Definition of Risk Variability of Possible Returns Or The Chance That The Outcome Will Not Be As Expected copyright anbirts

Interest Rate Risk The risk of loss of interest revenue that occurs when interest rates change, through the mismatch of re-pricing of assets and liabilities. copyright anbirts

Interest Rate Risk Measuring Impact Gap analysis Duration (later) Example 4 year loan, USD 9,000,000 Current interest rate 8% Amortised by 8 equal semi annual payments of principal copyright anbirts

Interest Rate Risk - Gap Analysis Months 0-6 6-12 12-18 18-24 24-30 30-36 36-42 42-48 Principal 9000 7875 6750 5625 4500 3375 2250 1125 i @ 8% 365 319 273 228 182 137 91 46 + Principal 1490 1444 1398 1353 1307 1262 1216 1171 Op profit 1598 1597 I @ 10% 456 399 342 285 171 114 57 1581 1524 1467 1410 1296 1239 1182 i @ 12% 547 479 411 205 68 1672 1604 1536 1330 1193 Short Fall (78) (7) 62 130 200 267 336 404 (1) Op Profit 1279 1278 (393) (326) (257) (189) (119) (52) 16 86 (2) Op Profit (302) (246) (188) (132) (74) (18) 39 97 At 12% interest and 80% forecast op profit (2) at 10% interest and 80% forecast op profit copyright anbirts

Forward Rate Agreement Interest Rate Swap Interest Rate Options Interest Rate Risk Instruments Forward Forward Money Financial Futures Forward Rate Agreement Interest Rate Swap Interest Rate Options copyright anbirts

Forward Forward Money Situation: Need to borrow GBP 1,000,000 from 30 days time for 30 days Current Interest Rate 1 month 3-3½ 2 month 3¾-4 Borrowing Spread ¼% Action: Borrow for 2 months at 4¼%, Deposit for 1 month at 3% Borrow today GBP 997,540.31 and Deposit for 1 month 997,540.31 x .03 x 30/365 = 2,459.69 = 1,000,000 in total at T30 Cost of Borrowing: 997,540.31 x .0425 x 60/365 = 6969.12 Total to Repay at 60 days = 1,004,509.43 Effective Cost of Borrowing = 4,509.43 x 365/30 = 5.4865 from T30-T60 1,000,000 copyright anbirts

Financial Futures Definition A term used to designate the standardised contracts covering the purchase or sale of an agricultural commodity e.g. corn, commodity e.g. oil, foreign currency or financial instrument for future delivery on an organised futures exchange copyright anbirts

Financial Futures An Example Three Month Eurodollar Interest Rate Future Unit of Trading USD 1,000,000 Delivery/Expiry Months March, June, September, December and four serial months, such that 24 delivery months are available for trading, with the nearest six delivery months being consecutive calendar months Delivery /Expiry Day First business day after last trading day Last Trading Day 11.00 Two business days prior to third Wednesday of delivery month Quotation 100.00 minus rate of interest Minimum Price Movement (tick size & value) 0.01 (USD 25) Initial Margin (Straddle Margin) USD 625 (USD 200) Trading hours 08.30 – 16.00

Financial Futures Example Date: 21st October 2014 Situation: USD 1,000,000 due November 21st 2014 Intention: Invest three month on interbank market Problem: Expect rates to fall from current rate of 2 % Questions Will you buy or sell futures? How many? copyright anbirts

Financial Futures Example Action Today Today in the Futures Market: Buy one December contract at 98.1 (100 -1.9%) Note: at today’s rate of 2 % USD 1,000,000 would earn 1,000,000 x .02 x 90/360 = 5,000 copyright anbirts

Financial Futures Example Action on 21st November In cash market, arrange three month deposit of USD at current rate of 1.5 % 1,000,000 x .015 x 90/360 = 3,750 This equals a ‘loss’ of 1,250 over 2% rate Sell the future for 98.6 (100 -1.4) copyright anbirts

Financial Futures Example Net Result 1,000,000 x .015 x 90/360 = 3,750 Bought Future at 98.10 Sold Future at 98.60 Gain 50 basis points At USD 25 per ‘tick’ = 1,250 = 5,000 copyright anbirts

