Chapter 13 - Interest rate risk management

Question 1

Which one is more volatile? Interest rates or exchange rates?

Answer 1

Exchange rates are more volatile

Question 2

What are the methods of Internal hedging?

Answer 2

1. Smoothing - the company tries to maintain a certain balance between its fixed rate and floating rate borrowing. The portfolio of fixed and floating rate debts thus provide a natural hedge against changes in interest rates. There will be less exposure to a favourable movements in the interest rates.
2. Matching - the company matches its assets and liabilities to have a common interest rate (i.e. loan and investment both have floating rates)
3. Netting - the company aggregates all positions, both assets and liabilities, to determine its net exposure.

Question 3

What are the external hedging techniques? Explain in and where they are traded

Answer 3

1 FRA - Forward rate agreements are OTC instruments and they’re considered fixing instruments

2. Interest rate futures - also fixing instruments, but traded in an exchange
3. IRG - interest rate guarantees are OTC traded, insurance instruments.
4. Interest rate options - traded on an exchange and also insurance instruments

Question 4

Differentiate between Fixing and Insurance instruments, and OTC with exchange instruments.

Answer 4

Fixing instruments lock a company into a particular interest rate providing certainty as to the future cashflow, whilst ‘insurance’ instruments allow some upside flexibility in the interest rate i.e. the company can benefit from favourable movements but are protected from adverse movements.

OTC instruments are bespoke, tailored products that fit the companies needs exactly. Exchange traded instruments are ready-made and standardised.

Question 5

What is FRA?

Answer 5

Forward rate agreement is a contract on an interest rate for a future short-term loan or deposit. An FRA can therefore be used to fix the interest rate on a loan or deposit starting at a date in the future.

It is a contract relating to the level of a short-term interest rate, such as three-month LIBOR and etc. FRAs are normally for amounts greater than 1 mil.

Question 6

How to hedge using an FRA?

Answer 6

Hedging is achieved by a combination of an FRA with the normal loan or deposit.

• Borrowing (if concerned about interest rate rises) - the firm will borrow the required sum on the target date and will thus contract at the market interest rate on that date. Previously the firm will have bought a matching FRA from a bank or other market maker and thus receive compensation if rates rise.
• Depositing (concerned about a fall in interest rates) - the firm will deposit the required sum on the target date and will thus contract the market interest rate on that date. Previously the firm will have sold a matching FRA to a bank or other market maker and thus receive compensation if rates fall.

Question 7

It is 30 June. A company needs a $10 mil 6 month fixed rate loan from 1 Oct which it intends to hedge using a forward rate agreement. The relevant FRA rate is 6% on 30 June.

What will the net payment on the loan be if interest rates rose to 9% by October?

Answer 7

$300,000

At 9% the company will pay 450k (9% x 10 mil x 6/12)
The FRA receipt will be 150k (10 mil x (9% - 6%) x 6/12)
Net payment 450k - 150k = 300k
Or to simplify, the company will essentially pay 6% x 10 mil x 1/2 year = 300k

Question 8

What are IRG and how companies could use them?

Answer 8

Interest rate guarantees are options on FRAs so the treasurer has the choice whether to exercise or not.

IRGs sometimes are referred to as interest rate options or interest rate caps and floors. They are OTC instruments arranged directly with a bank and have a maximum maturity of one year.

A company wishing to borrow in the future could hedge by buying an FRA so would need an IRG that provides a call option on FRAs.

A company wishing to deposit in the future could hedge by selling an FRA so would need an IRG that provides a call option on FRAs.

Question 9

How to decide on whether to exercise the option or abandon.

Answer 9

If there is an adverse movement, exercise the option to protect.
If there is a favourable movement, allow the option to lapse.
IRGs are more expensive than the FRAs as one has to pay for the flexibility to be able to take advantage of a favourable movement.

Question 10

What is IRF?

Answer 10

Interest rate futures are similar in principle to forward rate agreements in that they give a commitment to an interest rate for a set of period. They are tradable contracts and operate for set period of three months and terminate in March, June, September and December. As with currency futures, the future position will normally be closed out for cash and the gain or loss will be used to offset changes in interest rates.

