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CIMA P3 Course Notes

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CIMA P3 Course Notes


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Chapter 13 Interest rate risk

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1.

Interest rate risk

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.

Hedging interest rate risk

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

Forward rate agreement


! forward rate agreement "F#!$ is a contract between two parties that determines the rate of interest to be paid or received on an obligation beginning at a future start date. "It is similar in nature to a currency forward, but for interest rates$. The contract will determine the rates to be used along with the termination date and notional value. %n this type of agreement, it is only the differential that is paid on the notional amount of the contract, so for instance if rates rise by &' between taking out the F#! and the date when the actual loan is taken out, then the company takes out the loan at the higher rate, but is able to recoup the additional &' interest from the party with whom the F#! was taken out. (ou are not re)uired to undertake calculations on F#!s in the exam.

Interest rate guarantees (I !"


!n interest rate guarantee "I#*$ is an option on a forward rate agreement "F#!$ that is agreed between two parties "e.g. the company and a bank$. +hen exercising an I#*, the holder has the option "but is not obliged$ to take a loan of a predetermined amount at a predetermined interest rate for a predetermined time period.

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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.

Interest rate #utures


!n interest rate future is an exchange traded agreement that determines the rate of interest, to be paid or received on an obligation beginning at a future start date. It is similar in nature to a currency future. Key characteristics !n exchange traded F#! "which gives security that the counterparty will fulfil their obligations$ -tandard amounts -it alongside the actual loan "like currency futures$ .orrowers sell futures to hedge against an increase in rates.

,o calculations are re)uired for interest rate futures in the exam.

Interest rate options


!n interest rate option grants the buyer the right but not the obligation to deal in interest rate futures. It is therefore exchange traded. ! premium is payable. ,o calculations are re)uired for interest rate options in the exam.

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$ummar% o# interest rate hedging techni&ues


'(er )he Counter (i.e. agreed direct*% with the +ank"

,-change traded

Fi-ing instruments

Forward #ate !greement

Interest #ate Futures

Insurance instruments (right +ut not o+*igation"

Interest #ate *uarantees

Interest #ate %ptions

3.

Interest rate $.AP$

.hat is an interest rate $.AP/


!n interest rate swap is where two parties agree to exchange interest rate cash flows for mutual benefit. The contract will be based on a specified notional amount from a fixed rate to a floating rate "or vice versa$ or from one floating rate to another.

How can +oth parties gain #rom 0$wapping1 *oans/


!n example of a -+!/ in its simplest form would be if one party can get low rates of interest on floating rate loans "but want fixed$ while another party can get low rates on fixed rate loans "but want floating$, so by taking out the loan they can get cheaply and 0swapping it1 by effectively paying each other1s interest payments, then both parties can gain.

How does it work/


The most common interest rate swap is one where one counterparty ! pays a fixed rate "the swap rate$ to counterparty ., while receiving a floating rate. The floating rate is usually referred to compared to a reference rate "such as 2I.%# or 34#I.%#$ e.g. 2I.%# 5 6'. If the current 2I.%# rate is 7' then the payment is 8'. The 2I.%# "2ondon Inter+ank '##ered ate" is the
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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.

(ou C% need to be able to calculations like this in the examD

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.

Caps9 F*oors and Co**ars

!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.

:.

Financia* reporting and risks o# deri(ati(es

!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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