Financial Futures Example Question? Why have we managed a perfect hedge? i.e. ended up with USD 1,005,000 at end of deposit? Note: the cash price moved from 2 to 1.5 A movement of 50 basis points The futures price also moved by 50 basis points exactly offsetting the loss on the cash market copyright anbirts

Financial Futures Example Will this always be so? No Futures market Basis Cash market Expiry Today copyright anbirts

Financial Futures Example So what if held to expiry? Cash market = 1.5 therefore futures price would be 98.50 But bought at 98.10 Gain 40 basis points Therefore net result = 40 x 25 = 1,000 Plus interest earned at 1.5 = 3,750 Total 4,750 So effective interest = 4,750/1,000,000 x 360/90 x 100 = 1.9% copyright anbirts

Forward Rate Agreements (FRA’s) An agreement between two parties to compensate one another, in cash, on a certain date for the effect of any subsequent movement in market rates in respect of a future interest period. copyright anbirts

FRA Example Need to borrow GBP 1,000,000 in 30 days time for 30 days. Worried rates will rise. Quote Period Rate 1-2 5 - 51/8 1-4 51/8 - 51/4 3-12 51/4 - 53/8 copyright anbirts

Compensation amount paid by Bank to Company Rate Agreed 51/8 (5.125) Actual Rate On Day T30 51/4 Compensation amount paid by Bank to Company 1,000,000 x .05125 x 30/365 = 4,212.33 1,000,000 x .0525 x 30/365 = 4,315.07 = 102.74 = 102.74 = 102.30 1 + (.0525 x 30/365) copyright anbirts

Test 1,000,000 - 102.30 = 999,897.70 999,897.70 x .0525 x30/365 = 4,314.63 Less Compensation Amount = 102.30 Total Net Interest Paid 4,212.33 copyright anbirts

Interest Rate Swap Comparative Advantage Fixed Floating AAA 8 Libor + 1/4 BBB 10 Libor + 1/2 Difference 2 1/4 Benefit 13/4 copyright anbirts

AAA BBB 81/2 81/2 (8) + 8.1/2 -L Net – (L –1/2) Benefit ¾ + 1 13/4 L copyright anbirts

Interest Rate Swap AAA Bank 81/2 BBB L (8) -(L + ½) + 8.51/2 +(L) -L Net – (L –1/2) 1/4 ¾ ¾ 13/4 Benefit Bank 81/2 L -(L + ½) +(L) 83/4 –91/4 BBB + 1/4 copyright anbirts

Interest Rate Cap or Ceiling Agreement An interest rate cap is an agreement between the seller or provider of the cap and the borrower to limit the borrower’s floating interest rate to a specified level for an agreed period of time. For the investor substitute floor and investor above. copyright anbirts

Interest Rate Cap Effective Interest Rate Cap: 5 Years, 6 Mo Rollover, Strike Price 7%, Premium 225 per million copyright anbirts

Interest Rate Collar Agreements An interest rate collar is an agreement whereby the seller or provider of the collar agrees to limit the borrower/investors floating interest rate to a band limited by a specified ceiling rate and floor rate. copyright anbirts

Interest Rate Collar Collar: 5 year, 6 Mo Rollover, Zero Premium, Strike Prices 7% and 3% copyright anbirts

Duration You have a bond, life 5 years with annual interest payments of 8%, face value GBP 1,000 What is your problem? Market Price Risk Re-Investment Rate Risk copyright anbirts

Duration Duration gives an ‘average life’ of the cash flows of an instrument by weighting the Net Present Values of the cash flows by their timing. Cash Flow Year NPV NPV x Y 80 1 74.07 2 68.59 137.18 3 63.51 190.53 4 58.80 235.20 1080 5 735.03 3675.15 1,000 4,312.13 copyright anbirts

Duration = 4,312.13 = 4.31 years 1,000 Known as Macauley Duration copyright anbirts

Uses of Duration Immunisation Wish to fix yield on a portfolio of bonds regardless of whether interest rates go up or down. Done by creating a portfolio of bonds with a Duration equal to the required period. copyright anbirts

Uses of Duration Price Sensitivity Modified Duration which is Macauley Duration (1 + y/n) Where y = yield n = number of discounting periods 4.31 = 3.99 (1.08) Or increase in the market interest rate of 1% will lead to a drop in the value of the bond of approximately 3.99%. copyright anbirts