Module 15

Question 1

Borrower faces interest risk that

Answer 1

Interest rates with rise, increasing finance costs

Question 2

Investor faced interest risk that

Answer 2

Interest rates will fall, meaning return received is reduced

Question 3

Smoothing

Answer 3

Ensuring a prudent mix of fixed and floating rate finance

Question 4

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

Answer 4

Forward rate agreement

Future

Question 5

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

Answer 5

Options

Question 6

Interest rate swaps used

Answer 6

To adjust the mix of fixed and variable rate finance

Question 7

Forward Rate Agreement (FRA)

Answer 7

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

Question 8

FRAs provide

Answer 8

Compensation for adverse interest rate movements

Does NOT involve lending or borrowing principle sum

Question 9

FRA > To protect against increase in interest rates, borrower

Answer 9

Buys

Question 10

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

Answer 10

Sells

Question 11

FRA > Step 1

Answer 11

Identify the type of FRA required

Question 12

FRA > Step 2

Answer 12

Evaluate borrowing costs/ interest received if LIBOR rises

Question 13

FRA > Step 3

Answer 13

Evaluate borrowing costs/ interest received if LIBOR falls

Question 14

Interest rate future

Answer 14

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)

Question 15

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

Answer 15

Sell

Question 16

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

Answer 16

Buy

Question 17

Price of future

Answer 17

Quoted on index basis, therefore 100 - implied interest rate

Question 18

Future > Step 1

Answer 18

Today: enter into futures contract

Question 19

Future > Step 2

Answer 19

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

Question 20

Future > Step 3

Answer 20

In the future: Close out the futures contract

Question 21

Interest rate options used by borrowers to

Answer 21

Place upper limit on interest cost

Question 22

Interest rate options used by lenders/ investors to

Answer 22

Guarantee minimum rate of return

Question 23

Interest rate put option

Answer 23

Borrower > Option to pay interest at pre-determined rate

Question 24

Interest rate call option

Answer 24

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

Question 25

Option > Step 1

Answer 25

Calculate premium (today)

Question 26

Option > Step 2

Answer 26

Go to the spot market (in the future)

Question 27

Option > Step 3

Answer 27

Decide whether to exercise the option

Question 28

Interest rate cap

Answer 28

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

Question 29

Who buys interest rate cap?

Answer 29

Borrower

Question 30

Interest rate floor

Answer 30

Contract that gives buyer right to set minimum interest receivable

Question 31

Who buys interest rate floor?

Answer 31

Investor/ lender

Question 32

Interest rate floor can be

Answer 32

Sold by a borrower to a lender

Question 33

Interest rate collar

Answer 33

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

Question 34

Interest rate swap

Answer 34

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

Question 35

Interest rate swaps are attractive because (3)

Answer 35

- 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)

Question 36

Variable rate of a swap will be at

Answer 36

LIBOR (unless otherwise stated)

Question 37

Risks associated with derivatives (5)

Answer 37

- Credit risk - Liquidity risk - Basis risk - Accounting risk - Earnings risk

Question 38

Interest rate swap > Step 1

Answer 38

What you're paying to the lender

Question 39

Interest rate swap > Step 2

Answer 39

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

Question 40

Interest rate swap > Step 3

Answer 40

Opposite of step 2, what you receive from the bank

Question 41

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

Answer 41

Pay ask price

Question 42

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

Answer 42

Pay bid price