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ICAS - AFin > Module 15 > Flashcards

Module 15 Flashcards

1
Q

Borrower faces interest risk that

A

Interest rates with rise, increasing finance costs

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2
Q

Investor faced interest risk that

A

Interest rates will fall, meaning return received is reduced

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3
Q

Smoothing

A

Ensuring a prudent mix of fixed and floating rate finance

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4
Q

Interest rate derivatives that fix the rate of interest (2)

A

Forward rate agreement

Future

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5
Q

Interest rate derivative that caps the max rate of interest for borrowers and min rate of interest for investors

A

Options

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6
Q

Interest rate swaps used

A

To adjust the mix of fixed and variable rate finance

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7
Q

Forward Rate Agreement (FRA)

A

Forward contract in which both parties agree that a specified interest rate will apply to a notional principle over a specified period in the future

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8
Q

FRAs provide

A

Compensation for adverse interest rate movements

Does NOT involve lending or borrowing principle sum

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9
Q

FRA > To protect against increase in interest rates, borrower

A

Buys

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10
Q

FRA > To protect against decrease in interest rates, investor/ lender

A

Sells

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11
Q

FRA > Step 1

A

Identify the type of FRA required

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12
Q

FRA > Step 2

A

Evaluate borrowing costs/ interest received if LIBOR rises

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13
Q

FRA > Step 3

A

Evaluate borrowing costs/ interest received if LIBOR falls

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14
Q

Interest rate future

A

Agreement to buy or sell interest at a pre-determined rate on a standard notional amount over a fixed period in the future (assume standard 3 month borrowing period)

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15
Q

Future > borrower will (to hedge fall in bond prices and rise in interest rates)

A

Sell

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16
Q

Future > investor/ lender will (to hedge bond prices rising and fall in interest rates)

A

Buy

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17
Q

Price of future

A

Quoted on index basis, therefore 100 - implied interest rate

18
Q

Future > Step 1

A

Today: enter into futures contract

19
Q

Future > Step 2

A

In the future: Go to the spot market and borrow in the spot market

20
Q

Future > Step 3

A

In the future: Close out the futures contract

21
Q

Interest rate options used by borrowers to

A

Place upper limit on interest cost

22
Q

Interest rate options used by lenders/ investors to

A

Guarantee minimum rate of return

23
Q

Interest rate put option

A

Borrower > Option to pay interest at pre-determined rate

24
Q

Interest rate call option

A

Lender > Option to receive interest at a pre-determined rate

25
Q

Option > Step 1

A

Calculate premium (today)

26
Q

Option > Step 2

A

Go to the spot market (in the future)

27
Q

Option > Step 3

A

Decide whether to exercise the option

28
Q

Interest rate cap

A

Contract that gives buyer right to set maximum level for interest rates

29
Q

Who buys interest rate cap?

A

Borrower

30
Q

Interest rate floor

A

Contract that gives buyer right to set minimum interest receivable

31
Q

Who buys interest rate floor?

A

Investor/ lender

32
Q

Interest rate floor can be

A

Sold by a borrower to a lender

33
Q

Interest rate collar

A

Borrower selling floor at low strike rate and buying cap at higher strike rate

34
Q

Interest rate swap

A

Agreement between two counterparties which agree to swap liabilities (fixed or floating) for interest payments

35
Q

Interest rate swaps are attractive because (3)

A
  • If variable finance is significantly cheaper than fixed rate finance
  • If interest rates are expected to fall
  • If a company has revenue that directly varies with interest rates (eg bank)
36
Q

Variable rate of a swap will be at

A

LIBOR (unless otherwise stated)

37
Q

Risks associated with derivatives (5)

A
  • Credit risk
  • Liquidity risk
  • Basis risk
  • Accounting risk
  • Earnings risk
38
Q

Interest rate swap > Step 1

A

What you’re paying to the lender

39
Q

Interest rate swap > Step 2

A

What rate you pay to the bank depending on what you want to pay

40
Q

Interest rate swap > Step 3

A

Opposite of step 2, what you receive from the bank

41
Q

Interest swap > do I want to pay a fixed rate? Yes

A

Pay ask price

42
Q

Interest rate swap > do I want to pay fixed? No

A

Pay bid price

ICAS - AFin (21 decks)

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