Chapter 9: Managing financial risk – interest rate and other risks Flashcards
1.1 Forwards and futures
A forward is a binding agreement to buy or sell (or borrow or lend) something in the future at a price agreed today. It is an agreement between two parties and therefore can be for any amount for any product at any point in time.
Futures are just forward contracts that have been standardised. The contract which guarantees the price is separated from the transaction itself, allowing contracts to be easily traded.
To protect against a price rise, a business will buy the future today and sell it as the expiry date. When futures contracts are entered into, a deposit known as the initial margin must be made to the futures exchange. This deposit is refunded when the contract is closed out. The initial margin should cover any potential losses from the first day’s trading. Any further losses must be covered by topping up this account, known as variation margin. This process is known as marketing to market.
2.1 Options and traded options
An option gives the right but not the obligation to buy or sell a specific quantity of an item at a predetermined price (the exercise price) within a stated period or on a fixed date. Options can therefore be:
- Exercised if the exercise price is better than the spot rate
- Abandoned if the exercise price is worse than the spot rate
In order to be given the option, the buyer pays a fee to the writer of the option. An option to buy something is known as a call option, option to sell something is a put option.
Options that require physical delivery have generally been replaced by a standardised derivative which can be traded. These are known as traded options. The options contract is separated from transaction itself allowing the contracts to be easily traded.
3.1 Interest rate risk
Interest rate risk is the risk of incurring losses due to adverse movements in interest rates. If we are borrowing, the risk of interest rates rising. If we are putting money on deposit, the risk of interest rates falling. The risks can be reduced in the following ways: pooling of assets and liabilities, forward rate agreements, interest rate futures, interest rate options and interest rate swaps.
4.1 Pooling of assets and liabilities
Risks may be netted off where both assets and liabilities are subject to interest rate risk.
5.1 Forward rate agreements (FRAs)
An FRA is a commitment to an interest rate on a future loan. Like a normal forward, it is a tailor made product, which can be for any amount of loan for any duration. However, the contract which guarantees the interest rate is separate to the underlying loan transaction.
Workings of an FRA: a company has a requirement to borrow money in the future, to offset the interest rate risk, the company enters an FRA.
- The capital amount is borrowed and interest is paid on the loan in the normal way
- If the interest is greater than the agreed forward rate the bank supplying the FRA contract pays the difference to the company
- If the interest is less than the agreed forward rate the company pays the difference to the bank supplying the FRA
The outcome is the company ends up suffering a fixed rate of interest.
A 5-8 FRA means an FRA on a notional three month loan, starting in five months. An FRA priced at 3.2 – 2.6, means a fix borrowing cost at 3.2% or investment return at 2.6%. selling an FRA fixes the interest received on a deposit. Buying an FRA fixes the interest paid on a loan.
6.1 Interest rate futures (IRFs)
Similar to an FRA but are for standardised amounts, starting on predetermined dates. The workings involves:
- The capital amount is borrowed on the open market and interest is paid on the loan in the normal way
- If interest rates rise, the more expensive cost of borrowing is offset by a profit on the futures contract
- If rates fall, the fall in the cost of borrowing is offset by a loss on the futures contract
The outcome is the company ends up suffering a fixed rate of interest. Interest rate futures are quoted at 100 – the expected market reference rate, as a percentage. Selling a futures contract fixes the interest paid on borrowing and buying a futures contract fixes the interest received on deposits.
6.2 Calculating the number of contracts needed
The number of contracts required must cover:
- The size of the loan / deposit
- The length of the loan / deposit
Number of contracts = (loan or deposit amount / contract size) x (loan or deposit period in months / 3 months).
7.1 Interest rate options
An interest rate option gives the buyer the right, but not the obligations, to borrow/lend at an agreed interest rate at a future date. An interest rate guarantee is a term for an interest rate option which hedges the interest rate for a single period (less than one year). These are also called short term interest rate caps (put option) or short term interest rate floors (call option).
Over the counter interest rate options are tailor made agreements between two parties, that give the party buying the option, the right but not the obligations to borrow (put option) or lend (call option) at a fixed rate. They require a premium to be paid upfront, regardless of whether the option is exercised or not.
7.2 Traded interest rate options
These are options on interest rate futures. Give the holder the right to buy (call option) or sell (put option) one futures contract on or before the expiry of the option at a specified price (strike price). If the company has the intention to borrow (purchase put options), if they intend to invest (purchase call options).
