Chapter 9

Question 1

Reasons why interest rate differ

Answer 1

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

Question 2

Interest Rate Risk (1)

Have 5 point

Answer 2

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

Question 3

Interest Rate Risk (2)

Answer 3

2. Currency of debt

Effect of adverse movements if borrow in another currency

Question 4

Interest Rate Risk (3)

Answer 4

3. Term of loan

Having to repay loan at time when funds not available

Need for new loan at higher interest rate

Question 5

Interest Rate Risk (4)

Answer 5

Term loan v Overdraft

Term loan = interest based on borrowed amount

Overdraft = based on amount used

Question 6

Interest rate risk

Answer 6

Deposit @ floating rate

Question 7

Factors which affect interest rates
(interest rate increase)

Answer 7

1. Economy is growing, demand for funds increase-interest rates rise
2. Inflation pressures - pushes interest rates higher
3. International forces - Foreign investors willing to lend money driving interest rates down
4. £ fluctuations - major or volatile exchange rate movements

Question 8

Forward Rate Agreement (FRA)

Advantages of FRAs

Answer 8

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

Question 9

Forward Rate Agreement (FRA)

Disadvantage of FRAs (1)

Have 4 points

Answer 9

1. 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

Question 10

Forward Rate Agreement (FRA)

Disadvantage of FRAs (2)

Answer 10

2. Falling interest rate

Borrower cannot take advantage if interest rate fall unexpectedly

Question 11

Forward Rate Agreement (FRA)

Disadvantage of FRAs (3)

Answer 11

3. Term of FRA

FRA terminate on a fixed date

Question 12

Forward Rate Agreement (FRA)

Disadvantage of FRAs (4)

Answer 12

4. Binding agreement

- FRAs are binding agreement
- So less easy to sell to other parties

No secondary market

Question 13

INTEREST RATE FUTURES

General information

Answer 13

1. Hedge against interest rate movements
2. The terms, amounts and period are standardized
3. Price of short-term futures = 100-r

Question 14

INTEREST RATE FUTURES

Borrower

Answer 14

-sell a future
- close out by buying future
- borrowing on spot market

Question 15

INTEREST RATE FUTURES

Investor

Answer 15

• buys a future
• close out by selling future
• investing on spot market

Question 16

INTEREST RATE FUTURES

Advantages of interest rate futures

Answer 16

1. Cost - reasonably low
2. Amount hedged - co can hedge large exposures of cash with a small initial cash investment

Question 17

INTEREST RATE FUTURES

Disadvantages of interest rate futures (1)

Have 3 points

Answer 17

1. Inflexibility of terms
   - fixed period cover begins every quarter
   - contracts are for fixed, large, amounts
   - so, may not entirely match the amount being hedged

Question 18

INTEREST RATE FUTURES

Disadvantages of interest rate futures (2)

Answer 18

2.Basis risk

- futures price of contracts may not move in the expected direction

Question 18

INTEREST RATE FUTURES

Disadvantages of interest rate futures (3)

Answer 18

3. Daily settlement

- company will have to settle daily profits or losses on the contract

Question 19

Interest Rate Option

General info

1) OTC options
2) Traded option

Use two method:

Answer 19

Generally: premiums may be high

Premium are paid on the first day itself

Question 20

Interest Rate Option

What is OTC rate interest options call?

(method 1)

Answer 20

• Borrowers - buy a CAP
• Investors - buysa FLOOR

Question 21

Interest Rate Option

1) OTC method

Answer 21

• can be tailored
• used over a long period
• may only be exercisable at a particular time
• not transferable

Question 22

Interest Rate Option

2) Traded options

(method 2)

Answer 22

• exercisable at any time
• straightforward to use
• could be sold on if an early exit is needed

Question 23

Interest Rate Option

Borrower of traded option

Answer 23

• Buy a put option
• Gives a cap (interest rate cap sets an interest rate ceiling)

Question 24

Interest Rate Option

Investor of traded option

Answer 24

• Buy a call option
• Gives a floor (interest rate floor sets a lower limit to interest rates)

Question 25

Interest Rate Option

Advantages of interest rate option

( 3 points)

Answer 25

1) Upside risk
- Company has choice to not exercise option
- advantage of falling interest rates

Question 26

Interest Rate Option

Advantages of interest rate option

Answer 26

2) Over the counter option
- tailored to the specific needs
- more flexible than exchanged traded options for a more exact hedge

Question 27

Interest Rate Option

Advantages of interest rate option

Answer 27

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

Question 28

Interest Rate Option

Disadvantages of options

(3 points)

Answer 28

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

Question 29

Interest Rate Option

Disadvantages of options

Answer 29

2) Maturity
- maturity of exchange traded options may be limited to 1 yr

Question 30

Interest Rate Option

Question 31

Interest Rate Option