Question 11

Explain and list types of IRF.

Answer 11

• Short term interest futures - standardised exchange-traded forward contracts on notional deposit of standard amount, starting on contract’s settlement date and used to hedge short-term risk.
• Bond futures - contracts on a standard quantity of notional government bonds. If reach settlement date and position not closed, contracts must be settled by physical delivery. Used to hedge long-term interest rate changes.

Question 12

How the pricing of IRF work?

Answer 12

The future is prices by deducting the interest rate from 100. If the interest rate is 5% the future will be priced at 95.00. The reason for this is that if interest rates increase, the value of the future will fall and vice versa if interest rates reduce.

Question 13

What are the issues with IRFs?

Answer 13

1. Futures are for a standard size of contract, whereas the amount of the loan or deposit to be hedged might not be an exact multiple of the amount of the future contract’s notional deposit.
2. Existence of basis risk - the future rate (as defined by the future prices) moves approximately but not precisely in line with the cash market rate. The current futures price is usually different from the current cash market price of the underlying item. In the case of interest rate futures, the current market price of an interest rate future and the current interest rate will be different, and will only start to converge when the final settlement date for the futures contract approaches. This difference is knows as the ‘basis’.

Question 14

What are the differences and similarities between FRAs and STIRs?

Answer 14

Short-term interest rate futures are an alternative method of hedging to FRAs. They have a number of similarities.

• Both are binding forward contracts on a short-term interest rate
• both are contracts on a notional amount of principal
• both are cash settled at the start of the notional interest period.

FRAs have the advantage that they can be tailored to a company’s exact requirements, in terms of amount of principal, length of notional interest period and settlement date.

However, futures are more flexible with regard to settlement, because a position can be closed quickly and easily at any time up to settlement date for the contract.

Question 15

Borrowers will wish to hedge against an interest rate rise by:

A Selling futures now and selling futures on the day that the interest rate is fixed
B Selling futures now and buying futures on the day that the interest rate is fixed
C Buying futures now and selling futures on the day that the interest rate is fixed
D Buying futures now and buying futures on the day that the interest rate is fixed

Answer 15

B - The interest rate risk arises between present day and when the loan is taken out - the rate may rise and cost the borrower more. A borrower should sell an interest rate future now at a low interest rate (100 - r where r is say, 5% = 95%) and buy it later at the higher rate (100 -r where r say 10% = 90%). Buying at 90 and selling at 95 creates the profit you will need to offset the increased borrowing cost.

Question 16

I tis 24 May. A company needs to borrow 20 mil for 9 months from 1 December and, to limit interest rate risk exposure, intends to hedge using short term interest futures (STIRs). The notional deposit/loan for STIRs is 500k.

Which of the following statements are/is true? (select all that apply.)

A The company will need 240 futures contracts
B The company will need 120 futures contracts
C The company will need 40 futures contracts
D The company will set up the hedge by buying futures
E The company will set up the hedge by selling futures
F The futures hedge will eliminate all interest rate risk for the company

Answer 16

B and E - STIRS are standardised for 3 month notional deposit or loans, so the number of contracts = (20 million / 500k) x (9 months / 3 months) = 120

The company wishes to borrow funds so would set up a hedge on the futures market by selling futures.

Question 17

It is 4 July. A company needs to deposit 5 million for 6 months from 1 November and, to limit interest rate risk exposure, intends to hedge using options on STIRs. The notional sterling deposit/loan for STIRs is 500k.

Which of the following statements is/are true? (Select all that apply.)

A The company will need 10 options contracts
B The company will need 20 options contracts
C The company will need 5 options contracts
D The company will need put options
E The company will need call options

Answer 17

B and E

Question 18

An option whereby the lender sets a maximum and minimum rate simultaneously is called:

A A cap
B A floor
C A collar
D An interest rate guarantee

Answer 18

C

Question 19

What is an interest rate swap?

Answer 19

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 vice versa. There is no exchange of principal.

