Lecture 9 Flashcards
What is a forward rate agreement?
Allows borrower to manage interest rate risk exposure
Locks in an interest rate today that will apply later like a future
More flexible to manage and no requirement to make margin payments
Contractual agreement between two parties to lock in a rate under specified conditions
What are the FRA terms?
Agreed rate is fixed interest rate set at start
Settlement date is the nominated date specified
contract period is just the term the rate is being protected for
A notional principle or face value needs to be specified
Reference rate is specified in the FRA and is compared to the agreed date on the settlement date
How does an FRA work?
Not a borrowing or lending arrangement
On the date of settlement, if the reference rate is different from the agreed rate then one of the parties will compensate the other
usually one of the parties is a financial institution
What happens with FRA from financial institutions?
They will provide a 2 way quote where the higher rate is used on a borrowing hedge and the lower on a investment hedge.
What happens in a borrowing hedge?
In a borrowing hedge, when the agreed rate is less than the
reference rate the bank compensates the borrower for
having to borrow at the higher reference rate.
When the agreed rate is more than the
reference rate the borrower will have to pay the bank.
What happens in an investment hedge?
In an investment hedge, when the agreed rate is greater
than the reference rate the bank compensates the investor
for having to invest at the lower reference rate.
When the agreed rate is less than the
reference rate the investor will have to pay the bank.
What is a swap contract?
Over the counter financial product that lets parties swap cash flows. Direct swap is person to person and intermediated is with bank in middle. This is what a majority of the swaps and helps to facilitate management of interest rate risk exposure.
What is a vanilla swap?
main type where one party agrees to pay an amount determined by a fixed interest rate while the other agrees to pay an amount determined by a variable reference rate. In reality, the parties will swap the net difference at each reset date in the swap
How does hedging interest rate risk work?
Corporation has variable rate loan and is worried about rates rising so enters into a vanilla swap with a bank
Corp pays fixed swap rate while banks pays variable reference rate
What are credit default swaps?
Buyer pays seller a fee over the life of the swap fro protection against default. Seller receives the income but pays the buyer if the issuer defaults
What are some other swaps?
Delayed Start Options, Equity Swaps, Tax Swaps, Swaptions, Contracts for Differences
What are warrants?
A derivative similar to futures and options, but where the
seller is a financial institution.
Examples include Instalment, Equity, Knock out
What are company issued calls?
Call options issued by a company which will result in
new shares in the company being issued if exercised.
A method of raising equity capital for a company
