Chapter 18 Interest Rate Risk



Chapter 20 Interest Rate Risk

|SYLLABUS |

| |

|1. Describe and discuss different types of interest rate risk: |

|(a) gap exposure |

|(b) basis risk |

|2. Describe the causes of interest rate fluctuations, including: |

|(a) structure of interest rates and yield curves |

|(b) expectations theory |

|(c) liquidity preference theory |

|(d) market segmentation |

|3. Discuss and apply traditional and basic methods of interest rate risk management, including: |

|(a) matching and smoothing |

|(b) asset and liability management |

|(c) forward rate agreements |

|4. Identify the main types of interest rate derivatives used to hedge interest rate risk and explain how they are used in hedging. (No |

|numerical questions will be set on this topic) |

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1. Interest Rate Risk

1.1 Introduction

1.1.1 Many companies borrow, and if they do they have to choose between borrowing at a fixed rate of interest (usually by issuing bonds) or borrow at a floating (variable) rate (possibly through bank loans). There is some risk in deciding the balance or mix between floating rate and fixed rate debt. Too much fixed-rate debt creates an exposure to falling long-term interest rates and too much floating-rate debt creates an exposure to a rise in short-term interest rates.

1.1.2 Interest rate risk is faced by companies with floating and fixed rate debt. It can arise from gap exposure and basis risk.

1.2 Gap/interest rate exposure (差距風險)

1.2.1 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 – It occurs when a firm has a larger amount if 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 in a particular time exceeds the amount of interest-sensitive liabilities maturing at the same time.

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

1.3 Basis risk (基差風險)

1.3.1 The basis is the difference between the futures price and the spot price.

Basis = Futures - Spot

1.3.2 Normally, the futures do not completely eliminate interest rate exposure and the remaining exposure is known as basis risk.

1.3.3 For example, a company might borrow at a variable rate of interest, with interest payable every six months and the amount of the interest charged each time varying according to whether short-term interest rates have risen or fallen since the previous payment.

|Multiple Choice Questions |

| |

|1. Which is the best definition of basis risk? |

| |

|A Interest rates on deposits and on loans are revised at different times. |

|B Interest rates on deposits and loans move by different amounts. |

|C Interest rates move. |

|D The bank base rate might move with a knock on effect to other interest rates. |

| |

|2. If a business benefits from gap exposure what does this mean? |

| |

|A The timing of interest rate movements on deposits and loans means it has made a profit |

|B The timing of interest rate movements on deposits and loans means it has made a loss |

|C The interest rates reduce between deciding a loan is needed and signing for that loan. |

|D The inefficiencies between two markets means arbitrage gains are possible. |

2. The Causes of Interest Rate Fluctuations

|2.1 |The Causes of Interest Rate Fluctuations |

| |The causes of interest rate fluctuations include the structure of interest rates and yield curves and changing economic |

| |factors. |

2.2 The term structure of interest rates

(Dec 09)

2.2.1 There are several reasons why interest rates differ in different markets and market segments.

(a) Risk – Higher risk borrowers must pay higher rates on their borrowing, to compensate lenders for the greater risk involved.

(b) The need to make a profit on re-lending – Financial intermediaries make their profits from re-lending at a higher rate of interest than the cost of their borrowing.

(c) The size of the loan – Deposits above a certain amount with a bank or building society might attract higher rates of interest than smaller deposits.

(d) Different types of financial asset – Different types of financial asset attract different rates of interest. This is largely because of the competition for deposits between different types of financial institution.

(e) Government policy – The policy on interest rates might be significant too. A policy of keeping interest rates relatively high might therefore have the effect of forcing short-term interest rates higher than long-term rates.

(f) The duration of the lending – The term structure of interest rates refers to the way in which the yield on a security varies according to the term of the borrowing, that is the length of time until the debt will be repaid as shown by the yield curve. Normally, the longer the term of an asset to maturity, the higher the rate of interest paid on the asset.

2.2 Yield curve (收益率曲線)

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

2.2.2 A yield curve can have any shape, and can fluctuate up and down for different maturities.

2.2.3 There are three main types of yield curve shapes: normal, inverted and flat (humped):

(a) Normal yield curve – longer maturity bonds have a higher yield compared with shorter-term bonds due to the risks associated with time.

