Chapter 10 - Interest rate risk management

Question 1

What are some types of risk exposure on interest rate?

Answer 1

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

Question 2

What are some internal methods for interest rate risk management?

Answer 2

Smoothing
Matching
Netting

Question 3

What is the smoothing method?

Answer 3

Company has a balance between its fixed rate and floating rate borrowing.
Natural hedge against changes in interest rates

Question 4

What is the matching method with interest rate risk management?

Answer 4

The company matches its assets and liabilities to have a common interest rate

Question 5

What is the netting method with the interest rate risk management?

Answer 5

Company aggregates all positions, both assets and liabilities, to determine its net exposure

Question 6

What are some external hedging techniques with interest rate risk management?

Answer 6

Fixing instruments - Forward rate agreements, Interest rate futures
Insurance instruments - interest rate guarantees, interest rate options

Question 7

What is a forward rate agreement?

Answer 7

Forward contract on an interest rate for a notional future short-term loan or deposit

Question 8

What are the features and operations of forward rate agreements?

Answer 8

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

Question 9

What are interest rate guarantees?

Answer 9

IRGs are options on FRAs
Treasurer has the choice whether to exercise or not

Question 10

What is the operation of an interest rate guarantee?

Answer 10

1. Set up the IRG:
   Borrowing - would buy the FRA, so need a call
   Depositing - would sell FRA, so need a put
2. Future transaction date
   Compare the IRG rate with the prevailing spot rate and make decision
   Calculate receipt on FRA if necessary

Question 11

What are caps?

Answer 11

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

Question 12

What are floors?

Answer 12

Another name for an IRG on a deposit (put option) as it creates a ‘floor’ for the minimum loan rate received

Question 13

What is a collar?

Answer 13

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.

Question 14

What are the two types of interest rate futures?

Answer 14

Short term interest rate futures
Long term bond futures

Question 15

How do we calculate a future hedging?

Answer 15

1. 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
2. Contact the exchange and pay the initial margin
3. Future transaction date - close out the futures position.
   Buy or sell?
   Calculate gain or loss

Question 16

What are traded interest rate options?

Answer 16

Options on STIRs - i.e. futures contracts

Question 17

How do we calculate a options hedging?

Answer 17

1. 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
2. Contact the exchange and pay the premium
3. 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

Question 18

What is SWAPs?

Answer 18

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

Question 19

What are the reasons for using swaps?

Answer 19

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’

Question 20

What are forex swaps?

Answer 20

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

Question 21

What are the main objectives of a forex swap?

Answer 21

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

Question 22

What are currency swaps?

Answer 22

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

Question 23

What are the two elements of a currence swap?

Answer 23

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