AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E3. The use of financial derivatives to hedge against interest rate risk

E3a. Interest Rate - Forwards & Futures 2 / 13

Syllabus E3a)

a) Evaluate, for a given hedging requirement, which of the following is the most appropriate given the nature of the underlying position and the risk exposure:

i) Forward Rate Agreements (FRAs) 
ii) Interest rate futures
iii) Interest rate swaps
iv) Interest rate options.

Interest Rate - Forwards & Futures

Forward rate

This locks the company into one rate (no adverse or favourable movement) for a future loan

If actual borrowing rate is higher than the forward rate then the bank pays the company the difference and vice versa

They are usually only available on loans of at least £500,000

Procedure

  1. Get loan as normal

  2. Get forward rate agreement

  3. Difference between 2 rates is paid/received from the bank

Illustration

Company gets 6% 600,000 FRA
Actual rate was 10%

  • Solution

FRA receipt from bank (10%-6%) x 600k 24,000
Payment made (10% x 600,000) (60,000)
Net payment 36,000

Interest Futures

Standard contract for set interest rate at a set date

It is a market traded forward rate basically

Calculations of how these work are NOT required in the F9 exam. (ONLY REQUIRED IN THE P4 EXAM)

As interest rates rise - bond prices fall

  • Let’s say you are expecting interest rates to rise.

    You would sell a bond futures contract, and when the interest rate rises, the value of the bond futures contract will fall.

    You would then buy the return of the contract at a normal price, making a profit.

As interest rates fall - bond prices increase

  • Let’s say you are expecting interest rates to decline in the near future.

    You would buy a futures contract for bonds.

    When interest rates fall, the price of bonds increase, and so does the bonds futures contract.

    You then sell the bond futures contract at a higher price.

Borrowers sell futures to hedge against rises

Lenders buy futures to hedge against falls