(b) Inverted yield curve – the short-term yields are higher than the longer-term yields, which can be a sign of upcoming recession.

(c) 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.

2.2.4 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.

[pic]

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2.2.5 The shape of the yield curve at any point in time is the result of the three following theories acting together:

(a) Liquidity preference theory (流動性偏好理論)

(b) Expectations theory

(c) Market segmentation theory (市場分割理論)

|2.2.6 |Liquidity Preference, Expectations and Market Segmentation Theories |

| |(Dec 09, Dec 13) |

| |(a) 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. |

| | |

| |Therefore the longer the maturity period, the higher the yield required leading to an upward sloping curve, assuming that |

| |the interest rates were not expected to fall in the future. |

| | |

| |(b) Expectations theory |

| |This theory states that the shape of the yield curve varies according to investors' expectations of future interest rates.|

| |A curve that rises steeply from left to right indicates that rates of interest are expected to rise in the future. There |

| |is more demand for short-term securities than long-term securities since investors' expectation is that they will be able |

| |to secure higher interest rates in the future so there is no point in buying long-term assets now. The price of short-term|

| |assets will be bid up, the price of long-term assets will fall, so the yields on short-term and long-term assets will |

| |consequently fall and rise. |

| | |

| |(c) 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. As a result the two ends of the curve may have different shapes, as they are influenced |

| |independently by different factors. |

| | |

| |The result is separate yield curves that probably do not meet very smoothly. This introduces a ‘kink’ to the yield curve |

| |presumably determined by arbitrage between the different markets to gain risk-free return. |

[pic]

|2.2.7 |Significance of Yield Curves to Financial Managers |

| |Financial managers should inspect the current shape of the yield curve when deciding on the term of borrowings or |

| |deposits, since the curve encapsulates the market's expectations of future movements in interest rates. |

| | |

| |A corporate treasurer might analyse a yield curve to decide for how long to borrow. For example, suppose a company wants |

| |to borrow $20 million for five years and would prefer to issue bonds at a fixed rate of interest. One option would be to |

| |issue bonds with a five-year maturity. Another option might be to borrow short-term for one year, say, in the expectation |

| |that interest rates will fall, and then issue a four-year bond. When borrowing large amounts of capital, a small |

| |difference in the interest rate can have a significant effect on profit. For example, if a company borrowed $20 million, a|

| |difference of just 25 basis points (0.25% or one quarter of one per cent) would mean a difference of $50,000 each year in |

| |interest costs. So if the yield curve indicates that interest rates are expected to fall then short-term borrowing for a |

| |year, followed by a 4-year bond might be the cheapest option. |

|Multiple Choice Questions |

| |

|3. Which of the following is NOT an explanation of a downward slope in the yield curve? |

| |

|A Liquidity preference |

|B Expectations theory |

|C Government policy |

|D Market segmentation |

| |

|4. An inverse yield curve is a possible indication of |

| |

|A An expected rise in interest rates |

|B An expected fall in interest rates |

|C Higher expected inflation |

|D Lower expected inflation |

| |

|5. A yield curve shows |

| |

|A the relationship between liquidity and bond interest rates |

|B the relationship between time to maturity and bond interest rates |

|C the relationship between risk and bond interest rates |

|D the relationship between bond interest rates and bond prices |

| |

|6. Which of the following statements is correct? |

| |

|A Governments can keep interest rates low by buying short-dated government bills in the money market |

|B The normal yield curve slopes upward to reflect increasing compensation to investors for being unable to use their cash now |

|C The yield on long-term loan notes is lower than the yield on short-term loan notes because long-term debt is less risky for a company|

|than short-term debt |

|D Expectations theory states that future interest rates reflect expectations of future inflation rate movements |

|(ACCA F9 Financial Management December 2014) |

|Question 1 |

|Discuss the reasons why different bonds of the same company might have different costs of debt. (6 marks) |

|(ACCA F9 Financial Management December 2009 Q2b) |

3. Interest Rate Risk Management

3.1 Interest rate risk can be managed using internal hedging in the form of asset and liability management, matching and smoothing or using external hedging instruments such as forward rate agreements and derivatives.

