Interest Rate Risk Flashcards
What effects can IR movements have on a company?
1) Changes in cash flow
2) Changes in cost of borrowing
3) Reduction in sales by changes in customer spending
4) Cost of purchases to increase due to suppliers increasing their own prices
5) Major risk for LTD geared orgs
Floating vs Fixed interest rates
Floating
1) Frequent adjustments
2) Sonia rates change(6 months)
3) Dependent on market conditions
Fixed
1) Stays the same regardless of current market conditions until end of payment/deposit term
What are the ‘do’s’ a CT must follow when creating an Interest Rate Policy
1) Consistent with general business risks of a co.
2) Based on past experiences of changes in IR and their affects.
3) Clear guidelines on fixed/floating rate mix of borrowings.
4) Risky businesses with high gearing to move to fixed rate funding
Portfolio Policy vs Alternative
1) Portfolio: Either keep overall borrowing within a set/ expectation dependent on falling rates & likelihood of a market rise.
2) Alternative: Borrowing at floating rates and fixed.
What is a Forward Rate Agreement
1) Similar to a Currency Forward, FRA’s are OTC contracts between parties that determine the IR paid on an agreed upon fixed rate at a date in the future.
2) It involves 3 parties, Borrower, Lender and a dealer
Steps to calculate FRA
1) Determine months
2) Is CIR lower or higher than QIR
CIR-QIRloann/12
3) Calculate borrowers TIA to pay to lender
ITAloann/12
4) Add FRA payment or Subtract FRA receipt
ITA+(-) FRAP(FRAR) = TIC
5) Effective interest
TIC/loan*12/n
What are the advantages and disadvantages of FRA’s
Advantages
1) OTC-Tailored
2) protect against adverse IR movements
Disadvantages
1) Removes upside potential
2) For short term use(IR swaps for long)
3) May include a premium
Other external IR hedging techniques?
1) IR Swaps
2) IR options(normal or collar)
What are the associated risks and rewards of not hedging?
1) Risks: IR increasing could lead to BC increasing
2) Rewards: IR decreasing could lead to BC decreasing
