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MANAGING INTEREST RATE RISK. THEORIES OF INTEREST RATE DETERMINATION. Expectation theory : Forward interest rate are representative of expected future interest rates shape of the yield curve reflects market’s expectation. THEORIES OF INTEREST RATE DETERMINATION. Liquidity theory : - PowerPoint PPT Presentation
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MANAGING INTEREST RATE RISK
THEORIES OF INTEREST RATE DETERMINATION
• Expectation theory :– Forward interest rate are representative
of expected future interest rates shape of the yield curve reflects market’s expectation
THEORIES OF INTEREST RATE DETERMINATION
• Liquidity theory :– Investors will choose longer term
maturities as long as additional yield compensates the lack of liquidity forward interest rates possess a liquidity premium as well as future interest rate expectation
THEORIES OF INTEREST RATE DETERMINATION
• Preferred habitat theory :– Investors who habitually prefers a
certain investment horizon can be convinced to change maturity horizon by giving an appropriate premium shape of the yield curve also depends on policies of market participants
THEORIES OF INTEREST RATE DETERMINATION
• Market segmentation theory :– Different investors have different time
horizon due to nature of their business or as a result of investment restrictions shape of the yield curve is also influenced by investors compositions
FACTORS THAT AFFECT INTEREST RATES
• Expected levels of inflation
• General economic conditions
• Monetary policy and the stance of the central bank
• Foreign exchange market activity
• Foreign investor demand for debt outstanding
• Financial and political stability
SOURCE OF INTEREST RATE RISK
• Changes in the level of interest rates Absolute Interest Rate Risk
• Changes in the shape of the yield curve Yield Curve Risk
• Mismatches between exposure and the risk management strategies undertaken Basis Risk
• Risk of availability of similar or better investment opportunities at the end of investment duration Refunding Risk
ABSOLUTE INTEREST RATE RISK
• The possibility of change in interest rate• The longer the duration, the higher the risk of
interest rate change• Can be hedged operationally or using
instruments
YIELD CURVE RISK
15
20
25
30
35
40
45
50
55
'99 '00 '01 '02 '03 '04 '05 '06
UPWARDSLOPE
VOLATILE
DOWNWARDSLOPE
BASIS RISK
• Unavailability of hedge instrument for specific needs
• Some knock out features incorporated in the hedge instrument
REFUNDING RISK
• Inability to forecast interest rate at maturity of a loan or investment
• Callable bonds• Mismatch of investment duration vs
financing duration
FORWARD RATE AGRREMENT
• A forward rate agreement (FRA) is a forward contract in which one party pays a fixed interest rate, and receives a floating interest rate equal to a reference rate (the underlying rate).
FORWARD RATE AGREEMENT
• Over the counter agreement to receive or pay interest for a certain period starting from the agreed time
• Consist of FRA rate & Reference Rate • Forward term is the time prior to the beginning of FRA• Contract term is the period covered• Settlement is usually at forward term/ beginning of contract
term, usually discounted• Maturity is the end of contract term• A borrower buys an FRA to protect against rising interest
rates• A lender sells an FRA to protect against declining interest
rates• The payer of the fixed interest rate is also known as the
borrower or the buyer, whilst the receiver of the fixed interest rate is the lender or the seller.
FORWARD RATE AGREEMENT
• 3 X 6 FRA at 10.00% FRA begins in 3 months time for a period of 6 months with a confirmed rate of 10.00% per annum
FORWARD RATE AGREEMENT
REFERENCE RATE (LIBOR)
FRA RATE (FIXED)
LENDER / SELLER
PAY FLOATING
BORROWER / BUYER
PAY FIX
8.00 % 10.00 % Receives 10.00%
Pays 8.00%
Pays 10.00 %
Receives 8.00%
11.00 % 10.00 % Receives 10.00%
Pays 11.00%
Pays 10.00 %
Receives 11.00%
PAYOFF FORMULA
1Re
)(Re
360
360
days
days
xRateference
xRateFixedRateferencexamountNotionalPayment
INTEREST RATE FUTURES
• Exchange traded forwards• No credit line needed
BOND FUTURES
• Guarantees the future holder a certain price for a respective bond.
