BSFB206
GROUP ASSIGNMENT 1
SURNAME NAME REG NUMBER PROGRAMM
ZURA KEITH A R195463E HASC
5 INSTRUMENTS THAT ARE USED TO
MANAGE INTEREST RATE RISK
INTEREST RATE RISK ARISES FROM THE POSSIBILITY OF A CHANGE IN THE VALUE OF
ASSETS AND LIABILITIES IN RESPONSE TO CHANGES IN MARKET INTEREST RATES. INTEREST
RATE RISK IS THE POTENTIAL FOR INVESTMENT LOSSES THAT RESULT FROM A CHANGE IN INTEREST RATES. IF
INTEREST RATES RISE, FOR INSTANCE, THE VALUE OF A BOND OR OTHER FIXED-INCOME INVESTMENT WILL
DECLINE. THE CHANGE IN A BOND'S PRICE GIVEN A CHANGE IN INTEREST RATES IS KNOWN AS ITS DURATION
1 INTEREST RATE FUTURES
A FUTURES CONTRACT ARE LEGAL AGREEMENTSBTO BUY OR SELL A PARTICULAR COMMODITY, ASSET OR
SECURITY AT A PREDETERMINED SPECIFIED TIME IN THE FUTURE.
HOW ARE THEY USED?
AN INTEREST RATE FUTURES ALLOWS EXPOSURE TO CHANGES IN INTEREST RATES.IT ENABLES INESTORS TO
SPECULATE THE DIRECTION OF THE INTEREST RATE OR ELSE THE CONTRACTS TO HEDGE AGAINST CHANGES IN
RATES.
HOW THEY MITIGATE THE RISK OF LOSSES
INTEREST RATE FUTURES ARE USED TO HEDGE AGAINST THE RISK THAT THE INTEREST RATES WILL MOVE IN AN
ADVERSE DIRECTION CAUSING A COST TO THE COMPANY.INTEREST RATE FUTURES USE THE INVERSE
RELATIONSHIP BETWEEN INTERESTS RATES AND BOND PRICES TO HEDGE AGAINST THE RISK OF RISING INTEREST
RATES.
BENEFITS OF INTEREST RATE FUTURES
THE COMMISSION CHARGES FOR FUTURES CONTRACTS ARE RELATIVELY SMALL AS COMPARED TO THE OTHER
TYPES OF INVESTMENTS
LEEDS TO HIGH LIQUIDITY
IT IS POSSIBLE TO OPEN SHORT AS WELL AS LONG POSITION
FUTURES ARE HIGHLY LEVERAGED FINANCIAL INSTRUMENTS WHICH PERMIT ACHIEVING GREATER GAINS USING A
LIMITED AMOUNT OF INVESTED FUNDS
DRAWBACKS OF INTEREST RATE FUTURES
IT OFFERS ONLY A PARTIAL HEDGE
2 FORWARD RATE AGREEMENTS
FORWARD RATE AGREEMENTS (FRA) ARE OVER-THE-COUNTER CONTRACTS BETWEEN PARTIES THAT DETERMINE THE RATE OF INTEREST TO BE PAID ON AN
AGREED-UPON DATE IN THE FUTURE.
A BORROWER BUYS AN FRA TO PROTECT AGAINST RISING INTEREST RATES, WHILE A LENDER SELLS AN FRA TO PROTECT AGAINST DECLINING INTERESR RATES.
COUNTERPARTIES TO AN FRA CONTINUE TO BORROW OR INVEST THROUGH NORMAL CHANNELS.
IF THE FRA RATE IS MORE THAN THE LIBOR RATE, THEN THE BORROWER HAS TO PAY THE LENDER FOR THE DIFFERENCE IN THE INTEREST RATE. AND, IF THE
FRA RATE IS LESS THAN THE LIBOR RATE, THEN THE BORROWER COULD EFFECTIVELY GET MONEY AT LESS THAN THE MARKET RATE.
WHERE:
FRAP=FRA PAYMENT
FRA=FORWARD RATE AGREEMENT RATE, OR FIXED INTERESTRATE THAT WILL BE PAID
R=REFERENCE, OR FLOATING INTEREST RATE USED IN THE CONTRACT
NP=NOTIONAL PRINCIPAL, OR AMOUNT OF THE LOAN THAT INTEREST IS APPLIED TO
P=PERIOD, OR NUMBER OF DAYS IN THE CONTRACT PERIOD
BENEFITS OF FORWARD RATE AGREENENTS
IT HELPS THE PARTIES TO REDUCE THEIR RISK OF ANY BORROWING AND LENDING IN THE FUTURE FROM UNFAVORABLE MARKET
MOVEMENTS.
ONE CAN ALSO USE FRA FOR TRADING AND EARNING ON THE BASIS OF INTEREST RATE EXPECTATIONS.
THEY ARE OFF-BALANCE SHEET ITEMS. THUS, THEY HAVE NO IMPACT ON FINANCIAL RATIOS.
DRAWBACKS
AS FRA’S ARE OTC CONTRACTS, THEY CARRY A HIGHER AMOUNT OF RISK THAN FUTURES CONTRACTS.
IN CASE A PARTY WANTS TO CLOSE THE CONTRACT BEFORE MATURITY, THEN IT MAY BE DIFFICULT TO FIND ANOTHER
PARTY IF THE ORIGINAL PARTY ISN’T WILLING TO DO THAT.
EXAMPLE
ASSUME THERE ARE TWO PARTIES MR. A AND MR. B, WHO FORGE AN AGREEMENT. A AGREES TO LEND A SUM OF $10,000 TO B AFTER 1 MONTH FOR 2
3 INTEREST RATE OPTIONS
INTEREST RATE OPTIONS INCLUDE CAPS, FLOORS, AND COLLARS USED TO PROTECT
AGAINST DIFFERENT REFERENCE INTEREST RATES OR PRICES OF UNDERLYING ASSETS.
