Chapter 15 - Interest rate risk

Question 1

What is basis risk?

Answer 1

The risk of interest rates on assets and liabilities not moving in line with eachother because influenced by different basis e.g. BOE & LIBOR

Question 2

What is gap exposure?

Answer 2

The risk of interest rates on assets and liabilities not moving in line with eachother because revised at different times e.g. fixed rate for 3 months vs 6 months

Question 3

What are the basic interest rate hedging methods?

Answer 3

• Smoothing - mix of fixed and floating interest rates

- Matching - assets based on same interest rates as liabilities

Question 4

What is a forward rate agreement?

Answer 4

A contract with a bank covering a specific amount of money to be borrowed at an interest rate agreed now e.g. 3 V 9

Question 5

What are the advantages of a FRA?

Answer 5

• Simple
• Low set up costs
• Available

Question 6

What are the disadvantages of a FRA?

Answer 6

• Fixed date
• Unattractive rate
• Counterparty risk

Question 7

What are the characteristics of interest rate futures?

Answer 7

Contract to receive or pay interest on a standard quantity of money at an agreed future date at a specified interest rate

• Fixed rate
• Margin paid up front
• Separate from transaction

Question 8

What does a contract to sell an interest rate future result in and what does a contract to buy result in?

Answer 8

• Sell (put) = to pay interest (borrower)

- Buy (call) = to receive interest (investor)

Question 9

What are the advantages of interest rate futures?

Answer 9

• Period of time

- Lower counterparty risk

Question 10

What are the disadvantages of interest rate futures?

Answer 10

• Standard contract sizes

- Basis risk

Question 11

What are caps, floors and collars?

Answer 11

• Cap = borrower will not pay interest above this rate
• Floor = investor will not receive interest below this rate
• Collar = simultaneous put + call

Question 12

What are the characteristics of the yield curve?

Answer 12

• Expectations theory - steeper curve if interest rate rises expected
• Liquidity preference - investors require higher return to compensate for less liquidity
• Market segmentation - interest rates reflect different market conditions in different market segments.

Question 13

What are the the characteristics of interest rate options?

Answer 13

Option holder has right to pay or receive interest on an agreed quantity, at a specified rate on or before expiry date

• OTC or exchange traded
• Premium paid

Question 14

What are the advantages of interest rate options?

Answer 14

• Period of time

- Sold on if not needed

Question 15

What are the disadvantages of interest rate options?

Answer 15

• Premium paid - expensive

- Large standard contract sizes