Topic 18: Interest rate risk management Flashcards
What is interest rate risk and explain its affects to a company
The risk of an adverse movement in interest rates that will reduce net cashflows.
If a company is borrowing an increase in interest rates causes higher repayment
If a company is lending and decrease in interest rates causes less money received.
What is Gap Exposure? and what is negative gap and positive gap?
It is for interest sensitive assets and liabilities. Gap exposure is the difference between interest sensitive assets and interest sensitive liabilities.
Negative Gap is interest sensitive liabilities are greater than interest sensitive assets and a raise in interest rates causes a loss.
Positive Gap is interest sensitive assets are greater than interest senstive liabilities and a loss can be suffered if interest rates lower.
What are the theories that influence teh interest rate yield curve?
Liquidity preference theory - Investors prefer more liquid assets (short term=Greater liquidity = Lower yield = Lower profitability)
Expectation Theory - What investors expects affects the curve.
Market segmentation - Invetsors when investing in the short term are different compared to investors invest for the long term.
These theroies create the yield curve togther they make a normal yield (Upwards sloping) or inverse (Downwards sloping).
What are the basic techniquies for managing interest?
Matching - Future cash outflow arising from interest rates is matched to future cash inflow arising from interest rates.
Smoothing - Some fixed rate and some variable rate, this stops some isk and can potentially gain advantages from interest rates falling (Neutral approach)
Assets and Liabilities managment - Avoiding gap exposure by matching assets and liabilities and theyre maturity.
What are the other techniques for managing interest rate risk besides the basic techniques?
Forward rate agreement (FRA) - An agreement between two parties (over the counter) on an interest rate. on a notional amount borrowing or investment for a certain point.
Interest rate guarentees (IRG) - This is an option to enter into a FRA agreement but they dont have to go through with it.
Interest rate futures - It is a way of fixing the interest (Similar to Exchange rate futures contract)
How to calculate a forward rate agreement?
The format is IS v IE FRA IP% - BP%
IS = Investment/borrowing start
IE = Investment/borrowing End
IP = Investment percentage
BP = Borrowing percentage.
Example (for hannah to ask me) is 3 v 8 FRA 4.5% - 5%
3 = When the investment/borrowing period starts
8 = When the investment/borrowing period ends
4.5% = The fixed rate for investing
5% = Fixed rate for borrowing.
What are the positives and negatives of Interest rate guarentees?
Positives:
Protects against adverse risk because we can exercise the option.
Allows us to take advantage of the financial interest rates because we can allow the option to lapse.
Negatives:
Expensive and paid upfront
What are the characteristics of interest rate futures contracts?
Standardised - Standard amount of notiable principle, Cover interest for 3 month period, standard dates (Mar,June,Sep,Dec) , Traded
Pricing - They are priced at $100 less interest rate (Market interest rate is the expected rate on date of expiry)
What are the various names for different stages of interest rate level and explain and what they mean for investors
Different stages:
Cap - This is the maximum an interest rate
Floor - This is the minimum rate
Collar - is where a maximum and minimum rat eof interest are agreed.
For investors:
A Cap is when you should buy put options as they would be best value for money.
A Floor is when you buy Call options for the best value for money.
