Chapter 20 - Interest rate risk Flashcards
What does interest rate risk refer to?
The adverse movements of interest rates
When can interest rate risk arise?
- When a business borrows money
- When a business has surplus cash (opportunity cost)
What is described below?
Where there is a difference between the amount of interest sensitive assets and the amount of interest sensitive liabilities that mature at the same time in the future.
Gap exposure
The bigger the gap exposure the greater the…
Interest rate risk
What is a negative gap?
When interest sensitive liabilities maturing at a certain time in the future are greater than interest sensitive assets maturing at the same time.
What is a positive gap?
When interest sensitive assets maturing at a certain time in the future are greater than interest sensitive liabilities maturing at the same time.
What must happen for a business to suffer a loss when there is a negative gap?
In this situation the business will suffer a loss if interest rates rise.
What must happen for a business to suffer a loss when there is a positive gap?
In this situation the business will suffer a loss if interest rates fall.
What is the true annual return that an investor who invests in debt capital expects to receive between the date of investing and the maturity date.
The yield or yield to maturity
What is the shape of the yield curve determined by? (3 things)
Liquidity preference theory
Expectations theory
Market segmentation theory
What is described below?
Investors prefer more liquid investments. The shorter the period of time until maturity the more liquid the investment.
Liquidity preference theory
What is described below?
The shape of the yield curve is influenced by investors’ expectations of the way in which short term interest rates will change in the long term
Expectations theory
What is described below?
This suggests that investors that are interested in investing in short term debt are not the same as the investors who are interested in investing in long term debt.
Market segmentation theory
If investors are to invest for longer periods of time then they will demand…
A higher return or yield
If investors expect short term interest rates to rise in the long term then the yield curve will be more…
strongly upward sloping.
What happens as a result of Market segmentation theory?
The supply/demand relationship is different for short term debt compared to long term debt
What is described below?
This is the idea that every future cash outflow arising from interest rates is matched by a future cash inflow from interest rates.
Matching
What is described below?
This is the idea that a company should have some fixed rate borrowings and some variable rate borrowings. By doing so it seeks to strike a balance between being exposed to a rise in interest rates and being able to take advantage of a fall in interest rates.
Smoothing
What is described below?
This is a forward contract on an interest rate for a future short-term loan or deposit
Forward Rate Agreement (FRA)
What is described below?
Avoiding gap exposure by seeking to have approximately the same amount of interest sensitive assets and interest sensitive liabilities maturing at the same time in the future.
Asset and liability management
What is described below?
This is an option to enter into an FRA agreement.
Like all options this means that a company has a right to enter into an FRA agreement but does not have the
obligation to do so.
Interest rate agreement
What is described below?
They protect against adverse interest rate risk but do
not allow a company to take advantage of favourable interest rate risk
Interest rate futures
What is basis risk?
Where the gain or loss on the futures contracts may not exactly offset the effect of the change in interest rates. i.e the hedge may not be perfect.
Who’s responsibility is it to hedge interest rate risk?
The treasurer
What is the inverted yield curve a sign of?
Upcoming recession
What is a swap?
Where a company swaps a floating stream of interest payments for a fixed one and vice versa
What is another type of swap?
Currency swap
