Chapter 13

Question 1

Techniques for minimising interest rate risk management

Answer 1

Asset liability management.

Forward rate agreements

Question 2

That is likely to affect the level of interest rates in an economy

Answer 2

Supply and demand

Government policy

Taxation

Inflation

Liquidity preferences of investors 

Question 3

What is the risk associated with the interest rates of a bond?

Answer 3

The rest of the overall return of the bond will be affected by future changes in interest rates

Question 4

Definition of smoothing regarding interest rate risk management

Answer 4

Company uses more fixed interest, debit finance to reduce the impact of increases and decreases in interest rates

Question 5

interest rate cap

Answer 5

a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price.

Question 6

interest rate floor

Answer 6

A floor rate is the minimum rate a borrower will be charged. Alternatively, a ceiling rate protects the borrow and caps the upper limit at which a borrower can be charged. A floor rate protects the lender, as the lender can always expect to collect a minimum amount of interest.

Question 7

Hedging instruments - fixed or insured

Answer 7

Interest rate guarantee - insure
Interest rate futures - fix
Forward rate agreement - fix

Question 8

Hedging instruments - OTC or Traded

Answer 8

IRG - OTC
interest rate futures - Traded
forward rate agreement - OTC

Question 9

Interest rate future

Answer 9

Derivative only available in standardised sizes
Used to fix the interest rate
Traded on an organised exchange
Available for three month periods only
Binding contracts
Indendent of the loan or deposit that is being hedged
Settled at the start of the notional interest rate period

Question 10

FRAs

Answer 10

Can be tailored to a company’s exact requirements

Available to periods other than three months

Binding contracts

Indendent of the loan or deposit that is being hedged

Settled at the start of the notional interest rate period

Question 11

Interest rates guarantee

Answer 11

an option on a forward rate agreement (FRA) that is handled over-the-counter (OTC) and insures against adverse movements.

is an interest rate option that hedges the interest rate for a single interest period of up to one year

A call IRG is called a borrower’s IRG. A put IRG is called a lender’s IRG. As with all options, the seller has the obligation to fulfill the condition of the option.

Question 12

Black-Scholes Model: What It Is, How It Works

Answer 12

estimates the theoretical value of derivatives based on other investment instruments, taking into account the impact of time and other risk factors

The Black-Scholes model requires five input variables:

the strike price of an option,
the current stock price,
the time to expiration,
the risk-free rate,
the volatility.

Question 13

The interest rate risk of a bond is…

Answer 13

The risk of changes in a bonds return due to changes in interest rates over time 

Question 14

Buy or sell interest rate futures

Answer 14

Borrowers sell interest rate futures - selling a future, creates your obligation to borrow money and the obligation to pay interest

Buying a future creates the obligation to deposit money and the right to receive interest

Question 15

Interest rate risk management

Smoothing

Answer 15

We are company uses more fixed interest, debit finance to reduce the impact of increases and decreases in interest rates.

Question 16

Outcomes at the end of a forward rate agreement for a borrower

Answer 16

Will pay cash if interest rates have dropped and receive cash if interest rates have increased

When combined with the actual loan interest, this effectively fixes the interest rate on the loan at the agreed FRA rate