CH11 - Interest Rate Risk

Question 1

Interest Rate Risk - FORWARDS

Answer 1

Same as currency hedging - Forward
* Locks into a target rate
* Hedges both adverse and favourable movement
How to – Interest Rate Forwards
Essentially the below compares if the rate moved to 7% or 4%.
2-5 FRA 5.00% - 4.70% = 3 month FRA starting at month 2.
If borrowing, choose higher of the spread given always.

Loan Payments 7% 4%

Interest payable on loan: 8m7%3/12 (140,000)
8m4%3/12 (80,000)

FRA Payments

Receivable 8m(7%-5%)3/12 40,000
Payable 8m(4%-5%)3/12 (20,000)

Combination (100,000) (100,000)

Question 2

Finding the FRA Rate

Answer 2

If wanting to borrow at 2 years
Borrow at 1 year
And borrow at 2 years at the rate using the calc below:
(1+r)=(1+ Year 2 Curve %^2)/(1+ Year 1 Curve %^1)

Question 3

Interest Rate Futures – The odd one involving ticks

Answer 3

Step 1: Define Buy or Sell
Borrowing = selling bonds so sell futures contracts– put
Depositing = buying bonds, so buy futures contracts – call

Step 2: Find Contract amount
=Loan or deposit amount/Contract Size MULTIPLIED BY Loan or deposit duration/Contract duration

Step 3: Expiry date = closest after

Step 4: Calculate Interest = Loan/deposit amount * Time Apportionment* Interest Rate Future

Step 5: Calculate Profit/Loss on Ticks:
Number of ticks movement per contract: Futures Price now MINUS Futures price future * 100
Value of a tick: Contract sizeTime Apportion0.0001
Profit on Futures: Ticks per contract aboveTick ValueNumber of contracts

Question 4

Futures Lock in Rate

Answer 4

100 – (current futures price + unexpired basis on the transaction date)
Multiply by borrow value (time apportioned as above) to get interest – will be the same as above

Question 5

Options on Interest Rate Futures

Answer 5

Borrowing = selling bonds so sell futures contracts– put
Depositing = buying bonds, so buy futures contracts – call

Choosing exercise price:
* May be told which price so check first
* Choose closest price to current interest rate
* Or choose the higherest interest receipt or lot total payment.

1. Determine Contract Size – same as above:
   Loan or deposit amount/Contract Size MULTIPLIED BY Loan or deposit duration/Contract duration
2. Premium Calculation – Pay Upfront
   Premiumcontract sizeTime apportionment on contract*Contracts required
3. Define if exercising or not – Remember if we are borrowing, and futures price is lower, then exercise as it means less payable
4. Calculate Interest:
   Total Borrowed * Borrowing period apportionment * Spot rate now
5. Calculate the hedge amount:
   Sell at exercise price
   Close out and buy at futures price given in Q = Gain/Loss
   GainContractsContract Size*Time Apportionment on Contract

Question 6

WHAT THE FUCK WE GOT AYE

Answer 6

1. Futures – shows the same net effect remember
   Interest payable on base % + any extra
   Futures working:
   Gain or loss on futures now vs futures in future

OR use lock in method

May need to use Basis working if Futures FUTURE not given

2. Options
   Define Put or BUY, find cheapest depending on borrowing or lending,
   Compare exercise price of option vs base rate in future to see if exercise or not
   Calculate the interest, premium
   Do the Option working: eg sell at and buy and close if gain then work out based on contract business working e.g. size etc
   Add all together

Question 7

Interest Rate Swaps Using the Bank

Answer 7

Compare Fixed and Floating Rate differential from the Home and Counterparty

Then SUM:

Floating Rate Differential MINUS
Fixed Rate Differential MINUS
Charge from Bank Total
= TOTAL Divided by 2 to Split evenly

Then Fixed rate as above
+ Benefit TOTAL
= Net Interest Rate