ALTHOUGH OPTION STRATEGIES USUALLY INVOLVE OVER-THE-COUNTER OPTIONS,
THEY CAN ALSO BE CONSTRUCTED FROM EXCHANGE-TRADED OPTIONS.
THE BUSINESS OF OPTIONS IS ANALOGOUS TO INSURANCE. ONE PARTY PAYS TO
REDUCE OR ELIMINATE RISK, WHILE THE OTHER PARTY ACCEPTS THE RISK IN
EXCHANGE FOR OPTION PREMIUM. OPTION PREMIUM PAID INCREASES THE EFFECTIVE
BORROWING COST, OR DECREASES THE EFFECTIVE RETURN ON ASSETS, FOR HEDGERS.
4 SWAPTIONS
INTEREST RATE SWAPS ALLOW COMPANIES TO EXCHANGE INTEREST PAYMENTS ON AN AGREED
NOTIONAL AMOUNT FOR AN AGREED PERIOD OF TIME. SWAPS MAY BE USED TO HEDGE
AGAINST ADVERSE INTEREST RATE MOVEMENTS OR TO ACHIEVE A DESIRED BALANCED
BETWEEN FIXED AND VARIABLE RATE DEBT.
INTEREST RATE SWAPS ARE ARRANGED BY A FINANCIAL INTERMEDIARY SUCH AS A BANK, SO THE
COUNTERPARTIES MAY NEVER MEET. HOWEVER, THE OBLIGATION TO MEET THE ORIGINAL
INTEREST PAYMENTS REMAINS WITH THE ORIGINAL BORROWER IF A COUNTERPARTY DEFAULTS,
BUT THIS COUNTERPARTY RISK IS REDUCED OR ELIMINATED IF A FINANCIAL INTERMEDIARY
ARRANGES THE SWAP
A FIXED-TO-FLOATING SWAP INVOLVES ONE COMPANY RECEIVING A FIXED-RATE, AND PAYING A
FLOATING RATE SINCE IT BELIEVES THAT A FLOATING RATE WILL GENERATE STRONGER CASH
FLOW.
FLOATING-TO-FIXED SWAP IS WHERE A COMPANY WISHES TO RECEIVE A FIXED RATE TO HEDGE
INTEREST RATE EXPOSURE, FOR EXAMPLE
Example
OFTEN THE TWO PARTIES INVOLVED IN INTEREST RATE SWAP AGREEMENTS ARE A COMPANY AND A
LARGE BANK. THE COMPANY MAY NOT BE SATISFIED WITH THE BORROWING COSTS AVAILABLE TO IT
IN THE MARKETPLACE. FOR EXAMPLE, THE COMPANY MAY ONLY HAVE ACCESS TO LOANS WITH
FLOATING INTEREST RATES. BUT THE COMPANY PREFERS A LOAN WITH A FIXED INTEREST RATE.
THAT COMPANY CAN ARRANGE AN INTEREST RATE SWAP WITH A LARGE BANK THAT ALLOWS IT TO
PAY INTEREST BASED ON A FIXED RATE TO THE BANK IN EXCHANGE FOR PAYMENTS BASED ON A
BENEFITS OF SWAPTIONS
THE BORROWING (LENDING) BUSINESS IS PROTECTED AGAINST EXCESSIVE RISE (FALL) IN INTEREST BY A
GUARANTEED MAXIMUM (MINIMUM) RATE
FLEXIBILITY: IT CAN BE ADAPTED TO THE BUSINESS’ DEBT STRUCTURE
POSSIBILITY OF REVERSING THE TRANSACTION AT ANY TIME GIVEN THAT IT IS VERY LIQUID MARKET
AND IN THE EVENT OF EARLY REPAYMENT OF THE UNDERLYING CREDIT
EASY TO MANAGE, RECORDED OFF BALANCE SHEET FOR THE BUSINESS
DRAWBACKS OF SWAPTIONS
NO POSSIBILITY OF BENEFITING FROM A FAVOURABLE INTEREST RATE FLUCTUATION BETWEEN THE
DETERMINATION DATE AND THE SETTLEMENT DATE;
SEPARATION FROM THE UNDERLYING LOAN (INVESTMENT), MEANING THAT THE HEDGING
CONTINUES TO BE EFFECTIVE EVEN IF THE UNDERLYING NO LONGER EXISTS.
5 INTEREST RATE SWAPS
TRANSACTED IN THE OVER-THE-COUNTER MARKET, INTEREST RATE
SWAPS ARE RELATED TO FORWARDS AND FUTURES BUT FACILITATE
INTEREST RATE HEDGING OVER A LONGER TIME INTERVAL. COMMON
SWAPS INCLUDE ASSET SWAPS, BASIS SWAPS, ZEROCOUPON SWAPS,
AND FORWARD INTEREST RATE SWAPS. SWAP’S CONDITIONS, AND
THUS THERE MAY BE A COST TO EXIT FROM AN EXISTING.
THE SWAP IS AN AGREEMENT BETWEEN TWO PARTIES TO EXCHANGE
THEIR RESPECTIVE CASH FLOWS.MOST COMMONLY, THIS INVOLVES A
FIXED RATE PAYMENT EXCHANGED FOR A FLOATING RATE PAYMENT.
BOTH PARTIES ARE OBLIGATED BY THE SWAP, DEPENDING ON HOW
RATES HAVE CHANGED SINCE IT WAS TRANSACTED.
