Chapter 14 - Interest rate risk Flashcards
What is the risk on variable rate loans?
risk that interest rates will rise
What is the risk on fixed rate loans?
risk that interest rates will fall (so company cant take advantage)
What is the risk on variable rate deposits?
risk that interest rates will fall
What is the risk on variable rate deposits?
risk that interest rates will rise (and so the company can’t take advantage of the rise0)
What is basis risk?
the risk that investments that, in theory, should offset each other in terms of changing values, do not do so
What is gap exposure?
Mismatch in size e.g., paying off a £10m loan with £9m savings
What is a negative gap?
interest-sensitive liabilities maturing at a certain time are greater than interest-sensitive assets maturing at the same time. Exposure to rising interest rates.
What is a positive gap?
- interest sensitive liabilities maturing at a certain time are less than interest-sensitive assets maturing at the same time. Exposure to falling interest rates
The term structure of interest rates refers to what?
the length of time before borrowing will be repaid
What is a normal yield curve?
longer maturity bonds have a higher yield due to the risks associated with time
What is a inverted yield curve?
shorter-term yields are higher than longer-term ones, which can be a sign of an upcoming recession
What is a flat (or humped) yield curve?
the shorter-and longer-term yields are very close to each other, which is also a predictor of an economic transition
What are the 3 theories that can explain the shape of the yield curve?
- Liquidity preference theory
- expectations theory
- market segmentation
what is liquidity preference thoery?
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
What is the expectations theory?
Growth is forecast, the normal upward sloping curve reflects the expectation that inflation levels, and therefore interest rates, will increase in future
What is the market segmentation theory?
separate markets for short and long term interest rates
What does a normal upward sloping yield curve suggest?
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
What is the aim of forwards rate agreements (FRA)?
- lock the company into a target interest rate
- hedge both adverse and favourable interest rate movements
What is a FRA?
a forward contract on an interest rate for a notional future short-term loan or deposit
what are the steps for a FRA?
- 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
In regards to an FRA if you are borrowing what do you do?
BUY an FRA as need a ceiling on rate
LOAN = ceiling
In regards to an FRA if you are investing what do you do?
you will sell an FRA as need a floor on rate
INVEST = floor
If there is a spread for FRA what one should be chosen for investments (deposits)?
lower rate
If there is a spread for FRA what one should be chosen for loans (borrowings)?
higher rate
What are interest rate guarantees?
options on forward rate agreements
What do interest rate guarantees allow?
the company a period of time during which it has the option to buy an FRA at a set price
What are more expensive a IRGs or FRAs?
IRGs
What are interest rate futures (IRFs)?
derivative contracts that operate a bit like standardised versions of FRAs
What are the aims of interest rate futures?
- 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
What are the rules with IRGs if we are borrowing money?
Sell futures today (BS)
Buy back on borrowing date
What are the rules with IRGs if we are depositing money?
- Buy futures today (DB)
- Sell on deposit date
What is an interest rate option?
an option on an interest rate futures contact
What does an interest rate option give?
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
What are interest rate swaps?
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
What are practical ways to manage interest rate risk?
cash flow matching
asset and liability management
interest rate smoothing
What is cash flow matching
the concept of cash matching is to eliminate interest rate risk by eliminating all net future cash flows
What is asset and liability management?
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
what is interest rate smoothing?
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
