Interest rate

risk
Exam guide
The material in this chapter, if it appears in a Section B question, will be
examined almost entirely as a discussion question. It is important that you
understand and can explain the terminology.

Interest rate
The interest rates on financial assets are influenced by the risk of the assets,
the duration of the lending, and the size of the loan.
There is a trade-off between risk and return. Investors in riskier assets expect
to be compensated for the risk.

Interest rate risk

Interest rate risk relates to the sensitivity of profit and cash flows to changes in
interest rates.
Interest rate risk is faced by companies with floating and fixed rate debt. It can
arise from gap exposure and basis risk.

Interest rate risk is the risk of a change in interest rates, and the effect that
this will have on profits and cash flows. This type of risk is greatest for
organisations with large amounts of assets that yield interest or liabilities on
which interest is payable. Banks and investment institutions are therefore
heavily exposed to interest rate risk, but so too are companies with large
borrowings.

Gap exposure
The degree to which a firm is exposed to interest rate risk can be identified by
using the method of gap analysis. Gap analysis is based on the principle of
grouping together assets and liabilities, which are sensitive to interest rate
changes according to their maturity dates. Two different types of 'gap' may
occur.
a) A negative gap
A negative gap occurs when a firm has a larger amount of interest-sensitive
liabilities maturing at a certain time or in a certain period than it has interest
sensitive assets maturing at the same time. The difference between the two
amounts indicates the net exposure.

b) A positive gap
There is a positive gap if the amount of interest-sensitive assets maturing at a
particular time exceeds the amount of interest-sensitive liabilities maturing at
the same time.

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With a negative gap, the company faces exposure if interest rates rise by the
time of maturity. With a positive gap, the company will lose out if interest rates
fall by maturity.

The causes of interest rate fluctuations

The yield curve

The term structure of interest rates refers to the way in which the yield (return)
of a debt security or bond varies according to the term of the security, i.e. to
the length of time before the borrowing will be repaid.

The yield curve is an analysis of the relationship between the yields on debt
with different periods to maturity.

A yield curve can have any shape, and can fluctuate up and down for different
maturities.
There are three main types of yield curve shapes: normal, inverted and flat (or
humped):
 Normal yield curve – longer maturity bonds have a higher yield compared
with shorter-term bonds due to the risks associated with time
 Inverted yield curve – the shorter-term yields are higher than the longer
term yields, which can be a sign of upcoming recession
 flat (or humped) yield curve – the shorter and longer-term yields are very
close to each other, which is also a predictor of an economic transition.

The slope of the yield curve is also seen as important: the greater the slope,
the greater the gap between short and long-term rates.

The shape of the yield curve at any point in time is the result of the three
following theories acting together:
 Liquidity preference theory
 Expectations theory
 Market segmentation theory.

Liquidity preference theory

Investors have a natural preference for more liquid (shorter maturity)
investments. They will need to be compensated if they are deprived of cash
for a longer period.

Expectations theory
The normal upward sloping yield curve reflects the expectation that inflation
levels, and therefore interest rates will increase in the future.

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Market segmentation theory
The market segmentation theory suggests that there are different players in
the short-term end of the market and the long-term end of the market.
The yield curve is therefore shaped according to the supply and demand of
securities within each maturity length.

Hedging interest rate risk

Forward rate agreements (FRAs)
The aim of an FRA is to:
 lock the company into a target interest rate
 hedge both adverse and favourable interest rate movements.

The company enters into a normal loan but independently organises a forward
rate agreement with a bank:
 interest is paid on the loan in the normal way
 if the interest is greater than the agreed forward rate, the bank pays the
difference to the company
 if the interest is less than the agreed forward rate, the company pays the
difference to the bank.

Test your understanding 1

Nero Co’s cash flow forecast shows that it will have to borrow $2m from
Goodfellow’s Bank in four months’ time for a period of three months. The
company fears that by the time the loan is taken out, interest rates will have
risen. The current interest rate is 5% and this is offered by Helpy Bank on the
required FRA.
Required
I. What kind of FRA is needed?
II. What are the cash flows if the interest rate has risen to 6.5% when the
loan is taken out?
III. What are the cash flows if the interest rate has fallen to 4% when the
loan is taken out?

Test your understanding 2

Lynn plc is a UK listed company. It is 30 June. Lynn will need a £10 million 6-
month fixed rate loan from 1 October. Lynn wants to hedge its exposure to the
risk of a rise in the 6-month interest rate between the end of June and 1
October, using an FRA. The relevant FRA rate is 6% on 30 June and the
reference rate for the FRA is the 6-month LIBOR rate. The current 6-month
FRA rate is 6.25%.
(a) State what FRA is required.

