Chapter 9

Question 1

What is a derivative? What are examples?

Answer 1

Financial instrument whose value is derived from the value and characteristics of an underlying financial item

Option contracted futures and swaps

Question 2

What is the hedge efficiency?

Answer 2

Gain (loss) on the hedging instrument/ gain (loss) on hedged item

Question 3

What is a forward contract?

Answer 3

Binding agreement to exchange a set amount of goods at a set future date at a price agreed today

Bespoke agreement between two parties referred to as “over the counter”

Question 4

What is a futures contract and what is standardised about it?

Answer 4

Is a standardised contract to buy or sell a specific amount of a commodity, currency or financial instrument at a particular price on a stipulated future date.

Contract size

Maturity date

Traded on centralised exchanges

Question 5

Why do you hedge shareholdings and what are the types of financial instruments used to hedge them?

Answer 5

May hold large portfolios of shareholdings in other companies

Concern is that share prices fall and they can hedge against this using following financial instruments:

Index futures
Share options
Index options

Question 6

What are index futures?

Whag are the hedging steps?

Answer 6

Cash settled futures based on the value of stock index (FTSE 100) can be used to hedge a portfolio of shares

Each contract is for notional value of index value multiplied by £10 ie contract for 4500 is £45,000

Buying index future is similar to agreeing to buy the index constituent shares at a set price

When you close out the futures you get a net cash payment or receipt (no shares change hands)

Setup of hedge:

Sell index futures
Choose futures date (based on when you want to hedge to)
Note the futures price
Calculate no of future contracts: share portfolio value/futures level x£10

Outcome of hedge:

Close out futures by buying same number of contracts (gain or loss on futures

(Futures level at start - current futures level) x # contracts x £10

Calculate gain or loss on portfolio

Question 7

What are the pros and cons of index futures?

Answer 7

Pros:

Hedges away downside risk of share prices falling

Can close out futures position at any time

Cons:

Standardised contracts so may over and under hedge the value of share portfolio

Only an appropriate hedge if the share portfolio is similar to the index

Removes upside potential

Must post initial merging to the exchange at the start

Must post variation must if you make losses on the futures position

Basis risk (difference between spot index level and futures level before futures maturity date) leads to hedge not being 100% efficient

Question 8

What is an option?

What does it offer the choice between?

What must the buyer do?

Answer 8

Is an agreement giving the buyer of the option:
The right to buy but not obligation
To buy (call) or to sell (put) a specific quantity of something (eg shares in a company)
At a set price (strike or exercise price) within a stated period.

Choice between:

Exercising option

Allowing option to lapse

Must pay a premium now to buy the option

Question 9

What can the options be?

What can options be for?

What does in the money, at the money or out of the money mean?

Answer 9

Over the counter (specific and bespoke) or traded (standardised and traded on exchanges

For:
The right to apply for newly issued shares (share options)

The right to buy or sell existing shares (pure options)

In money: generate a profit if exercised today

At money: if exercise price = current spot price)

Out of money: loss would be made if contract exercised today

Question 10

What components make up the value of the option?

Answer 10

Intrinsic value: what option would be worth if exercised today.

Time premium: is the difference between the total value (=premium) and the intrinsic value driven by:

Time to expiry: longer time to expiry, more valuable the option

Volatility of underlying: higher the volatility the greater the option value

Question 11

What are the hedging steps for index options?

Answer 11

Set up:

Buy put index options

Choose strike level and maturity date (based on when you want to hedge until)

Calculate number of contracts: share portfolio value/strike level x£10

Pay premium = points x £10 x # no of contracts

Outcome of hedge:

Choose whether to exercise option

Calculate gain or loss on options if exercise = (strike level - current spot index level) x # contracts x £10

Calculate gain or loss on portfolio

Deduct premium

Question 12

What are the pros and cons of index options?

Answer 12

Pros:
Protects from downside risk and allows buyer to benefit from upside (by letting option lapse if share prices rise)

Cons :

Standardised contracts so may under or over hedge

Only an appropriate hedge if share portfolio is similar to index

Option premiums can be expensive

Question 13

What are the four methods of hedging interest rate risk?

Answer 13

Forward rate agreements

Interest rate futures

Interest rate options

Interest rate swaps

Question 14

What are the four risks from interest rate movements c

Answer 14

Having fixed rate debt in times of falling interest rates

Liquidity - can a company find the cash to repay a loan when it reaches its redemption rate?

Interest is paid at all times in a term loan, whereas you only pay interest on an overdraft when overdrawn

Depositing at variable rates in times of falling interest rates / fixed rates debt in times of rising interest rates

Question 15

What are the five methods of reducing interest rate risk?

Answer 15

Pooling of assets and liabilities

Forward rate agreements

Interest rate futures

Interest rate options

Interest rate swaps

Question 16

What does pooling of assets and liabilities mean

Answer 16

Some interest rate risks may cancel out where there are assets and liabilities which both have exposure to interest rate changes

Question 17

What is a forward rate agreement?

What are the hedging steps?

