Chapter 10 - Managing Interest Rate Risk

Question 1

Interest Rate Risk:

Answer 1

1. Interest rate risk = risk that the interest rate will move in such a way so as to cost the company money
2. For a borrower, the risk is that the interest rate will rise
3. For an investor, the risk is that the interest rate will fall

Question 2

Internal controls over Interest Rate Risk

Answer 2

1. Smoothing = maintaining a balance of fixed and floating rate borrowing
2. Matching the type of loans with the asset to be acquired
3. Groups of companies pooling their cash to reduce interest payable, gain better rates of interest on deposit + allow tighter control

Question 3

External controls over interest rate risk:

Answer 3

1. Forward rate agreements
2. Interest rate futures
3. Interest rate options
4. Interest rate swaps

Question 4

Forward Rate Agreements (FRAs) – fixing the rate:

Answer 4

1. FRA = contract with a bank to receive/ pay interest at a predetermined interest rate on a set amount over a fixed period of time
2. Like a currency forward, FRAs fixes the rate, but unlike a currency forward, the FRA is a separate transaction
3. An FRA is structured to create a fixed outcome by counterbalancing the impact of interest rate movements on the actual transaction

Question 5

Quotation of forward rates:

Answer 5

• $5m (size of loan) 3-9 FRA (start and end month) at 5% (base rate guaranteed)
• FRA is an over the counter agreement with an investment bank
• Separate from actual transaction
• Allows company to borrow/ invest at a future date at the best rate available at that time

Question 6

Advantages of forward rate agreements:

Answer 6

• Simpler than other derivative agreements
• Normally free, always cheap (in terms of agreement fees)
• Tailored to the company’s precise requirements (in terms of amount of cover needed)

Question 7

Disadvantages of forward rate agreements:

Answer 7

• Fixed date agreements (the term of a 3-9 FRA is fixed in the FRA contract)
• Rate quoted may be unattractive
• Higher default risk than an exchange-based derivative

Question 8

Interest Rate Futures – fixing the interest rate:

Answer 8

1. General features of futures regarding standardised dates and amounts, margins and marking to market all apply to interest rate futures
2. Key difference includes:
   * Interest rate futures have a standardised period of three months (loan for 6 months needs to be covered by two contracts of three months)

Question 9

Types of futures contract:

Answer 9

1. Company with cash surplus = worried about interest rate falling
   * A futures contract that receives interest is needed (contract to buy because buying financial assets results in interest being received)
2. Company needing to borrow money = worried about interest rates rising
   * Futures contract to pay interest is needed (contract to sell – sell bonds which creates obligation to pay interest)

Question 10

Quotation of futures contract:

Answer 10

1. December 94.75
   * December refers to date at which future expires
   * Price is in fact interest rate when subtracted from 100 (100- 94.75 = 5.25)

Question 11

Steps in futures hedge:

Answer 11

1. Now:
   a) Type of contract?
   b) No of contracts? (loan / contract size x (term of loan/ 3 months)
   c) Date (START of loan)
2. In the future = complete the actual transaction on the spot market
3. At the same time as step 2 = calculate the net outcome
   a) (Future price - LIBOR) x 1/months left till end of future = future price p/month
   b) future price p/month + LIBOR
   c) calculate difference between two rates
   d) Step 2 + Step 3 (c)
   e) Step 3 (d) x loan amount x term of loan / 12 months

Question 12

Advantages of Futures:

Answer 12

1. Flexible dates (December future can be used any day up to end of December)
2. Lower credit risk because exchange traded

Question 13

Disadvantages of Futures:

Answer 13

• Only available in large contract sizes
• Margin may need to be topped up on a daily basis to cover expected losses
• Basis may not fall in a linear way over time (basis risk)

Question 14

Exchange Traded Interest Rate Options - cap the interest:

Answer 14

1. Exchange traded interest rate option = agreement to pay/ receive interest at a predetermined rate on a standardised notional amount over a fixed standard period in the future (usually 3 months)
   * Gives holder the right (but not obligation) to use the predetermined rate
2. Same as interest rate futures contracts except they only ever pay compensation, they never incur losses (often called options on futures)
3. Key difference = involve payment of premium
4. Interest rate put option = option to pay interest (put option = pay)
5. Interest rate call option = option to receive interest

