Interest Rate Risk

Question 1

IR Risk occurs when

Answer 1

dont know how much interst to pay on borrowing or how much interst earned on deposit

Question 2

Aim of IR Risk management

Answer 2

Reduce uncertainty / not guaruntee profit

Question 3

Smoothing and matching

Answer 3

Use mixture of fixed and variable rate
Subject assets and laibilities to a similar rate
Liability length v investment length

Question 4

Forward rate agreement

Answer 4

Allow borrowing / depoist of funds as if fixed rate

Question 5

4 types of interest rate derivatives

Answer 5

Futures
Options
Caps/Floors/Collars
Swap

Question 6

Interest rate futures

-Buyer and seller

Answer 6

Fixed sizes, given durations, right to earn interst at a given rate or obligation to pay a given rate

BUYER –> Obligation to deposit money and right to receive interest
SELLER –> obligation to borrow money and pay interest

Question 7

Interest rate options

Answer 7

Give holder right BUT NOT OBLIGATION to either buy futures or sell at agreed price at agreed date
Borrowers set max cost
Lenders set min income

Benefit from favourable but protect against the adverse

Like insurance - pay a premium for something you may not need but good if youdo

SELL FUTURES IS PUT
BUY FUTURES IS CALL

Question 8

Caps floors and collars

Answer 8

Cap - max int rate for borrower
floor - min rate for investor
Collar - limit interest paid or earned at pre-determed rate

Borrower buy cap and sell floor
Depositor Buy floor and sell cap

Question 9

Swaps

Answer 9

OTC // Bank is a counterparty
Fixed or floating
Notional amount specified time

Question 10

Comparative advantage

Answer 10

Companies want to borrow in specific way / var or fixed
“advantage” ability to borrow more cheaply in certain markets
Can then swap cash flows