Ch.9 - Managing financial risk: Interest rate and other risks

Question 1

When do you buy/sell an forward rate agreement (FRA)?

Answer 1

Buy FRA => fixes interest paid on loan

Sell FRA => fixes interest received on deposit

Question 2

When do you buy/sell an future interest rate contract?

Answer 2

Buy future => fixes interest received on deposits

Sell future => fixes interest paid on borrowing

Question 3

When do you buy/sell an option on interest rate?

Answer 3

Buy option - CALL => borrow at fixed rate

Sell option - PUT => lend at fixed rate

Question 4

When do you buy/sell an traded option on interest rate?

Answer 4

Buy option - CALL => intention to invest

Sell option - PUT => intention to borrow

Question 5

What are possible reasons for imperfect hedge?

Answer 5

1. number of contracts

2. closing out before the expiry date

Question 6

What are main reasons for interest rate swaps?

Answer 6

• used to hedge against an adverse movement in interest rates
• can be used to obtain cheaper finance
• can run for up to 30 years - preferable to futures for long-term borrowing
• transaction costs may be cheaper than refinancing

Question 7

What are disadvantages of interest rate swaps?

Answer 7

• counter-party risk (risk that counter-party will default)
• market risk (risk or adverse movement in interest rates or exchange rates)
• transparency risk (risk that accounts may be misleading)

Question 8

What is intrinsic value of an option?

Answer 8

The difference between the exercise price and current market value (in the money option).

Question 9

What is the time value of an option?

Answer 9

The difference between the actual premium and the intrinsic value.
Increases with:
- time to expiry (the longer the time, the higher the time value)
- volatility of the underlying share (the more volatile, the greater the chance of option being ‘in the money’ which increases time value)
- interest rates (time value of option reflects the PV of the exercise price)

Question 10

What are benefits of the future/forward?

Answer 10

• eliminates risk completely
• no downside risk, but no upside potential
• if underlying transaction falls through, the business is re-exposed to risk

Question 11

What are the benefits of the options?

Answer 11

• downside risk is eliminated
• upside potential is retained
• if the underlying transaction falls through, there is still no risk
• more flexible than forward, but more expensive