Mod 15: Interest rate dividends

Question 1

What is interest rate risk?

Answer 1

Risk faced by both borrowers and lenders

It is the risk that the interest rates will move in such a way so as to cost the company, or an individual, money

Question 2

Borrower risk

Answer 2

faces the risk that interest rates will INCREASE => INCREASING FINANCING COSTS

A borrow will benefit from a fall in interest rates

Question 3

Investor interest risk

Answer 3

an investor, lending out money, faces the risk that interest rates will FALL => the return they receive is REDUCED (income falls)

An investor/lender will benefit from a risk in interest rates

Question 4

Ways of managing interest rate risk

Answer 4

1. FIX the rate of interest
   - futures and forward rate agreements
2. cap the rate of interest for borrowers and minimum rate for investors
   - options

Question 5

FRAs (Forward rate agreements)

Answer 5

• OTC instruments
• usually have a value in excess of £1m
• ‘FIXING of an interest rate’
• DO NOT involve lending or borrowing the principal sum, the simply PROVIDE COMPENSATION FOR ADVERSE INTEREST RATE MOVEMENTS
• specified interest rate (LIBOR)
• buy or sell contracts

Question 6

FRAs: buy or sell

Answer 6

To protect against an increase in interest rates, a BORROWER should enter in to a COMTRACT TO BUY => allows the holder to receive compensation if the rate rises above the agreed rate

To protect against a FALL in interest rates, a LENDER/INVESTOR should enter into a CONTRACT TO SELL => protects against a fall in interest rates and entitles the holder to receive compensation if the rates fall below an agreed rate

Question 7

Interest rate futures

Answer 7

• fixing of interest rates
• agreement to buy or sell interest at a pre-determined rate on a standard notional amount over a fixed period in the future
• assumes a standard THREE MONTH borrowing period

Question 8

Interest rate futures: buy or sell?

Answer 8

• as bond prices rise, interest rates fall

Opposite of FRAs
BORROWER
- entering into a contract to sell (selling futures) will hedge against a fall in bond prices (rise in interest rates)
=> BORROWER WILL ENTER CONTRACTS TO SELL

INVESTOR/LENDER
- entering into a contract to buy (buying futures) will hedge a rise in bond prices (fall in interest rate)
=> INVESTOR WILL ENTER INTO CONTRACTS TO BUY

Question 9

Interest rate options

Answer 9

• do NOT fix the interest rate
• options are used by borrowers to place an UPPER LIMIT on the interest cost they will incur, but also allow borrowers to take advantage of a fall in interest rates
• investors/lenders use interest rate options to guarantee a MINIMUM RATE OF RETURN, but also allow them to take advantage of any increase in interest rates

Question 10

Interest rate options: borrower and investor positions

Answer 10

BORROWER wants to hedge away increased interest rates through selling interest rate futures => PUT on interest futures

INVESTOR will hedge a fall in interest rates through buying interest rate futures => CALL on interest rate futures

Remember you can only have ONE DOUBLE L

Put option => SELL (Borrower)
Call option => BUY (investor)

Question 11

Put option

Answer 11

SELL
BORROWER
- an option to PAY interest at a pre-determined rate on a standard notional amount over a fixed period in the future

Question 12

Call option

Answer 12

BUY
INVESTOR

• an option to RECEIVE interest at a pre-determined rate on a standard notional amount over a fixed period in the future

Question 13

Risks associated with derivatives: think CABLE

Answer 13

Credit risk
Accounting risk
Liquidity risk
Basis risk
Earnings risk

Question 14

Risks associated with derivatives: Credit risk

Answer 14

risk that the counterparty will not perform in terms of the contract, particularly when trading forwards (OTC), as performance is NOT guaranteed by any exchange

Question 15

Risks associated with derivatives: Accounting risk

Answer 15

Risk that derivatives are not being properly accounted for or that the time and effort taken to ensure correct accounting is higher than expected

Includes the risk that derivatives are not correctly valued (more complex)

Question 16

Risks associated with derivatives: Basis risk

Answer 16

risk that the change in value of the derivative will not move exactly in line with the value of the underlying transaction => changes in the value of the derivative may not be sufficient to match adverse changes in the value of the underlying transaction

Question 17

Risks associated with derivatives: Liquidity risk

Answer 17

The risk of the market being temporarily illiquid, causing problems when futures or options need to be closed out

Question 18

Risks associated with derivatives: Earnings risk

Answer 18

the risk that the cost of administration and time taken to obtain derivatives is higher than expected => reducing earnings

Question 19

Hedge funds

Answer 19

use derivatives to seek risk and profit

- returns of a hedge funds driven by manager’s ability or skill