3.2 Matching and smoothing (Dec 12)

3.2.1 Matching is where liabilities and assets with a common interest rate are matched.

|3.2.2 |Example 1 |

| |Subsidiary A of a company might be investing in the money markets at LIBOR and subsidiary B is borrowing through the same |

| |market at LIBOR. If LIBOR increases, subsidiary A’s borrowing cost increases and subsidiary B’s return increase. The |

| |interest rates on the assets and liabilities are therefore matched. |

3.2.3 This method is most widely used by financial institutions such as banks, who find it easier to match the magnitudes and characteristics of their assets and liabilities than commercial or industrial companies.

3.2.4 Smoothing is where a company keeps a balance between its fixed rate and floating rate borrowing.

3.2.5 A rise in interest rates will make the floating rate loan more expensive but this will be compensated for by the less expensive fixed rate loan. The company may however incur increased transaction and arrangement costs.

3.3 Forward rate agreements (FRAs) (遠期利率協議)

(Dec 12, Jun 15)

3.3.1 A company can enter into a FRA with a bank that fixes the rate of interest for borrowing at a certain time in the future.

(a) If the actual interest rate proves to be higher than the rate agreed, the bank pays the company the difference.

(b) If the actual interest rate is lower than the rate agreed, the company pays the bank the difference.

|3.3.2 |Example 2 |

| |A company’s financial projections show an expected cash deficit in two months' time of $8 million, which will last for |

| |approximately three months. It is now 1 November 2010. The treasurer is concerned that interest rates may rise before 1 |

| |January 2011. Protection is required for two months. |

| | |

| |[pic] |

| |The treasurer can lock into an interest rate today, for a future loan. The company takes out a loan as normal, i.e. the |

| |rate it pays is the going market rate at the date the loan is taken out. It will then receive or pay compensation under |

| |the separate FRA to return to the locked-in rate. |

| | |

| |A 2-5 FRA at 5.00 – 4.70 is agreed. |

| | |

| |This means that: |

| |The agreement starts in 2 months time and ends in 5 months' time. |

| |The FRA is quoted as simple annual interest rates for borrowing and lending, e.g. 5.00 – 4.70. |

| |The borrowing rate is always the highest. |

| | |

| |Required: |

| | |

| |Calculate the interest payable if in two months’ time the market rate is: |

| |(a) 7% |

| |(b) 4%. |

| | |

| |Solution: |

| | |

| |The FRA: |

| |7% |

| |4% |

| | |

| |Interest payable: 8m x 7% x 3/12 |

| |(140,000) |

| | |

| | |

| |8m x 4% x 3/12 |

| | |

| |(80,000) |

| | |

| |Compensation receivable |

| |40,000 |

| | |

| | |

| |Payable |

| | |

| |(20,000) |

| | |

| |Locked into the effective interest rate of 5% |

| |(100,000) |

| |(100,000) |

| | |

| | |

| |In this case the company is protected from a rise in interest rates but is not able to benefit from a fall in interest |

| |rates – it is locked into a rate of 5% – an FRA hedges the company against both an adverse movement and a favourable |

| |movement. |

| | |

| |Note: |

| |The FRA is a totally separate contractual agreement from the loan itself and could be arranged with a completely different|

| |bank. |

| |They can be tailor-made to the company’s precise requirements. |

| |Enables you to hedge for a period of one month up to two years. |

| |Usually on amounts > £1 million. The daily turnover in FRAs now exceeds £4 billion. |

|Question 2 |

|A company needs to borrow $30 million for eight months, starting in three month’s time. |

| |

|A 3-11 FRA at 2.75 – 2.60 is available. |

| |

|Show the interest payable if the market rate is (a) 4%, (b) 2%. |

3.4 Futures contracts

(Dec 08, Dec 12)

|3.4.1 |Interest Rate Futures |

| |Interest rate futures can be used to hedge against interest rate changes between the current date and the date at which |

| |the interest rate on the lending or borrowing is set. Borrowers sell futures to hedge against interest rate rises, lenders|

| |buy futures to hedge against interest rate falls. |

| | |

| |Interest rate futures are notional fixed-term deposits, usually for three-month periods starting at a specific time in the|

| |future. The buyer of one contract is buying the (theoretical) right to deposit money at a particular rate of interest for |

| |three months. |

| | |

| |Interest rate futures are quoted on an index basis rather than on the basis of the interest rate itself. The price is |