• Used to hedge bond and interest rate risk, change portfolio asset allocation or alter portfolio duration
• Bond issuer can hedge by buying bond futures to sell
• If interest rates increases ( bond prices falls), bond futures value increase
• If interest rates declines ( bond prices increases), bond futures value decline but has been offset by bond price increase
INTEREST RATE SWAP
Cy A
Bank/Bond X
Cy B
Bank/Bond Y
floating fixed
floating
fixed
Payments are done by calculating the differentials
INTEREST RATE SWAPS
• Over the counter transaction between counterparties
• Interchanging of rates, e.g. fixed vs floating
Fixed rate quotation :– Term of swap :……years– Bank bid-offer: 4.25% – 5.35%
• Exchanging floating to fixed receive floating, pay fixed take bank offer rate
• Exchanging fixed to floating receive fixed, pay floating take bank bid rate
INTEREST RATE SWAP
Cy A
Floating ratelenders
Cy B
Eurobonds
LIBOR + 0.5% 6.50%
IntermediaryBank
5.35% 4.25%
LIBOR LIBOR
Floatin
gA
$ Interest
LIB
OR
+1.25%F
ixed
US
$ In
tere
st
At
5.5%
Deutsche BankInterest flows
Fixed US$ InterestAt 6%
CROSS CURENCY & INTEREST RATE SWAP
Company A
Deutsche BankInitial exchange
4/2008
Bank of Commonwealth
Swap with Notional Deposit A$ 200 Mio
Facility US$ 170 Mio
Swap Counterparty
Interest Flows forUS$ 170 Mio loan
Deutsche Bankfinal exchange
4/2013
A$ 200 Mio proceeds
A$
200
Mio
A$ 200 MioUS$ 1 = A$ 1.1125
US$ 178 Mio
US
$ 170 Mio
US$ 160 MioUS$ 1 = A$ 1.25
A$ 200 Mio
US
$ 170 Mio A
$ 20
0 M
io
A$ 200 Mio
Fixed US$ Interest at 5.25%
FloatingA$ InterestLIBOR+1.28%
Floating A$ InterestLIBOR + 1.5%
Floating A$ InterestLIBOR + 2.5%
ANZ transactSwap Contract,Starting spot FX
A$ 200 Mio Floating rate Bond
Due 4/2013
ANZ transactForward in accordTo Swap contract
Swap Counterparty
Interest Flows forA$ 200 Mio deposit
ZERO COUPON SWAP
Cy A
Bank/Bond X
Swap issuer
floating
floating
Zero Coupon
Payments are done by cy A at the end of swap term
Floatin
gA
$ Interest
LIB
OR
+2%
Deutsche BankInterest flows
Baloon amount ofUS$ 80 Mio
CROSS CURENCY & ZERO COUPON SWAP
Company A
Deutsche BankInitial exchange
4/2008
Bank of Commonwealth
Deposit A$ 200 Mio
A$ DebtorInterest Flows
Deutsche Bankfinal exchange
4/2013
A$ 200 Mio proceeds
A$
125
Mio
A$ 125 MioUS$ 1 = A$ 1.1125
US$ 113 Mio
US
$ 110 Mio
US$ 100 MioUS$ 1 = A$ 1.25
A$ 200 Mio
US
$ 110 Mio A
$ 20
0 M
io
A$ 200 Mio
FloatingA$ Interest
LIBOR+1.5%
Floating A$ InterestLIBOR + 2.5%
Floating A$ InterestLIBOR + 2.5%
ANZ transactSwap Contract,Starting spot FX
A$ 200 Mio Floating rate Bond
Due 4/2013
ANZ transactForward in accordTo Swap contract
A$ 200 Mio
US
$ 60 Mio
A$ 200 Mio
FORWARD INTEREST RATE SWAPS
• Arranging a swap in advance of its requirements and commencement
CLOSING OUT AN IRS
• Offset the swap with another that will produce the required payments stream
• Cancel the existing swap by paying or receiving a lump sum (NPV of remaining payments)
• Extend the swap• Sell the swap to another party if
possible
INTEREST RATE OPTIONS
• CAPS– A series of interest rate options
(caplets) to protect against rising interest rates.
– European style
– At the expiry date of each caplets, the cap seller reimburse the cap buyer for the difference if reference rate > strike rate
INTEREST RATE CAP
CAP = 14%
REF. RATE = 17%
REF. RATE = 5%
Receive 3 % if loan(buyer),Pay 3% if deposit (issuer)
Option not exercised
BUY A CAP : option for maximum interest for loan ; ISSUE A CAP : issuing rights for maximum interest to be paid
INTEREST RATE OPTIONS
• FLOORS– A series of interest rate options (caplets) to
protect against falling interest rates.
– European style
– At the expiry date of each caplets, the cap seller reimburse the cap buyer for the difference if reference rate < strike rate
– Alternative of buying a cap is selling a floor
INTEREST RATE FLOORS
FLOOR = 8%
REF. RATE = 17%
REF. RATE = 5%
Option not exercised
Pay 3% if loan (issuer), Receive 3% if deposit (buyer)
BUY A FLOOR : option for minimum interest for deposit ; ISSUE A FLOOR : issuing rights for minimum interest to be received
INTEREST RATE COLLARS
• Comprises a cap and a floor, whereby one is purchased and the other one sold
• Purchased options provides protection against adverse interest movements
• Sold options provides income to offset premium paid for purchased options
• European style
• Zero cost collar : – premium payment for an option = premium received from
the other option
INTEREST RATE COLLARS for DEPOSIT
ISSUE A CAP = 14%
BUY A FLOOR = 8%
REF. RATE = 17%
REF. RATE = 5%
Pay 3 %
Option not exercised
Receive 3%
INTEREST RATE COLLARS for LOAN
BUY A CAP = 14%
SELL A FLOOR = 8%
REF. RATE = 17%
REF. RATE = 5%
Receive 3 %
Option not exercised
Pay 3%
SWAPTIONS
• Options on Interest Rate Swaps• Payer swaptions : gives the option
holders the right to pay fix and receive floating
• Receiver swaptions : gives the option holders the right to receive fix and pay floating
ASSET – LIABILITY MANAGEMENT
• Gap management : – matches duration of assets to liabilities,
eg account payables to account receivables