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F9 > Chapter 20 > Flashcards

Chapter 20 Flashcards

1
Q

What influences interest rates on financial assets?

A

Risk of the assets, duration of lending, and loan size.

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2
Q

How is risk related to interest rates?

A

Riskier assets demand higher returns.

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3
Q

What are interest rates in economic terms?

A

Prices for lending and costs for borrowing.

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4
Q

Where were interest rates discussed in the text?

A

Section 4 of Chapter 3.

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5
Q

What is interest rate risk?

A

Interest rate risk is the sensitivity of profit and cash flows to changes in interest rates.

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6
Q

Who faces interest rate risk?

A

Companies with both floating and fixed rate debt, especially those with large asset and liability exposures to interest rates.

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7
Q

Why are banks and investment institutions heavily exposed to interest rate risk?

A

Because they deal with significant amounts of assets and liabilities affected by interest rates.

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8
Q

What is the main form of interest rate risk for non-bank companies?

A

The main form is the volatility of cash flows associated with floating (variable) interest rate debt.

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9
Q

How do interest rates on floating interest rate debt behave?

A

They rise or fall in line with changes in benchmark interest rates, such as the bank’s base rate or LIBOR.

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10
Q

How can some interest rate risks cancel each other out?

A

When a company has both assets and liabilities sensitive to interest rate changes, changes in interest rates affecting one side may offset the impact on the other side.

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11
Q

What commitment does a company with fixed interest rate debt have?

A

They have a commitment to fixed interest payments, regardless of interest rate movements.

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12
Q

How does a company with fixed rate debt face interest rate risk?

A

If interest rates fall sharply, they may lose competitive advantage compared to companies with floating rate debt whose costs of borrowing decrease.

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13
Q

What is gap analysis used for in assessing interest rate risk?

A

Gap analysis groups assets and liabilities sensitive to interest rates by maturity dates to determine exposure.

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14
Q

What is a negative gap in gap analysis?

A

A negative gap occurs when a company has more interest-sensitive liabilities maturing at a certain time than assets, indicating exposure if interest rates rise.

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15
Q

What is a positive gap in gap analysis?

A

A positive gap happens when a company has more interest-sensitive assets maturing at a certain time than liabilities, leading to potential losses if interest rates fall.

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16
Q

What is basis risk in the context of interest rates?

A

Basis risk occurs when floating rates are based on different benchmarks or bases, making it unlikely that they will move perfectly in sync.

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17
Q

How does basis risk affect companies?

A

Basis risk can result in differences in how interest rates change between assets and liabilities, potentially causing unexpected cash flow variations.

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18
Q

What are the causes of interest rate fluctuations?

A

The structure of interest rates, yield curves, and changing economic factors.

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19
Q

Why do higher risk borrowers typically pay higher interest rates?

A

To compensate lenders for the greater risk involved.

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20
Q

Why can large listed companies borrow at lower rates than small start-up businesses?

A

Because they are considered less risky borrowers.

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21
Q

What is the purpose of financial intermediaries making a profit on re-lending?

A

They make a profit by re-lending at a higher rate of interest than the cost of their borrowing.

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22
Q

How does the size of a deposit affect the interest rate offered by a bank or building society?

A

Larger deposits may attract higher rates of interest than smaller deposits.

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23
Q

Why do different types of financial assets attract different rates of interest?

A

Due to competition for deposits between different types of financial institutions.

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24
Q

What is the term structure of interest rates, and how is it represented?

A

It refers to how the yield on a security varies with the term of the borrowing and is represented by a yield curve.

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25
Q

Normally, how does the interest rate change with the term to maturity?

A

Normally, longer-term maturities have higher interest rates.

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26
Q

What is a negative yield curve, and when does it occur?

A

A negative yield curve occurs when short-term interest rates are higher than long-term rates.

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27
Q

What does liquidity preference theory suggest about yield curves?

A

It suggests that long-term interest rates are higher than short-term rates because investors prefer having cash now.

28
Q

What does expectations theory indicate about yield curves?

A

It states that yield curves reflect expectations of future changes in interest rates.

29
Q

According to the market segmentation theory, why might the yield curve differ?

A

It suggests that the slope of the yield curve reflects conditions in different segments of the market, and investors remain in their respective segments.

30
Q

How can government policy impact interest rates?

A

Government policy can affect interest rates, such as keeping short-term rates high or low, impacting the yield curve.

31
Q

What factors affect the general level of interest rates?

A

Factors include the need for a real return, inflation, uncertainty about future inflation rates, liquidity preference, demand for borrowing, balance of payments, and monetary policy.

32
Q

How does interest rate risk management work?

A

It can be managed through internal hedging (asset and liability management, matching, and smoothing) or external hedging instruments (forward rate agreements and interest rate derivatives).

33
Q

What is matching in interest rate risk management?

