Managing interest rate and other financial risks

Question 1

What is a forward?

Answer 1

A forward is a binding agreement to buy or sell (or borrow or lend) something in the future at a price agreed today.

Over the counter

Perect hedge

Question 2

Forward: Pros

Answer 2

It is a tailor-made agreement between two parties and therefore can be
for any amount of any product at any point in time.

Question 3

FOrwardd: COns

Answer 3

Because a forward is a tailor made agreement between two parties, and requires the physical delivery of the goods (or money), it can be awkward to cancel if the need
arises.

Question 4

Future: Definition

Answer 4

Futures are just forward contracts that have been standardised (in terms of delivery date and quantity).

The contract which guarantees the price (known as the futures contract)
is separated from the transaction itself, allowing the contracts to be easily traded.

To protect against a price rise, a business will buy the future today and sell it at the
expiry date, (when its price will be the same as the spot price).

To protect against a fall in prices, a business
will sell the future today and buy it back
at the expiry date, (when its price will be the same as the spot price).

Standardised (so traded)

Question 5

Futures: Initial Margin

Answer 5

When futures contracts are entered into, a deposit known as the initial margin must
be made to the futures exchange. This deposit is refunded when the contract is
closed out.

The initial margin should cover any potential losses from the first day’s trading. Any further losses must be covered by topping up this account, known as a variation margin. This process is known as marking to market.

Question 6

Option: Definitiion

Answer 6

An option gives the right but not the obligation to buy or sell (or borrow
or lend) a specific quantity of an item at a predetermined price (the
exercise price) within a stated period (American-style) or on a fixed date
(European-style)

Options can therefore be:
1. Exercised if the exercise price is better than the spot rate
2. Abandoned if the exercise price is worse than the spot rate.

Traded
Standedrdiesd
RIght to walk away

Question 7

How is the extra benefit of an otoin charges?

Answer 7

Buyer pays a fee (option premium)

Question 8

An option to buy something (or to lend money)

Answer 8

Call option

Question 9

The option to sell something (or to borrow money)

Answer 9

Put option

Question 10

Can you have negotiaed options?

Answer 10

Yes

Like a forward, this is a tailor-made agreement between two parties. It can be for any amount, or any date.
Just like forwards largely being replaced by futures, options that require physical
delivery have generally been replaced by a standardised derivative which can be
traded. These are known as traded options.

Aka negotiated/OTC optoins

Question 11

The standardised version of an OTC option

Answer 11

‘traded option’

As for futures, the options contract is separated from transaction itself
allowing the contracts to be easily traded.

Question 12

Interest rate risk

Answer 12

The risk of incurring losses due to adverse
movements in interest rates.

If we are borrowing – the risk of interest rates rising.

If we are putting money on deposit – the risk of interest rates falling.

Question 13

How can interest rate risks be reduced?

Answer 13

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

Question 14

Interest rate management: Pooling assets adli bailitlies

Answer 14

Don;t forgrt! Risks may be netted off where both assets and liabilities are subject to interest rate
risk

Question 15

What is an FRA?

Answer 15

An FRA is a commitment to an interest rate on a future loan. (sets the interest rate mow)

Like a normal forward, it is a tailor made product, which can be for any
amount of loan for any duration.

However, like a future, the contract which guarantees the interest rate is separate to
the underlying loan transaction.

Question 16

‘5 – 8 FRA’ =

Answer 16

An FRA on a notional three-month loan/deposit starting in five
months’ time

Question 17

‘An FRA priced at 3.2 – 2.6’

Answer 17

Would effectively fix borrowing cost at 3.2% or investment return at 2.6%

Question 18

‘Selling an FRA’

Answer 18

Fixes the interest received on a deposit

Question 19

‘Buying an FRA’

Answer 19

Fixes the interest paid on a loan

Question 20

Interest rate futures (IRFs)

Answer 20

These operate in a very similar way to FRAs, however they are for standardised amounts, starting on predetermined dates

Question 21

How are interest futures quoted?

Answer 21

Interest rate futures are quoted at ‘100 – the expected market reference rate’ as
a percentage (i.e. 95.5 would imply an interest rate of 4.5%)

Question 22

What does selling a futures contract fix?

Answer 22

Selling a futures contract fixes the interest paid on borrowing

Question 23

What does buying an interest futures contract fix?

Answer 23

Buying a futures contract fixes the interest received on deposits.

Question 24

Interest rate futures: Calculating the number of contracts needed

Answer 24

The number of contracts required must cover:
1. The size of the loan/deposit
2. The length of the loan/deposit.

So no. contracts =
(Amount/Contract size) X (Length/3m)

Because IRF period is always 3 months

Question 25

Interest rate options

Answer 25

An interest rate option gives the buyer the right, but not the obligation, to
borrow/lend at an agreed interest rate at a future date.

Like all options, they require a premium to be paid up front, regardless of whether the
option is exercised or not.

Question 26

interest rate guarantee

Answer 26

An interest rate guarantee is a term for an interest rate option which hedges the
interest rate for a single period (less than one year). These are also called short term
interest rate caps (put option) or short term interest rate floors (call option).

Question 27

Over the counter interest rate options

Answer 27

These are tailor made agreements between two parties, that give the
party buying the option, the right but not the obligation to borrow (put
option) or lend (call option) at a fixed rate.

Question 28

Traded interest rate options

Answer 28

These are in fact options on interest rate futures. They give the holder
the right to buy (call option) or sell (put option) one futures contract on
or before the expiry of the option at a specified price (known as the
strike price - what the market is doing).

Question 29

Traded interest rate options: What to do if strike price not given?

Answer 29

Pick strike price closest to current sport rate

Question 30

Reasons for an imperfect hedge

Answer 30

Futures and traded options are standardised products. They come in standard sizes
with standard expiry dates.