| |defined as: |

| | |

| |P = 100 – i |

| |Where P = price index; |

| |i = the future interest rate in percentage terms |

| | |

| |[pic] |

| | |

| | |

| |On 29 November 2004 the settlement price for a June three-month sterling future was 95.28, which implies an interest rate |

| |of 100 – 95.28 = 4.72 per cent for the period June to September. |

| |The September quote would imply an interest rate of 100 – 95.33 = 4.67 per cent for the three months September to December|

| |2005. |

| |The 4.72 per cent rate for three-month money starting from June 2005 is the annual rate of interest even though the deal |

| |is for a deposit of only one-quarter of a year. |

| | |

| |If traders in this market one week later, on 6 December 2004, pushed up the interest rates for three-month deposits |

| |starting in June 2005 to, say, 5.0 per cent then the price of the future would fall to 95.00. |

|3.4.2 |Example 3 – Hedging three-month deposits |

| |The treasurer of a company anticipates the receipt of £100m in December 2005, almost 13 months hence |

| |The money will be needed for production purposes in the spring of 2006 but for the three months following late December it|

| |can be placed on deposit |

| |The Sterling 3m Dec. future shows a price of 95.33, indicating an interest rate of 4.67, that is 100 – 95.33 = 4.67 |

| |To achieve certainty in December 2005 the treasurer buys, in November 2004, December 2005 expiry three-month sterling |

| |interest rate futures at a price of 95.33 |

| |She has to buy 200 to hedge the £100m inflow |

| |Suppose in December 2005 that three-month interest rates have fallen to 4 per cent |

| | |

| |£ |

| | |

| |Return at 4.67 per cent (£100m × 0.0467 × 3/12) |

| |1,167,500 |

| | |

| |Return at 4.00 per cent (£100m × 0.040 × 3/12) |

| |1,000,000 |

| | |

| |Loss |

| |(167,500) |

| | |

| | |

| |Futures profit |

| |The 200 futures contracts were bought at 95.33 |

| |The futures in December have a value of 100 – 4 = 96.00 |

| |The treasurer in December can close the futures position by selling the futures for 96.00 |

| |Therefore the gain that is made amounts to 96.00 – 95.33 = 0.67 |

| |A tick is the minimum price movement on a future |

| |A tick is a movement of 0.01 per cent on a trading unit of £500,000 |

| |One-hundredth of 1 per cent of £500,000 is equal to £50 |

| |£50/4 = £12.50 is the value of a tick movement in a three-month sterling interest rate futures contract |

| |We have a gain of 67 ticks with an overall value of 67 × £12.50 = £837.5 per contract, or £167,500 for 200 contracts |

|3.4.3 |Example 4 – Hedging a loan |

| |In November 2010 Holwell plc plans to borrow £5m for three months beginning in June 2011 |

| |Holwell hedges by selling ten three-month sterling interest rate futures contracts with June expiry |

| |The price of each futures contract is 95.28, so Holwell has locked into an annual interest rate of 4.72 per cent or 1.18 |

| |per cent for three months |

| |The cost of borrowing is therefore: £5m × 0.0118 = £59,000 |

| |Suppose that interest rates rise to annual rates of 6 per cent, or 1.5 per cent per quarter |

| |£5m × 0.015 = £75,000 |

| |However, Holwell is able to buy ten futures contracts to close the position on the exchange |

| |Each contract has fallen in value from 95.28 to 94.00 (100 – 6); this is 128 ticks. Bought at 94.00, sold at 95.28: |

| |128 ticks × £12.50 × 10 contracts = £16,000 |

3.5 Interest rate options

(Dec 08)

3.5.1 An interest rate option grants the buyer of it the right, but not the obligation, to deal at an agreed interest rate (strike rate) at a future maturity date. On the date of expiry of the option, the buyer must decide whether or not to exercise the right.

3.5.2 Clearly, a buyer of an option to borrow will not wish to exercise it if the market interest rate is now below that specified in the option agreement. Conversely, an option to lend will not be worth exercising if market rates have risen above the rate specified in the option by the time the option has expired.

3.5.3 Tailor-made over-the-counter interest rate options can be purchased from major banks, with specific values, periods of maturity, denominated currencies and rates of agreed interest. The cost of the option is the premium. Interest rate options offer more flexibility than and are more expensive than FRAs.