They work by:
- The capital is borrowed on the open market and interest is paid on the loan in the normal way
- If intertest rates rise, the option is exercised, therefore the more expensive cost of borrowing is offset by a profit on the futures contract
- If rates fall, the option is allowed to lapse, and the company therefore benefits from a cheaper cost of borrowing
The outcome is the company ends up with an interest rate no higher than the guaranteed maximum, but which could be lower if rates fall.
7.3 Reasons for an imperfect hedge
Futures and traded options are standardised products, they have standard sizes and standard expiry dates. This means a hedge is imperfect for two reasons:
- Rounding the number of contracts: if the transaction is not an exact number of contracts, then it must be rounded to the nearest whole number. This means an element of risk remains
- Closing out before the expiry date: if transactions occurs (and the future is closed out) before its expiry date, the futures price may not match the spot rate at the date it closed. The difference (bias risk) means the hedge is imperfect.
8.1 Interest rate swaps
Basic swap is an agreement whereby two partis agree to swap a floating stream of interest payments for a fixed stream of interest payments and via versa. There is no exchange of principal. The companies are termed ‘counter-parties’.
Scenario: one company (A) will want to borrow at a fixed rate, but is offered a good variable loan. Company B will wants to borrow at a variable rate, but offered a good fixed rate loan. Instead of the companies borrowing as they want to:
- A will borrow at a variable rate and B will borrow at a fixed rate
- B will make a variable interest payment to A and A will make a fixed interest payment to B, thereby the companies effectively swap interest payments.
In order to calculate the payments required:
- Establish the total benefit to be gained from the swap (the reduction in the total interest rate paid by doing the swap)
- Establish the final rates that can be achieved by each party, by splitting the benefit between them (equally unless told otherwise)
- Establish the payments between the parties that will achieve this result
Main reasons for swaps include:
- Can be used to hedge against adverse movement in interest rates.
- A swap can be used to obtain cheaper finance. A swap should result in a company being able to borrow what it wants at a better rate under a swap arrangement, than borrowing it directly itself
- Swaps can run for up to 30 years, therefore preferable to futures for long term borrowing
- Transaction costs involved in a swap may be cheaper than costs involved in refinancing
Disadvantages include:
- Counterparty risk (risk counter party will default)
- Market risk (risk of an adverse movement in interest or exchange rates)
- Transparency risk (risk that the accounts may be misleading)
9.1 Index products
Futures and traded options protect against stock market falling.
Index futures: futures contract whose value depends on value of FTSE100 Index. A company has a portfolio of shares and will sell index futures. Later when the portfolio is sold, the futures position is closed out (contracts are bought back). If the market has fallen, the loss is offset by the profit on the futures contract. If it has risen, the increased portfolio is offset by a loss on the futures contract.
Index futures are quoted in points. The contract size is always equal to the futures price x £10
Index options: option to buy or sell a notional portfolio of shares whose value mirrors the FTSE index. To mitigate against a fall in the stock market, the company will buy put options on index futures. Later the portfolio is sold on the open market. If the market has fallen, the option is exercised and the loss in value of the portfolio is offset by the profit on the futures contracts. If it has risen, the option is allowed to lapse and the company benefits from the increased value. The outcome is the company ends up with a minimum price for its portfolio, this could be higher if the stock market rises more than expected.
10.1 Option value
Purchasers of an option pay a premium to the writer of the option to buy it. The value of this premium is made up of two components. The intrinsic value is the difference between the exercise price of the option and the current market value of the product. An option with intrinsic value is known as ‘in the money’. An option which is out of the money has no intrinsic value.
The time value is the difference between the actual premium and the intrinsic value. Time value of a call option increases with time to expiry, volatility of the underlying share and interest rates.
11.1 Choice of products
Forward/future vs option
A forward / future eliminates risk completely, no downside risk, but not upside potential but if the underlying transaction falls through, the business is re-exposed to risk. Whereas for an option the downside risk is eliminated, the upside potential is retained but if the underlying transaction falls through, there is still no risk. Therefore an option is more flexible than a forward but is more expensive.
OTC vs standardised products
OTC can be for any amount and any date and they tend to be more expensive unless for large amounts. Standardised are only for set dates and amounts, therefore may not provide a perfect hedge and they can be closed out easily if the underlying transaction falls through.