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(b) What is the result of the FRA and the effective loan rate if the spot 6-month
LIBOR rate (the benchmark or reference rate for the FRA) is:
(i) 5%
(ii) 9%

INTEREST RATE DERIVATIVES

The interest rate derivatives that will be discussed are:
I. Interest rate futures
II. Interest rate options
III. Interest rate caps, floors and collars
IV. Interest rate swaps

INTEREST RATE FUTURES

Futures contracts are of fixed sizes and for given durations. They give their
owners the right to earn interest at a given rate, or the obligation to pay
interest at a given rate.

Selling a future creates the obligation to borrow money and the obligation

to pay interest
Buying a future creates the obligation to deposit money and the right
to receive interest.

Interest rate futures can be bought and sold on exchanges such as

Intercontinental Exchange (ICE) Futures Europe.

The price of futures contracts depends on the prevailing rate of interest and it
is crucial to understand that as interest rates rise, the market price of futures
contracts falls.

 A rise in interest rates reduces futures prices.

 A fall in interest rates increases futures prices.

In practice, futures price movements do not move perfectly with interest rates
so there are some imperfections in the mechanism. This is known as basis
risk.

The approach used with futures to hedge interest rates depends on two
parallel transactions:
 Borrow/deposit at the market rates
 Buy and sell futures in such a way that any gain that the profit or loss on
the futures deals compensates for the loss or gain on the interest
payments.

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Borrowing or depositing can therefore be protected as follows:

Depositing and earning interest

The depositor fears that interest rates will fall as this will reduce income.
If interest rates fall, futures prices will rise, so buy futures contracts now (at
the relatively low price) and sell later (at the higher price). The gain on futures
can be used to offset the lower interest earned.
Of course, if interest rates rise the deposit will earn more, but a loss will be
made on the futures contracts (bought at a relatively high price then sold at a
lower price).

Borrowing and paying interest

The borrower fears that interest rates will rise as this will increase expense.
If interest rates rise, futures prices will fall, so sell futures contracts now (at
the relatively high price) and buy later (at the lower price). The gain on futures
can be used to offset the lower interest earned.
Of course, if interest rates fall the loan will cost less, but a loss will be made
on the futures contracts (sold at a relatively low price then bought at a higher
price).
Once again, the aim is stability of the combined cash flows.

Summary
The summary rule for interest rate futures is:
 Depositing: buy futures then sell
 Borrowing: sell futures then buy

INTEREST RATE OPTIONS

Interest rate options allow businesses to protect themselves against adverse
interest rate movements while allowing them to benefit from favourable
movements. They are also known as interest rate guarantees. Options are like
insurance policies:
I. You pay a premium to take out the protection. This is non-returnable
whether or not you make use of the protection.
II. If interest rates move in an unfavorable direction you can call on the
insurance.
III. If interest rates move favourable you ignore the insurance.

Options are taken on interest rate futures contracts and they give the holder
the right, but not the obligation, either to buy the futures or sell the futures at
an agreed price at an agreed date.

Using options when borrowing

As explained above, if using simple futures contracts the business would sell
futures now then buy later.
When using options, the borrower takes out an option to sell futures contracts
at today’s price (or another agreed price). Let’s say that price is 95. An option

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to sell is known as a put option (think about putting something up for sale).
If interest rates rise the futures contract price will fall, let’s say to 93. Therefore
the borrower will buy at 93 and will then choose to exercise the option by
exercising their right to sell at 95. The gain on the options is used to offset the
extra interest that has to be paid.
If interest rates fall the futures contract price will rise, let’s say to 97. Clearly,
the borrower would not buy at 97 then exercise the option to sell at 95, so the
option is allowed to lapse and the business will simply benefit from the lower
interest rate.

Using options when depositing

As explained above, if using simple futures contracts the business would buy
futures now and then sell later.
When using options, the investor takes out an option to buy futures contracts
at today’s price (or another agreed price). Let’s say that price is 95. An option
to buy is known as a call option.

If interest rates fall the futures contract price will rise, let’s say to 97. The
investor would therefore sell at 97 then exercise the option to buy at 95. The
gain on the options is used to offset the lower interest that has been earned.
If interest rates rise the futures contract price will fall, let’s say to 93. Clearly,
the investor would not sell futures at 93 and exercise the option by insisting on
their right to sell at 95. The option is allowed to lapse and the investor enjoys
extra income form the higher interest rate.

Options therefore give borrowers and lenders a way of guaranteeing minimum

income or maximum costs whilst leaving the door open to the possibility of
higher income or lower costs. These ‘heads I win, tails you lose’ benefits have
to be paid for and a non-returnable premium has to be paid up front to
acquire the options.