Interest Rate Risk (1) Flashcards
How can a company face interest rate risk on borrowings?
Higher interest rates will increase financing costs
How can a company face interest rate risk on investments?
Lower interest rates will reduce the return on cash investments
Can company still face risks even if borrowings and investments are the same?
Yes
Risk that interest rate rises on borrowings and investments?
Interest is earned at a fixed rate on investments but interest is paid at a variable rate on borrowings
Risk that interest rate falls on borrowings and investments?
Interest is earned at a variable rate on investments but interest is paid at a fixed rate on borrowings
An example of risk even if company has assets and liabilities of similar size and both investment borrowings are at a variable rate of interest?
The variable interest rates are not determined by the same basis. Known as the basis risk
What is the gap exposure?
There is a time gap that gives rise to risk
When may gap exposure arise? (time)
Interest rates on investments and borrowings are revised at different points in time
When may gap exposure arise? (interest-sensitive)
Difference between value of interest-sensitive assets maturing at that time and the value of interest-sensitive liabilities maturing at that time
Liabilities > Assets in gap exposure?
Risk of interest rates arising (a negative gap)
Assets > Liabilities in gap exposure?
Risk of interest rates falling (a positive gap)
What is smoothing?
Using a prudent mix of fixed and floating rate finance to mitigate the impact of interest rate changes
What is matching?
Involves creating assets that are based on the same interest rate (e.g. base rate) as their liabilities (used by banks)
What is asset and liability management?
Creating liabilities that match the duration of the asset they relate to
Example of asset and liability management?
Taking out a loan that has the same duration as the investment that the loan was taken out to finance
