Managing financial risk: Interest rate and other risks

Question 1

Define an interest rate swap (2)

Answer 1

• An agreement whereby two parties agree to exchange interest payments over an agreed period of at least one year and typically longer.
• The major players in the swaps markets are usually banks.

Question 2

Define a simple interest rate swap (3)

Answer 2

• Also known as a plain vanilla swap.
• Two parties agree to exchange payments of interest on a notional amount of principal at regular intervals over the term of the swap.
• The most common arrangement is for one party to pay interest at a fixed rate of interest and the counterparty to pay interest at a variable rate of interest (usually LIBOR).

Question 3

Define LIBOR

Answer 3

• The London Interbank Offered Rate
• A benchmark rate of interest representing the rate of interest at which one major bank will be prepared to deposit funds with another major bank.

Question 4

3 factors that affect the time value of options on shares

Answer 4

VIT

• Volatility of the market price of the shares: If share price becomes more volatile this will increase the probability of the options becoming either in the money or deeper in the money, which would increase the value of the options.
• general level of Interest rates: The exercising of the option will be at some point in the future and so the value depends on the present value of the exercise price.
• Time period to the expiry of the option: The longer the time to expiry, the more the option is worth.

Question 5

2 factors that affect the intrinsic value of options on shares

Answer 5

1. Exercise price
   - For a call option: The lower the exercise price in relation to the share price, the higher will be the intrinsic value and this will make the option more valuable.
   - For a put option: The higher the exercise price in relation to the share price, the higher will be the intrinsic value and this will make the option more valuable.
2. Share price
   - For a call option: As the share price rises, the option becomes deeper in the money and more valuable as the intrinsic value increases. The opposite is true for a fall in the share price.
   - For a put option: As the share price falls, the option becomes deeper in the money and more valuable as the intrinsic value increases. The opposite is true for a rise in the share price.

Question 6

7 advantages of interest rate swaps

Answer 6

CALF WRAP

1. interest rate savings are possible either out of the counterparty or out of the loan markets by using the principle of Comparative Advantage.
2. available for Longer periods than the short-term methods of hedging such as FRAs, futures and options.
3. they are Flexible since they can be arranged for tailor-made amounts and periods.
4. it makes it possible to obtain the type of interest rate (fixed or floating) that the company Wants.
5. Reversible.
6. Arrangement costs are significantly less than terminating an existing loan and taking out a new one.
7. swapping to a fixed interest rate will assist in cash flow Planning.

Question 7

Define forward contract

Answer 7

A binding, tailored agreement to buy or sell an item for settlement at a future date at a price agreed today.

Question 8

Define future

Answer 8

A standardised contract to buy or sell a specific amount of a commodity, currency or financial instrument at an agreed price on a stipulated future date

Question 9

Define long future position

Answer 9

When someone buys futures not having traded in the futures contract before, they open a long position in a futures contract.

Question 10

Define short future position

Answer 10

When someone sells futures without previously having bought them they open a short position.

Question 11

Define index futures

Answer 11

Futures contracts on a portfolio of shares represented by a stock market index.

Question 12

What is each FTSE100 index futures contract worth?

Answer 12

notional value of the futures price x £10

Question 13

If you’re worried about share prices decreasing, would you buy or sell a future / option?

Answer 13

Sell futures / options to protect the value.

Question 14

How to calculate number of future contracts

Answer 14

market value / contract value

Question 15

Define option

Answer 15

An agreement giving the buyer of the option the right, but not the obligation, to buy or to sell a specific quantity of an item at a fixed price on or before a specified date, after which the option expires if not exercised.

Question 16

Over the counter option

Answer 16

A company or an investor can arrange a tailor-made option for their specific needs with a financial institution

Question 17

Define call option

Answer 17

An investor is entitled to buy the shares

Question 18

Define put option

Answer 18

An investor is entitled to sell the shares

Question 19

Define strike price

Answer 19

Same as exercise price

Question 20

5 methods of reducing interest rate risk

Answer 20

1. Pooling of assets and liabilities
2. Forward rate agreements (FRAs)
3. Interest rate futures
4. Interest rate options (or interest rate guarantees)
5. Interest rate swaps

Question 21

3 limitations of forward rate agreements

Answer 21

1. Usually only available for amounts of at least £500,000.
2. Likely to be difficult to obtain for interest periods over 12 months.
3. Remove upside potential.

Question 22

2 advantages of forward rate agreements

Answer 22

1. Protect the borrower or investor from adverse market interest rate movements.
2. Tailored.

Question 23

What does the suitability of strategies depend on?

Answer 23

1. Attitude to risk

2. Probability of outcomes