Interest Rate risk

Question 1

FRA’s
(Forward Rate Agreements)

Answer 1

Same as currency hedging - Forward
Locks into a target rate
Hedges both adverse and favourable movement

Question 2

IRGs

Answer 2

Option of the FRA
Adverse movement = exercise option to protect
Favourable movement = let it lapse

Question 3

Interest rate futures

Answer 3

Locks company into interest rate
Hedges adverse and favourable rates - can be traded
Standard contract size

Question 4

Basis risk

Answer 4

Gain or loss on a futures contract may not exactly offset the cash effect of the change in interest rate risk

One reason for an imperfect hedge, other is rounding
The possibility the movement in the currency futures price and the spot price may be different

Question 5

Caps, Floors, Collars

Answer 5

Cap - set maximum rate, if actual interest lower, option allowed to lapse
Floors, set minimum rate, if actual interest rate higher, option allowed to lapse
Collar - cheaper than a floor and cap, set both maximum and minimum rate

Question 6

Swaps

Answer 6

Used to hedge against an adverse interest rate movement

Question 7

Interest rate smoothing

Answer 7

Taking up both fixed and variable rates to reduce exposure

Question 8

Payment = borrow = lower rate of spread
Receipt = higher rate

Question 9

When to apply non annual periods

Answer 9

Calculating forward rates,
Money market hedges
Inflation rates when figuring out PPPT