3.6 Interest rate caps, collars and floors

|3.6.1 |Interest Rate Caps (利率上限) |

| |An interest rate cap is a contract that gives the purchaser the right effectively to set a maximum level for interest |

| |rates payable. Compensation is paid to the purchaser of a cap if interest rates rise above an agreed level. |

| | |

| |This is a hedging technique used to cover interest rate risk on longer-term borrowing (usually 2 to 5 years). Under these |

| |arrangements a company borrowing money can benefit from interest rate falls but can place a limit to the amount paid in |

| |interest should interest rates rise. |

|3.6.2 |Example 5 – Interest rate cap |

| |Oakham plc wishes to borrow £20m for five years. It arranges this with bank A at a variable rate based on Libor plus 1.5 |

| |per cent. |

| |The interest rate is reset every quarter based on three-month Libor. Currently this stands at an annual rate of 7 per |

| |cent. |

| |Oakham buys an interest rate cap set at Libor of 8.5 per cent. |

| |Assume that this costs 2.3 per cent of the principal amount, or £20m × 0.023 = £460,000 payable immediately to the cap |

| |seller. |

| |So if for the whole of the third year Libor rose to 9.5 per cent Oakham would pay interest at 9.5 per cent plus 1.5 per |

| |cent to bank A but would also receive 1 per cent compensation from the cap seller. |

|3.6.3 |Interest Rate Floors (利率下限) |

| |An interest rate cap is an option which sets a lower limit to interest rates. It protects the floor buyer from losses |

| |resulting from a decrease in interest rates. The floor seller compensates the buyer with a payoff when the reference |

| |interest rate falls below the floor's strike rate. |

|3.6.4 |Interest Rate Collar (利率上下限，利率兩頭封) |

| |Using a collar arrangement, the borrower can buy an interest rate cap and at the same time sell an interest rate floor. |

| |This limits the cost for the company as it receives a premium for the option it’s sold. |

|3.6.5 |Example 6 – Interest rate collar |

| |Returning to Oakham, the treasurer could buy a cap set at 8.5 per cent Libor for a premium of £460,000 and sell a floor at|

| |6 per cent Libor receiving, say, £200,000 |

| |If Libor fell below 6 per cent Oakham would save on the amount paid to bank A but will have to make payments to the floor |

| |buyer, thus restricting the benefits from falls in Libor |

| |Oakham, for a net premium of £260,000, has ensured that its effective interest payments will not diverge from the range 6 |

| |per cent + 1.5 per cent = 7.5 per cent at the lower end, to 8.5 per cent + 1.5 per cent = 10 per cent at the upper end |

3.7 Interest rate swaps (利率互換)

(Dec 08, Dec 12)

|3.7.1 |Interest Rate Swaps |

| |Interest rate swaps are where two parties agree to exchange interest rate payments. There is no exchange of principal. |

| | |

| |Swap can be used to hedge against an adverse movement in interest rates. Swaps may also be sought by firms that desire a |

| |type of interest rate structure that another firm cam provide less expensively. |

|3.7.2 |Example 7 – Interest rate swap |

| |Cat plc and Dog plc, both want to borrow £150m for eight years |

| |Cat would like to borrow on a fixed-rate basis |

| |Dog prefers to borrow at floating rates |

| | |

| | |

| |Fixed |

| |Floating |

| | |

| |Cat can borrow at |

| |10% |

| |LIBOR +2% |

| | |

| |Dog can borrow at |

| |8% |

| |LIBOR +1% |

| | |

| | |

| |Dog has an absolute advantage in both |

| |Cat has an absolute disadvantage in both, but has a comparative advantage in the floating-rate market |

| |Cat borrows floating-rate funds, paying Libor +2 per cent, and Dog borrows fixed-rate debt, paying 8 per cent |

