Chapter 24 - Interest Rate Risk Management

Question 1

Ways to borrow money

Answer 1

1. Floating rate - charges actual interest rate from day to day
2. Fixed rate - even borrowing this way there is a risk, what if I need to borrow 100k in 3 months time. The risk is what rate will I get in 3 months time ?

Question 2

What are the 4 methods of managing interest rate risk ?

Answer 2

1. Forward rate agreement (fra) - the bank quotes me a rate now that applies to a loan started on a future date
2. Interest rate guarantees - like an option. We tell bank what the maximum is you want the interest to be and if lower than this then I want this instead. The bank will charge me a premium, when the loans starts in a few months time, my rate is capped at my maximum.

Interest rate futures - oddly the way futures are quoted is not the interest rate but 100 - the interest rate. For example a 10% interest rate is quoted on the futures market as 90 or 8% is quoted as 92. Oddly as the interest decreases the future quoted increases.

4. Interest rate options

Question 3

What are caps, collars and floors

Answer 3

Cap - fixing maximum rate
Floor - fixing minimum rate
Collar - fix a maximum and a minimum

Question 4

What are interest rate swap

Answer 4

2 companies, both borrowing money swap their interest rates

It’s beneficial when one wants to fix and the other stays on floating.

Question 5

What does LIBOR mean ?

Answer 5

London interbank official rate which is the floating rate that goes up or down so you have to pay more, it’s like the base rate