Hedging - Interest Rate Risk Flashcards
A borrower will …. a FRA
Buy
An investor will …. a FRA
Sell
Elements of an FRA
- allow the borrower/lender to fix their future rate of interest
- FRAs are separate from the underlying loan/deposit
Advantages of FRAs
- For the period of FRA, they protect the borrower/investor from adverse interest rate movements
- FRAs can be tailored to the amount and duration required, whereas other hedges are standardised (e.g. futures)
Disadvantages of FRAs
- Only usually available on loans of at least £500k
- Difficult to obtain for periods >1yr
- Remove any upside potential (ie they give a fixed rate of interest)
Borrowers will wish to hedge against an interest rate rise by …. futures now and …. futures on the day that the interest rate is fixed
- Sell futures now
- Buy futures on the day interest rate is fixed
Savers will wish to hedge against the possibility of falling interest rates by …. futures now and …. futures on the date the actual saving starts
- Buying futures now
- Selling futures when actual saving starts
Pricing of an interest rate futures contract is calculated by…
100 - r
r = interest rate
As the interest rate increases, the price of a futures contract…
Decreases
Define maturity mismatch for futures contracts
When the actual period of lending or borrowing does NOT match the notional period of the futures contract (3 months)
No. of futures contracts = ?
(Amount of loan or deposit
DIVIDED BY
Futures contract size)
Multiplied by
(Length of loan / 3 months)
Effective rate of a futures contract (annual) =
(Gain or loss on futures
DIVIDED BY
Amount of loan or deposit)
Multiplied by
(Length of loan-deposit / 3 months)
Elements of Over The Counter interest rate options
- can be purchased by major banks
- premium has to be paid
- tailored to customer specifications (principal amount, period of maturity, rates of agreed interest)
- more flexible than FRAs
Traded interest rate options:
A borrower will purchase an option to … futures (a … option)
- Sell futures
- Put option
A saver will purchase an option to … futures (a … option)
- Buy futures
- Call option
Elements of a swap agreement
- contractual agreement to exchange future interest rate payments
- size of loan must be notionally equal for both parties
- a means of switching from paying one type of interest to another much more cheaply than renegotiating an existing debt
Advantages of swaps
- Enables switch from floating to fixed
- Arrangement costs are less than terminating existing loan/debt
- Available for longer periods than FRAs (>1yr)
- Flexible - tailor made amounts and periods, and are reversible
Disadvantages of swaps
- Counterparty might default before completion
- Risk of unfavourable market movements if interest or exchange rates after the swap is entered into
- May lead to the financial statements of the party involved being misleading
