a company wanting to pay a fixed rate in exchange for receiving LIBOR (thus convert floating into fixed) => 3.10% paid by company to bank

and a company wanting to pay LIBOR in exchange for receiving fixed (thus convert fixed into floating) => 3.00% paid by bank to company

remember - bank always sets up swap rates to ensure it makes a profit

Question 41

Diagram - Swaps

Answer 41

Company D wants to swap fixed into floating - thus pays LIBOR to bank in exchange for 3%

Company E wants to swap floating into fixed - thus pays 3.10% to bank in exchange for LIBOR

Bank profits because LIBOR payments net and the fixed rate received by the bank exceeds that paid

Question 42

Interest Fixing date and Interest cash flows in Interest Rate Swap

Answer 42

LIBOR rates fluctuate daily

thus to calculate the interest CF in a swap, an “interest fixing date” is agreed when the swap is set up - the LIBOR on this fixing date is used in the calculation

generally the interest fixing date is the start date of the swap period

Question 43

Advantages of using interest rate swaps

Answer 43

to manage fixed/floating rate debt profiles without having to change underlying borrowing

to hedge against variations in interest on floating rate debt, or conversely to protect the fair value of fixed rate debt instruments

to obtain cheaper finance - e.g. cheaper to obtain floating rate finance by (e.g.) issuing a bond and swapping into a floating rate, rather than borrowing at floating rate directly from bank

Question 44

Disadvantages of using interest rate swaps

Answer 44

interest rates may change in the future, the company may be locked into an unfavorable rate

creditworthiness of the bank - the company and the bank arrange to make payments for a fixed period, the company thus needs to be confident about the creditworthiness of the bank before signing up to a swap

Question 45

Cross Currency Swaps

Answer 45

allows a company to swap a currency it currently holds for a different currency for a fixed period, and then swap back at same rate at end of period

counterparty is generally a bank

two elements:

(1) exchange of principals in different currencies, which are swapped back at the original spot rate
(2) exchange of interest rates - the timing of which depends on the individual contract

swap of interest rates could be “fixed for fixed”, “floating for floating”, or “fixed for floating”

company entering the x-currency swap will end up with the currency it need, also the type of interest rate it prefers (fixed or floating)

Question 46

Advantages of using cross currency swaps

Answer 46

useful tool for changing the currency profile of debt

may help reduce interest costs - where debt can be raised more easily/cheaply in a second currency - it may be cheaper/easier to borrow in one currency and simultaneously enter a swap

x-curr swaps may also be used as part of broader strategy for managing currency risk - e.g. obtaining foreign currency borrowings to on-lend to foreign subs denominated in their currencies

Question 47

Disadvantages of using cross currency swaps

Answer 47

risk that the other party might default

heightened in this case because:

CF in different currencies (thus no possible agreement to net them - unlike for interest rate swaps) AND

final principals are exchanged (unlike interest rate swaps, where no principal is exchanged)