Chapter 10

Question 1

Types of risk exposure

Answer 1

On existing loans or deposits
On future loans or deposits

Question 2

Internal methods of risk management

Answer 2

Smoothing
Netting
Matching

Question 3

Smoothing

Answer 3

Company has balance between fixed rate and floating rate borrowing

Question 4

Matching

Answer 4

Company matches its assets and liabilities to have a common interest rate

Question 5

Netting

Answer 5

Company agregates all positions, both assets and liabilities, to determine its risk exposure

Question 6

FRA

Answer 6

Forward rate agreement is a forward contract on an interest rate for a national future short-term loan or deposit

Question 7

Features and operation of FRA

Answer 7

Does no replace taking out the loan but rather the combination of the loan and the FRA result in a fixed effective interest rate
If looking to BORROW they you need to BUY an FRA
If looking to DEPOSIT money they you need to SELL an FRA
A Reciept or payment will be made at the start of the loan period that will compensate for interest rate changes

Question 8

IRGS

Answer 8

Interest rate guarantees are options of FRAs
Treasurer have choice whether to exercise or not

Question 9

Caps

Answer 9

Caps are simply another name for an IRG on a loan (call option) as it ‘caps’ the maximum loan rate paid

Question 10

Floors

Answer 10

Floors are another name for an IRG on a deposit (Put option) as it creates a floor for the minimum loan rate received

Question 11

Collar

Answer 11

Can be created for either a loan or deposit and sets both a minimum and maximum interest rate. This is done by entering into both a call and a put option.

Question 12

Two types of interest rate futures

Answer 12

Short term interest rate futures (STIRs)
Long term bond futures

Question 13

Traded interest rate options

Answer 13

Options on STIRs

Question 14

SWAPs

Answer 14

An interest rate swap is an agreement wherby the parties agree to swap a floating stream of interest rate payments for a fixed stream of interest payments and via versa

Question 15

Reasons for using swap

Answer 15

As a way of managing fixed and floating rate debt profiles without having to change underlying borrowing
Take advantage of unexpected increases or decreases in rates
Hedge against variations in interest rates
Benefit from ‘comparative advantage’

Question 16

SWAPs with intermediaries

Answer 16

Bank offers two rates:
1. ‘ask rate’ at which the bank is willing to receive a fixed interest cash flow stream in exchange for paying the RFR
2. ‘Bid rate’ that they are willing to pay in exchange for receiving RFR

Question 17

Forex swaps

Answer 17

Two parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the period at an agreed swap rate

Question 18

Objectives of forex swap

Answer 18

Hedge against forex risk, possibly for a longer period than is possible on the forward market
Access capital markets, in which it may be impossible to borrow directly

Forex swaps are especially useful when dealing with coutries that have exchange controls and/or volatile rates

Question 19

Currency swaps

Answer 19

Allows two counterparties to swap interest rate commitments on borrowings in different currencies

Question 20

Two elements of currency swaps

Answer 20

An exchange in principle in different currencies, which are swapped back at the original swap rate
An exchange of interest rates - the timing of these depends on the individual contracts