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13 Cards in this Set
- Front
- Back
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Interest Rate Risk |
Basis Risk Gap Risk Net Interest Income (NII) |
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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 |
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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 |
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Net Interest Income (NII) |
Difference between interest earned on assets and paid on liabilities |
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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 |
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Interest Rate Management Tools |
Forward Currency Forward Swaps Forward Rate Agreements Interest Rate Swaps Currency Swaps |
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Forward Currency Forward Swaps |
Combining of 2 forward offsetting positions |
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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 |
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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! |
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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 |
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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) |
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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 |
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Currency Swaps |
Exchange debt service obligations that are denominated in another currency Could swap fixed for floating as well |
