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FM - Financial Management > Chapter 14 - Interest rate risk > Flashcards

Chapter 14 - Interest rate risk Flashcards

1
Q

What is the risk on variable rate loans?

A

risk that interest rates will rise

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2
Q

What is the risk on fixed rate loans?

A

risk that interest rates will fall (so company cant take advantage)

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3
Q

What is the risk on variable rate deposits?

A

risk that interest rates will fall

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4
Q

What is the risk on variable rate deposits?

A

risk that interest rates will rise (and so the company can’t take advantage of the rise0)

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5
Q

What is basis risk?

A

the risk that investments that, in theory, should offset each other in terms of changing values, do not do so

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6
Q

What is gap exposure?

A

Mismatch in size e.g., paying off a £10m loan with £9m savings

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7
Q

What is a negative gap?

A

interest-sensitive liabilities maturing at a certain time are greater than interest-sensitive assets maturing at the same time. Exposure to rising interest rates.

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8
Q

What is a positive gap?

A
  • interest sensitive liabilities maturing at a certain time are less than interest-sensitive assets maturing at the same time. Exposure to falling interest rates
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9
Q

The term structure of interest rates refers to what?

A

the length of time before borrowing will be repaid

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10
Q

What is a normal yield curve?

A

longer maturity bonds have a higher yield due to the risks associated with time

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11
Q

What is a inverted yield curve?

A

shorter-term yields are higher than longer-term ones, which can be a sign of an upcoming recession

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12
Q

What is a flat (or humped) yield curve?

A

the shorter-and longer-term yields are very close to each other, which is also a predictor of an economic transition

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13
Q

What are the 3 theories that can explain the shape of the yield curve?

A
  • Liquidity preference theory
  • expectations theory
  • market segmentation
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14
Q

what is liquidity preference thoery?

A

investors prefer cash for more liquid investments and will need to be compensated with a higher return if they are deprived of cash for a longer period

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15
Q

What is the expectations theory?

A

Growth is forecast, the normal upward sloping curve reflects the expectation that inflation levels, and therefore interest rates, will increase in future

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16
Q

What is the market segmentation theory?

A

separate markets for short and long term interest rates

17
Q

What does a normal upward sloping yield curve suggest?

A

that interest rates may rise in the future:
avoid borrowing long-term variable rates
choose to borrow short-term variable or long term fixed rates instead

18
Q

What is the aim of forwards rate agreements (FRA)?

A
  • lock the company into a target interest rate
  • hedge both adverse and favourable interest rate movements
19
Q

What is a FRA?

A

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

20
Q

what are the steps for a FRA?

A
  • company enters into a normal loan and separately into an FRA
  • company pays interest on the loan in normal way
  • if interest rate is greater than the agreed forward rate, the FRA provider pays the difference to the company
  • if the interest rate paid is less than the agreed forward rate, the company pays the difference to the FPA provider
    vice versa for a deposit
21
Q

In regards to an FRA if you are borrowing what do you do?

A

BUY an FRA as need a ceiling on rate
LOAN = ceiling

22
Q

In regards to an FRA if you are investing what do you do?

A

you will sell an FRA as need a floor on rate
INVEST = floor

23
Q

If there is a spread for FRA what one should be chosen for investments (deposits)?

A

lower rate

24
Q

If there is a spread for FRA what one should be chosen for loans (borrowings)?

A

higher rate

25
Q

What are interest rate guarantees?

A

options on forward rate agreements

26
Q

What do interest rate guarantees allow?

A

the company a period of time during which it has the option to buy an FRA at a set price

27
Q

What are more expensive a IRGs or FRAs?

A

IRGs

28
Q

What are interest rate futures (IRFs)?

A

derivative contracts that operate a bit like standardised versions of FRAs

29
Q

What are the aims of interest rate futures?

A
  • like an FRA in that they fix the interest rate and are binding
  • like currency futures in that they are standardised by date and value
30
Q

What are the rules with IRGs if we are borrowing money?

A

Sell futures today (BS)
Buy back on borrowing date

31
Q

What are the rules with IRGs if we are depositing money?

A
  • Buy futures today (DB)
  • Sell on deposit date
32
Q

What is an interest rate option?

A

an option on an interest rate futures contact

33
Q

What does an interest rate option give?

A

gives the right but not the obligation to buy or sell something - in this case the right to buy (to fix the highest rate payable) or sell (to fix the lowest rate receivable) interest rates

34
Q

What are interest rate swaps?

A

swaps are an agreement between two parties to exchange interest payments for a period of time, set up in such a way as to change the position of the companies payment

35
Q

What are practical ways to manage interest rate risk?

A

cash flow matching
asset and liability management
interest rate smoothing

36
Q

What is cash flow matching

A

the concept of cash matching is to eliminate interest rate risk by eliminating all net future cash flows

37
Q

What is asset and liability management?

A

by matching timescales of interest rate sensitive assets and liabilities, there will be a net position at all times, limiting the overall exposure to interest rate movements

38
Q

what is interest rate smoothing?

A

where the exposure to changing interest rates is reduced by holding some borrowings or deposits with fixed rate interest and some with variable rate. reduces exposure

FM - Financial Management (19 decks)

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