Answer 17

FRAs are contracts which fix the effective rate of interest to be paid on future borrowing

FRAs settle on the start date on the underlying loan (no amounts actually lent as part of FRA - still need to borrow from bank

Borrowers but FRAS lenders sell FRAs

Borrower pays FRA fixed rate and receive the spot (benchmark) rate (one net settlement)

5.75-5.70 means you can borrow at the fixed rate at 5.75 and get a deposit rate of 5.70

A 3-6 starts in 3 months, lasts 3 months

The interest rates which banks will be willing to set for FRAs will reflect their current expectations if interest rate movements

Hedging steps:

Set up:

Buy FRA if borrowing in the future

Outcome of hedge:

(When borrowing starts)

Net settlement of FRA =

(Spot rate - FRA rate) X nominal value x #cmonths /12

Borrrow money from bank at spot rate

Question 18

What are the hedging steps of a forward rate agreement?

Answer 18

Pros:

Hedges away downside risk
Tailored to investor (so won’t be over or under hedged)

Cons:

Usually only available on loans >500k

Usually for >1 year

Removes any upside potential

Difficult to exit (if date or size of borrowing changes)

Question 19

What are interest rate futures?

What are the hedge steps?

Answer 19

Similar to FRAs but are standardised and traded on stock exchanges

Mature at the end of march, June, sept, dec. lending starts when futures contract expires

Three month interest rate futures have contract size of 500k

Futures price = 100-r (r is fixed interest rate)

Buying futures. Is akin to agreeing to receive fixed rate interest and selling futures is akin to agreeing to make fixed interest payment s

Borrower sell futures now and buy futures on date borrowing starts

Lenders buy futures now and sell futures on the date their lending starts.

Set up:

Sell futures if borrowing

Choose maturity date (as close to borrow start date as possible)

Calculate no of contracts = borrowing notional value / 500k x (borrowing period/3)

Outcome of hedge:

Close out futures by buying same number of contracts gives a gain or loss on futures =

(Sell price - buy price)/100 x # contracts x 500k x 3/12

Borrow spot rate from bank

Question 20

What are the pros and cons of interest rate futures?

Answer 20

Hedges away downside risk

Can close out position at any time (more flexible than FRAS)

Cons:

Removes upside potential

Standardised contracts so may over or under hedge

Basis risk (difference between spot rate and futures rate before futures maturity date) may lead to hedge not being 100% efficient

Must post margin (collateral) to the exchange

Question 21

What are interest rate options?

What is the interest rate guarantee?

Answer 21

Grants the buyer of tbe option of a right but not the obligation to borrow/lend at an agreed interest rate at a future maturity date

On date of expiry of option, buyer must decide whether or not to exercise right

There is a premium

IRG: refers to an interest rate option which hedges the interest rate for a single period of up to one year.

Question 22

What are traded interest rate options? Related to interest rate options?
What are the hedging steps?

Answer 22

Are available as options on interest rate futures which give the holder the right to:
Buy (call) or sell (put) one futures contract
On or before the expiry of the option

Borrowers buy puts
Lenders buy calls

Hedging steps:

Set up:

Buy put options (if borrowing)

Choose strike price (based on 1 - maximum rate you want to pay)

Choose maturity date (as close to borrow start date as possible)

Calculate no of contracts = borrowing notional value / 500k x borrowing period/3

Pay premium = # contracts x 500k x preniumc% x 3/12

Outcome of hedge:

If rates rise above rate implied by strike price exercise option:

Sell futures at strike price

Close out futures by buying same number of contracts - gain on futures =

(Sell price - buy price) / 100 x # contracts x 500k x 3/12

Borrow money from bank at spot rate

If rates fall below rate implied by strike price: let option lapse

Borrow money from bank at spot rate

Question 23

What are the pros and cons of traded interest rate options?

Answer 23

Pro:

Protects from downside risk and allows buyer to benefit from upside by letting put option lapse if interest rates fall

Cons:

Option premiums can be expensive and must be paid now

May over or under hedge just to standardised contracts

Basis risk (difference between spot rate and futures rate before futures maturity date) may lead to hedge not being 10”% efficient

Question 24

What is an interest rate swap?

Answer 24

OTC whereby the parties to the agreement exchange interest rate commitments.
A agree this pay the interest on party B’s loan, while party B reciprocates by paying interest on party As loan

The two parties must swap interest which has different characteristics. One party must want fixed interest payments c the other must want floating interest pahments.

Question 25

How do you calculate savings on interest rate swaps?

Answer 25

If the difference between the fixed rates which two parties can borrow at and the variable rates which the two parties can borrow at are no equal, then it will be beneficial for them to enter into an IR swap.

Set out the rates each company would pay (with no swap) and could pay (if they did the opposite) and work out the total rate in each case

Calculate the total potential benefit finding the difference between the two totals in part 1

Split this potential saving between the two parties as instructed in the question

Calculate the overall effective rate with a swap for each party by deducting their share of the saving from the rate they would pay if there was no swap

Use this end result to calculate the two legs of the swap.

Question 26

What are the pros and cons of interest rate swaps?

Answer 26

Pros:

Can either provide fixed or floating interest

Can be either longer term than FRAs/ futures/ options

Can be used to achieve lower borrowing costs for each counter party

Cons:

If you swap to pay fixed interest you lose upside potential of variable rates

If you swap to pay floating interest you risk impact of rate rises

There is a risk that the swap counterparty defaults

There is a risk that the swap might make our sccohnts appear misleading