Chapter 20 - Interest rate risk

Question 1

What does interest rate risk refer to?

Answer 1

The adverse movements of interest rates

Question 2

When can interest rate risk arise?

Answer 2

• When a business borrows money

- When a business has surplus cash (opportunity cost)

Question 3

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.

Answer 3

Gap exposure

Question 4

The bigger the gap exposure the greater the…

Answer 4

Interest rate risk

Question 5

What is a negative gap?

Answer 5

When interest sensitive liabilities maturing at a certain time in the future are greater than interest sensitive assets maturing at the same time.

Question 6

What is a positive gap?

Answer 6

When interest sensitive assets maturing at a certain time in the future are greater than interest sensitive liabilities maturing at the same time.

Question 7

What must happen for a business to suffer a loss when there is a negative gap?

Answer 7

In this situation the business will suffer a loss if interest rates rise.

Question 8

What must happen for a business to suffer a loss when there is a positive gap?

Answer 8

In this situation the business will suffer a loss if interest rates fall.

Question 9

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.

Answer 9

The yield or yield to maturity

Question 10

What is the shape of the yield curve determined by? (3 things)

Answer 10

Liquidity preference theory
Expectations theory
Market segmentation theory

Question 11

What is described below?

Investors prefer more liquid investments. The shorter the period of time until maturity the more liquid the investment.

Answer 11

Liquidity preference theory

Question 12

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

Answer 12

Expectations theory

Question 13

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.

Answer 13

Market segmentation theory

Question 14

If investors are to invest for longer periods of time then they will demand…

Answer 14

A higher return or yield

Question 15

If investors expect short term interest rates to rise in the long term then the yield curve will be more…

Answer 15

strongly upward sloping.

Question 16

What happens as a result of Market segmentation theory?

Answer 16

The supply/demand relationship is different for short term debt compared to long term debt

Question 17

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.

Answer 17

Matching

Question 18

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.

Answer 18

Smoothing

Question 19

What is described below?

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

Answer 19

Forward Rate Agreement (FRA)

Question 20

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.

Answer 20

Asset and liability management

Question 21

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.

Answer 21

Interest rate agreement

Question 22

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

Answer 22

Interest rate futures

Question 23

What is basis risk?

Answer 23

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.

Question 24

Who’s responsibility is it to hedge interest rate risk?

Answer 24

The treasurer

Question 25

What is the inverted yield curve a sign of?

Answer 25

Upcoming recession

Question 26

What is a swap?

Answer 26

Where a company swaps a floating stream of interest payments for a fixed one and vice versa

Question 27

What is another type of swap?

Answer 27

Currency swap