Chapter 14 - Interest rate risk

Question 1

What is the risk on variable rate loans?

Answer 1

risk that interest rates will rise

Question 2

What is the risk on fixed rate loans?

Answer 2

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

Question 3

What is the risk on variable rate deposits?

Answer 3

risk that interest rates will fall

Question 4

What is the risk on variable rate deposits?

Answer 4

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

Question 5

What is basis risk?

Answer 5

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

Question 6

What is gap exposure?

Answer 6

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

Question 7

What is a negative gap?

Answer 7

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

Question 8

What is a positive gap?

Answer 8

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

Question 9

The term structure of interest rates refers to what?

Answer 9

the way in which the yield (return) of a debt security or bond varies according to the term of the security i.e., the length of time before borrowing will be repaid

Question 10

What is a normal yield curve?

Answer 10

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

Question 11

What is a inverted yield curve?

Answer 11

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

Question 12

What is a flat (or humped) yield curve?

Answer 12

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

Question 13

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

Answer 13

• Liquidity preference theory
• expectations theory
• market segmentation

Question 14

what is liquidity preference thoery?

Answer 14

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

Question 15

What is the expectations theory?

Answer 15

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

Question 16

What is the market segmentation theory?

Answer 16

separate markets for short and long term interest rates

Question 17

What does a normal upward sloping yield curve suggest?

Answer 17

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

Question 18

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

Answer 18

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

Question 19

What is a FRA?

Answer 19

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

Question 20

what are the steps for a FRA?

Answer 20

• 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

Question 21

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

Answer 21

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

Question 22

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

Answer 22

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

Question 23

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

Answer 23

lower rate

Question 24

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

Answer 24

higher rate

Question 25

What are interest rate guarantees?

Answer 25

options on forward rate agreements

Question 26

What do interest rate guarantees allow?

Answer 26

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

Question 27

What are more expensive a IRGs or FRAs?

Answer 27

IRGs

Question 28

What are interest rate futures (IRFs)?

Answer 28

derivative contracts that operate a bit like standardised versions of FRAs

Question 29

What are the aims of interest rate futures?

Answer 29

• 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

Question 30

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

Answer 30

Sell futures today (BS)
Buy back on borrowing date

Question 31

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

Answer 31

• Buy futures today (DB)
• Sell on deposit date

Question 32

What is an interest rate option?

Answer 32

an option on an interest rate futures contact

Question 33

What does an interest rate option give?

Answer 33

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

Question 34

What are interest rate swaps?

Answer 34

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

Question 35

What are practical ways to manage interest rate risk?

Answer 35

cash flow matching
asset and liability management
interest rate smoothing

Question 36

What is cash flow matching

Answer 36

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

Question 37

What is asset and liability management?

Answer 37

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

Question 38

what is interest rate smoothing?

Answer 38

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