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CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK

INTEREST RATE RISK

INTEREST RATE RISK MANAGEMENT

Forward rate agreements (FRAs)

Interest rate futures

Interest rate options or interest rate guarantees

Interest rate swaps

w w w.s tud yi nt er a c ti ve . or g

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80 3 v 6 . Show the outcome of the FRA if: (a) LIBOR increases by 0.55 – 3.3.45 Solutions: w w w. The company wishers to protect the short-term borrowing from adverse movements in interest rates by entering a forward rate agreement.5% and LIBOR is currently at 3. or g 2 .58 – 3. The company can borrow at LIBOR + 0.5% (b) LIBOR decreases by 0.3.85 – 3.53 6 v 9 .CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK FORWARD RATE AGREEMENT (FRA) Definition: – an agreement between a business and a bank that fixes an interest rate in the future for a set period of time on a specified level of borrowing or lending.3.5%.s tud yi nt er a c ti ve . EXAMPLE A company wishes to borrow £100 million in three months time for a period of six months.5% FRA prices are: 3 v 9 .

dates and interest rates.50 3 . June.00 Interest rate futures position A company hedging against a rise in interest rates in the future enters into a futures contract to cover £10million of borrowing for a period of 3 months at 95.CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK INTEREST RATE FUTURES Definition: – is a binding contract between a buyer and a seller for delivery of an agreed interest rate commitment on an agreed date and at an agreed price. September and December) • Tick size – minimum price movement on futures contract • Price – 100 – interest rate • Buy or sell Interest rate futures pricing Futures price = 100 – interest rate If interest rates are expected to be at 5.00 and closes out the contract at 93. then the future will be quoted at 95. The contracts are traded on the LIFFE and the terms are standardised.00% p. conversely a person hedging against interest rate falls will buy at 95.00 Sell later @ 93.a. Terminology • Contract size – standardised quantity of underlying item (interest rates) • Delivery dates – settlement date on contract (March.00. with respect to the amounts. Buy now @ 95.s tud yi nt er a c ti ve .50 Loss w w w.50. or g 1.00 and a person hedging against interest rate rises will sell at 95.

Calculate the number of contracts required. Hedging imperfection • Basis risk – difference between the market price and the futures price • Number of contracts – difficult to achieve an exact number of contracts Solutions: 1. No. of moths cash deposited/invested for 3 months Example A company wishes to borrow £60million in three months time for a period of two year. The standard contract size on one three month sterling futures contracts is £500. Set up the hedge 2. Closing futures price 3.000 and covers a period of three months.CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK Interest rate futures contracts The standard size of an interest rate futures contract is £500. of contracts = Amt of cash deposited/invested Standard contract size x No.s tud yi nt er a c ti ve . or g 4 . Closing spot price 4.000. Net outcome w w w.

790 93. Three month sterling futures (£500. w w w.50 tick size) December March June 93.680 Illustrate how the short-term interest risk might be hedged if interest rates increase by 0. The market has been very volatile of late and the finance director is concerned that short term interest rates could increase.CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK EXAMPLE The finance director of Popa plc has recently reviewed the company’s monthly cash budgets for the next year and has revealed that the company is likely to need £60 million in three months’ time for a period of two months. £12.870 93. LIBOR is currently 6% per annum and Popaplc can borrow at LIBOR + 0.9%.5%. Assume that it is now mid-December. He has therefore decided to protect against a possible increase in interest rates using interest rate futures.000 contract size.s tud yi nt er a c ti ve . or g 5 . Derivative contracts may be assumed to mature at the end of the month.

The market has been very volatile of late and the finance director is concerned that short term interest rates could increase. Closing spot price 4. Solutions: 1. £12. Set up the hedge . Net outcome EXAMPLE The finance director of Popa plc has recently reviewed the company’s monthly cash budgets for the next year and has revealed that the company is likely to need £60 million in three months’ time for a period of two years. Three month sterling futures (£500.9%.s tud yi nt er a c ti ve . Closing futures price 3.premium 2. LIBOR is currently 6% per annum and Popa plc can borrow at LIBOR + 0.# of contracts .tick size .buy/sell initially .date .CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK INTEREST RATE OPTIONS (TRADED) Definition: provides the buyer with the right.000 contract size.870 93. Derivative contracts may be assumed to mature at the end of the month.50 tick size) December March June w w w. or g 93. but not the obligation to buy or sell the related interest rate futures contract.790 93.680 6 . He has therefore decided to protect against a possible increase in interest rates using interest rate futures.

