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13 Cards in this Set

  • Front
  • Back

Interest Rate Risk

Basis Risk

Gap Risk

Net Interest Income (NII)

Basis Risk

Mismatching of interest rate bases of associated assets and liabilities

- Ex. Some of our assets and liabilities might be based on LIBOR while others are based on the prime rate

Gap Risk

Mismatching of timing in repricing interest rate sensitive assets and liabilities

- firms have fewer interest rate sensitive assets but fund them with interest rate sensitive liabilities

Net Interest Income (NII)

Difference between interest earned on assets and paid on liabilities

Managing Interest Rate Risk

Identify types and size of interest rate exposure

Identify goals of management

Form a view of interest rate movements (examine forward markets)

Choose an appropriate tool to manage

Interest Rate Management Tools

Forward Currency Forward Swaps

Forward Rate Agreements

Interest Rate Swaps

Currency Swaps

Forward Currency Forward Swaps

Combining of 2 forward offsetting positions

Forward Currency Forward Swap Example

MNC manager knows money is needed at some point in the future for a specific time period

- Need 1M euros in 3 months for 6 months

1) Buy 1 M euros FW (3 mths) for $1.60/euro

2) Sell 1 M euros FW (9 mths) for $1.6550/euro

Forward Currency Forward Swap Example: What is the implied interest rate on the transaction?

Buy 1 M euros x $1.6/euro = $1,600,000

Sell 1 M euros x $1.6550/euro = $1,655,000

Implied rate = (1,655,000/1,600,000) - 1 = 3.4375% per 6 mths or 6.875% per annum.

Know with certainty of our rate!

Forward Rate Agreements (FRA)

Contractual agreement between 2 parties

- Seller of FRA will pay the buyer if rates rise above a specified rate

- Buyer of FRA will pay seller if rates fall below a specified rate

FRA Example

Notional Amount: $1,000,000

Agreed upon rate: 9%

Time period: 6mths

Start date: 3 mths from now

If in 3 mths - actual 6 mth rate = 12%:

- Buyer receives $ from seller:

$1,000,000 x [(.12-.09) x (180/360)] = $15,000

Net Interest payment on $1M borrowed:

Interest payment = 60,000

FRA inflow = 15,000

Net payment = 45,000

So really paying 4.5% per 6 mths or 9% per annum. (locked in to particular interest rate)

Interest Rate Swap

Swap debt service obligations

Plan Vanilla swap (standard type; swapping fixed rate for floating rate)

Used by bond issuers to reconfigure debt structure

Works because:

- lower risk firms have a comparative advantage in the fixed rate market

- higher risk firms have a comparative advantage in the floating rate market

Currency Swaps

Exchange debt service obligations that are denominated in another currency

Could swap fixed for floating as well