Question 15

Steps in an exchange traded options hedge:

Answer 15

1. Now = contracts should be set in terms of call/put options – choosing the closest standardised option date AFTER the loan begins and adjusting the term of the loan compared to the three-month standard term + pay a premium for the option
2. In the future = complete the actual transaction on the spot market
3. At the same time as step 2 = close out the options contract on the futures market by doing the opposite of what was done in step 1 but only if the option makes a profit & calculate the net outcome

Question 16

Advantages of Options:

Answer 16

• Flexible dates
• Allow a company to take advantage of favourable movements in the interest rates
• Useful for uncertain transactions, can be sold if not needed

Question 17

Disadvantages of Options:

Answer 17

• Only available in large contract sizes

* Can be expensive due to the requirement to pay an up-front premium

Question 18

Over the counter options:

Answer 18

• Tailored to the precise loan size & timing required by the company but will be more expensive
• Cannot be sold on if not needed

Question 19

Interest Rate Caps:

Answer 19

• Capped on amounts borrowed by buying put options

* Guarantee that interest paid will not exceed a certain amount but come at a price – the premium

Question 20

Interest Rate Floors:

Answer 20

• Set by selling call options
• Bought by companies with interest bearing investments which want to ensure they receive a guaranteed minimum amount of interest
• Also requires the payment of a premium

Question 21

Interest Rate Collars:

Answer 21

1. Combined strategy of buying & selling options
2. For a borrower:
   * A collar will involve buying a put option to cap the cost of borrowing + selling a call option at a lower rate to establish a floor
   * If interest rates rise the borrower is protected by the cap
   * If interest rates fall the borrower will benefit until it falls to the level of the floor – if interest rates fall beyond the floor, the borrower will have to pay compensation to the purchaser of the call option
3. For an investor:
   * A collar will involve buying a call option to establish a floor and selling a put option at a higher rate to establish a cap
   * If interest rates fall the investor is protected by the floor
   * If interest rates rise the investor will benefit up to the level of the cap – if interest rates rise beyond the cap, the borrower will have to pay compensation to the purchased of the put option

Question 22

Swaps:

Answer 22

• Two counter parties agree to pay each other’s interest payments

Question 23

Interest Rate Swaps enable company to:

Answer 23

1. Manage interest rate risk
   * Swapping some of its existing variable rate finance into fixed rate finance to protect itself against interest rate rises
   * May be cheaper than refinancing the original debt (which may involve redemption fees for early repayment and issue costs for new debt)
2. Reduce borrowing costs
   * Taking out a loan in a market where they have a comparative interest rate advantage

• A bank will manage the swap
• In the exam, assume, unless otherwise specified in the question, that the variable interest rate payment is LIBOR

Question 24

Swaps as a spread:

Answer 24

• The bank operating as a middle man in a swap will identify two parties and will set up the two legs of the swap (fixed & variable) so that the companies are entering into agreements with the bank and not each other
• This helps minimise default risk
• As the variable rate can be assumed to be at LIBOR, the bank needs to establish the rate to apply to the fixed rate leg of the deal
• 4.95% - 5.35%
• 4.95% = bid price, rate the bank will pay on the fixed rate leg
• 5.35% = offer or ask price, rate the bank will receive on the fixed rate leg
• The bank makes a profit on the swap on the difference between these two rates

Question 25

Advantages of interest rate swaps:

Answer 25

• Relatively easy & cheap way of switching type of interest receivable or payable
• Flexible – can be arranges in any size and reverse if necessary
• Companies may be able to borrow more cheaply by using comparative advantage
• Last longer than other technique – up to 20 years

Question 26

Disadvantages of interest rate swaps:

Answer 26

• Costly legal and professional advice may be needed
• Counterparty risk – if one party defaults the swap will unravel
• Not subject to the control of an exchange