Chapter 5: Interest Rate Risks

Lecturer : Amadeus GABRIEL

La Rochelle Business School

 Introduction
⚫ Usually derivatives are used to hedge the risk, but
there are also other measures to deal with interest
rate risk

⚫ Global cash netting/inhouse bank

⚫ Intercompany lending
⚫ Embedded options in debt
⚫ Changes to payment schedules
⚫ Asset–liability management
 Global Cash Netting
⚫ When an organization has cash flows in multiple
currencies, some parts of the organization may
have excess cash while others may have
shortages
⚫ Possible to pool funds from divisions and make
them available to other parts of the organization.
⚫ Also called inhouse bank
 Intercompany Lending
⚫ A longer-term approach to managing funding
shortages and surpluses across an organization is
intercompany lending.

⚫ When one part of an organization requires long-

term funding, and another part has excess cash
available for investment purposes, the
combination of the two may permit more control
over borrowing process
 Callable Debt
⚫ If you issue « callable debt », you have the option
to call provision.

⚫ For instance, if the interest rate declines, the issuer

can retire higher-interest debt and subsequently
reissue lower-interest debt

⚫ You have to pay a premium for the call option

 Changes to Payment
Schedules
⚫ Changes to supplier/vendor payment schedules
may permit a longer payment cycle, reducing the
need for borrowing.

⚫ Changes to customer payment schedules

⚫ Changes to contractual long-term payments,

such as royalties and license agreements, to
quarterly from annually, for example.
 Asset-Liability
Management
⚫ Asset–liability management involves the pairing or
matching of assets (customer loans and
mortgages in the case of a financial institution)
and liabilities (customer deposits)

⚫ Changes in interest rates do not adversely impact

the organization.

⚫ Also known as gap management

 Forward rate agreements
⚫ A forward rate agreement (FRA) is an over-the-
counter agreement between two parties to lock in
an interest rate at a specified date
⚫ A borrower buys an FRA to protect against rising
interest rates, while a lender sells an FRA to protect
against declining interest rates.
 Example
A company needs to borrow EUR 10 million in three
months’ time. Management is concerned that rates
may rise, so the company buys a 3 x 6 FRA at 4.00
percent. The term 3 x 6 indicates that the FRA term
begins three months from the trade date and ends
six months from the trade date (a term of three
months).

If interest rates have risen (as measured by the

reference rate compared with the FRA rate), the
bank will compensate the company. If the
reference rate has fallen, the company will
compensate the bank.
 Example
FRA Rate = 4 %
Reference rate (actual rate) = 5 %
Difference 1 %

Thus, 1 % * 90/360 * 10.000.000 = 25.000

Settlement is paid at the beginning of the period, thus

the net present value is paid to the company .
Around 24.696,91
 Interest Rate Futures
⚫ Traded on an exchange

⚫ No need to establish a line of credit with a bank

⚫ Futures may be based on a benchmark interest

rates, index or fixed income instruments
⚫ We'll do a small example in the tutorial to see the
arbitrage opportunities
 Hedge ratios
⚫ Goal of hedging is to match a change in the
exposure (e.g., bond portfolio) with an offsetting
change in the value of a hedge (e.g., futures
contract)
⚫ Hedge ratio = rate of change of the future
compared to rate of change of underlying
exposure
⚫ Basic calculation = nominal exposure divided by
nominal future size (e.g. you hold 10000 EUR of
foreign equity and you have a future position of
5000 EUR, hedge ratio is 0,5)
⚫ Hedge ratios are an estimate of the number of
contracts required
 Interest Rate Swaps
⚫ OTC market
⚫ Common swaps include asset swaps, basis swaps,
zero-coupon swaps, and forward interest rate
swaps.
⚫ Swap is an agreement between two parties to
exchange their respective cash flows
⚫ Most commonly, this involves a fixed rate payment
exchanged for a floating rate payment
⚫ Swaps permit a change to the effective nature of
an asset or liability without changing the
underlying exposure
 Interest Rate Swaps
⚫ When interest rates are expected to fall, market
participants move to floating interest rates, and
there is downward pressure on swap spreads.

