E3. The use of financial derivatives to hedge against interest rate risk

Question 1

Interest rate risk

Answer 1

Interest rate risk is faced by both borrowers and lenders. It is the risk that the interest rate will move in such a way so as to cost a company, or individual, money.
• For a borrower the risk is that interest rate rise
• For an investor the risk is that interest rate falls

Question 2

Risks from interest rate movements

Answer 2

• Fixed rate vs floating rate debt. A company can get caught paying higher interest rates by having fixed rather than floating rate debt, or floating rather than fixed rate debt, as market interest rates change. Expectations of interest rate movements will determine whether a company chooses to borrow at a fixed or floating rate. Fixed rate finance may be more expensive; however, business runs the risk of adverse upward rate movements if it chooses floating rate finance.
• Currency of debt. A company can face higher costs if it borrows in a currency for which exchange rates move adversely against the company’s domestic currency. The treasurer should seek to match the currency of the loan with the currency of the underlying operations/assets that generate revenue to pay interest/repay the loans.
• Term of loan. A company can be exposed by having to repay a loan earlier than it can afford to, resulting in a need to reborrow, perhaps at a higher rate of interest.
• Term loan or overdraft facility. A company might prefer to pay for borrowing only when it needs the money as with an overdraft facility (bank will charge commitment fee), alternatively a term loan might be preferred (but will cost interest).
• Rises in interest rates. A company may plan to take out borrowing at some time in the future, but face the possibility that interest rates may rise before the term of borrowing commences.

Question 3

Interest rate risk management.

Answer 3

Interest rate risk management. If the organization faces interest risk, it can seek to hedge the risk.
• Where the magnitude of the risk is immaterial in comparison with the company’s overall cash flows or appetite for risk, one option is to do nothing.
• The company may also decide to do nothing if risk management costs are excessive, both in terms of the cost of using derivatives and staff resources.
• Appropriate products may not be available, or company may consider hedging unnecessary, as it believes that the chances of an adverse movement are remote.
• The company’s taxi situation may also affect decision, If hedging likely to reduce variability of earnings, this may have tax advantages if the company faces a higher rate of tax for higher earnings levels.
• Directors may also be unwilling to undertake hedging because of the need to monitor the arrangements, and the requirements to fulfil the disclosure requirements of IFRS.

Question 4

Simple techniques of reducing interest rate risk.

Answer 4

• Netting – aggregating all positions, assets and liabilities, and hedging the net exposure.
• Smoothing – maintain a balance between fixed and floating rate borrowing
• Matching – matching assets and liabilities to have a common interest rate.
• Pooling – asking the bank to pool the amounts of all its subsidiaries when considering interest levels and overdraft limits. It should reduce the interest payable, stop overdraft limits being breached and allow greater control by the treasury department. It also gives the company the potential to take advantage of better rates of interest on larger cash deposits.

Question 5

Yield Curves (Return to debtholder)

Answer 5

• Normal. Long term loans - higher yields (more risk)
• Inverted. Longer term loans - Less yield (upcoming recession)
• Flat. Yields are same for short- and long-term loans

Why is yield curve important? It predicts interest rates. Normal curves are upward sloping. Therefore, in these circumstances, use short term variable rate borrowing and long-term fixed rate.

Question 6

The shape of the yield curve depends on:

Answer 6

• Liquidity preference. Investors want their cash back quickly therefore charge more for long term loans which tie up their cash for longer and thus expose it to more risk
• Expectations. Interest rates rise (like inflation) - so longer term more charged. NB. Recession expected means less inflation and less interest rates so producing an inverted curve
• Market segmentation. If demand for long-term loans is greater than the supply, interest rates in the long-term loan market will increase. Differing interest rates between markets for loans of different maturity can also explain why the yield curve may not be smooth, but kinked.
• Fiscal policy. Governments may act to increase short-term interest rates in order to reduce inflation This can result in short-term interest rates being higher than long-term interest rates.

