Chp 10: Managing Interest Rate Risk Flashcards
What are three ways for a compnay to internally contorl interest rate risk?
- Smoothing - maintaining a balance of fixed and floating rate borrowing
- Matching the type of loans with the asset to be acquired.
- Groups of companies pooling their cash to reduce interest payable, gain better rates on deposit and allow tighter control
What are four external ways to control interest rate risk?
- Forward rate agreements
- Interest rate futures
- Interest rate options
- Interest rate swaps
What are three advantages and three disadvantages of Forward Rate Agreements (FRAs)?
Adv.
1. Simpler than other derivatives
2. Normally free, always cheap
3. Tailored to the companies requirements
Disadv.
1. Fixed date agreements
2. Rate quoted may be unattractive
3. Higher default risk than an exchange based derivative
What is the main difference between Interest rate futures and currency futures?
Interest rate futures have a standardised period of 3 months
What are two advantages and three disadvantages of interest rate futures?
Adv.
1. Flexible dates - ie. a March future can be used on any day untilt he end of March
2. Lower credit risk because exchange traded
Disadv.
1. Only available in large contract sizes
2. Margin may need to be topped up on a daily basis to cover expected losses
3. Basis may not fall in a linear way over time (basis risk)
When do you buy or sell an interest rate futures contract?
Buy - when a compnay has a cash surplus and is worried about interest rates falling
Sell - when a company is borrowing money and is worried about interest rates rising
What is an exchange traded interest rate option?
The same as an interest rate future but it only ever pays compensation
Companies therefore have to pay a premium to obtain them
Also known as options on futures.
Put Options pay interest. Call options receive interest.
What are three advantages and two disadvantages of exchange traded options?
Adv.
1. Flexible dates
2. Allow a company to take advantage of favourable movements in interest rates
3. Useful for uncertain transactions, can be sold if needed.
Disadv.
1. Only available in large contract sizes
2. Can be expensive due to the premium
How will investors and borrowers buy/sell puts and calls to establish a collar?
Investors - buy a call option (to establish a floor) and sell a put option (to establish a cap).
Borrowers - buy a put option (to cap the cost of borrowing) and sell a call option (to establish a floor) at a lower rate.
Interest Rate Collars - What does buying a put do?
Sets the maximum rate for borrowing - a cap
Interest Rate Collars - What does selling a call do?
Sets a minimum effective rate - a floor
How do interest rate swaps work?
- It uses different companies available interest rates to get the best rate for both parties.
- This could include swapping a fixed rate for a variable interest rate
- Banks may charge an additional fee
- Companies will typically split the profit/gain
- Variable rates typically assumed to be at SONIA (risk free rate) in the exam
How do you work out the potential savings to be shared between two companies in an interest rate swap?
Calculate the difference between the variable rate saving and the fixed rate saving
Otherwise known as the difference of differences
What are four advantages of interest rate swaps?
- Relatively cheap and easy way of switching type of interest
- Flexible - can be arranged in any size, if necessary
- Companies may be able to borrow more, chepaly
- Last longer than other techniques - up to 20 years
What are three disadvantages of interest rate swaps?
- Costly legal and professional advice may be needed
- Counterparty risk - if one party defaults the whole swap unravels
- Not subject to the control of an exchange
