Chapter 9 Flashcards
Managing Financial Risk: Interest Rate and Other Risks
Reasons why interest rate differ
1.Risk
2. Need to make profit on re-lending
3. Size of loan
4. International interest rate
5. Different types of financial asset - Money, stocks, bonds
Interest Rate Risk (1)
Have 5 point
1. Fixed v floating rate debt
Change in interest rate may make type of borrowing chosen the less attra
- Applies to both planned loans and actual loans
Interest Rate Risk (2)
2. Currency of debt
Effect of adverse movements if borrow in another currency
Interest Rate Risk (3)
- Term of loan
Having to repay loan at time when funds not available
Need for new loan at higher interest rate
Interest Rate Risk (4)
Term loan v Overdraft
Term loan = interest based on borrowed amount
Overdraft = based on amount used
Interest rate risk
Deposit @ floating rate
Factors which affect interest rates
(interest rate increase)
- Economy is growing, demand for funds increase-interest rates rise
- Inflation pressures - pushes interest rates higher
- International forces - Foreign investors willing to lend money driving interest rates down
- £ fluctuations - major or volatile exchange rate movements
Forward Rate Agreement (FRA)
Advantages of FRAs
1. Protection provided
- protect borrower from adverse interest rate movements above rate negotiated
2. Flexibility
- In theory- can be arranged for any amounts and any duration
3. Cost
- FRA may well be free and will in any case cost little
Forward Rate Agreement (FRA)
Disadvantage of FRAs (1)
Have 4 points
- Rate available
- bank will set for the FRA = reflects expectations of future interest r
- if interest rates are expected to rise, the bank may set a higher rate than the rate currently available
Forward Rate Agreement (FRA)
Disadvantage of FRAs (2)
2. Falling interest rate
Borrower cannot take advantage if interest rate fall unexpectedly
Forward Rate Agreement (FRA)
Disadvantage of FRAs (3)
- Term of FRA
FRA terminate on a fixed date
Forward Rate Agreement (FRA)
Disadvantage of FRAs (4)
- Binding agreement
- FRAs are binding agreement
- So less easy to sell to other parties
No secondary market
INTEREST RATE FUTURES
General information
- Hedge against interest rate movements
- The terms, amounts and period are standardized
- Price of short-term futures = 100-r
INTEREST RATE FUTURES
Borrower
-sell a future
- close out by buying future
- borrowing on spot market
INTEREST RATE FUTURES
Investor
- buys a future
- close out by selling future
- investing on spot market
INTEREST RATE FUTURES
Advantages of interest rate futures
1. Cost - reasonably low
2. Amount hedged - co can hedge large exposures of cash with a small initial cash investment
INTEREST RATE FUTURES
Disadvantages of interest rate futures (1)
Have 3 points
- Inflexibility of terms
- fixed period cover begins every quarter
- contracts are for fixed, large, amounts
- so, may not entirely match the amount being hedged
INTEREST RATE FUTURES
Disadvantages of interest rate futures (2)
2.Basis risk
- futures price of contracts may not move in the expected direction
INTEREST RATE FUTURES
Disadvantages of interest rate futures (3)
- Daily settlement
- company will have to settle daily profits or losses on the contract
Interest Rate Option
General info
1) OTC options
2) Traded option
Use two method:
Generally: premiums may be high
Premium are paid on the first day itself
Interest Rate Option
What is OTC rate interest options call?
(method 1)
- Borrowers - buy a CAP
- Investors - buysa FLOOR
Interest Rate Option
1) OTC method
- can be tailored
- used over a long period
- may only be exercisable at a particular time
- not transferable
Interest Rate Option
2) Traded options
(method 2)
- exercisable at any time
- straightforward to use
- could be sold on if an early exit is needed
Interest Rate Option
Borrower of traded option
- Buy a put option
- Gives a cap (interest rate cap sets an interest rate ceiling)
Interest Rate Option
Investor of traded option
- Buy a call option
- Gives a floor (interest rate floor sets a lower limit to interest rates)
Interest Rate Option
Advantages of interest rate option
( 3 points)
1) Upside risk
- Company has choice to not exercise option
- advantage of falling interest rates
Interest Rate Option
Advantages of interest rate option
2) Over the counter option
- tailored to the specific needs
- more flexible than exchanged traded options for a more exact hedge
Interest Rate Option
Advantages of interest rate option
3) Exchange traded options
- Useful for uncertain transactions
- eg: if unsure the loan actually be needed > if it evident that the option is not required, it can be sold
Interest Rate Option
Disadvantages of options
(3 points)
1) Premium
- relatively expensive compared with the costs of hedging instruments
- payable whatever the movement of interest rate or option had been exercised or not
Interest Rate Option
Disadvantages of options
2) Maturity
- maturity of exchange traded options may be limited to 1 yr
Interest Rate Option
Interest Rate Option
