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

E3a. Interest Rate Risk 1 / 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 Risk

Fixed rate borrowing - risk that variable rates drop

Variable rate borrowing - risk that variable rates rise

Yield Curves (Return to debtholder)

Normal

Long term loans - higher yields (more risk)

Inverted

Longer term loans - Less yield (upcoming recession)

Flat

Yields are same for short and long term loans

The shape of the curve depends on:

In a bit more detail, the shape of the yield curve and thus the expectations of what the interest rates will be depends on…

  1. Liquidity preference

    Investors want their cash back quickly therefore charge more for long term loans which tie up their cash for longer and thus expose it to more risk

  2. Expectations

    Interest rates rise (like inflation) - so longer term more charged

    NB. Recession expected means less inflation and less interest rates so producing an inverted curve

  3. Market segmentation

    If demand for long-term loans is greater than the supply,  interest rates in the long-term loan market will increase 

    Differing interest rates between markets for loans of different maturity can also explain why the yield curve may not be smooth, but kinked

  4. Fiscal policy

    Governments may act to increase short-term interest rates in order to reduce inflation

    This can result in short-term interest rates being higher than long-term interest rates,

Why is yield curve important?

It predicts interest rates. 

Normal curves are upward sloping.

Therefore, in these circumstances, use short term variable rate borrowing and long term fixed rate.

  • Gap Exposure? 

    The risk of an adverse movement in the interest rates reducing a company’s cashflow