A

Matching involves matching liabilities and assets with common interest rates.

33
Q

What is asset and liability management’s goal?

A

To achieve similar durations for payments and earnings by matching liabilities and assets with a common interest rate.

34
Q

What is smoothing in interest rate risk management?

A

Smoothing involves maintaining a balance between fixed-rate and floating-rate borrowing.

35
Q

What is a forward rate agreement (FRA), and how does it work?

A

An FRA fixes an interest rate for short-term lending/investing or borrowing that starts at a future date, protecting against adverse interest rate movements.

36
Q

Why might banks arrange FRAs with higher rates than current rates?

A

Banks consider their expectations of interest rate movements when setting FRA rates.

37
Q

Explain the terminology ‘5.75-5.70’ in an FRA.

A

It means that you can fix a borrowing rate at 5.75% and a deposit rate at 5.70%.

38
Q

In the example provided, what FRA is required by Lynn plc?

A

Lynn plc requires a ‘3-9’ FRA, covering a 6-month period starting after 3 months.

39
Q

How does an FRA protect against interest rate risk?

A

It fixes the borrowing rate, ensuring predictability regardless of market rate fluctuations.

40
Q

What happens if the actual interest rate at the FRA start date differs from the FRA rate?

A

The party receiving the benefit pays the difference between the FRA rate and the actual rate.

41
Q

What does the effective interest rate on a loan depend on?

A

It depends on the FRA rate and any differences between the FRA rate and the actual market rate.

42
Q

What are interest rate derivatives?

A

Financial instruments used to hedge against interest rate changes.

43
Q

What are some types of interest rate derivatives?

A

Interest rate futures, interest rate options, and interest rate swaps.

44
Q

What is the purpose of interest rate futures?

A

To hedge against the risk of interest rate movements.

45
Q

How do interest rate futures work?

A

They involve speculating on whether interest rates will rise or fall.

46
Q

How do interest rate futures differ from FRAs?

A

Interest rate futures are standardized, while FRAs are customized.

47
Q

What is the main benefit of using interest rate futures?

A

They require a smaller initial cash outlay compared to buying the underlying financial instrument.

48
Q

What do interest rate futures entitle the buyer and seller to?

A

Buyers receive interest receipts, and sellers incur an obligation to make interest payments.

49
Q

How do borrowers and lenders use interest rate futures?

A

Borrowers sell futures to hedge against rate increases, while lenders buy futures to hedge against rate decreases.

50
Q

What is the contract size of a three-month sterling interest rate futures March contract?

A

It represents £500,000 of notional lending or borrowing for three months.

51
Q

When do interest rate futures on LIFFE mature?

A

They mature at the end of March, June, September, and December.

52
Q

What currency is the three-month eurodollar interest rate futures contract denominated in?

A

It is denominated in US dollars with a contract size of $1 million.

53
Q

What is the purpose of interest rate options?

A

To limit exposure to adverse interest rate movements while taking advantage of favorable movements.

54
Q

What is the key characteristic of an interest rate option?

A

It grants the buyer the right, but not the obligation, to deal at an agreed interest rate at a future maturity date.

55
Q

How does the buyer of an interest rate option decide whether to exercise it?

A

They consider whether the market interest rate is above or below the specified rate in the option agreement.

56
Q

What are tailor-made ‘over the counter’ interest rate options?

A

Customized options purchased from major banks with specific values, currencies, maturities, and interest rates.

57
Q

How do interest rate options compare to FRAs in terms of flexibility and cost?

A

Options offer more flexibility but are more expensive than FRAs.

58
Q

What are interest rate caps, collars, and floors used for?

A

Caps set a ceiling, floors set a lower limit, and collars combine both to limit interest rate risk.

59
Q

What is the motivation behind using a collar arrangement?

A

To reduce costs by receiving a premium for selling a floor while buying a cap.

60
Q

What is the potential outcome of a zero-cost collar?

A

It may occur if the premium paid for buying the cap equals the premium received for selling the floor.

61
Q

What are interest rate swaps used for?

A

To exchange interest rate payments, switch from fixed to floating rates or vice versa, and secure better loan and deposit rates.

62
Q

What is a fixed to floating rate currency swap?

A

It combines a currency swap with an interest rate swap.

63
Q

Who typically participates in interest rate swaps?

A

Banks and various institutions, including governments, may participate.

64
Q

What is the most common motivation for a ‘plain vanilla’ interest rate swap?

A

To switch from paying floating rate interest to fixed interest or vice versa.

65
Q

Why might companies prefer using interest rate swaps over terminating and reissuing loans?

A

Transaction costs for termination and reissuance, including fees and issue costs, can be higher than arranging a swap.

66
Q

What factors should be considered when choosing an instrument to hedge interest rate risk?

A

Cost, flexibility, expectations, and the ability to benefit from favorable rate movements.

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