Risk management interest rate exposure

Question 1

what are interest rates influenced by?

Answer 1

• risk of asset
• duration of loan
• size of loan

highly levered firms have high exposure to interest rate.

Banks and investment institutions are heavily impacted. Since both their assets and liabilities yield interest.

Interest on loans is higher so therefore they make money.

Question 2

What is floating interest rate debt?

Answer 2

• most common interest rate risk of a non-financial is volatility of cash flows.
• interest earned on assets may cancel out interest payable on liabilities.

Question 3

What is fixed interest rate debt?

Answer 3

when the firm has a commitment to fixed interest payments. If rates fall they are at a disadvantage as still have higher liability relative to those with floating interest rate.

Question 4

What is gap exposure?

Answer 4

when you group together interest rate sensitive assets and liabilities according to maturity dates.

Negative gap = firm has a larger amount of interest liabilities maturing at a certain time/period relative to assets. IMPLY EXPOSURE IF INTEREST RATES RISE BY TIME OF MATURITY

Positive gap = firms has more interest sensitive assets maturing a a particular time/ period compared to liabilities. IMPLY EXPOSURE IF INTEREST RATES FALL BY THE TIME OF EXPOSURE

Question 5

Interest rate fluctuations

Answer 5

Risk - high risk borrowers pay higher interest rates to account for higher default risk.

Re-lending profit - financial intermediaries make profits from re-lending at higher rates than the cost of borrowing.

Loan size - deposits above certain amounts with banks may attract higher interest rates.

Type of asset - different types of financial assets attract different rates. Largely due to comparisons of deposits between institution.

Duration of lending - the term structure if interest rates shows as a yield curve.

Question 6

what are the explanations for term structure?

Answer 6

Liquidity preference theory
= investors require compensation to forego cash now in the form of higher return. ( Long-term yield > shorter-term yield)

Expectations theory
= yields incorporate investor expectations regarding future interest rates. (if investors expect rates to rise/fall, yields will slope upwards/downwards)

Market segmentation
= slope reflects conditions in different segments in the market. Implies major investors are confined to segments and will unlikely switch even when considering expected changes.

Government policy
= high short-term rates relative to longer-term rates could result if government policy keeps them high