| | |

| |[pic] |

| | |

| |Cat |

| | |

| | |

| |Pays |

| |LIBOR +2% |

| | |

| |Receives |

| |LIBOR +2% |

| | |

| |Pays |

| |Fixed 9.5% |

| | |

| |Net payment |

| |Fixed 9.5% |

| | |

| | |

| | |

| | |

| |Dog |

| | |

| | |

| |Pays |

| |Fixed 8% |

| | |

| |Receives |

| |Fixed 9.5% |

| | |

| |Pays |

| |LIBOR +2% |

| | |

| |Net payment |

| |LIBOR +0.5% |

| | |

| | |

| |There is a saving of 50 basis point or £750,000 per year. |

|Multiple Choice Questions |

| |

|7. Consider the following statements concerning forward rate agreements (FRAs): |

| |

|1. FRAs cannot be tailored to the specific requirements of a customer. |

|2. FRAs are binding agreements that must be settled at the settlement date. |

|3. FRAs do not require any payments or receipts until the settlement date. |

|4. FRAs can be resold in the secondary market. |

| |

|Which of the above statements are correct? |

| |

| |

|A 1 and 2 |

|B 1, 2 and 4 |

|C 2 and 3 |

|D 2, 3 and 4 |

| |

|8. A company plans to take out a $50 million loan in six months’ time and wishes to fix the interest rate for a 12-month period. The |

|company wants to use a forward rate agreement to hedge the interest rate risk and the following rates have been quoted by a bank: |

| |

| |

|Bid % |

|Offer % |

| |

|6 v 12 |

|5.65 |

|5.60 |

| |

|6 v 18 |

|5.70 |

|5.64 |

| |

| |

|LIBOR is 5·5% at the fixing date and the company can borrow at 45 basis points above this figure. |

| |

|What rate of interest will the company pay to, or receive from, the bank as a result of the forward rate agreement? |

| |

|A 0·15% paid to bank |

|B 0·20% paid to bank |

|C 0·25% received from bank |

|D 0·31% received from bank |

| |

|9. Indus plc wishes to fix the interest rate for a six-month period on a £20 million loan that it plans to take out in three months’ |

|time. The company decides to use a forward rate agreement (FRA) to hedge the interest rate risk and a bank quotes the following rates: |

| |

| |

|Bid |

|Offer |

| |

|3 v 6 |

|6.60 |

|6.56 |

| |

|3 v 9 |

|6.65 |

|6.61 |

| |

| |

|The company can borrow at 60 basis points above LIBOR and, at the fixing date, the relevant LIBOR is 6·4%. |

| |

| |

|What is the amount of interest (in percentage terms) that the company will pay to, or receive from, the bank as a result of the forward|

|rate agreement? |

| |

|A 0·20% paid to bank |

|B 0·25% paid to bank |

|C 0·35% received from bank |

|D 0·39% received from bank |

| |

|10. LIBOR rates are quoted as follows for FRAs. |

| |

| |

| |

| |

|2 v 5 |

|3.37% – 3.32% |

| |

|3 v 5 |

|3.45% – 3.39% |

| |

| |

|A company can borrow at 65 basis points over LIBOR. In order to stabilise its finance costs, it wants to fix the interest rate for a |

|three-month borrowing starting in two months’ time. |

| |

|What is the effective rate of interest that the company will fix its loan? |

| |

|A 4·10% |

|B 4·04% |

|C 4·02% |

|D 3·97% |

| |

|11. It is 30 June. Greg plc will need a $10 million 6 month fixed rate loan from 1 October. Greg wants to hedge using a forward rate |

|agreement (FRA). The relevant FRA rate is 6% on 30 June. |

| |

|What is the compensation payable/receivable if in 6 months' time the market rate is 9%? |

| |

|A $150,000 receivable |

|B $150,000 payable |

|C $450,000 receivable |

|D $450,000 payable |

| |

| |

|12. Which of the following statements, concerning interest rate futures, is incorrect? |

| |

|A Interest rate futures can be used to hedge against interest rate changes between the current date and the date at which the interest |

|rate on the lending or borrowing is set |

|B Borrowers buy futures to hedge against interest rate rises |

|C Interest rate futures have standardised terms, amounts and periods |

|D The futures price is likely to vary with changes in interest rates |

| |

|13. Consider the following statements concerning financial options. |

| |

|1 An interest rate cap is a series of lenders’ options on a notional loan. |

|2 An American-style option may be exercised before the expiry date of the option. |

| |

|Which of the following combinations (true/false) concerning the above statements is correct? |