In practice interest rate swaps are probably the most common form of interest rate hedge used by companies because they can hedge loans of anywhere between a year and 30 years and therefore used for long-term borrowings.

In practice banks often act as counterparties and attempt to hedge their risk by having a large number of positions in the fixed and floating rate markets.

Question 20

Company A wishes to raise $10 million and to pay interest at a floating rates, as it would like to be able to take advantage of any fall in interest rates. It can borrow for one year at a fixed rate of 10% or at a floating rate of 1% above LIBOR.

Company B also wishes to raise $10 million. They would prefer to issue fixed rate debt because they want certainty about their future interest payments, but can only borrow for one year at 13% fixed or LIBOR + 2% floating, as it has a lower credit rating than company A.

Calculate the effective swap rate for each company - assume savings are split equally.

Answer 20

Step 1: identify the type of loan with the biggest difference in rates: Fixed (difference of 3% (13% vs. 10%) as opposed to just 1% for variable)
Step 2: Identify the party that can borrow this type of loan the cheapest.
Answer: Company A. Thus, company A should borrow fixed, company B variable reflecting their comparative advantage.
Step 3: Interest difference.
Now A can get 10% fixed, but wants LIBOR + 1.
Now B can get LIBOR + 2, but wants 13%.
Now TOTAL: 10 + LIBOR + 2 = LIBOR + 12
Want TOTAL: LIBOR + 1 + 13 = LIBOR + 14
Difference: LIBOR + 12 - LIBOR + 14 = 2

Now refers to the loan that the companies will take out.
Want refers to the type of interest payments that they desire to have, and the cost that they would have to pay if they arranged it themselves.
The difference is share equally between the companies.
Step 4: Possible swap:
A give LIBOR + 2 to B and B gives 12 to A.
13 - (1/2 x 2)
The method can be:
1. Company B pays off ALL company A’s variable rate interest (LIBOR + 2% in this case)
2. Company A then pays to B interest equivalent to its own fixed rate (13%) less share of the difference (1/2 x 2% = 1% in this case)
Step 5: Check

                              A                     B Pay own interest     (10%)           (LIBOR + 2) Receive                    12%             LIBOR + 2 Pay                        (LIBOR + 2)       (12%)
                           \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ Net interest           (LIBOR)             (12%)

Both companies achieved what they wanted, so the swap works.

Question 21

How does the quoted rate from intermediary from the banks work and calculated?

Answer 21

In practice a bank normally arranges the swap and will quote the following:

• The ask rate at which the bank is willing to receive a fixed interest cash flow stream in exchange for paying LIBOR
• The bid rate that they are willing to pay in exchange for receiving LIBOR
• The difference between these gives the bank’s profit margin and is usually at least 2 basis points.

Question 22

Co A currently has a 12 month loan at a fixed rate of 5% but would like to swap to variable. It can currently borrow at a variable rate of LIBOR + 12 basis points.

The bank is currently quoting 12 month swap rates of 4.90 (bid) and 4.95 (ask).

Show Co A’s financial position if it enters the swap.

Answer 22

Actual borrowing (5.00%)
Payment to the bank (LIBOR)
Receipt from the bank 4.90%
_________________________________
Net interest rate after swap (LIBOR + 0.10%)
Open market cost - no swap (LIBOR + 0.12%)
Saving 2 basis points

Question 23

Co B has a 12-moth loan at a variable rate of LIBOR + 15 basis point but, do to fears over interest rates rises, would like to swap to a fixed rate. It can currently borrow at 5.12% fixed.

The bank is currently quoting 12-month swap rates of 4.90 (bid) and 4.95 (ask).

Show Co B’s financial position if it enters the swap.

Answer 23

Actual borrowing (LIBOR + 0.15%)
Payment to the bank (4.95%)
Receipt from the bank LIBOR
_________________________________
Net interest rate after swap (5.10%)
Open market cost - no swap (5.12%)
Saving 2 basis points

Question 24

Company A has a 12 month loan at a variable rate of LIBOR + 50 basis points but, due to fears over interest rates rises, would like to swap a fixed rate. It can currently borrow at 5.40% fixed.

