Chapter 14 - Interest Rate Risk

Question 1

Yield curve

Answer 1

1. The term structure of interest rates refers to the way in which the yield of a debt security or bond varies according to the term of the security i.e. To the length of time before the borrowing will be repaid.
2. There are three main types of yield curve shapes:
   - Normal yield curve - longer maturity bonds have a higher yield compared with shorter-term bonds due to the risks associated with time.
   - Inverted yield curve - the shorter term yield are higher than the longer term yields which can be a sign of upcoming recession.
   - Flat yield curve - the shorter and longer term yields are very close to each other which can be a sign of an economic transition.

Question 2

Shape of the yield curve

Answer 2

The shape of the yield curve is generally believed to be a combination of three theories acting together:

1. Liquidity preference theory.
2. Expectations theory.
3. Market segmentation theory.

Question 3

Liquidity preference theory

Answer 3

1. Investors have a natural preference for holding cash rather than other investments.
2. They therefore need to be compensated with a higher yield for being deprived of their cash for a longer period of time.
3. The normal shape of the curve as being upwards sloping can be explained by liquidity preference theory.

Question 4

Expectations theory

Answer 4

1. States that the shape of the yield curve varies according to investors’ expectations of future interest rates.
2. A curve that rises steeply from left to right indicates that rates of interest are expected to rise in the future.
3. There is more demand for short term securities than long term securities since investors’ expectation is that they will be able to secure higher interest rates in the future so there is no point in buying long term assets now.
4. The price of short term assets will be bid up, the price of long term assets will fall so the yields on short term and long term assets will consequently fall and rise.
5. A falling yield curve indicates interest rates are expected to fall.
6. A flat yield curve indicates expectations that interest rates are not expected to change materially in the future.

Question 5

Market segmentation theory

Answer 5

1. In market segmentation theory, the two ends of the curve may have different shapes as they are influenced independently by different factors.
   - Investors are assumed to be risk averse and to invest in segments of the market that match their liability commitments.
   e. g. Banks tend to be active in the short term end of the market.
   e. g. Pension funds tend to invest in long term maturities to match the long term nature of the liabilities.

• The supply and demand forces in various segments of the market part influences the shape of the yield curve.
  2. Market segmentation explains the ‘wiggle’ seen in the middle of the curve. This is where two different curves are joining and the influence of both short term and long term factors are weakest.

Question 6

Forward rate agreements

Answer 6

1. The aim of an FRA is to
   - Lock the company into a target interest rate.
   - Hedge both adverse and favourable interest rate movements.
2. The company enters into a normal loan but independently organises a FRA with a bank.
   - Interest is paid on the loan in a normal way.
   - If the interest is greater than the agreed forward rate, the bank pays the difference to the company.
   - If the interest is less than the agreed forward rate, the company pays the difference to the bank.

Question 7

Gap exposure

Answer 7

1. Negative gap
   - Occurs when interest-sensitive liabilities maturing at a certain time are greater than interest-sensitive assets maturing at the same time.
   - This results in a net exposure of interest rates rise by the time of maturity.
2. Positive gap
   - Occurs when the amount of interest-sensitive assets maturing in a certain time period exceeds the amount of interest-sensitive liabilities maturing at the same time.
   - In this situation the firm will lose out if interest rates fall by maturity.