Question 7

Gap Exposure?

Answer 7

The risk of an adverse movement in the interest rates reducing a company’s cashflow.

Question 8

Forward rate agreement (fixing the rate)

Answer 8

Forward rate agreement (fixing the rate): a contract with a bank to receive or pay interest at a pre-determined interest rate on a notional amount over a fixed period in the future.
Like a currency forward, an FRA effectively fixes the rate. Unlike a currency forward, the FRA is a separate transaction, and is structured to create a fixed outcome by counterbalancing the impact that interest rate movements have on the actual transaction (ie loan or investment). If actual borrowing rate is higher than the forward rate then the bank pays the company the difference and vice versa.

Question 9

Advantages of forward rates:

Answer 9

• Simpler than other derivative agreements
• Normally free, always cheap (in terms of arrangement fees)
• Tailored to the company’s precise requirements (in terms of amount cover)

Question 10

Disadvantages of forward rates:

Answer 10

• Fixed date agreements (term is fixed e.g. 3-9)
• Rate quoted may be unattractive
• Higher default risk than an exchange-based derivative.

Question 11

Procedure forward rates:

Answer 11

• Get loan as normal
• Get forward rate agreement
• Difference between 2 rates is paid/received from the bank

Question 12

Interest rate future:

Answer 12

Interest rate future: an agreement with an exchange to pay or receive interest at a pre-determined rate on a standard notional amount over a fixed standard period (usually 3 months) in the future.
General features are the same as for currency futures, with key difference being interest rate futures have a standardised period of three months. Like FRAs, interest rate futures allow the fixing of an interest rate (losses on actual transaction will be covered by profits from futures and vice versa).

Question 13

Pricing interest rate futures contracts.

Answer 13

The pricing of an interest rate futures contract is determined by the three months interest rate (r %) contracted for and is calculated as (100 – r). For example, if three months Eurodollar time deposit interest rate is 9%, a three months Eurodollar futures contract will be priced at (100-9) = 91; and if interest rate is 10%, the future price = 90= (100-10). The decrease in price or value of the contract reflects the reduced attractiveness of a fixed rate deposit in times of rising interest rates.

Question 14

Maturity mismatch.

Answer 14

Maturity mismatch occurs if the actual period of lending or borrowing does not match the notional period of the futures contract (three months). The number of futures contracts used has to be adjusted accordingly. Since fixed interest is involved, the number of contracts is adjusted in proportion to the time period of the actual loan or deposit compared with three months.

Question 15

Types of Interest rate futures contract.

Answer 15

• A company with a cash surplus over a period of time in the future will be worried about interest rates falling; a futures contract to receive interest is needed, this is a contract to buy (buy assets=receive interest).
• A company needing to borrow money in the future will be worried about interest rates rising; this requires futures contract to pay interest, this is a contract to sell (sell bonds = pay interest).

Question 16

Advantages of Interest rate futures:

Answer 16

• Flexible dates (march future can be used on any day till end of march)
• Lower credit risk because exchange traded

Question 17

Disadvantages of Interest rate futures:

Answer 17

• Only available in large contract sizes
• Margin may need to be topped up on a daily basis to cover expected losses
• Basis may not fall in a linear way over time (basis risk).

Question 18

Steps in interest rate future hedge.

Answer 18

• Step 1: Now. Contracts should be set in terms of buying or selling interest – choosing the closest standardised futures date after the loan begins and adjusting for the term of the loan compared to the 3-month standard term of an interest rate future.
• Step 2: In the future. Complete the actual transaction on the spot market
• Step 3: At the same time. Close out the futures contract by doing the opposite of Step 1. Calculate net outcome.
• The value (amount) of futures x(sell-buy)/400 gives gain or loss on futures.
• Effective interest is net outcome/loan amount x12/6

Question 19

Interest rate swap

Answer 19

A swap is where two counterparties agree to pay each other’s interest payments. This may be in the same currency (interest swap) or in different currencies (currency swap).
Swaps enable company to:
• Manage interest rate risk e.g. by swapping some of existing variable rate finance to fixed rate finance; this may be cheaper than refinancing original debt (redemption fees and issue costs).
• Reduce borrowing costs – by taking out a loan in a market where they have comparative interest rate advantage.