This means that a hedge may not be perfectly efficient for two reasons:

1. Rounding the number of contracts
2. Closing out before the expiry date

Question 31

Reasons for an imperfect hedge: Rounding the number of contracts

Answer 31

If the transaction is not an exact number of contracts, then the number of
contracts must be rounded to the nearest whole number. This will mean that an
element of risk remains.

Question 32

Reasons for an imperfect hedge: Closing out before the expiry date

Answer 32

If the transaction occurs (and the future is closed out) before its expiry date, the
futures price may not exactly match the spot rate at the date it is closed out.
This difference (known as basis risk) will mean that the hedge is again,
imperfect. (You will not need to calculate basis risk in the exam, but you may be
asked to identify it or explain what it is.)

Question 33

Interest rate swaps: Basic swaps (Plain vanilla swaps)

Answer 33

An agreement whereby two parties agree to swap a floating stream of
interest payments for a fixed stream of interest payments and via versa.
There is no exchange of principal. The companies involved are termed
‘counter-parties’.

Question 34

Interest rate swaps: Basic swaps: Calculating the payments

Answer 34

In order to calculate the payments required from A to B and vice versa,
a 3 step process needs to be followed:

1 Establish the total benefit to be gained from the swap (the reduction in the total
interest rate paid by doing the swap)

2 Establish the final rates that can be achieved by each party, by splitting the
benefit between them (equally unless told otherwise)

3 Establish the payments between the parties that will achieve this resul

Question 35

Main reasons for interest rate swaps

Answer 35

1. Swaps can be used to hedge against an adverse movement in interest rates.
   Say a company has a $200m floating loan and the treasurer believes that
   interest rates are likely to rise over the next five years. The treasurer could enter
   into a five-year swap with a counter party to swap into a fixed rate of interest for
   the next five years. From year six onwards, the company will once again pay a
   floating rate of interest.
2. A swap can be used to obtain cheaper finance. A swap should result in a
   company being able to borrow what it wants at a better rate under a swap
   arrangement, than borrowing it directly itself.
3. Swaps can run for up to 30 years – therefore preferable to futures for long term borrowing.
4. Transaction costs involved in a swap may be cheaper than costs involved in refinancing.

Question 36

Disadvantages of interest rate swaps

Answer 36

1. Counterparty risk (the risk the counter party will default)
2. Market risk (the risk of an adverse movement in interest or exchange rates)
3. Transparency risk (the risk that the accounts may be misleading).

Question 37

Index futures

Answer 37

Where companies have significant stock market portfolios, they are subject to the risk of the stock market falling.

Futures and traded options are available to protect against this.

An index future is a futures contract whose value depends on the value of the
FTSE100 Index.

Question 38

The working of an index future

Answer 38

Imagine a company has a portfolio of shares which it will need to sell in the future. To protect against a fall in the market, the company will sell index futures.

Later on, the portfolio is sold on the open market and the futures position is closed
out (the futures contracts are bought back).

If the market has fallen, the loss in value of the portfolio is offset by the profit on the
futures contract.

If it has risen, the increased value of the portfolio is offset by a loss on the futures
contract.

Regardless of what happens to the FTSE100, the company receives a guaranteed value for its portfolio.

Question 39

The terminology

Answer 39

Index futures are quoted in ‘points’ (just like the stock market index).

The contract size is always equal to the futures price × £10 (i.e. if the futures price
stands at 4,500 points, then each futures contract will cover a value of £45,000).

Question 40

Index options

Answer 40

An index option is an option to buy (call) or sell (put) a notional portfolio of shares whose value mirrors the FTSE Index.

Question 41

The working of an index option

Answer 41

Imagine a company has a portfolio of shares which it will need to sell in the future. To protect against a fall in the market, the company will buy put options on index futures.

Later on, the portfolio is sold on the open market.

If the market has fallen, the option will be exercised and the loss in value of the
portfolio is offset by the profit on the futures contract.

If it has risen, the option is allowed to lapse and the company benefits from the
increased value of the portfolio.

The company ends up with a minimum price for its portfolio – but this could be higher if the stock market rises more than expected.

Question 42

What is an option permium made of?

Answer 42

1. Intrinsic value
2. Time value

Question 43

Option premium: Intrinsic value

Answer 43

The difference between the exercise price of the option and the current market value
of the product.

An option with intrinsic value is known as ‘in the money’ (that is, if it were to be
exercised today, a profit would be made). An option which is out of the money has no
intrinsic value.

For example, if a share has a market price of £5 then a call option of £4.50 would
have an intrinsic value of 50p (£5 – £4.50).

Question 44

Option premium: Time value

Answer 44

The difference between the actual premium and the intrinsic value.

Question 45

Option premium: Time value: Time value of a call option increases with:

Answer 45

1. time to expiry
2. volatility of the underlying share
3. interest rates (since the present value of the exercise price decreases).

Question 46

Benefits of a forward/future vs an optoin

Answer 46

1. Eliminates risk completely
2. No downside risk, but no upside potential
3. If the underlying transaction falls through, the business is re-exposed to risk

Question 47

Benefits of an option vs a forward/future

Answer 47

1. Downside risk is eliminated
2. Upside potential is retained
3. If the underlying transaction falls through, there is still no risk.
4. More flexible but more expensive

Question 48

OTC vs standardised products: Benefits of OTC

Answer 48

1. Can be for any amount and any date
2. Tend to be more expensive unless for large amounts.

Question 49

OTC vs standardised products: Standardised

Answer 49

1. Only set dates and amounts, therefore may not provide a perfect hedge (see
   below)
2. Can be closed out easily if the underlying transaction falls through