Interest Risk Management

Question 1

What is interest rate risk?

Answer 1

The adverse movement in interest rates.

i.e Interest rates rising when a business borrow money resulting on a great cash outflow, or interest rates falling on when a business has a surplus of cash, resulting in a decreased cash inflow.

Question 2

What is gap exposure?

Answer 2

Where there is a difference between the amount of interest sensitive assets and interest sensitive liabilities. The bigger the gap, the greater the risk

Question 3

What is a negative gap?

Answer 3

Sensitive interest liabilities maturing at a certain time in the future are greater than interest sensitive assets. The business will suffer a loss if interest rates rise.

Question 4

What is a positive gap?

Answer 4

When interest sensitive assets maturing at a certain date in the future are greater than interest sensitive liabilities. The business will suffer a loss if interest rates fall.

Question 5

A company can use gap exposure to determine the likely impact on the company of…

Answer 5

interest rate changes

Question 6

The interest rate yield is also known as…

Answer 6

the term structure of interest rates.

Question 7

A normal yield curve is…

Answer 7

upward sloping

Question 8

A decision to invest in short term is prioritising…

Answer 8

liquidity

Question 9

A decision to invest in the longer term is prioritising

Answer 9

Profitability.

Question 10

What is the yield to maturity?

Answer 10

The true annual rate of return that an investor expects to receive between the date of investing and the maturity date.

Question 11

What is the liquidity preference theory?

Answer 11

Investors prefer more liquid investments and invest for shorter periods.

Question 12

What is the expectations theory?

Answer 12

The shape of the yield curve is influenced by investors expectations of the way the short term interest rates will change in the long term.

Question 13

If investors expect the short term interest rates to rise, then the curve will be more…

Answer 13

strongly upward sloping

Question 14

What is the market segmentation theory?

Answer 14

Investors that want to investor short term, are different to those who want to invest long term.

Question 15

What is the result of market segmentation?

Answer 15

The supply/ demand relationship is different for short term debt compared to long term debt.

Question 16

What are the 6 interest rate management techniques?

Answer 16

1. Matching
2. Smoothing
3. Asset and Liability Managements
4. Forward rate guarantees
5. Interest rate guarantees
6. Other derivatives (futures, options, swaps)

Question 17

What is matching?

Answer 17

Every future outflow arising from interest rates, is matched by a future inflow from interest rates.

Match deposits and borrowing of money with the same type of interest rate ( variable/ fixed)

Question 18

What is smoothing?

Answer 18

A company should have some fixed rate borrowings and some variable rate borrowings to strike a balance between being exposed to interest risk, as well as take advantage of a fall in interest rates.

Question 19

What is asset and liability management?

Answer 19

Seeks to reduce interest rate risk by seeking to avoid either a negative or positive gap - ie. a company will have the same interest sensitive liabilities as interest sensitive assets maturing at the same time.

Question 20

What is a Forward rate agreement? (FRA)

Answer 20

Forward contract of an interest rate for a future short term loan or deposit

Question 21

A FRA can be used to …

Answer 21

fix a rate of interest on a loan or deposit starting at a date in the future.

Question 22

FRA’s are normally of amounts over…

Answer 22

£1 million

Question 23

FRA is a contract relating to the level of a short term market interest rate, such as…

Answer 23

a three month LIBOR or a six month LIBOR

Question 24

3 - 7 FRA at 4.00% - 3.8%

What do the 3 and 7 represent?
Which of the %’s is the borrow /deposit %?

Answer 24

the months until the FRA starts and ends.

4% Borrow 3.8% deposit

Question 25

What is an interest rate gaurantee?

Answer 25

The option to enter into a FRA ( not obligation)

Question 26

What is a advantage or an IRG?

Answer 26

Protects against adverse risk whilst being able take advantage of favourable interest rate risk. If interest rates fall the option can be allowed to lapse.

Question 27

What is the disadvantage of an IRG?

Answer 27

Expensive. The premium is payable regardless of whether you exercise the option or allow it to lapse.

Question 28

How are interest rate futures different from a FRA?

Answer 28

Standardised and traded on a futures exchange.

FRA’s are tailor made and cannot be traded.

Question 29

How would you set up an interest rate future hedge if you’re borrowing?

Answer 29

Sell an interest rate future and later buy one when the closing out the hedge

Question 30

How would you set up an interest rate future hedge if you’re depositing?

Answer 30

Buy an interest rate future when setting up the hedge and sell an interest rate future when closing out the hedge.

Question 31

What is basis risk?

Answer 31

Matching gains or losses on futures trading, with gains or losses when money is borrowed or deposited. - The basis risk is that they may not exactly match.

Question 32

What are traded options?

Answer 32

Options to buy or sell futures contracts. (protects adverse, takes advantage of favourable, expensive)

Question 33

What are collars caps and floors?

Answer 33

Collars - min and max rate
Caps - Max rate
Floor - Min rate

Question 34

What is an interest rate swap?

Answer 34

An agreement between two parties to swap the interest that they pay on a common nominal amount of debt capital.