⚫ When interest rates are expected to rise, market

participants will move to borrow at fixed interest
rates, putting upward pressure on swap spreads
⚫ The spread is added to the benchmark
(government) yield for the fixed rate.
 Example from Bank Management

by Koch & McDonald

Swap Rates
Term US Treasuries (%) Swap Spread Bid Offer
2 years 3.53 42.5 3.95 3.96
3 years 3.81 64.5 4.45 4.46
4 years 4.29 66.5 4.95 4.96
5 years 4.66 57.5 5.23 5.24
7 years 4.91 69.5 5.6 5.61
10 years 5.28 64 5.915 5.925
20 years 5.5 76.5 6.26 6.27
30 years 5.73 56.5 6.29 6.3

If you will agree to pay dealer 3 month LIBOR for 5 years, he

will agree to pay you a fixed rate of 5.23.
If you will agree to pay dealer a fixed interest rate of 5.23,
he will agree to pay you 3 month LIBOR.
 Standard Interest Rate Swap: Example

Example:
➢ Fixed-rate payer pays 5.5% every six
months

➢ Floating-rate payer pays LIBOR every six

months

➢ Notional Principal = $EUR 10 million

➢ Effective Dates are 3/1 and 9/1 for the

next three years
 Standard Interest Rate Swap: Example

1 2 3 4 5 6
Effective Dates LIBOR Floating-Rate Fixed-Rate Net Interest Received Net Interest Received
Payer's Payment* Payer's Payment** by Fixed-Rate Payer by Floating-Rate Payer
Column 3 - Column 4 Column 4 - Column 3
3/1/Y1 0.045
9/1/Y1 0.050 $225,000 $275,000 -$50,000 $50,000
3/1/Y2 0.055 $250,000 $275,000 -$25,000 $25,000
9/1/Y2 0.060 $275,000 $275,000 $0 $0
3/1/Y3 0.065 $300,000 $275,000 $25,000 -$25,000
9/1/Y3 0.070 $325,000 $275,000 $50,000 -$50,000
3/1/Y4 $350,000 $275,000 $75,000 -$75,000
* (LIBOR/2)($10,000,000)
** (.055/2)($10,000,000)
 Eliminate existing swap?
⚫ Buy another swap that moves in the other
direction

⚫ Cancel the existing swap by paying or receiving a

lump sum representing the net present value of
remaining payments

⚫ Extend the swap by blending it with a new one

(blend-and-extend)
⚫ Assign swap to another party
 Interest Rate Options
⚫ A less conservative hedging device for interest
rate exposure is interest rate options
⚫ A call option on interest rate gives the holder
the right to borrow funds for a specified
duration at a specified interest rate without an
obligation to do so
⚫ A put option on interest rate gives the holder
the right to invest funds for a specified duration
at a specified return without an obligation to
do so
 Call Option
Consider first a European call option on 6 month LIBOR. The
contract specifications are as follows :
Time to expiry: 3 months (say 92 days)
Underlying Interest Rate: 6 month LIBOR
Strike Rate: 9%
Face Value: $5 million
Premium or Option Value : 50 bp (0.5% of face value)
= $25000
The current three and six month LIBORS are 8.60 and 8.75%.
respectively.
 Option is not exercised if interest
rate is below strike rate
3 months later 6 month LIBOR  9%.
The option is not exercised. The firm borrows in the market. The
payoff is a loss of compounded value of the premium paid three
months ago. The present value of the loss (at the time of option
expiry) is the premium compounded for three months at the 3
month rate which prevailed at option initiation. In the above
example it is
$ 25000[1+0.0860*(92/360)] = $25,549.44
If the loss is to be reckoned at the maturity of the loan, this
amount must be further compounded for 6 months at the 6
month LIBOR at the time the option expires.
Option is exercised if interest rate is
above strike rate
3 months later the 6 month LIBOR > 9%. Say 10%.
The option is exercised. The option writer has to pay the option
buyer an amount which equals the difference in interest on $5
million for 6 months at today's 6 month LIBOR (10%) and the
strike rate 9% :
(0.10-0.09)*5000000*(182/360) = $25277.78
This amount would be paid not at the time of exercise of the
option but at the maturity of the loan 6 months later.
Alternatively, its discounted value using the 6-month LIBOR at
option exercise can be paid at the time of exercise :
(25277.78)/[1+0.10(182/360)] = $24061.36

23
 Put Option
Consider an investor who expects to have surplus cash 3 months
from now to be invested in a 3-month Eurodeposit. The
amount involved is $10 million. The current 3 month rate is
10.50% which the investor considers to be satisfactory. A put
option on LIBOR is available with the following features :
Maturity : 3 months (91 days)
Strike Rate : 10.50%
Face Value : $10 million
Underlying : 3-month LIBOR.
Premium : 25 bp (0.25% of face value) = $ 25000
 Put Option
3 Months later if 3-month LIBOR > 10.50%’ option
lapses
If 3-month LIBOR < 10.50%, say 9%, put holder
exercises. Put seller pays the put holder
(0.1050-0.09)*(10000000)*(91/360) = $37916.67
This is paid 3 months later or its discounted value at
option exercise:
37916.67/[1+0.09(91/360)] = 37073.25