Company B currently has a 12 month loan at a fixed rate of 4.85% but would like to swap to variable. It can currently borrow at a variable rate of LIBOR + 65 basis points.

The bank is currently quoting 12 month swap rates of 4.50 and 4.52.

Show how the swap via the intermediary would work.

Answer 24

Co A already has a variable outflow so must receive LIBOR from the bank to convert this to fixed. It will pay the bank the ask rate. Similarly Co B must pay the bank variable and receive fixed at the bid rate.

                                      A                          B Actual borrowing           (LIBOR + 0.5%)     (4.85%) Payment to bank           (4.52%)                 (LIBOR) Receipt from bank         LIBOR                   4.50%
                                     \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ Net interest rates after  (5.02%)                 (LIBOR + 0.35%) swap Open market cost -        (5.40%)                (LIBOR + 0.65%) no swap Savings                            38 b.p.                 30 b.p. 

Note: In this case A can borrow variable cheaper but B can get the best fixed rates. In this case the total potential saving = D fixed + D variable = 55+15 = 70 basis points.
Of this, 2 basis points have gone to the bank via the spread in quoted prices, leaving 68 to be shared between the two companies

Question 25

What are advantages of using swaps?

Answer 25

• As a way of managing fixed and floating rate debt profiles without having to change underlying borrowing
• To take advantage of expected increases or decreases in interest rates
• To hedge against variations in interest on floating rate debt, or conversely to protect the fair value of fixed rate debt instruments
• A swap can be used to obtain cheaper finance. A swap should result in a company being able to borrow what they want at a better rate under a swap agreement, than borrowing it directly themselves (comparative advantage)

Question 26

What are the disadvantages of using swaps?

Answer 26

• Finding a swap partner can be difficult, although banks help (for a fee) in this respect nowadays.
• Creditworthiness of your swap partner - default on an interest payment may be a worry, but again, using a bank to credit check the swap partner beforehand should alleviate this concern
• Interest rates may change in the future and your company might be locked into an unfavourable rate.

Question 27

In a country which expects interest rates to rise, which type of debt would charge the highest rate of interest when issued?

A A fixed rate
B A floating rate

Answer 27

A

Question 28

Company A can borrow at 6% fixed or LIBOR + 0.2% variable and would like a variable rate. Company B can borrow at 6.5% fixed or 0.4% variable and would like a fixed rate. If the companies agree to share the differential equally, what is A’s effective loan rate?

Answer 28

A will effectively pay LIBOR + 0.2% - 0.15% (spread differential) = LIBOR + 0.05%

Question 29

L has a high credit rating and can borrow 10% fixed or LIBOR + 0.3% variable. It would like to borrow variable. T has a lower credit rating. It can borrow 11% fixed or LIBOR + 0.5% variable. It would like to borrow fixed. What is the quality spread differential?

Answer 29

10 - 11 = 1%
0.5 - 0.3 = 0.2%
1 - 0.2 = 0.8%

Question 30

Which of the following is an internal hedging technique? (Select all that apply.)

A A forward contract
B Netting
C Smoothing
D Matching

Answer 30

B C D

Question 31

An interest rate derivative characterised by being available for any amount, redeemable on any date, payment on settlement and traded over the counter is called?

A An interest rate swap
B A forward rate agreement
C An interest rate future
D An interest rate option

Answer 31

B

Question 32

In relation to interest rate hedging, which of the following statements is correct? (Select all that are relevant)

A The flexible nature of interest rate futures means that they can always be matched with a specific interest rate exposure
B Interest rate options carry an obligation to the holder to complete the contract at maturity
C Forward rate agreements are the interest rate equivalent of forward exchange contracts
D Matching is where a balance is maintained between fixed rate and floating rate debt

Answer 32

C

Question 33

When purchasing temporary investments, which of the following best describes the risk associated with the ability to sell the investment in a short time without significant price concessions?

A Liquidity risk
B Investment risk
C Interest rate risk
D Purchasing power risk

Answer 33

A