Chapter 10 - Interest rate risk management Flashcards
What are some types of risk exposure on interest rate?
On existing loans or deposits - Exposed to changes in interest rates if existing loans and deposits have variable interest rates, Can avoid by using fixed rates or using swaps
On future loans or deposits - Even if we want to use fixed rates, we do not know what the rate will be when we need the loan/deposit
What are some internal methods for interest rate risk management?
Smoothing
Matching
Netting
What is the smoothing method?
Company has a balance between its fixed rate and floating rate borrowing.
Natural hedge against changes in interest rates
What is the matching method with interest rate risk management?
The company matches its assets and liabilities to have a common interest rate
What is the netting method with the interest rate risk management?
Company aggregates all positions, both assets and liabilities, to determine its net exposure
What are some external hedging techniques with interest rate risk management?
Fixing instruments - Forward rate agreements, Interest rate futures
Insurance instruments - interest rate guarantees, interest rate options
What is a forward rate agreement?
Forward contract on an interest rate for a notional future short-term loan or deposit
What are the features and operations of forward rate agreements?
Does not 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 money then you need to BUY an FRA
If looking to DEPOSIT money then you need to SELL an FRA
A RECEIPT OR PAYMENT will be made at the START OF THE LOAN period that will compensate for interest rate changes between the market rate for the loan and FRA.
Terminology - ‘5v8 FRA’, ‘5-8 FRA’
Quoted rates - use higher if borrowing, lower rate if depositing
What are interest rate guarantees?
IRGs are options on FRAs
Treasurer has the choice whether to exercise or not
What is the operation of an interest rate guarantee?
- Set up the IRG:
Borrowing - would buy the FRA, so need a call
Depositing - would sell FRA, so need a put - Future transaction date
Compare the IRG rate with the prevailing spot rate and make decision
Calculate receipt on FRA if necessary
What are caps?
Simply another name for an IRG on a loan (call option) as it ‘caps’ the maximum loan rate paid
What are floors?
Another name for an IRG on a deposit (put option) as it creates a ‘floor’ for the minimum loan rate received
What is a collar?
Created for either a loan or a deposit and sets both a minimum and maximum interest rate. This is done by entering into bothe a call and a put option. These are usually cheaper than a cap or a floor.
What are the two types of interest rate futures?
Short term interest rate futures
Long term bond futures
How do we calculate a future hedging?
- Set up the hedge
Buy or sell futures? Borrow = sell, deposit = buy
Why expiry date? First contract to expire after future transaction
How many contracts? Look at contract size and duration - Contact the exchange and pay the initial margin
- Future transaction date - close out the futures position.
Buy or sell?
Calculate gain or loss
What are traded interest rate options?
Options on STIRs - i.e. futures contracts
How do we calculate a options hedging?
- Set up the hedge
Borrowing - would sell STIR, so need a put
Depositing - would buy STIR, so need a call
Expiry date: First contract to expire after future transaction
How many contracts? Same as for futures - Contact the exchange and pay the premium
- Future transaction date
Compare the option price with the prevailing spot rate and make decision - to exercise or allow to lapse?
Calculate gain on futures position
What is SWAPs?
An interest rate swap is an agreement whereby the parties agree to swap a floating stream of interest payments for a fixed stream of interest payments and via versa
There is no exchange of principal
What are the reasons for using swaps?
As a way of managing fixed and floating rate debt profiles without having to change underlying borrowing
To take advantage of unexpected increases or decreases in rates
To hedge against variations in interest rates
To benefit from ‘comparative advantage’
What are forex swaps?
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
Swap rate and amount of currency is agreed between the parties in advance
What are the main objectives of a forex swap?
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
Especially useful when dealing with countries that have exchange controls and/or volatile exchange rates
What are currency swaps?
Allows the two counterparties to swap interest rate commitments on borrowings in different currencies
What are the two elements of a currence swap?
An exchange of principle in different countries, which are swapped back at the original spot rate
An exchange of interest rates - the timings of these depends on the individual contract
