Flashcards in 20 Deck (25)
what is interest rate risk
this is the risk arising from changes interes rate onloan/borrowing
- variable interest on existing loan/deposit
- when you want to borrow/ deposit in the future
What are the 3 theory to the term structure of interest rates
- Liquidity preference theory
- expectations theory
- market segment theory
what is liquidity preference theory?
It's that investors prefer liquid investments.
- Shorter the period of time till maturity, the more liquid the investment
- If investors invest for longer, they'll demand a higher yield
what is the expectations theory?
shape of curve is influenced by expectations of changes in Short Term interest rates in the long term.
what is the market segmentation theory?
Suggests there are 2 different groups of investors who invest in short and long term
therefore the demand and supply relationship for short is different to long term debt
what are the ways of hedgin against interest rate risk?
asset and liability management (gap exposure)
interest rate guarantees
Derivatives ( futures and options, swaps)
Forward rate agreements
what is forward rate agreement
contract to fix an interest rate that will apply in the future
FRA: 3-6 FRA at 6%-5%
(3)- rate starts in 3months time.
(6) rate ends in 6 months time
difference between is the period the deposit or the borrowing.
(6-5%) are the interest rate ANNUALLY
high 6- borrowing rate
low 5% deposit rate
and OFC Bank always will win
how is FRA done with bank regardless of position
1) interest on the loan paid to bank
2) (Additional payment of % difference in the interst that had actually decreased ) OR have it decreased with the difference)
What is the aim of forward rate agreement
: The aim of a forward rate agreement (FRA) is to lock the company into a target interest rate and hedge both adverse and favourable interest rate moveme
what is an interest rate guarantee
An interest rate guarantees (IRG) is more expensive than an FRA as one has to pay for the flexibility to be able to take advantage of favourable interest rate movements
If you sell a futures contract you have a contract to borrow OR lend?
If you sell a futures contract you have a contract to borrow money (not lend). What you are selling is the contract to make interest payment
what is basis risk
Basis risk is the possibility that movements in the currency futures price and spot price will be different.
It is one of the reasons for an imperfect currency futures hedge
what is basis
The difference between the price of a futures contract and the spot price on a given date is known a basis
Which one is more expensive- cost of Interest rate floor or collar?
Interest rate floor
what is negative gap
A negative gap is when interest sensitive liabilities maturing at a certain time in the future are greater than interest sensitive assets maturing at the same time. In this situation the business will suffer a loss if interest rates rise.
what is positive gap
A positive gap is when interest sensitive assets maturing at a certain time in the future are greater than interest sensitive liabilities maturing at the same time. In this situation the business will suffer a loss if interest rates fall.
what is gap exposure
Gap exposure can be used by any company to determine the likely impact on the company of interest rate changes. It is often used by financial institutions like banks who often have interest sensitive assets (money lent out) and interest sensitive liabilities (money deposited with the bank).
what is matching
Matching is the idea that every future cash outflow arising from interest rates is matched by a future cash inflow from interest rates.
In a practical sense this means that if a company has a surplus of cash that it deposits at a variable rate of interest then it should also borrow at a variable rate of interest. It is matching the type of interest that it earns when money is deposited with the type of interest it will pay when money is borrowed. The company will therefore be less exposed to interest rate changes than would otherwise be the case.
what is smoothing
This is the idea that a company should have some fixed rate borrowings and some variable rate borrowings. By doing so it seeks to strike a balance between being exposed to a rise in interest rates and being able to take advantage of a fall in interest rates.
If all of the company’s borrowings are at a variable rate then when interest rates rise the company is completely exposed. If, however, all of the company’s borrowings are at a fixed rate then when interest rates fall the company will be unable to take advantage of this.
what is asset and liability management
Gap exposure was identified earlier as a problem. Asset and liability management seeks to reduce interest rate risk by seeking to avoid either a negative or positive gap.
To achieve this a company will seek to have approximately the same amount of interest sensitive assets and interest sensitive liabilities maturing at the same time in the future.
what is FRA
An FRA is a forward contract on an interest rate for a future short-term loan or deposit. An FRA can be used to fix the interest rate on a loan or deposit starting at a date in the future.
It is a contract relating to the level of a short-term market interest rate, such as three month LIBOR or six-month LIBOR. FRA’s are normally for amounts of more than £1 million.
FRA’s are typically quoted as follows:
3 – 7 FRA at 4.00% - 3.80%
The 3 and 7 refer to the months until the FRA starts and the months until the FRA ends. In this case the FRA will start in 3 months’ time and end in 7 months’ time.
The FRA is therefore an agreement for a period of 5 months.
WHAT IS INTEREST RATE GUARANTEE
An interest rate guarantee is an option to enter into an FRA agreement.
Like all options this means that a company has a right to enter into an FRA agreement but does not have the obligation to do so.
A company taking out an IRG is therefore able to protect against adverse risk (when borrowing this is the risk that interest rates will risk) whilst at the same time take advantage of favourable interest rate risk. If interest rates fall the option can be allowed to lapse.
An IRG is expensive! A premium will be payable in advance.
The premium is payable irrespective of whether or not the option is exercised or allowed to lapse.
What is interest rate futures
These are fixing instruments which are very similar to FRA’s. They protect against adverse interest rate risk but do not allow a company to take advantage of favourable interest rate risk.
The key differences between futures and FRA’s are:
▪ Futures are standardised contracts whereas FRA’s are tailor made.
▪ Futures are traded on a futures exchange. FRA’s cannot be traded.