250 0.750 0.085 0.000 0.020 0.000 0.165 0.115 0.335 94.400 0.000 contract size. or g 7 . Assume that it is now mid-December.015 0.270 0.CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK Options on three month sterling futures (£500.075 0.085 0.555 Illustrate how the short-term interest risk might be hedged if interest rates increase by 0.120 0.s tud yi nt er a c ti ve .030 0. w w w.195 0.480 0.5%.255 0. premium cost in annual percentage) Calls Puts December March June December March June 93.180 94.

CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK INTEREST RATE SWAPS Definition: a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Calculate the gain 2. Split the gain and calculate the expected outcome 3. or g 8 . Solution (vanilla swaps): 1. Demonstrate how the swap works w w w.s tud yi nt er a c ti ve . Interest rate swaps can be used by hedgers to manage their fixed or floating rates of interest.

to pay or receive a fixed.CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK INTEREST RATE GUARANTEE (IRG) Definition: An interest rate guarantee (IRG) provides the right. or g 9 .s tud yi nt er a c ti ve . w w w. specified rate of interest for a defined period of time with a bank. but not the obligation.

or g 10 .5%. EXAMPLE NTY a UK based company is arranging a loan of £15 million over a period of two years. INTEREST RATE COLLAR A combination of: • Buying an interest rate cap and selling interest rate floor (borrowing) • Buying an interest rate floor and selling interest rate cap (investing) Or. Note: both cap and floor must be for the same notional principal and maturity w w w. The finance director has therefore decided to buy an interest rate cap from a bank at an exercise price of 8% and a premium of 0.CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK INTEREST RATE CAP Option which gives the holder the right to a series of compensations if interest rates increase above the exercise price at each interest fixing date or rollover date for the loan.4%. The market has been very volatile and the company is concerned about adverse movements in interest rate. Interest is payable at six months LIBOR + 1.s tud yi nt er a c ti ve . Calculate the effective rate of borrowing in each of the four interest periods assuming the six month LIBOR rate for each period is as follows: 1st interest period 10% 2nd interest period 7% 3rd interest period 11% 4th interest period 8% INTEREST RATE FLOOR Option which gives the holder the right to series of compensations if interest rates fall below the exercise price at each interest fixing date or rollover date for the loan.

Interest is payable at six months LIBOR + 1.15%).4%) and floor exercise price is 6% (premium 0. Calculate the effective rate of borrowing in each of the four interest periods assuming the six month LIBOR rate for each period is as follows: 1st interest period 9% 2nd interest period 10% 3rd interest period 7% 4th interest period 5% w w w.CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK EXAMPLE BWT a UK based company is arranging a loan of £15 million over a period of two years.s tud yi nt er a c ti ve . The market has been very volatile and the company is concerned about adverse movements in interest rate.5%. or g 11 . The finance director believes that interest rate cap would be expensive and has therefore decided to use interest rate collars in which the cap exercise price is 8% (premium 0.

01 per cent and has a gross yield to maturity of 11. or g 12 . Using the Macaulay duration method.063%.s tud yi nt er a c ti ve . • Changes in the value of a bond are inversely related to changes in the rate of return • Long-term bonds have higher interest rate risk than shorter term bonds • High coupon bonds have less interest rate risk than shorter term bonds CONCLUSION • Duration increases as maturity increases • Duration decreases as the coupon rate increases • Duration will decrease as interest rates rise w w w. Calculate each year’s discounted cash flow as a proportion of the current value of the bond 4. Multiply the proportion calculated for each time period its time period and sum the weightings EXAMPLE Seven years prior to the maturity of a bond with a 10% coupon.CH AP T E R 1 7 – H E D GI N G I N T ER E ST R A T E RI SK MACAULAY DURATION “Weighted average time for the recovery of the payments and principal in relation to the current market price of a bond” • Measures the number of years required to recover the cost of the bond • Enables two different bonds to be compared • Enables the value of a bond to be calculated for changes in interest rates CALCULATION 1. you are required to calculate the bond duration. Calculate the present value of these future cash flows 3. it is trading at a price of £95. Establish the cash flows arising at each future period 2.