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Strategic Case Study > F3 - 13. Interest Rate Risk > Flashcards

F3 - 13. Interest Rate Risk Flashcards

1
Q

What 5 thing expose a business to interest rate risk?

A
  1. Borrowing at a fixed rate in times of falling interest rates
  2. Borrowing at a variable rate in times of rising interest rates
  3. Depositing at a fixed rate in times of rising interest rates
  4. Depositing at a variable rate in times of falling interest rates
  5. Being exposed to rising interest rate when re-financing
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2
Q

What are the 3 internal methods for hedging interest rate risk?

A
  1. Matching at variable rates
  2. Smoothing (natural hedge with fixed and floating)
  3. Netting
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3
Q

What are the 3 external OTC methods of interest rate hedging?

A
  1. Forward Rate Agreements
  2. Interest Rate Guarantees
  3. Interest Rate Swaps
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4
Q

What are the 2 external traded methods of interest rate hedging?

A
  1. Interest Rate Futures
  2. Traded Interest Rate Options
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5
Q

What do Forward Rate Agreements do?

A

Fix the effective rate of interest on future short term borrowing

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6
Q

How is an FRA settled?

A

Take the net settlement of the FRA (dif between spot and FRA rate), then borrow at spot from a bank

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7
Q

What are the 2 main pros of FRAs?

A
  1. Hedge away downside risk
  2. Tailored to the investor
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8
Q

What are the 3 main cons of FRAs?

A
  1. Usually only available on loans >£500k and <1 year
  2. Remove upside potential
  3. Difficult to exit
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9
Q

In what 2 ways are interest rate futures similar to FRAs, and in what 2 ways are they different?

A

+ Set fixed rate for future borrowing
+ Don’t lead to money being exchanged
- Standardised size and time period
- Traded on the exchange

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10
Q

What is the futures price?

A

100 - r (r being the fixed interest rate)

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11
Q

How do borrowers set up an interest rate future?

A

Sell futures now and buy futures on borrowing date, choosing a maturity date as close to the borrowing date as possible

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12
Q

How is an interest rate futures hedge closed out?

A

Buy the same number of contracts and calculate the gain/loss on futures, then borrow from the bank at spot rate

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13
Q

What are the 2 main pors of interest rate futures?

A
  1. Hedge away downside risk
  2. Can close out position at any time (flexible)
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14
Q

What are the 4 main cons of interest rate futures?

A
  1. Remove upside potential
  2. Standardised size so may under/over hedge
  3. Basis risk (diff from maturity date)
  4. Need to post margin to the exchange
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15
Q

What are Interest Rate Guarantees?

A

Options on FRAs - provides a maximum interest rate for borrowers

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16
Q

Would a borrower buy or sell an interest rate guarantee option?

A

Buy a call option - gives option to buy an FRA and pay interest at a fixed rate

17
Q

What is an interest rate collar and how is it set up?

A

Buy a call option and sell a put option in order to set both a max and minimum interest rate - makes it cheaper by limiting the upside (as receive a premium)

18
Q

What are exchange traded interest rate options?

A

Options on interest rate futures

19
Q

Would a borrower buy a put or call option on futures contracts?

A

Buy a put option

20
Q

What is the strike price of a traded interest rate option?

A

1 - maximum rate wanted to pay

21
Q

What are the 2 possible outcomes of a traded interest rate option?

A
  1. Exercise and receive gain on futures, then borrow from bank at spot
  2. Do not exercise and borrow at spot
22
Q

What is the main pro of traded interest rate options?

A
  1. Protect from downside and benefit from upside
23
Q

What are the 3 cons of traded interest rate options?

A
  1. Option premium can be expensive, and is due now
  2. May over/under hedge
  3. Basis risk
24
Q

What is an interest rate swap?

A

An OTC agreement where two parties agree to exchange interest rate commitments - one party pays a variable rate to the other, and the other pays a fixed rate

25
Q

What is the saving on an interest rate swap?

A

Calculate total potential benefit of swapped rate and original combined rates, then split the saving between the two parties

26
Q

What are the 4 main pros of interest rate swaps?

A
  1. Low transaction costs
  2. Flexibility and reversibility
  3. Companies with different credit ratings can access the best rates
  4. Company taking on fixed rate is immune to interest rate rises
27
Q

What are the 3 main cons of interest rate swaps?

A
  1. Counterparty risk
  2. Company taking on floating rate is exposed to interest rate rises
  3. Difficult to find a partner, so may need to use bank and pay fees
28
Q

What are currency swaps?

A

Swap both currency of debt and profile of interest rate payments

Strategic Case Study (27 decks)

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