Chapter 9 - Managing Financial risks: interest rate and others Flashcards
Derivative definition
Financial instrument whose value derives from an underlying financial item
Futures contract definition
Standardised exchange contract to buy/sell specific amount of notional underlying financial item on a certain date. They fix the price for buying or selling.
Forward contract definition
Binding agreement to buy or sell an item for settlement at a future date at a price agreed today
Futures definition
Standardised contract to buy or sell a specific amount of commodity, currency or financial instrument at an agreed price on a stipulated future date. They are bought and sold on exchanges
If someone buys futures not having traded before, what position do they open
Long position in futures contracts
If someone sells futures without previously having traded them before, they open
a short position
What are index futures
futures contracts on a portfolio of shares represented by a stock market index, used to protect investors against falls in value (important for e.g. pension funds)
Price of FTSE100 index futures contract
67000
Futures - To protect the value of a portfolio when worried about prices falling
Sell futures now
if the index falls, buy at lower price
gain will offset loss
Objective of a futures hedge
remove price risk by fixing price in advance
Disadvantage of futures hedge
price fixed so any upside removed
Futures - contract size definition
fixed quantity which can be bought or sold with one futures contract
has to be whole number
Futures - Contract price
price at which the futures contract is bought or sold
Futures - settlement date
date when trading on a particular futures contract stops and all accounts are settled
Futures - initial margin
Deposit that must be paid, size usually depends on the contract but often 5% of the value and this is refunded when contract is closed. Covers any losses in first day trading
Futures - Basis
Difference between futures contract price and spot price
= Spot price - futures price
Two factors that prevent futures market giving perfect hedge
value of commodity hedged must be rounded to whole number of contracts
basis risk - change in spot over period is not matched exactly by changes in futures price
Option - definition
gives buyer the right, but not the obligation to buy or sell a specific quantity of an item at a fixed price on or before a set date
What are over the counter options
tailor made options for specific needs made with financial institutions. can be for any number of shares or other stocks
What is a call option q
Investor is entitled to buy the shares at exercise price within specified period
What is a put option
investor is entitled to sell shares at exercise price within specified period
Strike price definition
price written into the option (also exercise price)
When is an option in the money
if exercised today, profit would be made as exercise price is more favourable than current market price
When is an option out of the money
if it were exercised today a loss would be made. Exercise price is less favourable than current market price
When is an option at the money
if exercise price = market price of underlying share
Types of options
Share options
Pure options - buy or sell assets that already exist
Currency option - buy or sell currency
Disadvantage of OTC options
all different so can’t be traded as no market for them
American style option
can be exercised any day up to expiry date
European style option
exercised only on its expiry date
What is the value of an option
sum of intrinsic value and time value
What is the intrinsic value of an option
assume expires today, minimum value is zero, out of the money options intrinsic clause zero. In the money options value is difference between exercise price and market price
Time value for a call option depends on
expectation that the market price will rise
time value for a put otpion
depends on the expectation that the market price of the underlying item will fall
Time value depends on three factors
- Time to expiry (longer worth more)
volatility of market price (more volatile more value) - General interest rates (TV money) - PV of exercise price
Where magnitude of interest risk is immaterial compared to overall cash flows one option
do nothing and accept movement
Risks from interest rate movements factors
Fixed v floating debt
Term of loan (exposed by repay earlier)
Term loan / overdraft facility
Deposit at floating rate
How to reduce interest rate risks
pool assets and liabilities
FRAs
Interest Rate futures
Interest rate options
Interest rate swaps
How does pooling assets and liabilities work
some interest risk may cancel each other out - if both assets and liabilities exposed and rate rises more payable on liabilities but offset by higher interest received on assets
FRA allow lenders/borrowers to
fix a rate of interest with a term that starts in future and lasts for several months, purchased OTC from a bank
FRA - if actual interest rate is higher than rate fixed by FRA agreed
bank pays customer the difference
FRA - if the actual interest rate is lower than the rate fixed by the FRA
customer pays bank the difference
FRA - Borrower will
buy to fix rate
FRA - investor will
Sell to fix rate on future deposit
Limitations of fRA
Usually only available for amounts > £500,000
difficult to obtain for periods more than 12 months
remove upside potential
Advantages of FRA
For period of FRA, protect borrower/investor from adverse market interest rate movements
OTC - can e tailored to amount and duration required
Interest rate futures are
standardised and hence cannot always be matched with specific interest exposures
What is bought with interest futures
entitlement to interest receipts
What is sold with interest rate futures
promise to make interest payments
Borrowers wishing to hedge against interest rate rise will
Sell now and buy to close
Lenders/depositors wanting to hedge against the possibility of falling interest rates will
buy futures now and sell to close
What are STIRS
Short term interest rate futures contracts
contracts on notional deposits/loans for three months beginning on a standard future date
What is the price of interest rate futures contract
100 - r
Interest rate futures - to hedge against risk of future increase in interest rates, a borrower will
sell to buy and close at lower price
When does maturity mismatch occur
if actual term of lending/borrowing does not match notional period of futures contract (3m)
Maturity mismatch equation number of futures contracts =
amount of actual loan/futures contract size * length of loan/3m
What is an interest rate guarantee/short term interest rate cap(put)/floor(call)
term for interest rate option which hedges interest rate for single period up to one year
Traded interest rate options are available as
options on interest rate futures
Option to buy
call option
option to sell
put option
Strike price definition
price that will be paid for futures contract if exercised
Interest rate options - if a company needs to hedge borrowing it should
purchase a put option - option to sell futures
Interest rate options - If a company needs to lend/deposit money it should
purchase call option - option to buy futures
Define interest rate swap
agreement whereby parties to the agreement exchange interest payments on notional amount of principal at intervals over a period of years
Advantages of interest rate swaps
- hedge exposure over long period
- change net payment fixed to floating
- costs are less than terminating loan and taking out another
- available for Longer periods
- flexible as tailor-made and reversible
- can do cross currency
For n interest rate swap to benefit both parties
- each must borrow in the market where it has comparative advantage
both parties must want the interest of the opposite type to which they have the comparative advantage
Risks of interest rate swaps
- counter party risk
- position/market risk
- transparency risk
Counterparty risk
Risk that counterparty to a swap will default before completion of agreement.
Lessen by using reputable intermediary
Interest rate swap
Position/Market risk
risk of unfavourable market movements of interest / exchange rates after entering swap
Transparency risk
risk that swap activity may lead to accounts of party involved being misleading