| |

| |

|Statement 1 |

|Statement 2 |

| |

|A |

|True |

|True |

| |

|B |

|True |

|False |

| |

|C |

|False |

|True |

| |

|D |

|False |

|False |

| |

| |

|14. Consider the following statements concerning financial derivatives. |

|1. Interest rate swaps are a form of over-the-counter derivative. |

|2. A European-style option will give the right to buy or sell at any time up to and including the expiry date. |

| |

|Which ONE of the following combinations (true/false) is correct? |

| |

| |

|Statement 1 |

|Statement 2 |

| |

|A |

|True |

|True |

| |

|B |

|True |

|False |

| |

|C |

|False |

|True |

| |

|D |

|False |

|False |

| |

| |

| |

| |

|15. In relation to hedging interest rate risk, which of the following statements is correct? |

| |

|A The flexible nature of interest rate futures means that they can always be matched with a specific interest rate exposure |

|B Interest rate options carry an obligation to the holder to complete the contract at maturity |

|C Forward rate agreements are the interest rate equivalent of forward exchange contracts |

|D Matching is where a balance is maintained between fixed rate and floating rate debt |

|(ACCA F9 Financial Management Pilot Paper 2014) |

| |

|16. Which of the following is true of exchange traded interest rate options? |

| |

|1 They maintain access to upside risk whilst limiting the downside to the premium. |

|2 They can be sold if not needed. |

|3 They are expensive. |

|4 They are tailored to an investor’s needs. |

| |

|A 1 and 2 only |

|B 1 and 3 only |

|C 2, 3 and 4 only |

|D 1, 2 and 3 only |

| |

|17. An interest rate swap |

| |

|A allows the company a period of time during which it has the option to buy a forward rate agreement at a set price |

|B locks the company into an effective interest rate |

|C is an agreement whereby the parties to the agreement exchange interest rate commitments |

|D involves the exchange of principle |

| |

| |

| |

| |

| |

| |

|18. Which of the following statements are correct? |

| |

|(1) Interest rate options allow the buyer to take advantage of favourable interest rate movements |

|(2) A forward rate agreement does not allow a borrower to benefit from a decrease in interest rates |

|(3) Borrowers hedging against an interest rate increase will buy interest rate futures now and sell them at a future date |

| |

|A 1 and 2 only |

|B 1 and 3 only |

|C 2 and 3 only |

|D 1, 2 and 3 |

|(ACCA F9 Financial Management June 2015) |

Additional Examination Style Questions

Question 3 – Interest Rate Risk

The following financial information related to Gorwa Co:

|Income statements |2007 |2006 |

| |$000 |$000 |

|Sales (all on credit) |37,400 |26,720 |

|Cost of sales |34,408 |23,781 |

|Operating profit |2,992 |2,939 |

|Finance costs (interest payments) |355 |274 |

|Profit before taxation |2,637 |2,665 |

|Statement of financial position |2007 |2006 |

| |$000 |$000 |$000 |$000 |

|Non-current assets | |13,632 | |12,750 |

|Current assets | | | | |

|Inventory |4,600 | |2,400 | |

|Trade receivables |4,600 | |2,200 | |

| |9,200 | |4,600 | |

|Current liabilities | | | | |

|Trade payables |4,750 | |2,000 | |

|Overdraft |3,225 | |1,600 | |

| |7,975 | |3,600 | |

|Net current assets | |1,225 | |1,000 |

| | |14,857 | |13,750 |

|8% Bonds | |2,425 | |2,425 |

| | |12,432 | |11,325 |

|Capital and reserves | | | | |

|Share capital | |6,000 | |6,000 |

|Reserves | |6,432 | |5,325 |

| | |12,432 | |11,325 |

The average variable overdraft interest rate in each year was 5%. The 8% bonds are redeemable in ten years’ time.

Required:

Discuss, with supporting calculations, the possible effects on Gorwa Co of an increase in interest rates and advise the company of steps it can take to protect itself against interest rate risk. (7 marks)

(ACCA F9 Financial Management December 2008 Q2(a))

Question 4 – Interest rate risk management

Discuss the use of exchanged traded and Over-The-Counter (OTC) derivatives for hedging and how they may be used to reduce the exchange rate and interest rate risks a company faces. Illustrate your answer by comparing and contrasting the main features of appropriate derivatives. (12 marks)

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