W4: managing financial risk - interest rate

• interest rate movements create risks for companies with interest- paying liabilities and interest- earning assets
• risk from interest rate movements:

  firm may pay higher interest rates by having fixed rather than floating rate debt (vice versa), as market rates change
• risk from interest rate movements:

  if interest rate falls, a company would suffer a loss of interest from borrowers
• risk from interest rate movements:

  company may be exposed by having to repay a loan earlier than it can afford to → re-borrowing at a higher interest rate
• forward rate agreements (FRAs) allows lenders/borrowers to fix an interest rate on deposit/borrowing with a term that starts in the future
• FRAs:

  • borrower buys a FRA to fix future rate on borrowing
  • investor sells a FRA to fix rate of future deposit
• borrower FRA:

  • actual interest rate > forward rate → bank pays customer
  • actual interest rate < forward rate → customer pays bank
• under FRA, there is no actual delivery; only delivery of the profit or loss
• FRAs - limitations:

  • usually only available for large companies - £500,000 minimum
  • suitable for short-term lending
  • cannot benefit from favourable interest rate movements
• FRAs - advantages:

  • protection from adverse interest rate movements
  • OTC - contracts can be tailored
• interest rate futures are similar to FRAs but are standardised and exchange-traded
• interest rate futures:

  • lender buys (long position) the entitlement to interest receipts
  • borrower sells (short position) promise to make interest payments
• interest rate futures:

  • borrowers sell futures now and close their position by buying the futures, up until settlement date
• interest rate futures:

  • lenders will buy futures now and close their position by selling futures
• price of interest rate future = 100 - r
• interest rate option - buyer has the right, but not obligation, to deal at an agreed interest rate (strike rate) at a future maturity date
• underlying variable of exchange-traded interest rate options is interest rate futures
• exchange-traded interest rate options:

  • borrower - put option
  • lender - call option
• interest rate option:

  • exercise call option: strike rate > market rate
  • exercise put option: market rate > strike rate
• OTC interest rate options:

  • more flexible than FRAs - right not obligation
  • more expensive than FRAs - premium paid for the option
• interest rate options:

  borrower purchases put options to set a maximum (strike) rate of interest they have to pay.
• interest rate options:

  lender purchases call options to set a minimum (strike) rate of interest they receive
• interest rate swaps - agreement where two parties exchange interest payments on a notional amount of principal at intervals over a period of years
• advantages of interest rate swaps:

  • arrangement costs are lower than terminating existing loan and entering a new one
  • long term
  • tailor-made and reversible
  • can be used to make interest rate savings through comparative advantage