managing interest rate risk. theories of interest rate determination expectation theory : –forward...

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


• 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


• 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


• 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.


• 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


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%


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%



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%


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 %


Receive 3%

INTEREST RATE COLLARS for LOAN

BUY A CAP = 14%

SELL A FLOOR = 8%

REF. RATE = 17%

REF. RATE = 5%

Receive 3 %


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

managing interest rate risk. theories of interest rate determination expectation theory : –forward...

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