Question 20

Organizaing interest rate swap

Answer 20

Usually a bank will organize the swap to remove the need for counterparties to find each other and remove default risk.

Because the variable rate of a swap can be assumed to be at LIBOR then all the bank has to establish is the rate to apply to the fixed rate leg of the deal. The fixed rate can then be quoted by the bank as a spread.
• The lower rate (bid price) is the rate a bank will pay on the fixed rate leg
• The higher rate (offer price) is the rate bank will receive on the fixed leg part of a swap.
• The bank makes profit from the difference between these rates

Question 21

Valuing interest rate swaps

Answer 21

Valuing interest rate swaps. An interest swap can also be valued as NPV of the net cash flows under the swap. At the start of the swap the swap contract is designed to give an NPV of zero based on the current FRA rates (zero NPV=return required).
• FRA rates are calculated by comparing borrowing between two years (e.g. 1.041^2/1.03)
• Calculate in $ payment expected by bank on FRA rates
• Net cash flows will be fixed rate R - payments
• Discount at annual spot rates (one for each year)
• Total NPV=0
• Divide result R by 100, that’s a fixed rate.

Question 22

Exchange-traded interest rate option:

Answer 22

Exchange-traded interest rate option: an agreement with an exchange to pay or receive interest at a pre-determined rate on a standard notional amount over a fixed standard period (usually 3 months) in the future. They are the same as interest rate futures contracts except that they only ever pay compensation, they never incur losses and involve the payment of a premium.
There are two types of option contract, calls and puts.
• Put option: an option to pay interest at a pre-determined rate on a standard notional amount over a fixed period in the future (a right to sell).
• Call option: an option to receive interest at a pre-determined rate on a standard notional amount over a fixed period in the future (a right to buy).

Question 23

Steps in an exchange-traded options hedge.

Answer 23

• Step 1: Now. Contracts should be set in terms of call or put options – choosing the closest standardised option date after the loan begins and adjusting for the term of the loan compared to the three-month standard term of an interest rate future. Pay a premium for the option.
• Step 2: In the future. Complete the actual transaction on the spot market.
• Step 3: At the same time. Close out the options contract on the future market by doing the opposite of step 1 but only if the option makes a profit. Calculate net outcome.
• Premium: no of futures x contract size x premium/400
• Calculate futures price using basis

Question 24

Advantages of interest rate options:

Answer 24

Advantages of options:
• Flexible dates (like future)
• Allow a company to take advantage of favourable movements in interest rates
• Useful for uncertain transactions, can be sold if not needed

Question 25

Disadvantages of interest rate options:

Answer 25

Disadvantages of options:
• Only available in large contract sizes
• Can be expensive due to the requirement to pay an up-front premium.

Question 26

Interest rate collars.

Answer 26

A company can write and sell options to raise revenue to reduce the expense of an exchange traded interest rate options. A combined strategy of buying and selling options is called collar.
• For a borrower a collar will involve buying a put option to cap the cost of borrowing and selling a call option at a lower rate to establish a floor (the borrower will not benefit if interest rates fall below this level). If interest rates rise the borrower is protected by the cap. If interest rates fall the borrower will benefit until the interest rate falls to the level of the floor. If interest rates fall below this then the borrower will have to pay compensation to the purchaser of the call option.
• For an investor a collar will involve buying a call option to establish a floor for the interest rate and selling a put option at a higher rate to establish a cap (the investor will not benefit if interest rates rise above this level). If interest rates fall the investor is protected by the floor. If interest rates rise the investor will benefit until the interest rate rises to the level of the cap. If interest rates rise above this then the investor will have to pay compensation to the purchaser of the put option.