Lecture 8- Interest rate risk management and Hedging Instruments (Forwards and Swaps) Flashcards
What is the term structure of interest rates?
A set of interest rates for a class of assets for a range of terms
What is a yield curve?
A graph of the term structure of interest rates at a particular point in time
a) Normal
b) Inverse
c) Flat
a) Normal: slopes upward because shorter term rates are lower than longer term rates
b) Inverse: Downward- because longer term rates are lower than shorter term rates
c) Flat: The curve is horizontal
How are yield curves constructed and on what types of securities?
1) Constructed from the yields on TRADED SECURITIES (rather than bank deposits)
2) The securities need to have little or no credit and liquidity risk- therefore BABs and Treasury bonds are used
3) The yields need to be calculated on a single payment instrument such as BABs (bonds need to be stripped of their coupons)
What are sport interest rates and how would we classify them in terms of ‘n’?
Current rate of interest- can refer to spot rates as oRn
What is a forward interest rate? How would we classify them in terms of ‘n’?
Commences at a future date and extends for a specified term- can refer to forward as 1Rn
What is the formula for converting spot rates to forward rates?
1r2= (F2/F1)-1
Where F2 and F1 are the future values
What is the formula for converting forward rates back to spot rates
0r2= (0r1+1r2)/ 2
What are the two yield curve theories?
1) Unbiased expectations theory
2) Liquidity premium theory
What does the unbiased expectations theory suggest?
Expectations of future sport rates determine forward rates and so decide the yield curve’s slope
What does the unbiased expectations theory say about normal and inverse yield curves
A normal yield curve= will occur when the market expects spot rates will rise in the future
An inverse yield curve will occur where the market expects the spot rates to fall in the future
What does the unbiased expectations theory assume and what does it ignore that the liquidity premium theory does not?
It assumes borrwers and lenders are unbiased in the choice between securities with different terms
IGNORES= transaction costs and price risk
What is the liquidity premium theory?
Theory that argues that market interest rates include risk premiums that are:
1) Higher for long term rates
2) May be expected to change
What is price risk? What does the liquidity theory say about price risk?
Price risk- the risk of a loss from adverse movement in interest rates
- Liquidity premium says choice between investment strategies is based on price risk
- Yield for longer term investments will include a risk premium to compensate investors for their price (liquidity) risk
What is the flaw of the liquidity premium theory?
Does not explain non- normal yield curves
What risks are borrowers and lenders exposed to?
Borrower- risk of interest rates increasing
Lenders- risk of interest rates decreasing
What are derivatives? What do they do?
Contracts that have their value to the value of another financial instrument market index or variable.
They establish the forward interest rate, however do not arrange the loan
What function do derivatives perform?
Risk transfer function (interest rate risk)
How do derivatives hedge risk?
Through cash settlement (net settlement)
Who does operates within the derivates market?
Hedgers- who are seeking to manage an exposure risk and speculators, who seek to profit from accepting a risk exposure
What are the four main types of derivative instruments?
1) FRAs
2) Swaps
3) Interest rate futures
4) Options
What is a forward rate agreement (FRA?)
Contract with a bank that establishes a forward interest rate for a specified future date on a nominal principal for a set period
What are the two key benefits or a FRA?
1) No upfront cost
2) Cash settlement attributable to the difference in the forward rate
What does the FRA standard documentation specify?
1) Settlement date
2) Term of the rte
3) Amount on which rate applies
4) Whether it is a borrowing or lending rate
5) Cash settlement equation: settlement= market- agreed
What rate must always equal the effective rate?
The FRA rate
How are FRA quotes determined?
Based on forward rates revealed by the bill futures market (liquid market & FRAs have to be competitive with this market)
How do dealers within the FRA market earn an income?
Through the spread between the rates provided to borrowers and lenders
What are the key features of the FRA market?
1) Primary, wholesale market- OTC basis
2) Main dealers= big four and some international banks
What is a swap?
Exchange of payments over an agreed period (i.e. changing from fixed to floating rate borrowing pattern)
Who operates in the swap market and what kind of market is it?
Dealers, OTC basis, primary market (no secondary market)
Do swap payments change the borrowers obligations?
No- the swap establishes an additional set of payment oblgiations, based on the swap rate and the BBSW
What is the cash settlement formula?
Q (nominal amount) (swap rate- BBSW) d/diy
How do I tell who has the obligation to pay the net settlement?
Whoever is paying the higher interest rate (swap rate= fixed rate PAYER) OR (BBSW= floating rate payer)
Who will benefit if the BBSW rises and BBSW falls?
If BBSW rises- fixed rate payer because it will receive higher than expected floating rate payments
If BBSW falls- floating rate payer- they will be paying less
What are the steps in hedging using a swap?
1) Determine the nominal (hedged) amount:
Q (Present value)
2) Determine the bill proceeds USING THE MARKET RATE
3) Determine the swap payment- Nominal amount - (Swap rate- BBSW)
