Module 15 Flashcards
Borrower faces interest risk that
Interest rates with rise, increasing finance costs
Investor faced interest risk that
Interest rates will fall, meaning return received is reduced
Smoothing
Ensuring a prudent mix of fixed and floating rate finance
Interest rate derivatives that fix the rate of interest (2)
Forward rate agreement
Future
Interest rate derivative that caps the max rate of interest for borrowers and min rate of interest for investors
Options
Interest rate swaps used
To adjust the mix of fixed and variable rate finance
Forward Rate Agreement (FRA)
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
FRAs provide
Compensation for adverse interest rate movements
Does NOT involve lending or borrowing principle sum
FRA > To protect against increase in interest rates, borrower
Buys
FRA > To protect against decrease in interest rates, investor/ lender
Sells
FRA > Step 1
Identify the type of FRA required
FRA > Step 2
Evaluate borrowing costs/ interest received if LIBOR rises
FRA > Step 3
Evaluate borrowing costs/ interest received if LIBOR falls
Interest rate future
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)
Future > borrower will (to hedge fall in bond prices and rise in interest rates)
Sell
Future > investor/ lender will (to hedge bond prices rising and fall in interest rates)
Buy
Price of future
Quoted on index basis, therefore 100 - implied interest rate
Future > Step 1
Today: enter into futures contract
Future > Step 2
In the future: Go to the spot market and borrow in the spot market
Future > Step 3
In the future: Close out the futures contract
Interest rate options used by borrowers to
Place upper limit on interest cost
Interest rate options used by lenders/ investors to
Guarantee minimum rate of return
Interest rate put option
Borrower > Option to pay interest at pre-determined rate
Interest rate call option
Lender > Option to receive interest at a pre-determined rate
Option > Step 1
Calculate premium (today)
Option > Step 2
Go to the spot market (in the future)
Option > Step 3
Decide whether to exercise the option
Interest rate cap
Contract that gives buyer right to set maximum level for interest rates
Who buys interest rate cap?
Borrower
Interest rate floor
Contract that gives buyer right to set minimum interest receivable
Who buys interest rate floor?
Investor/ lender
Interest rate floor can be
Sold by a borrower to a lender
Interest rate collar
Borrower selling floor at low strike rate and buying cap at higher strike rate
Interest rate swap
Agreement between two counterparties which agree to swap liabilities (fixed or floating) for interest payments
Interest rate swaps are attractive because (3)
- 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)
Variable rate of a swap will be at
LIBOR (unless otherwise stated)
Risks associated with derivatives (5)
- Credit risk
- Liquidity risk
- Basis risk
- Accounting risk
- Earnings risk
Interest rate swap > Step 1
What you’re paying to the lender
Interest rate swap > Step 2
What rate you pay to the bank depending on what you want to pay
Interest rate swap > Step 3
Opposite of step 2, what you receive from the bank
Interest swap > do I want to pay a fixed rate? Yes
Pay ask price
Interest rate swap > do I want to pay fixed? No
Pay bid price
