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1.
Interest rate risk is the risk of a change in interest rates on an interestbearing asset, such as a loan or a bond. Floating rate debt changes with market interest rates and so fluctuates with market movements, creating risk, for example if interest rates rise on a loan meaning future interest rate payments are higher. The interest on fixed rate debt does not change, so is lower risk.
2.
If an organisation knows they will be taking out loans at some point in the future, and want to hedge the risk that the interest rate will change prior taking out the loan then interest rate hedging can be used. Key types of interest rate hedge
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This is similar to a currency option, and enables the company "at a cost$ to remove the downside risk of rates rising, while benefitting from interest rate falls. !n up front fee called a premium is paid when an I#* is taken out. ,o calculations are re)uired.
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,-change traded
Fi-ing instruments
3.
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average interest rate estimated by leading banks in 2ondon that they would be charged if borrowing from other banks.
,-amp*e
9urrently, ! borrows from :arket ; 2I.%# 5&.8' "floating$ or fixed of &<'. . borrows from :arket ; =.8' "fixed$ or floating of 2I.%# 5 &'. ! wants a fixed rate, . wants a floating rate. Together both could borrow individually for a total of &<' 5 2I.%# 5 &' > 2I3' 4115 If they 0borrowed for each other1 the total amount payable to banks would be 2I.%# 5 &.8' 5 =.8' > 2I3' 4 165. There is therefore a &' saving to be made if each party can come to a suitable agreement on how to share the saving. If we consider the following swap in which /arty ! takes out a floating rate loan of 2I.%# 5 &.8', agrees to pay /arty . periodic fixed interest rate payments of =.?8'. /arty . takes out a fixed rate loan at =.8' and pays ! 2I.%# 5 <.@<' in the same currency. The following diagram shows the net position.
/arty ! pays "2I.%# 5 &.8<'$5=.?8' - "2I.%#5<.@<'$ > A.B8' net This is a saving of <.88' compared with taking out the fixed rate themselves.
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/arty . pays =.8' 5 2I.%# 5<.@'- =.?8' > 2I.%# 5 <.88' net This is a saving of <.B8' compared with taking out the floating rate alone.
Ad(antages
:ay reduce total borrowing costs Flexible E up to the two parties to agree terms 9an be used to foreign finance where one party may find it difficult to obtain Transaction costs are limited !ble to convert floating to fixed rate loans if that1s what the company wants
7isad(antages
/rofessional help re)uired "and they will charge a fee$ 9ounterparty risk "i.e. the other party does not meet their obligations under the contract$ 9omplex arrangements
8.
!n interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. !n example of a cap would be an agreement to receive a payment for each month the 2I.%# rate exceeds 7.8'. -imilarly an interest rate floor is a derivative contract in which the buyer receives payments and seller pays them at the end of each period in which the interest rate is below the agreed strike price "e.g. &'$.
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! collar combines a cap and a floor. The borrower buyers a cap, and sells a floor. To a borrower, by receiving a premium on the floor, that reduces the price paid for the premium paid on the cap, making a collar cheaper, but also not letting the borrower benefit when interest rates fall.
:.
!ccording to I!- 6A companies should recognise all financial assets including derivatives, such as futures and options, on the .alance -heet, split between those used for hedging "as we have been using them for currency and interest rates$ and those for speculation. The assets to be valued at their fair value reflecting market prices, with changes in fair value recognised as income. The fair value of derivatives can vary depending on a range of external factors such as economic and political change, as well as factors related to the specific investment. Cerivatives can be highly risky if used for speculative purposes as they are highly geared investments, where losses can be many times the amount actually invested. 9ases such as Ferome Kerviel who lost G8bn at -ociete *enerale, and ,ick 2eeson who caused the collapse of .arings bank, show the possible effects of poorly controlled derivative trading.
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$trategic Mock ,-ams ; ,39 F3 and P3 .ased around the *atest Preseen 7 full mocks are available for each strategic subHect Fu** marking and detai*ed #eed+ack Full mock marking Cetailed and personalised feedback to focus on helping to pass the exams Persona* coaching on %our mock e-am &hr personal coaching session with your marker /ersonalised feedback and guidance 3xam techni)ue and technical review $trategic and Financia* ana*%sis o# the Pre<seen $trategic ana*%sis - all key business strategy models in 36 Financia* ana*%sis E based around the F6 syllabus isk ana*%sis E based around the /6 syllabus 6< page strategic report Full video analysis of how all key models apply to the unseen Iideo introduction to all the key models Persona* Coaching Courses /ersonal coaching to get you through the exam )uition Course E /ersonalised tuition to give you the re)uired syllabus knowledge E tailored to your needs e(ision Course - /ractise past exam )uestions with personal feedback on your technical weaknesses and exam approach and techni)ue esit Course E Identifying weaknesses from past attempts and providing personalised guidance and study guides to get you through the exam
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